Ccounting AX Olicy: Avigation Uide

ACCOUNTING & TAX POLICY
February 27, 2013
10-K NAVIGATION GUIDE

A Primer on Reading Annual Reports
This report is our annual primer on understanding and analyzing 10-K disclosures. We believe a
thorough reading and understanding of a company’s annual report assists in identifying overlooked
investment opportunities and potential risk exposures. 10-Ks provide a once-a-year comprehensive
view of a company’s business and detailed financial statement footnotes. As many 10-Ks now
exceed 200 pages, to assist investors, we explain and interpret over 40 commonly found disclosures
as applied in analyzing equity and debt investments.
• Annual Reports are Due on March 1st for Most U.S. Publicly Traded Companies. For smaller
companies with market capitalizations below $700 million (but above $75 million), annual 10-K
reports are due on March 18, 2013 (and April 1st for recent IPOs).
• Top Three Disclosures to Watch Include Taxes, Mergers and Acquisitions, and Pensions.
First, cash taxes are cyclically low due to bonus depreciation and companies’ foreign earnings tax
deferral. Second, merger accounting distorts earnings if a high percentage of the purchase price
is allocated to goodwill, non-amortizable intangibles, and amortizable intangibles with long asset
lives. Third, record low corporate pension underfunding and July 2012 funding relief is creating a
larger difference between cash funding requirements and GAAP expense. Further, pension
assumptions for discount rates and expected rates of return remain highly subjective.
• Important Other Disclosures to Review in 2012 10-K’s Include: cost capitalization, equity
investments, depreciation, derivatives/foreign currency, foreign cash, inventory, operating leases,
off-balance sheet entities, reserves, segment disclosures, and voluntary accounting changes.
• Hidden Value Watch. 10-Ks provide new information on possible hidden assets including
undervalued real estate, tax loss carryforwards, segment disclosures (for a possible break-up),
and equity investments.
• Earnings Quality and Cash Flow Analysis. We highlight ways in which companies may
manage earnings and cash flows and how to spot such practices when reading through 10-K
filings. We summarize our Earnings Quality (EQ) model used to avoid underperforming stocks.
• Key Differences in U.S. GAAP and IFRS. We summarize the key differences between U.S.
GAAP and International Financial Reporting Standards (“IFRS”).
Chris Senyek, CFA, CPA Adam Calingasan, CFA, CPA Clinton Chang, CFA, CPA
(646) 845-0759 (646) 845-0757 (646) 845-0756
csenyek@WolfeTrahan.com acalingasan@WolfeTrahan.com cchang@WolfeTrahan.com
This report is limited solely for the use of clients of Wolfe Trahan & Co. Please refer to the DISCLOSURE SECTION located at the end
of this report for Analyst Certifications and Other Disclosures. For Important Disclosures, please go to
www.WolfeTrahan.com/Disclosures or write to us at Wolfe Trahan & Co., 420 Lexington Avenue, Suite 648, New York, NY 10170.
WolfeTrahan.com Page 1 of 233
Accounting & Tax Policy
TABLE OF CONTENTS
Introduction ........................................................................................................................................................ 5
Filing Deadlines ................................................................................................................................................... 5
Annual Report Sections ....................................................................................................................................... 6
Recent Accounting Pronouncements and Changes................................................................................................ 7
Recent FASB Proposals ........................................................................................................................................ 8
Recent Tax Policy Changes ................................................................................................................................... 9
Review 10-K for Unresolved SEC Staff Comments ............................................................................................... 10
Properties Section: Leased or Owned? ............................................................................................................... 10
Management’s Discussion and Analysis ............................................................................................................. 11
Critical Accounting Policies ................................................................................................................................ 16
Quality of Cash and Investments ........................................................................................................................ 19
Accounting for Inventory ................................................................................................................................... 20
Property, Plant, and Equipment: Check Asset Lives and For Changes in Policies ................................................... 26
Implications of Accelerated Depreciation ........................................................................................................... 29
Bonus Depreciation ........................................................................................................................................... 30
Hidden Asset Value?.......................................................................................................................................... 33
Accounting for Equity Investments: < 20% Ownership ........................................................................................ 36
Accounting for Equity Investments: 20% to 50% Ownership................................................................................ 37
Mergers & Acquisition Accounting: Red Alert for Accounting Abuse ................................................................... 38
Three Hot Areas of Potential Acquisition Accounting Abuse ............................................................................... 38
Acquisition Accounting Antics: The Perfect Storm .............................................................................................. 46
Goodwill Impairments (ASC 805, 350, and 360; formerly FAS 141R, 142, and 144) ............................................... 48
Look for Related Party Transactions ................................................................................................................... 51
When Are Segment Disclosures Required? ......................................................................................................... 52
Excessive Cost Capitalization on the Balance Sheet? ........................................................................................... 57
Loss Reserves .................................................................................................................................................... 61
Other Than Temporary Impairments .................................................................................................................. 62
Watch for Large Reserves and Reserve Reversals................................................................................................ 65
Warranty Reserves May be a Source of Earnings Growth .................................................................................... 67
Are There Underreported Accrued Expenses / Accounts Payable ........................................................................ 68
Accounting for Leases ........................................................................................................................................ 69
Convertible Debt ............................................................................................................................................... 78
Convertible Debt: Incorporating into Valuation .................................................................................................. 83
Debt and Debt Covenants .................................................................................................................................. 84
Accounting & Tax Policy February 27, 2013
TABLE OF CONTENTS (CONTINUED)
Floating Rate Debt? ........................................................................................................................................... 84
Accrued Capital Expenditures Understate True Cap-Ex ....................................................................................... 85
Other Assets and Liabilities ................................................................................................................................ 86
Accumulated Other Comprehensive Income....................................................................................................... 87
Fair Value Measurements .................................................................................................................................. 90
Balance Sheet Relationships .............................................................................................................................. 93
Revenue Recognition ......................................................................................................................................... 95
Non-Recurring Items? ........................................................................................................................................ 98
Comparability of Margins .................................................................................................................................100
Changes in Estimate Driven Expenses................................................................................................................101
Restructuring Costs ..........................................................................................................................................105
Reserve Reversal Gains Included in Earnings - Do Not Overlook the “Schedule II” ..............................................106
Stock Based Compensation ...............................................................................................................................108
Economic Cost of Stock Based Compensation ....................................................................................................115
Incorporating Stock Based Compensation Into Cash Flows and Valuation ..........................................................117
Modifications to Options and Vesting Periods ...................................................................................................118
Large Share Count Changes? Quant. Work Suggests Out/Under Performance ....................................................119
Income Taxes ...................................................................................................................................................120
NOL Internal Revenue Code Section 382 Limitations ..........................................................................................130
How to Value NOLs...........................................................................................................................................132
Off-Balance Sheet Hidden Tax Value: Are there Other Tax Shields? ....................................................................133
Share Repurchases ...........................................................................................................................................136
Earnings Per Share and Diluted Share Count......................................................................................................137
Statement of Cash Flows ..................................................................................................................................139
Material Non-Cash Activities / Supplemental Cash Flow Information .................................................................143
Pension and Postretirement Plan Disclosures ....................................................................................................145
Key Pension Items: Funded Status = Pension Plan Assets – Pension Liability.......................................................146
Key Pension Assumptions .................................................................................................................................147
Pension Cost ....................................................................................................................................................150
Pension Footnote Example – Illinois Tool Works................................................................................................152
Mark-to-Market Pension Accounting Changes ...................................................................................................158
A Move to “Pro Forma” Pension Cost ................................................................................................................158
Pension Funding Relief Provisions Enacted into Law in July 2012 .......................................................................159
Other Pension Measures Included in the Pension Funding Relief Legislation ......................................................160
TABLE OF CONTENTS (CONTINUED)
Pension Funding Relief: Financial Statement Impacts ........................................................................................160
Unfunded Multi-Employer Pension Plans ..........................................................................................................161
Pension Q&A ....................................................................................................................................................163
Market Risk Disclosures ....................................................................................................................................169
Hedging and Derivative Disclosures ..................................................................................................................172
Derivatives: An 8 Point Checklist To Analyze Disclosures ...................................................................................174
Analyzing Derivative Disclosures: Becton Dickinson Illustration .........................................................................176
Subsequent Event Disclosures...........................................................................................................................182
Dated Financial Statements ..............................................................................................................................184
Internal Controls ..............................................................................................................................................185
Auditor’s Opinion .............................................................................................................................................187
Earnings Quality Score Methodology ................................................................................................................191
Earnings Quality Metrics ...................................................................................................................................192
Earnings Quality Factors ...................................................................................................................................193
Differences Between U.S. GAAP and IFRS GAAP
Balance Sheet: Financial Assets ..............................................................................................................................201
Balance Sheet: Inventory ........................................................................................................................................202
Balance Sheet: PP&E and Intangibles .....................................................................................................................203
Balance Sheet: Asset Impairments .........................................................................................................................204
Balance Sheet: Leases.............................................................................................................................................205
Balance Sheet: Pensions .........................................................................................................................................206
Balance Sheet: JV and M&A Accounting ................................................................................................................207
Balance Sheet: Reserve Accounts – Restructuring and Other Accrued Liabilities .................................................208
Balance Sheet: Cost Capitalization .........................................................................................................................209
Balance Sheet: Convertible Bonds..........................................................................................................................210
Income Statement: Revenue Recognition ..............................................................................................................211
Income Statement: Classification & Presentation ..................................................................................................212
Income Statement: Stock Based Compensation ....................................................................................................213
Income Statement: Income Taxes ..........................................................................................................................214
Statement of Cash Flows ........................................................................................................................................215
Appendix: Accounting Case Studies
ProQuest (Revenue Recognition) ...........................................................................................................................217
Diebold (Revenue Recognition) ..............................................................................................................................219
VeriFone (Inventory Restatement) .........................................................................................................................220
Yellow Roadway (Changes to Depreciation Methods) ...........................................................................................221
HealthSouth (Cost Capitalization) ..........................................................................................................................222
Longtop Financial Technologies .............................................................................................................................224
Krispy Kreme ...........................................................................................................................................................229
Accounting & Tax Policy Research Library .........................................................................................................231
Disclosure Section ............................................................................................................................................233

INTRODUCTION
Graham and Dodd’s seminal book, Security Analysis, popularized financial statement analysis as a
critical component of investing. It fostered the notion that a thorough reading and understanding of a
company’s annual report would lead to identifying overlooked investment opportunities and potential risk
exposures. In short, reading an annual report increased the odds of producing alpha. We still believe the
same holds true today, but 10-K’s are larger than ever before with complicated accounting principles
underlying the figures and footnotes.
To assist investors in navigating through these lengthy documents, this report explains and interprets
essential financial statement disclosures and sections. We’ve arranged this report by key sections,
following the typical 10-K progression, and wrote each section in such a way that each topic may be
read individually.
FILING DEADLINES
For 10-K and 10-Q (quarterly reports) filing deadlines, the U.S. Securities and Exchange Commission
(“SEC”) rules classify companies as large accelerated filers, accelerated filers, or non-accelerated filers.
Companies that are classified as large accelerated filers have a worldwide common public equity float of
at least $700 million and have filed reports with the SEC for at least 12 months. Worldwide common
public equity float is measured on the last day of the most recently completed fiscal second quarter. The
10-K filing deadline for large accelerated filers is 60 days after year-end.
Accelerated filers are defined as companies with a common public equity market float of $75 million to
$700 million. The 10-K filing deadline for these companies is 75 days after year-end.
Non-accelerated filers is the third category of companies and is defined as a company with a public
common equity float of less than $75 million or a company completing an initial public offering (“IPO”)
during the year. Non-accelerated filers’ 10-K deadline is 90 days after year-end.
Sometimes a company’s filing deadline falls on a Saturday or Sunday in which case the company has
until the following Monday to file its 10-K. For a recent IPO, once a company has been subject to the
Securities Exchange Act’s reporting requirements for at least 12 calendar months and has filed at least
one annual report, the company is eligible for either large accelerated or accelerated filing status.
If a company can’t file its annual report without “unreasonable effort or expense”, it may seek temporary
relief under SEC rule 12b-25. In these circumstances, the SEC allows a 15-calendar-day extension to
the company’s 10-K filing deadline. When this happens, the company files a Form 8-K or NT-10-K,
explaining the reason for delay.
SEC Annual Report Filing Deadlines
SEC Classification Definition(1) Form 10-K Filing Deadline

Large Accelerated Filers Public float of at least $700 million 60 days after year-end (March 1, 2013 for calendar year-end companies)
Accelerated Filers Public float between $75 and $700 million 75 days after year-end (March 18, 2013 for calendar year-end companies)
Non-Accelerated Filers Public float less than $75 million; recent IPOs 90 days after year-end (April 1, 2013 for calendar year-end companies)
(1) Market value float is based on the date of the most recent second quarter (June 30, 2012 for calendar year-end companies). Once a company
becomes a Large Accelerated Filer, public float must fall below $500 million to return to Accelerated Filer status. To exit Accelerated Filer status,
the public float must drop below $50 million.
Source: Wolfe Trahan Accounting & Tax Policy Research; SEC.

ANNUAL REPORT SECTIONS
The 10-K is divided into four main parts, of which we focus on interpreting and reviewing the footnotes
and related disclosures. We also delve into other specific sections of the 10-K if they are applicable to
investment analysis.
Part I
Item 1. Business
Item 1A. Risk Factors
Item 1B. Unresolved SEC Comments
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Mine Safety Disclosures
Part II
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
Item 6. Selected Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Change in and Disagreements with Accountants on Accounting and Financial
Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
Part III (This section is usually included in a proxy statement and referenced in the Form 10-K)
Item 10. Directors and Executive Officers of the Registrant

Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
Item 13. Certain Relationships and Related Transactions
Item 14. Principal Accountant Fees and Services
Part IV
Item 15. Exhibits and Financial Statement Schedules

RECENT ACCOUNTING PRONOUNCEMENTS AND CHANGES
Disclosure of the financial impact of newly issued accounting standards (those that have not yet been
adopted) is required under SEC Staff Accounting Bulletin No. 74 (“SAB 74”). This information is typically
located following the summary of significant accounting policies section. Under this SEC guidance,
companies are required to describe the new accounting rule, adoption date, method of adoption (e.g.
prospective/retrospective), known estimated financial statement impact, and related potential impact on
other significant matters (e.g., debt covenants).
We note that some companies voluntarily choose to list all recently issued accounting standards not yet
adopted even if they do not expect a material impact. Many times, this disclosure may simply be
boilerplate language that contains only general information about the pending change. However, as the
effective date draws closer, analysts may find that the financial impact of adopting the new rule is
disclosed.
Below are recent and upcoming accounting rule changes that may impact companies.
Recent FASB / SEC Accounting Pronouncements and Changes

New / Pending Change Description Effective Date / Status
ASU No. 2011-11, Balance Sheet Requires additional disclosures of derivative assets and liabilities that are offset Effective 'Q1 2013 with retrospective
(Topic 210): Disclosures about for balance sheet purposes or are subject to master netting agreements. comparison.
Offsetting Assets and Liabilities Additional information must be described pertaining to the gross amounts of
assets / liabilities, the amounts offset within the balance sheet, and the amounts
subject to master netting agreements (whether offset or not).
ASU No. 2013-02, Comprehensive Requires a company to provide information by component about amounts Effective 'Q1 2013. Early adoption was
Income (Topic 220): Reporting of reclassified out of accumulated other comprehensive income into earnings. allowed.
Amounts Reclassified Out of
Accumulated Other Comprehensive
Income
ASU No. 2012-02, Goodwill and Other Adds a preliminary qualitative assessment to the testing for impairment of Effective 'Q1 2013. Early adoption was
(Topic 350): Testing Indefinite-Lived indefinite lived intangible assets. Instead of proceeding directly to the allowed.
Intangible Assets for Impairment quantitative impairment test, a company may use a qualitative events or
circumstances test to assess whether it's more likely than not (50% or greater)
that indefinite lived intangible asset is impaired. These events and
circumstances include macroeconomic conditions, industry & market
considerations, input cost factors, financial performance, entity specific events
such changes in management, customers, strategy, etc.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FASB.

RECENT FASB PROPOSALS
FASB Proposals
Topic Description Effective Date / Status
Revenue Recognition Joint FASB/IASB project. Intends to improve existing revenue recognition Exposure draft document issued November
standard, which contain inconsistencies. While direct impact is currently difficult 2011. Issuance of final standard expected
to quantify, the new standard is likely to materially affect a number of industries, summer 2013. Effective date currently
including telco, software, real estate and asset managers. General impact will be planned beginning 2017.
earlier recognition of revenue with more volatility.
Lease Accounting Joint FASB/IASB project. Will result in complete overhaul of current lease Significant changes have been made since
accounting policies. Operating lease commitments that are currently will be the original exposure draft issued August
capitalized on the balance sheet as intangible right to use asset and related debt 2010. New exposure draft will be issued in
obligation. Will impact debt ratios, earnings and reported operating cash flow. 'Q2 2013. There are still concerns over the
Largest impact on retail, restaurants, airlines, air freight, and certain industrials. revised proposal; therefore, we do not
The decision whether to include option renewals and contingent rent continues to expect a final standard to be effective
be a controversial topic. before 2017 at the earliest.
Financial Instruments Accounting Joint FASB/IASB project. Will result in overhaul of accounting for financial There have been significant changes since
instruments (loans, securities etc.). FASB and IASB taking two different FASB's exposure draft was issued in May
approaches to standard setting process. More items expected to be recorded at 2010. Re-deliberations continue. FASB
fair value on balance sheet as opposed to amortized cost (some items may be issued an exposure draft on classification
marked to market through earnings and some may be marked through OCI). and measurement in Feb. 2013 and a
Loans held for investment likely to retain amortized cost accounting model. proposed standard on credit losses in Dec.
Impairment (loan reserves) will be on a more expected basis vs. the current 2012. A joint supplementary exposure draft
incurred basis model. Hedge accounting will be simplified and clarified. on impairment was issued In January 2011
but the FASB has since departed views with
the IASB. IASB has broken the project into
3 phases. Phase 1 (Measurement) has
been completed but has delayed the
effective date to 2015. Phase 2
(Impairment) ED released 'Q4 2009 but
significant changes have been made since
then. Initial Phase 3 (Hedging) ED was
released 'Q2 2010. Any final standards will
not likely be effective before 2016.
Insurance Accounting Joint FASB/IASB project. Will overhaul and clarify the insurance contract Re-deliberations are ongoing based on
accounting. Deferred acquisition costs (DAC) likely to continue to receive similar FASB's informal discussion paper and IASB
accounting treatment as is currently provided (e.g. capitalized, not immediately exposure draft (June 2010). FASB is
expensed). targeting to release an exposure document
'Q2 2013 . We do not expect any changes
to be effective before 2015.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FASB.

RECENT TAX POLICY CHANGES
Tax Policy Changes
Topic Description Effective Date / Status
Corporate Tax Reform "Presidents Framework for Business Tax Reform" includes proposals to reduce Under consideration.
the corporate tax rate to 28%, reform the US international tax system in an
attempt to tax more foreign source income of US corporations pertaining to
deferral, foreign tax credits and intangible property profits shifting. Other
corporate tax reforms proposed in the budget include LIFO repeal, insurance
industry taxation, oil & gas industry taxation, and taxation of carried interests
(hedge funds and PE firms). The tax-advantaged status of many pass-through
entities may also be at risk under any reform. Outlook for passing any major
reform in the next several years is the highest in 2014-2015.
Bonus Depreciation Bonus depreciation extended at 50% for 2013 by American Taxpayer Relief Act. 50% bonus depreciation expires in 2014.
All bonus depreciation provisions will expire and revert to standard MACRS
beginning 2014.
Individual Tax Increases American Taxpayer Relief Act provided for increased personal income tax rates See our 1/4/2013 report, "American
for high earners ($450k joint / $400k single) Top bracket from 35 % to 39.6%). Taxpayer Relief Act: The Truth Hurts".
Dividend tax and capital gains tax rates to 20% for high earners. Retains the
lower Bush tax rates for those not considered "high-earners" (<$450k joint/
$400k single). Capital gains and dividend tax rates remain at 15% for this same
group. Personal exemption phase outs reinstated as well as the Pease phase-
out for itemized deductions. Healthcare bill imposes a 3.8% tax surcharge on
investment income and .9% of wages for high-earners >$250k.
Source: Wolfe Trahan Accounting & Tax Policy Research.

REVIEW 10-K FOR UNRESOLVED SEC STAFF COMMENTS
Analysts should review Item 1B, “unresolved SEC staff comments,” of the 10-K. Under the Sarbanes-
Oxley Act of 2002, the SEC must review every public company’s financial disclosures at least once
every three years. The SEC will send companies “comment letters” based on these reviews, requesting
additional disclosures or asking why certain disclosures were not included in their 10-Ks or 10-Qs.
SEC comment letters may also lead to a deeper SEC investigation into a company’s accounting
practices if questionable or non-Generally Accepted Accounting Principles (“GAAP”) are discovered.
Unresolved SEC comments must be disclosed under the following circumstances:
• The SEC’s written comment remains unresolved at the10-K filing date;

• The SEC written comments are material; and
• The SEC comments were issued more than 180 days before the end of the fiscal year to which
the annual report relates.
At least 45 days after the SEC review is finished, comment letters are publicly available on the SEC
website and other data provides such as Edgar. The filing type appears as “CORRESP” (the company’s
response to the SEC) or “UPLOAD” (the SEC’s letter to the company).
PROPERTIES SECTION: LEASED OR OWNED?

Item 2 of the 10-K requires a description of the company’s major properties and facilities, noting if they
are leased or owned. This footnote will aid investors in understanding a company’s mix of owned versus
leased real estate and its physical location. It may also assist in identifying hidden asset values in land
or other properties. There is no required standardized format and, therefore, disclosures do vary by
company as some are several pages in length while others are only one or two paragraphs. As an
example, below is the Item 2 disclosure for WhiteWave Foods Company.
Owned Properties: WhiteWave Foods Company
Item 2. Properties
We conduct our manufacturing operations from nine facilities, all of which are owned. We believe that our manufacturing facilities
are well maintained and are suitable to support our current business operations. Our manufacturing facilities are located in the following
cities:
Bridgeton, New Jersey City of Industry, California Dallas, Texas
Issenheim, France Jacksonville, Florida Kettering, United Kingdom
Landgraaf, Netherlands Mt. Crawford, Virginia Wevelgem, Belgium
We also own two organic dairy farms located in Paul, Idaho and Kennedyville, Maryland. Our principal executive offices, and Dean
Foods’ principal executive offices, are located in Dallas, Texas. Our operating company headquarters are located in Broomfield, Colorado,
where we lease approximately 137,000 square feet, and in Ghent, Belgium, where we lease approximately 2,500 square meters. Our R&D
facilities are located in leased premises in Broomfield, Colorado and in Wevelgem, Belgium.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings.

MANAGEMENT’S DISCUSSION AND ANALYSIS
SEC Regulation S-K requires a management’s discussion and analysis (“MD&A”) section. The MD&A
section, among other items, is a narrative on a company’s financial condition, results of operations,
liquidity, and capital resources. Since reading the MD&A for the results of operations is as much an art
as it is a science, we discuss other important MD&A disclosures related to off-balance sheet entities,
liquidity, and contractual obligations in the sections that follow.
OFF-BALANCE SHEET EXPOSURES

Off-balance sheet entities and disclosures are particularly important to review for many reasons. They
may require cash funding, consolidation, and/or some type of subordinated support and this might
impact debt covenants, balance sheet liquidity, and capital ratios (and in turn credit ratings). Although
uncommon, off-balance sheet entities may also be used to hide losses and manage earnings.
Companies must disclose detail and terms of significant off-balance sheet arrangements in a separate
section of MD&A. This section of the MD&A includes a discussion on joint ventures (“JVs”), debt
guarantees, certain contract guarantees, retained interests, derivatives classified as equity, and variable
interests (“VIEs”) in unconsolidated entities (e.g., CDOs, SIVs, and commercial paper conduits). Off-
balance sheet arrangements may also be disclosed in the debt footnote.
The accounting rules impart considerable subjectivity in assessing whether an entity should be
consolidated and, therefore, allow flexibility in structuring entities for the desired off-balance sheet
treatment. By finessing these complicated accounting rules, a company technically may not be required
to consolidate an entity even though it retains a significant amount of risk. In 2010, companies adopted
the Financial Accounting Standards Board’s (“FASB”) new Financial Accounting Standards (“FAS”) 166
and FAS 167 rules. These stringent rules, now codified in ASCs 810 and 860, require consolidation of
more off-balance sheet entities.
The most important disclosures, in our view, evaluate the loss probabilities of off-balance sheet entities
and guarantees, the underlying credit quality of the off-balance sheet arrangement, and the probability of
liquidity support for either contractual or reputational reasons. Investors should also review any year-
over-year language changes in the disclosures. Below are a few key questions and items that we
believe investors should consider when analyzing off-balance sheet entities:
1. Contingent events: What circumstances must occur for the contingent obligations to become a
liability of the parent company? Would any cash funding be required?
2. Potential losses: What is the off-balance sheet entity’s maximum exposure to loss? What events
would need to occur to trigger the maximum losses?
Companies may disclose “expected” losses from off-balance sheet entities, but we don’t give
much weight to these amounts since they are full of management assumptions, generally only
reflect current market conditions, and are not sensitivities to specific events. Also, note that the
disclosure of maximum losses may not reflect losses currently deemed to be remote.
3. Liquidity: Reviewing the disclosure for liquidity triggers is important. We suggest reviewing the
disclosures to see if there is a liquidity support agreement to the off-balance entity and if there are
specific asset value triggers to fund it (asset values declining below a certain amount may require
liquidity support). We also seek to identify if there are any additional cash funding requirements
and, if available, review the credit quality of the underlying assets in the VIE.

MANAGEMENT’S DISCUSSION AND ANALYSIS (CONTINUED)
4. Consolidation: It’s important to review the off-balance sheet disclosures and/or use them as a
basis in asking management for under what circumstances would the company be required to
consolidate the off-balance sheet entity. Under the relatively new FASB consolidation rules,
companies must evaluate off-balance sheet entities (e.g., variable interest entities) every quarter
to assess whether they should be consolidated. When thinking about consolidation, we assess
the following:
o How would consolidation impact the financial ratios and position of the company?
o Would consolidation violate debt covenants?
o How would consolidation impact capital? (Under GAAP, if a “reconsideration event” occurs, a
company may be required to consolidate an off-balance sheet entity.)
5. Voluntary Rescue: Even if a company is not legally obligated to provide financial or other support
to an off-balance sheet entity, there may be circumstance under which the company would
voluntarily choose to provide it. This would occur if the entity’s failure would hurt the parent
company’s reputation or limit its access to an important input to its business. As an example, a
parent company may choose to guarantee JV debt that wasn’t legally guaranteed previously to
keep the entity afloat if it was a key source of raw material inputs.
The disclosures should be also viewed with some caution since they don’t take into account any
offsetting financial instruments used to hedge these risks. These may be noted in a table footnote, but
we’ve found disclosures to be spotty in this area. The actual location of off-balance sheet arrangements
disclosures may vary by company. There may be some general disclosures within the MD&A section
with more detailed explanations and tables in the footnotes to the financial statements.
Wells Fargo’s MD&A and Footnote Off-Balance Sheet Entities Disclosures
In the ordinary course of business, we engage in financial transactions that are not recorded in the balance sheet, or may be recorded in
the balance sheet in amounts that are different from the full contract or notional amount of the transaction. These transactions are
designed to (1) meet the financial needs of customers, (2) manage our credit, market or liquidity risks, (3) diversify our funding sources,
and/or (4) optimize capital.
Off-Balance Sheet Transactions with Unconsolidated Entities

We routinely enter into various types of on- and off-balance sheet transactions with special purpose entities (SPEs), which are
corporations, trusts or partnerships that are established for a limited purpose. Historically, the majority of SPEs were formed in connection
with securitization transactions. For more information on securitizations, including sales proceeds and cash flows from securitizations, see
Note 8 (Securitizations and Variable Interest Entities) to Financial Statements in this Report.
Guarantees and Certain Contingent Arrangements

Guarantees are contracts that contingently require us to make payments to a guaranteed party based on an event or a change in an
underlying asset, liability, rate or index. Guarantees are generally in the form of standby letters of credit, securities lending and other
indemnifications, liquidity agreements, written put options, recourse obligations, residual value guarantees and contingent consideration.
For more information on guarantees and certain contingent arrangements, see Note 14 (Guarantees) to Financial Statements in this
Report.

As an off-balance sheet disclosure example, we’ve reproduced a portion of Wells Fargo’s 2011 10-K,
discussing the bank’s maximum loss exposure in unconsolidated VIEs.
Wells Fargo’s MD&A and Footnote Off-Balance Sheet Entities Disclosures (continued)
From footnote 8, Securitizations and Variable Interest Entities:

Other
Total Debt and commitments
VIE equity Servicing and Net
(in millions) assets interests (1) assets Derivatives guarantees assets
December 31, 2011
Carrying value - asset (liability)

Residential mortgage loan securitizations:
Conforming
$ 1,135,629 4,682 11,070 – (975) 14,777
Other/nonconforming
61,461 2,460 353 1 (48) 2,766
Commercial mortgage loan securitizations
179,007 7,063 623 349 – 8,035
Collateralized debt obligations:
Debt securities
11,240 1,107 – 193 – 1,300
Loans (2)
9,757 9,511 – – – 9,511
Asset-based finance structures
9,606 6,942 – (130) – 6,812
Tax credit structures
19,257 4,119 – – (1,439) 2,680
Collateralized loan obligations
12,191 2,019 – 40 – 2,059
Investment funds
6,318 – – – – –
Other (3)
18,717 1,896 34 190 (1) 2,119
Total
$ 1,463,183 39,799 12,080 643 (2,463) 50,059
Maximum exposure to loss

Residential mortgage loan securitizations:
Conforming
$ 4,682 11,070 – 3,657 19,409
Other/nonconforming
2,460 353 1 295 3,109
Commercial mortgage loan securitizations
7,063 623 538 – 8,224
Collateralized debt obligations:
Debt securities
1,107 – 874 – 1,981
Loans (2)
9,511 – – – 9,511
Asset-based finance structures
6,942 – 130 1,504 8,576
Tax credit structures
4,119 – – – 4,119
Collateralized loan obligations
2,019 – 41 523 2,583
Investment funds
– – – 41 41
Other (3)
1,896 34 903 150 2,983
Total
$ 39,799 12,080 2,487 6,170 60,536

USING OFF-BALANCE SHEET VEHICLES TO HIDE DEBT, INVENTORY, AND/OR EXPENSES
To boost earnings or improve reported financial ratios, a company may choose to move inventory and
debt into a joint venture or other off-balance sheet entity. A careful reading and analysis of joint venture
disclosures will help identify whether a significant increase in inventory might have been shifted off-
balance sheet. For example, a joint venture may produce and sell inventory to the parent company. The
parent company may control the purchases of inventory from this entity. Therefore, financial analysis of
the parent company’s inventory balance may be obfuscated by inventory increasing on the balance
sheet of the joint venture partner.
A company may also finance a joint venture with debt or with a parent company guarantee for all or a
portion of the joint venture debt. This debt amount or debt guarantee would not appear on the parent
company’s balance sheet, but may be a real obligation and very similar in substance to debt. An analyst
would find these types of debt arrangements or guarantees typically in the MD&A section listed as an
off-balance arrangement.
Furthermore, JV arrangements typically mask underlying leverage levels at the parent company due to
the equity method of accounting. In a JV arrangement, both companies usually account for an
investment under the equity method of accounting instead of consolidating the JV entity. Under the
equity method of accounting, the balance sheet contains a single line item, typically called “investments”
or “equity method investments,” classified under other long-term assets. On the liability side of the
balance sheet, the JV’s debt is not reported under the equity method of accounting. On the income
statement, the company’s proportion of the JV’s income is recorded as equity income/loss and usually
reported in other income. For financial analysis and ratios, we suggest analysts consolidate the portion
of the joint venture’s off-balance sheet debt amount as well as their percentage of any JV debt
guarantees attributable to the company (e.g., 50%).
The creation of new JVs or off-balance sheet entities is another way to improve reported margins. If the
business contributed to the new entity has lower overall margins, the remaining parent company will
report higher margins since the business will be deconsolidated and be reported under the equity
method of accounting. On the income statement, only one line “equity income/loss” is reported and
typically shown separate from gross and operating income.
CONTRACTUAL OBLIGATIONS AND FIXED CASH FLOW COMMITMENTS

Within the MD&A section, SEC rules require a table of contractual obligations. This table summarizes
information usually contained in other sections of the 10-K and lists fixed debt and debt like
commitments, such as long-term debt repayments, capital and operating lease payments, purchase
obligations, and other long-term contractual liabilities. It should (but does not always) include material
cash funding requirements for pension and OPEB plans, probable FIN 48 tax cash contingency
payments, and cash interest expense. We find the disclosure to be a great summary of a company’s
future contractual cash outflows and a tool in evaluating a company’s future liquidity needs.
Analysts should be mindful that not all contractual-type fixed payment arrangements are included in the
table of contractual obligations. If a contractual arrangement may be cancelled without any material
penalties, it may be excluded. Furthermore, the table does not include such items as salaries to
employees or dividend payments. The next exhibit is an example of a contractual obligations table.

Delta Air Lines (2012 Form 10-K): Contractual Obligations Table
Contractual Obligations by Year(1)
(in millions) 2013 2014 2015 2016 2017 Thereafter Total

Long-term debt (see Note 8)
Principal amount $ 1,267 $ 1,420 $ 1,062 $ 1,427 $ 2,144 $ 4,694 $ 12,014
Interest payments 600 540 460 390 300 660 2,950
Contract carrier obligations (see Note 10) 2,210 2,200 2,130 1,850 1,690 3,880 13,960
Operating lease payments (see Note 9) 1,507 1,433 1,332 1,159 1,000 7,415 13,846
Employee benefit obligations (see Note 11) 820 840 830 800 800 9,930 14,020
Aircraft purchase commitments (see Note 10) 1,000 1,525 815 810 760 3,240 8,150
Capital lease obligations (see Note 9) 209 173 158 164 97 113 914
Other obligations(2) 1,180 330 350 300 170 1,000 3,330
Total $ 8,793 $ 8,461 $ 7,137 $ 6,900 $ 6,961 $ 30,932 $ 69,184
(1)
For additional information, see the Notes to the Consolidated Financial Statements referenced in the table above.
(2)
Includes $360 million in 2013 related to our agreement to buy, pending regulatory approval, 49% of Virgin Atlantic, currently held by Singapore Airlines.

CRITICAL ACCOUNTING POLICIES
For financial reporting purposes, a critical accounting policy is one that requires significant and/or
subjective management judgment. The summary of “significant accounting policies” section is a similar
disclosure that overlaps with the critical accounting estimates section, typically located in the first or
second 10-K footnote.
The summary of significant accounting policies includes both critical accounting policies and other
material accounting policies. Both of these sections are important to uncover any year-over-year
changes in accounting policies that impact earnings or signal possible other business issues. A reading
of this section may help identify companies under/over earning relative to other companies. For
example, the section may describe a very conservative accounting policy that is reducing current period
earnings.
One of the first signs of a more aggressive accounting policy change may be a new one or two sentence
disclosure in this section. Additionally, a company’s accounting policies should be reviewed and
compared against competitors’ policies since differences may impact reported earnings and
comparability. Below is an example of select critical accounting policies disclosures for Whirlpool.
Whirlpool’s Critical Accounting Policies Excerpt (2012 Form 10-K)

Pension and Other Postretirement Benefits
Accounting for pensions and other postretirement benefits involves estimating the costs of future benefits and attributing the cost
over the employee’s expected period of employment. The determination of our obligation and expense for these costs requires the use of
certain assumptions. Those assumptions include, the discount rate, expected long-term rate of return on plan assets and health care cost
trend rates. These assumptions are subject to change based on interest rates on high quality bonds, stock and bond markets and medical
cost inflation, respectively. Actual results that differ from our assumptions are accumulated and amortized over future periods and
therefore, generally affect our recognized expense and accrued liability in such future periods. While we believe that our assumptions are
appropriate given current economic conditions and actual experience, significant differences in results or significant changes in our
assumptions may materially affect our pension and other postretirement benefit obligations and related future expense.
Income Taxes
We estimate our income taxes in each of the taxing jurisdictions in which we operate. This involves estimating actual current tax
expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for
recognizing expenses, for tax and accounting purposes. These differences may result in deferred tax assets or liabilities, which are included
in our Consolidated Balance Sheets. We are required to assess the likelihood that deferred tax assets, which include net operating loss
carryforwards, foreign tax credits and deductible temporary differences, are expected to be realizable in future years. Realization of our
net operating loss and foreign tax credit deferred tax assets is supported by specific tax planning strategies and, where possible, considers
projections of future profitability. If recovery is not more likely than not, we provide a valuation allowance based on estimates of future
taxable income in the various taxing jurisdictions, and the amount of deferred taxes that are ultimately realizable. If future taxable income
is lower than expected or if tax planning strategies are not available as anticipated, we may record additional valuation allowances through
income tax expense in the period such determination is made. Likewise, if we determine that we are able to realize our deferred tax assets
in the future in excess of net recorded amounts, an adjustment to the deferred tax asset will benefit income tax expense in the period
such determination is made.
Warranty Obligations
The estimation of warranty obligations is determined in the same period that revenue from the sale of the related products is
recognized. The warranty obligation is based on historical experience and represents our best estimate of expected costs at the time
products are sold. Warranty accruals are adjusted for known or anticipated warranty claims as new information becomes available. New
product launches require a greater use of judgment in developing estimates until historical experience becomes available. Future events
and circumstances could materially change our estimates and require adjustments to the warranty obligations. For additional information
about warranty obligations, see Note 6 of the Notes to the Consolidated Financial Statements.

CRITICAL ACCOUNTING POLICIES (CONTINUED)
Whirlpool’s Critical Accounting Policies Excerpt (2012 Form 10-K) (continued)
Goodwill and Intangibles

Certain business acquisitions have resulted in the recording of goodwill and trademark assets. Upon acquisition, the purchase price
is first allocated to identifiable assets and liabilities, including trademark assets, based on estimated fair value, with any remaining
purchase price recorded as goodwill. Most trademarks and goodwill are considered indefinite lived intangible assets and as such are not
amortized. At December 31, 2012, we have goodwill of $1,727 million, mostly recorded within our North America reporting unit. There
have been no changes to our reporting units or allocations of goodwill by reporting units. We have trademark assets in our North America
and EMEA operating segments with a carrying value of $1,470 million and $51 million, respectively, as of December 31, 2012.
During 2012, we voluntarily changed the date of our annual impairment assessment for goodwill and other indefinite-lived
intangible assets from November 30 to October 1. We determined that this change is preferable under the circumstances as the timing
better aligns with the Company's annual and long-term business planning cycle and financial reporting process. The voluntary change in
accounting principle was not made to delay, accelerate or avoid an impairment charge.
Goodwill Valuations
We evaluate goodwill using a qualitative assessment to determine whether it is more likely than not that the fair value of any
reporting unit is less than its carrying amount. If we determine that the fair value of the reporting unit may be less than its carrying
amount, we evaluate goodwill using a two-step impairment test. Otherwise, we conclude that no impairment is indicated and we do not
perform the two-step impairment test.
In conducting a qualitative assessment, the Company analyzes a variety of events or factors that may influence the fair value of the
reporting unit, including, but not limited to: the results of prior quantitative tests performed; changes in the carrying amount of the
reporting unit; actual and projected operating results; relevant market data for both the company and its peer companies; industry
outlooks; macroeconomic conditions; liquidity; changes in key personnel; and the Company's competitive position. Significant judgment is
used to evaluate the totality of these events and factors to make the determination of whether it is more likely than not that the fair value
of the reporting unit is less than its carrying value.
If the qualitative assessment concludes that the two-step impairment test is necessary, we first compare the book value of a
reporting unit, including goodwill, with its fair value. The fair value is estimated based on a market approach and a discounted cash flow
analysis, also known as the income approach, and is reconciled back to the current market capitalization for Whirlpool to ensure that the
implied control premium is reasonable. If the book value of a reporting unit exceeds its fair value, we perform the second step to estimate
an implied fair value of the reporting unit’s goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other
than goodwill (including any unrecognized intangible assets). The difference between the total fair value of the reporting unit and the fair
value of all the assets and liabilities other than goodwill is the implied fair value of that goodwill. The amount of impairment loss is equal
to the excess of the book value of the goodwill over the implied fair value of that goodwill.
Intangible Valuations
We evaluate certain indefinite-lived intangibles using a qualitative assessment to determine whether it is more likely than not that
the fair value of the indefinite lived intangible asset is less than its carrying amount. If we determine that the fair value may be less than its
carrying amount, the fair value of the trademark is estimated and compared to its carrying value to determine if an impairment exists.
Otherwise, we conclude that no impairment is indicated and we do not perform the quantitative test.
When the qualitative assessment is not utilized and a quantitative test is performed, we estimate the fair value of these intangible
assets using the relief-from-royalty method, which requires assumptions related to projected revenues from our annual long-range plan;
assumed royalty rates that could be payable if we did not own the trademarks; and a discount rate based on our weighted average cost of
capital. We recognize an impairment loss when the estimated fair value of the indefinite-lived intangible asset is less than its carrying
value.

Balance Sheet

QUALITY OF CASH AND INVESTMENTS
The composition and location of cash and investments are often overlooked by analysts. To be
classified as cash under GAAP, the instrument must have a maturity date of 90 days or less.
Investments are classified as short-term or long-term depending on their maturity date. Historically,
auction rate securities (“ARS”) also met the GAAP definition of cash and equivalents since their interest
rate was reset every 7, 21, or 28 days and there was an auction into which to sell the securities.
CASH BALANCES ARE OFTEN OVERSTATED IN VALUATION

A significant portion of some multinational companies’ cash balances may be domiciled overseas and
not accessible for distribution to shareholders or other payments. Therefore, it’s important to ascertain
where the cash is located and if any additional taxes would be owed to access the cash. One common
mistake we observe in valuations is valuing cash at 100% of its balance sheet value. To calculate
distributable cash, the gross cash amount reported on companies’ balance sheets needs to be adjusted
downward for any U.S. taxes expected to be owed upon cash repatriation. Unfortunately, not all
companies disclose the percentage of cash residing overseas, but we have seen more companies begin
to disclose this item after a higher level of SEC scrutiny.
Current U.S. corporate tax law incentivizes companies to keep cash overseas as companies only pay
foreign taxes on the foreign earnings in the current period insofar as the earnings are not repatriated to
the U.S. This is often termed “foreign deferral”. To access overseas cash, a company would typically be
required to pay incremental U.S. taxes on cash amounts repatriated, reaching as high as the 35%
current U.S. corporate tax rate.
To illustrate the repatriation and cash issue, assume Chris Corp. operates a foreign sub. in Ireland and
earns $500 of foreign income that is taxed at 20%. In the current year, Chris Corp. would owe Ireland
taxes of $100, generating a $100 U.S. foreign tax credit. The remaining reported cash balance after
foreign taxes would be $400. The earnings remain in Ireland and are neither distributed to the U.S.
parent company nor included as income in Chris Corp.’s consolidated U.S. income tax return.
Additionally, under U.S. GAAP, it is common for cos. to deem their foreign earnings as “permanently
reinvested” overseas, removing additional U.S. GAAP income taxes from earnings. Therefore, the
company would report a 20% GAAP effective income tax rate ($100 tax expense / $500 income).
If the company decides to repatriate and distribute the foreign cash domiciled in Ireland to the U.S.
entity. To calculate U.S. taxable income on Chris Corp.’s U.S. tax return, the company’s foreign earnings
are grossed-up to their pre-tax foreign amount ($500). Then U.S. corporate taxes are calculated at the
current 35% corporate tax rate ($500 x 35% = $175). The foreign tax credit of $100 is applied to the U.S.
corporate tax of $175, leaving $75 of incremental taxes due. As a result of these taxes, the company’s
cash balance available for U.S. activities is reduced from $400 to $325 ($400 less $75 in U.S. taxes).
Apple (2012 Form 10-K): Cash Balance Overseas Example

The foreign provision for income taxes is based on foreign pretax earnings of $36.8 billion, $24.0 billion and $13.0 billion in 2012, 2011 and
2010, respectively. The Company’s consolidated financial statements provide for any related tax liability on amounts that may be
repatriated, aside from undistributed earnings of certain of the Company’s foreign subsidiaries that are intended to be indefinitely
reinvested in operations outside the U.S. As of September 29, 2012, U.S. income taxes have not been provided on a cumulative total of
$40.4 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be
approximately $13.8 billion. As of September 29, 2012 and September 24, 2011, $82.6 billion and $54.3 billion, respectively, of the
Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-
denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S.
Note: Emphasis added.

ACCOUNTING FOR INVENTORY
The inventory 10-K footnote should be reviewed for: (i) changes in inventory accounting policies, (ii)
inventory reserve changes, (iii) last-in, first-out (“LIFO”) liquidations, and (iv) inventory charges from
reduced production levels. Two important disclosures in this footnote are details of the inventory
balances (i.e., raw materials, work in progress and finished goods) and reserves.
LARGE INVENTORY RESERVE CHANGES MAY INFLATE PROSPECTIVE GROSS MARGINS

An analyst should review inventory for write downs to the lower of cost or market because in a quarter of
poor results or at year-end, a company might excessively write-down its inventory as a one-time charge
owing to a decrease in the inventory’s selling prices. The inventory write-down is recorded in an
inventory reserve account until the inventory is sold or scrapped (inventory reserves are required to be
disclosed if material). If the sales price of inventory previously written-down recovers in value, and the
product sells at the higher price, a company would record an inflated gross margin since it wrote-down
the inventory in a prior quarter. The increase in gross margin is unsustainable since there is only a
limited amount of inventory on the balance sheet at the lower value. The production of new inventory at
its normal or higher cost will result in the company recording a lower, but normal gross margin in the
income statement in the subsequent period. Inventory write-downs and subsequent recoveries in value
are common after recessions and this is why these events were more common in 2010 and 2011. Below
is an illustration of an inventory write down and subsequent sale for CF Industries.
Inventory Write-Downs Followed by Subsequent Sale
At December 31, 2008, we recorded a $57.0 million non-cash charge to write down our phosphate and potash inventories by $30.3 million
and $26.7 million, respectively, as the carrying cost of the inventories exceeded the estimated net realizable values. Net realizable values
for our phosphate and potash inventories are determined considering the fertilizer pricing environment at the time, as well as our
expectations of future price realizations. The inventory that was held at December 31, 2008 included inventory that was produced or
purchased earlier when input costs and fertilizer prices were higher. During the first quarter of 2009, we sold all of the higher cost
phosphate inventory that existed at December 31, 2008. At September 30, 2009, we reassessed the net realizable values of the inventory
held. Based on this analysis, no additional inventory valuation reserves were necessary for the phosphate fertilizer inventory. However,
during the first and second quarters of 2009, additional inventory valuation reserves of $24.3 million and $5.0 million, respectively, were
recognized related to the potash inventory. During the third quarter, we sold all remaining potash inventory.
LARGE CHANGES IN THE MIX OF INVENTORY RELATIVE TO TOTAL INVENTORIES?

A calculation of the percentage of each inventory category (raw materials, work in progress, and finished
goods) to total inventory will highlight any differences in the mix of inventory. While there are normal
reasons for mix shifts, any large changes may suggest changes in the business. For example, if the
finished goods balance materially increased relative to total inventory, it may presage slowing end
demand for the company’s product. At the same time, the total inventory balance may not have
materially changed if the company decreased raw material purchases to offset slowing demand (finished
goods increased and raw materials decreased).

ACCOUNTING FOR INVENTORY (CONTINUED)
HAVE THERE BEEN MATERIAL REDUCTIONS IN THE LIFO INVENTORY RESERVE?
Inventory is accounted for using one of several methods including first-in, first-out, average cost, last-in,
first-out or specific identification. By far, the FIFO accounting costing method is the most common.
However, to appease companies’ concerns over paying higher taxes on inflationary profits, LIFO
accounting was created in a 1970’s tax code change that allowed it to be used as an accounting cost
flow assumption. Under the tax code’s LIFO conformity rule, companies are required to use LIFO
accounting for GAAP purposes if they use it for tax purposes. LIFO is not allowed under International
Accounting Standards and is one of the major differences between U.S GAAP and IFRS. In a period of
rising prices, LIFO accounting generally results in higher costs and, therefore, lower earnings. However,
the reported earnings under LIFO are closest to economic reality and reflective of the current business
conditions than a company using FIFO accounting, where their cost of sales could reflect the cost of
inventory purchased many years ago.
Analysts may adjust a company from LIFO accounting to FIFO to compare like kind margins. To adjust a
company to FIFO, the LIFO company’s cost of sales is decreased/(increased) by the
increase/(decrease) in year-over-year (or quarter-over-quarter) LIFO inventory reserve balance. For
balance sheet purposes, the FIFO inventory balance is an approximation of replacement cost and
should be used for balance sheet ratios/analysis. The LIFO inventory balance is often outdated and may
reflect prices paid for inventory many years ago.
The LIFO reserve and material amounts of LIFO liquidations are required 10-K disclosures. The LIFO
reserve is the difference between the FIFO inventory balance and the LIFO inventory balance. It
represents the cumulative difference between FIFO and LIFO inventory. Put another way, if the reserve
is multiplied by the U.S. 35% corporate tax rate, it is the amount of cash taxes cumulatively saved by the
company.
The LIFO disclosures should be reviewed for items that may unsustainably increase gross margin: (i)
LIFO liquidations/LIFO income and (ii) large changes in the LIFO reserve. The reason for a decrease in
LIFO reserves should be closely examined. LIFO reserves will decline due to (1) a price decline or (2)
inventory quantity reduction. A decline in the LIFO reserve reduces cost of sales and increases gross
margins. As we discuss below, if a LIFO reserve decline is due to the quantity of goods sold, it is
unsustainable and, therefore, lowers the quality of gross margins and earnings.
Companies often refer to increases in the LIFO inventory reserve as a “charge” since recently
purchased inventory items are placed into the inventory balance at a higher cost than inventory
purchased in a prior period. We don’t view these as necessarily one-time charges since they are the
normal cost of doing business — the company experienced higher costs in the current period and this
reduced margins. A company with volatile raw material and/or other input costs using LIFO inventory will
experience more volatile and immediate gross margins changes than a company using FIFO.
Below we present an example of a LIFO liquidation using ConocoPhillips as an example.
ConocoPhillips’ LIFO Liquidation (2012 Form 10-K)

Inventories valued on the LIFO basis totaled $147 million and $3,387 million at December 31, 2012 and 2011, respectively. The estimated
excess of current replacement cost over LIFO cost of inventories amounted to approximately $200 million and $8,400 million at December
31, 2012 and 2011, respectively. In 2012, a liquidation of LIFO inventory values increased net income from continuing operations by $32
million.

If a reduction in inventory quantity is the cause of the LIFO reserve decline, similar to any reserve
reduction, there is a positive impact on earnings (in this case gross margins) — LIFO income or a gain.
This gain is unsustainable since inventory quantities cannot be realistically reduced to zero. To
normalize margins, we suggest removing the LIFO income effect by increasing reported cost of goods
sold by the LIFO income amount.
Conversely, if the decrease in the LIFO reserve is due to price changes, we don’t advise in making any
adjustments to normalize gross margins since input price changes are a normal part of the business.
However, we do believe margins should be adjusted if current input prices are viewed as unsustainable
or short-term aberrations.
INVENTORY ACCOUNTING POLICY CHANGES (E.G. LIFO TO FIFO)?

A change in an inventory costing method accounting policy is rare and, therefore, we view them with a
high level of skepticism. To boost earnings, a company may choose to change from LIFO to FIFO
inventory and we’ve observed this as most common (but still uncommon) accounting policy change.
We’ve seen it among companies encountering rising raw material costs since earnings are higher under
FIFO. A change in an inventory accounting policy is not generally allowed without good reason and
requires a preferability letter from the company’s auditor. Therefore, it piques our interest when we find
them.
As an example, in the next exhibit, Kodak changed their inventory method policy from LIFO to average
cost at the beginning of 2006.
Change of Inventory Method – Eastman Kodak
On January 1, 2006, the Company elected to change its method of costing its U.S. inventories to the
average cost method, which approximates FIFO, whereas in all prior years most of the Company’s
inventory in the U.S. was costed using the LIFO method. As a result of this change, the cost of all of the
Company’s inventories is determined by either the FIFO or average cost method. The new method of
accounting for inventory in the U.S. is deemed preferable as the average cost method provides better
matching of revenue and expenses given the rapid technological change in the Company’s products. The
average cost method also better reflects more current costs of inventory on the Company’s Statement of
Financial Position. As prescribed in SFAS No. 154, “Accounting Changes and Error Corrections,”
retrospective application of the change in accounting method is disclosed below.
The effects of the change in methodology of costing U.S. inventories from LIFO to average cost on
inventory and cost of goods sold for prior periods presented are as follows (in millions):
As of and for the Year As of and for the Year

Ended Ended
December 31, 2005 December 31, 2004
LIFO Average LIFO Average

Method Cost Method Method Cost Method
Inventory $ 1,140 $ 1,455 $ 1,158 $ 1,506
Cost of goods sold $ 10,617 $ 10,650 $ 9,582 $ 9,601
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filing.

ARE INVENTORY RESERVES BOOSTING MARGINS?
Large reductions in inventory reserves may boost gross margins. Inventory reserves are recorded on
obsolete, excessive, or returned inventory. As an example, selling previously written down inventory at a
higher expected margin (than at the time of write-down) boosts margins. It is unsustainable as the cost
of producing new inventory is higher than the previously written down amount. Another way margins
may temporarily benefit is by deferring an inventory write-down into a future period.
IS LOWER PRODUCTION DEPRESSING MARGINS FROM EXCESS OVERHEAD?

FAS 151, Inventory Costs, clarified that “abnormal” amounts of idle facility expense, handling cost,
freight, and spoilage must be expensed rather than capitalized as part of inventory on the balance sheet.
One large fixed cost included in inventory is fixed overhead costs, namely facility depreciation expense.
Allocation of fixed production overhead is calculated using the normal capacity of the plant or facility,
where normal capacity is defined as the typical production expected over a number of periods or
seasons. Prior to this guidance, companies accounted for these costs in different ways when there were
low capacity levels. In a period of low or idled production, margins may receive a boost when production
levels normalize as these currently expensed costs will be absorbed into inventory.
IS HIGHER PRODUCTION BOOSTING MARGINS?

Companies can overproduce inventory to increase gross margins by spreading the fixed overhead
expenses across more units, thereby lowering the inventory’s average cost per unit. Therefore, a
company may boost margins simply by overproducing inventory for which there may not be enough end-
market demand. We’ve observed this particularly in high fixed cost businesses. Both rising gross
margins and inventory balances (days of inventory or “DOI”, calculated as [inventory / annualized cost of
sales x 365]) are suggestive of lower earnings quality. We'd prefer to see rising margins and a stable (or
lower) DOI number.
ARE OTHER COSTS CAPITALIZED INTO INVENTORY?

A careful reading of the inventory footnote may identify other costs currently capitalized into inventory
balances. Two examples of costs that are typically capitalized into inventory are pension and stock
option expense. A portion of both expenses would be capitalized into inventory if it’s a labor cost of
producing inventory. Separately, inventory is an area where companies in the same industry group may
capitalize different costs into the inventory balance.
INVENTORY: EARNINGS QUALITY

Below we summarize a number of inventory maneuvers used to improve a company’s reported gross
margins:
• Change in inventory accounting methods;

• Gains from reversing inventory reserves;
• Delaying inventory write-downs by under-reserving for obsolete or old items;
• LIFO liquidations;
• Overproducing to lower average cost; and
• Large inventory write-downs in the current period followed by a recovery in the selling price in a
subsequent period.

HOW TO SPOT INVENTORY ISSUES
We've found that the trend in, and peer company comparison of, DOI is the most predictive variable at
identifying inventory related issues. A rise in DOI may presage slowing end demand and be an early
warning signal. Changes in inventory reserves should also be reviewed for draw-downs or the lack of
sufficient reserves.
HOW TO ADJUST LIFO TO FIFO INVENTORY

Companies are required to report their LIFO reserve annually. While we believe that the income
statement under LIFO accounting best reflects the current business economics of the company (rising,
stable or falling inflation), it’s not uncommon for different companies in the same industry to use different
inventory costing methods. In other words, margins aren’t comparable for companies using LIFO and
FIFO. Further, if an investor viewed the current environment as transitory, FIFO may better reflect future
long-term margin trends (e.g., commodity inflation was temporary and recedes). Based on public
disclosures, the only way to compare margin trends across companies is to convert everyone to a FIFO
basis. This is relatively easy to do given 10-K disclosures (the LIFO reserve isn’t always disclosed in 10-
Q filings as many companies only update the reserve/calculation once a year).
In the next exhibit, we illustrate the method of converting Dollar General’s gross margins (and earnings)
from LIFO to FIFO based on the company’s LIFO reserve disclosure. The company discloses a LIFO
reserve of $100.5 million at 2/3/12 compared to $52.8 million at 1/28/11 or an increase of approximately
$48 million during the fiscal year. To convert LIFO gross margin to FIFO gross margin, we use the
change in the LIFO reserve. That is, the increase (decrease) in the LIFO reserve is subtracted/(added)
to cost of sales. Alternatively, the company disclosed a LIFO provision of ~$48 million, which is simply
the byproduct of the change in LIFO reserve.
Example of Adjusting LIFO to FIFO: Dollar General ($ in millions)
Inventories are stated at the lower of cost or market with cost determined using the retail last-in, first-out ("LIFO") method as this method
results in a better matching of costs and revenues. Under the Company's retail inventory method ("RIM"), the calculation of gross profit
and the resulting valuation of inventories at cost are computed by applying a calculated cost-to-retail inventory ratio to the retail value of
sales at a department level. Costs directly associated with warehousing and distribution are capitalized into inventory. The excess of
current cost over LIFO cost was approximately $100.5 million and $52.8 million at February 3, 2012 and January 28, 2011, respectively.
Current cost is determined using the RIM on a first-in, first-out basis. Under the LIFO inventory method, the impacts of rising or falling
market price changes increase or decrease cost of sales (the LIFO provision or benefit). The Company recorded a LIFO provision of $47.7
million in 2011, a LIFO provision of $5.3 million in 2010, and a LIFO benefit of $2.5 million in 2009. [Emphasis added]
The 2011 LIFO provision was impacted by increased commodity costs related to food, housewares and apparel products which were driven
by increases in cotton, sugar, coffee, groundnut, resin, petroleum and other raw material commodity costs. These product costs were
relatively stable in 2010 and 2009.

Example of Adjusting LIFO to FIFO: Dollar General ($ in millions)
For the Year Ended
As reported Adjusted
February 3, LIFO to FIFO February 3,
2012 Adjustment 2012
Net sales 14,807 14,807

Cost of goods sold 10,109 -48 10,061
Gross profit 4,698 48 4,746
% Margin 31.7% 32.1%
Selling, general and
administrative expenses 3,207 0 3,207
Operating profit 1,491 48 1,539
Interest income 0 0
Interest expense 205 205
Other (income) expense 61 61
Income before income taxes 1,225 48 1,273
Income tax expense 459 18 477
Net income 767 796

Earnings per share:
Basic 2.25 2.33
Diluted 2.22 2.31

PROPERTY, PLANT, AND EQUIPMENT: CHECK ASSET LIVES AND FOR CHANGES IN POLICIES
Companies may boost future earnings by changing PP&E depreciable lives, residual values, and/or
depreciation methods. Over the years, we’ve found that these types of changes often signal trouble
around the corner. Companies must disclose the depreciation period and method for each material
asset group. GAAP requires that PP&E’s cost to be allocated as depreciation expense in earnings over
the asset’s estimated useful life in a “systematic and rational manner.” There are several allowable
methods of depreciation including straight-line (most common) and other various forms of accelerated
depreciation, such as sum of the year’s digits and double declining balance. Below are the formulas
used to calculate depreciation expense under each method.
Straight line = (Original cost – residual value) / depreciable life
Double declining balance = Depreciation in Year X = 2 / depreciable life x (asset book value at the
beginning of Year X)
Sum of the years’ digits = Depreciation in Year X = (original cost – salvage value) x (n – X + 1) /
sum of years digits
Another rarely used depreciation method is “units of production” (UOP). We highlight it in this section
since Whirlpool switched to the UOP method in 2009. Under this method, an asset is depreciated based
on the assumed total production units over the asset’s entire estimated life. Using this method will
increase depreciation expense during periods of high production levels and reduce depreciation
expense during low levels of production. In effect, it turns a fixed depreciation cost into a variable cost,
reducing the volatility of gross margins and earnings. However, this method is likely to understate
economic depreciation expense for a company in a mature industry or with a declining business as
lower current year production defers depreciation expense into a future period. If product obsolescence
or other items ultimately reduces the assets’ estimated production units, it will necessitate a PP&E write-
down and indicate that prior periods’ earnings were overstated (too low depreciation expense).
We suggest reviewing the 10-K’s accounting policy section for any changes or unusual depreciation
policies. Over the years, we’ve observed that a change in an asset’s depreciable life has sometimes
been a precursor to deterioration in the company’s business fundamentals. GAAP also requires
disclosure of any material changes in depreciable lives, residual values, or depreciation methods. Oddly,
PP&E’s residual value amounts are not required disclosures. Next, we highlight the disclosures of a few
companies with recent depreciation method changes.
Example of Depreciation Methodology Change: Weis Markets

In the first quarter of 2012, the Company changed its accounting policy for property and equipment. Property and equipment continue to
be recorded at cost. Prior to January 1, 2012, the Company provided for depreciation of buildings and improvements and equipment using
accelerated methods. Effective January 1, 2012, the Company changed its method of depreciation for this group of assets from the
accelerated methods to straight-line. Management deemed the change preferable because the straight-line method will more accurately
reflect the pattern of usage and the expected benefits of such assets. Management also considered that the change will provide greater
consistency with the depreciation methods used by other companies in the Company's industry. The change was accounted for as a
change in estimate. The net book value of assets acquired prior to January 1, 2012 with useful lives remaining will be depreciated using the
straight-line method prospectively. Depreciation expense in the first quarter 2012 would have been $2.9 million greater if the company
had continued using accelerated methods. Had accelerated methods continued to be used, after considering the impact of income taxes,
the effect would decrease net income by $1.6 million or $0.06 per share.

PROPERTY, PLANT, AND EQUIPMENT (CONTINUED)
Example of Depreciation Changes in Estimated Lives – Archer Daniels Midland
During the second quarter of fiscal year 2011, the Company updated its estimates for service lives of certain of its machinery and
equipment assets in order to better match the Company’s depreciation expense with the periods these assets are expected to generate
revenue based on planned and historical service periods. The new estimated service lives were established based on manufacturing
engineering data, external benchmark data and on new information obtained as a result of the Company’s recent major construction
projects. These new estimated service lives are also supported by biofuels legislation and mandates in many countries that are driving
requirements over time for greater future usage and higher blend rates of biofuels.
The Company accounted for this service life update as a change in accounting estimate as of October 1, 2010 in accordance with the
guidance of ASC Topic 250, Accounting Changes and Error Corrections, thereby impacting the quarter in which the change occurred and
future quarters. The effect of this change on after-tax earnings and diluted earnings per share was an increase of $83 million and $0.13,
respectively, for the year ended June 30, 2011.
Example of Depreciation Methodology Change: International Rectifier

Effective December 27, 2010, the Company changed its depreciation method for certain fabrication equipment from the units-of-
production method to the straight-line method. The Company considers this change of depreciation method a change in accounting
estimate affected by a change in accounting principle. This change in estimate is accounted for prospectively as of the beginning of the
third quarter of fiscal year 2011. While the Company believes the units-of-production method, as a function of usage, reasonably reflects
the matching of costs and revenues, it requires considerable effort to monitor and track the usage of certain fabrication equipment
consistently across all fabrication facilities. The Company believes the straight-line method of depreciation represents a better estimate of
the use of the equipment over its productive life and better reflects the pattern of economic consumption. Additionally, the Company
believes the revised practice is consistent with the predominant industry practice.
CHANGES: TWO WAYS TO USE PP&E TO BOOST EARNINGS

Changing assumptions used to calculate depreciation expense is one method used to increase earnings
and has been the underlying reason for numerous historical accounting restatements. Two ways to
lower annual depreciation expense are to extend an asset’s depreciation period or increase its residual
value. Either of these changes should be viewed with a lot of skepticism.
To calculate depreciation expense, there are three primary inputs: depreciation method (straight line,
accelerated depreciation, etc.), asset’s residual value, and depreciable life. To lower annual depreciation
expense and boost earnings, a company might change its assumptions by increasing residual values,
extending depreciable lives or changing the depreciation method. Any of these changes are red flags in
our view. To identify these changes, we suggest reading through the financial filings as material
changes in these items are required disclosures. The average depreciable life ratio is also helpful in
spotting changes in assumptions (gross PP&E divided by LTM depreciation expense). Within a sector or
industry group, comparing depreciation expense to sales assists in identifying companies with more
lenient depreciation expense policies.
Under GAAP, residual value or depreciable life changes are accounted for prospectively. Increasing an
asset’s depreciable life does not change the total depreciation expense amount recognized. Instead, it
defers a portion of current depreciation expense into future periods as a smaller annual amount of the
asset is expensed over a longer time period. Similarly, an increase in an asset’s residual value will
reduce the depreciable amount of the asset and, therefore, lower depreciation expense.

PROPERTY, PLANT, AND EQUIPMENT (CONTINUED)
The following exhibit is an illustration of a company increasing the salvage value of its equipment from
$1,000 to $3,000 after owning it for two years. By changing the salvage value, annual depreciation
expense declines from $1,800 to $1,133.
Example: Decreasing Depreciation Expense by Altering Salvage Values
Newly Acquired Asset with an Estimated $1,000 Two Years Later: New Salvage Value Estimate of
Salvage Value (Straight-Line Depr.) $3,000 (Straight-Line Depr.)
Original cost 10,000 Original cost 10,000
Salvage value 1,000 Amount already depreciated 3,600
Asset's depreciable amount 9,000 New salvage value 3,000
Depreciation period (years) 5 Asset's depreciable amount 3,400
Annual depreciation (a) 1,800 Remaining depr. period (years) 3
New annual depreciation (b) 1,133
Change in Depr. Expense Year 1 Year 2 Year 3 Year 4 Year 5

Original depr. Schedule (a) 1,800 1,800 1,800 1,800 1,800
Newly adjusted depr. Expense (b) n/a n/a 1,133 1,133 1,133
Lower depr. expense n/a n/a (667) (667) (667)
Here are a few financial ratios that detect changing depreciation policies and residual values.
Detecting Changes in Depreciation Methods and/or PP&E Residual Values
Gross PP&E
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐴𝐴𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 =
Accumulated Depreciation
Accumulated Depreciation
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 =
Gross PP&E
Gross PP&E
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷. 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
Depreciation Expense
Net PP&E
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 =
Depreciation Expense

IMPLICATIONS OF ACCELERATED DEPRECIATION
A reading of a company’s PP&E footnote and accounting policy section may identify a company with a
variant depreciation policy. One example of this is a company using accelerated depreciation for GAAP.
If a company depreciates PP&E on an accelerated basis, uses low residual values, or uses short
depreciable lives, the company’s true earnings power may be understated (accounting depreciation
might exceed the asset’s true economic decline in value). In our review of 10-K disclosures over the
years, we find this uncommon. However, other countries often use accelerated depreciation for GAAP
(for tax reasons). The next exhibit is Northrop Grumman’s 2012 10-K disclosure of its accelerated
depreciation policy for fixed assets.
Northrop Grumman (2012 Form 10-K): Accelerated Deprecation

BONUS DEPRECIATION
In recent years, in an effort to stimulate capital investment and growth, Congress has enacted “bonus
depreciation.” Under bonus depreciation, companies may elect an additional first year tax depreciation
deduction (usually 50%), thereby reducing the company’s cash taxes. Bonus depreciation was originally
enacted in 2008 and passed again through a series of extensions.
In 2010, the 50% bonus depreciation was extended by the Small Business Jobs Act. The Tax Relief,
Unemployment Insurance Reauthorization and Job Creation Act of 2010 allowed 100% bonus
depreciation for equipment placed in service after September 8, 2010 through December 31, 2011 and
50% bonus depreciation for equipment placed in service after December 31, 2011 through December
31, 2012. It was unprecedented when Congress allowed 100% immediate expensing of most U.S.
capital expenditures in 2011. Below we summarize bonus depreciation permitted in each year.
At 2012 year-end, bonus depreciation was scheduled to expire. The American Taxpayer Relief Act
extended 50% bonus depreciation by 1 year to the end of 2013 (end of 2014 for certain longer-
production and transportation assets). Interestingly, over the past year, the administration has been
questioning the need for any accelerated depreciation overall, much less bonus depreciation. Therefore,
the extension was not widely anticipated and we suspect many companies likely pulled forward some
capital expenditures into 2012 year-end. Sectors most impacted are utilities, telecommunications and
industrials. Below is a historical synopsis of bonus depreciation allowed under the U.S. tax law.
Recent Periods of Bonus / Accelerated Deprecation
Bonus Depreciation Allowed Under U.S. Tax Law for Corporations
2001 2002 2003 2004 2005 2006 2007

0% 30% 50% 50% 0% 0% 0%
2008 2009 2010 2011 2012 2013 2014

50% 50% 50% 100% 50% 50% 0%
Note: No known periods of bonus depreciation prior to above.

Source: Wolfe Trahan Accounting & Tax Policy Research; IRS.
Based on the guidance in the most recent bonus depreciation legislation, in order to qualify for the initial
bonus depreciation, companies must purchase and place the capital assets in use. A number of points
to keep in mind when thinking about bonus depreciation:
1. The asset must be subject to Modified Accelerated Cost Recovery System (“MACRS”) tax
depreciation with a maximum recovery period of 20 years. It also includes 25-year asset life water
utility properties, software, and qualified leasehold improvement property. This qualifies most
assets except real property/buildings.
2. Bonus depreciation typically only applies to capital expenditures by corporations in the U.S. and
tax consolidated foreign corporations, excluding most non-U.S. capital expenditures. Bonus
depreciation is also generally available for a foreign corporation’s U.S. capital expenditures, if it
files a U.S. corporate tax return.

BONUS DEPRECIATION (CONTINUED)
3. Some smaller capital expenditures may already be immediately expensed for tax purposes under
the de minimis rule and, therefore, not subject to bonus depreciation as described next:
A. IRS De Minimis Rule: The tax code does not require the capitalization of all incidental costs as
long as the following requirements are met:
i. The company immediately expenses the costs in its GAAP financial statements.
ii. The company has written accounting procedures in place at the beginning of the year
mandating the expensing of property with a purchase price below a certain amount.
iii. The total aggregate amounts paid for property and not capitalized are not distortive to the
taxpayer’s income for the year (IRS safe harbor: amounts expensed are the lesser of 0.1%
of a company’s gross receipts or 2% of a company’s total depreciation and amortization
expense).
B. Materials and supplies: if materials and supplies cost $100 or less, they may be expensed
immediately (subject to the IRS safe harbor rule mentioned herein).
4. Used equipment doesn’t qualify. Per the legislation: “original use of the property must commence
with the taxpayer.” Original use is the first use of the asset whether or not used by the taxpayer
(e.g., purchasing new equipment with the intent of leasing would qualify as long as the company
is the legal owner).
5. The asset must be purchased and placed into service during the relevant taxable year. Certain
time extensions are available for assets with long production periods. For the 50% bonus
depreciation in 2013, a one-year extension to January 1, 2015 (asset must be put into use by) is
available for:
A. Property with a production period in excess of one year,

B. An asset life of at least 10 years (also includes transportation property which has a different
asset life); and,
C. Purchase cost of at least $1 million.
The extension period also includes qualifying aircraft purchases. Aircraft purchases not
considered “transportation property” (commercial airlines don’t qualify for the extended place in
service rules) qualify for the extension period if they have an estimated production period
exceeding 4 months, a cost greater than $200,000 and, at the time of contract for purchase, the
purchaser made a nonrefundable deposit of the lesser of 10% of cost or $100,000.

BONUS DEPRECIATION (CONTINUED)
FINANCIAL STATEMENTS IMPACT
Depreciation deductions are just timing differences as the same total amount of the asset is depreciated
over its life under GAAP and tax. Bonus depreciation pulls forward the depreciation tax shield to earlier
periods than normally allowed under the tax code and as compared to GAAP depreciation (typically
straight line). The real benefit to companies electing accelerated depreciation is the time value of money
from cash tax savings in the current year.
Assuming no extension of the 50% bonus depreciation, companies will encounter higher cash taxes
beginning in 2014 and beyond as the benefits of more immediate capital expenditure tax deductions
reverse and companies use regular tax MACRS depreciation schedules. This will be a cash flow
headwind for companies with material U.S. capital expenditures. Since bonus depreciation has occurred
with increasing frequency over the past few years, historical cash tax rates (and cash flow) are distorted
by this benefit and analysts should use caution when using historical cash tax rates to project future
cash taxes.
All else being equal, bonus depreciation’s impact on the financial statements are lower cash tax
payments in the current period and, therefore, higher operating and free cash flow. Accelerated or bonus
depreciation does not generally have an impact on a company’s GAAP tax rate or EPS. The balance
sheet impact of bonus depreciation is an increase in a deferred tax liability representing the tax effected
difference between the current year tax depreciation (higher) and the current year GAAP depreciation
(lower and typically straight line). A review of the company’s table of deferred tax assets/liabilities in the
tax footnote should reveal an increasing deferred tax liability for property, plant, and equipment
depreciation at 2012 year-end. Technically speaking, a larger deferred tax liability will be built-up on
companies’ balance sheets in 2008 through 2013 that will begin to unwind (decrease) in 2014.

HIDDEN ASSET VALUE?
Companies may hold significant investments in other assets. Depending on ownership levels and
whether the assets are publicly traded, these investments often are not reported on the balance sheet at
fair market value. Therefore, investors may find hidden balance sheet value by reviewing the 10-K for
these types of inter-corporate investments.
Yahoo, Inc. is an example of a company with material equity investments accounted for using the equity
method. The company’s balance sheet does not reflect these investments at fair value. Below is
Yahoo’s disclosure of its significant investments accounted for under the equity method.
Yahoo (2011 Form 10-K): Investments in Equity Interests
As of December 31, investments in equity interests consisted of the following (dollars in thousands):
Equity Investment in Alibaba Group. On October 23, 2005, the Company acquired approximately 46 percent of the outstanding common
stock of Alibaba Group Holding Limited ("Alibaba Group"), which represented approximately 40 percent on a fully diluted basis, in
exchange for $1.0 billion in cash, the contribution of the Company's China- based businesses, including 3721 Network Software Company
Limited ("Yahoo! China"), and direct transaction costs of $8 million. Another investor in Alibaba Group is Softbank Corp., a Japanese
corporation ("Softbank"). Alibaba Group is a privately- held company. Through its investment in Alibaba Group, the Company combined its
search capabilities with Alibaba Group's leading online marketplace and online payment system and Alibaba Group's strong local presence,
expertise, and vision in the China market. These factors contributed to a purchase price in excess of the Company's share of the fair value
of Alibaba Group's net tangible and intangible assets acquired resulting in goodwill. As discussed below, following a restructuring in the
ownership of Alibaba Group's online payment system business, Alipay.com Co., Ltd. ("Alipay"), and the termination of certain control
agreements, Alipay was deconsolidated from Alibaba Group in the first quarter of 2011. Alibaba Group continues to receive payment
processing services on preferential terms from Alipay and its subsidiaries in accordance with a long- term agreement. See "Framework
Agreement with Alibaba Group regarding Alipay" below.
The investment in Alibaba Group is being accounted for using the equity method, and the total investment, including net tangible assets,
identifiable intangible assets and goodwill, is classified as part of investments in equity interests on the Company's consolidated balance
sheets. The Company records its share of the results of Alibaba Group and any related amortization expense, one quarter in arrears, within
earnings in equity interests in the consolidated statements of income. The Company recorded a dilution gain of $25 million, net of tax of
$15 million, in earnings in equity interests related to the dilution of the Company's ownership interest in Alibaba Group primarily as a
result of option exercises and the sale of stock to Alibaba Group employees during its quarter ended June 30, 2011 at an average price
higher than the Company's invested cost per share.
The Company's initial purchase price was based on acquiring a 40 percent equity interest in Alibaba Group on a fully diluted basis;
however, the Company acquired a 46 percent interest based on outstanding shares. In allocating the initial excess of the carrying value of
the investment in Alibaba Group over its proportionate share of the net assets of Alibaba Group, the Company allocated a portion of the
excess to goodwill to account for the estimated reductions in the carrying value of the investment in Alibaba that may occur as the
Company's equity interest is diluted to 40 percent based on specific events anticipated at the time. As of December 31, 2010 and 2011, the
Company's ownership interest in Alibaba Group was approximately 43 percent and 42 percent, respectively.

HIDDEN ASSET VALUE? (CONTINUED)
Accounting for an investment in another company is based on the parent company’s level of influence or
control. GAAP measures this influence and control using voting equity stock ownership. Below we
summarize the different ways of accounting for inter-corporate investments.
Accounting for Corporate Investments
Accounting
Method Ownership Threshold General FASB Codification Topic Accounting Standard
Cost or Market < 20% Passive; no influence or control ASC 320, Investments - Debt and Equity Securities FAS No. 115
Equity Method 20-50% Significant influence, but no control ASC 323, Investments - Equity Method and JVs APB No. 18
Consolidation > 50% Control ASC 805, Business Combinations FAS No. 141(R) / FIN No. 46(R)(1)
(1) FIN No. 46(R) superseded by FAS No. 167 effective Jan. 1, 2010 for calendar year-end companies.
The above ownership percentages are guidelines. Where influence and/or control aren’t equivalent to
the equity voting ownership percentages, a company may use a different method in accounting for the
investment (still very uncommon). To be sure, significant management judgment is required in
evaluating whether a company exerts “significant” influence over the investee. To illustrate, a company
may conclude that a 19% equity ownership interest constitutes “significant influence” if it had four out of
seven seats on the board of directors.
SEC and GAAP rules require specific disclosures for equity method investments. SEC Regulation S-X
requires separate financial statements for equity method investments when they are deemed individually
significant at a 20% level if either the investment or income test is met (as described below). In addition,
summary information is required when equity method companies in the aggregate exceed 10%
significance based on any of the three tests of significance.
The following summarized financial information is required (no explanatory notes are required) if any of
the three significance tests are met at the 10% level individually or in the aggregate:
• Current assets
• Noncurrent assets
• Current liabilities
• Noncurrent liabilities
• Redeemable preferred stock
• Non-controlling interest
• Net sales
• Gross profit
• Income or loss from continuing operations
• Net income or loss

HIDDEN ASSET VALUE? (CONTINUED)
The three tests of significance are:
1. Assets - Total parent company’s proportionate share of the total assets in investee(s) (after
intercompany eliminations) compared to the total consolidated assets of the company.
2. Investment - The parent company’s equity investment in the investee(s) (of which it owns 20% to
50%) compared to the total consolidated assets of the company.
3. Income - The parent company’s equity income from the investee(s) [before income taxes,
extraordinary items, and cumulative effect of accounting changes] compared to consolidated
income from continuing operations before taxes, extraordinary items, and cumulative effect of
accounting changes. There are also several items to keep in mind when using net income for
purposes of this test.
a. Impairment charges at the investee level are excluded from the income calculations.
b. If the parent company’s current year consolidated income (or absolute value of its loss) from
continuing operations is at least 10% less than the average of the last five years, a five year
historical average of income should be used in the denominator for the parent’s consolidated
income from continuing operations.
c. When testing whether entities are in the aggregate significant, no netting is allowed and,
therefore, the income test should be separately calculated for investees with income and
losses (aggregate all the entities with income and compare to consolidated income to
determine if at least the 10% threshold is met for increased disclosures; similarly, aggregate all
the entities with losses and compare the absolute value of this amount to consolidated
income).

ACCOUNTING FOR EQUITY INVESTMENTS: < 20% OWNERSHIP
GAAP requires less than 20% equity ownership interests to be accounted for either under the cost or fair
value market value method. The latter method is required when there is an active market for the
investment (e.g., publicly traded). If the investment is privately held, it is almost always reported at
historical cost on balance sheet. In either case, the investment amount is categorized as a one-line item
on the balance sheet typically under long-term investments in the other assets category.
If there is an active market for the equity security, it is accounted for under ASC 320, Investments
(formerly FAS No. 115) and classified as either: (1) trading or (2) available-for-sale. Trading securities
are recorded at fair value on the balance sheet based on the valuation at each period end. Both realized
and unrealized gains and losses from marking the security to market are recognized in earnings each
period. Available-for-sale securities are also marked to fair value on the balance sheet at each period
end, too. However, only realized gains and losses are recorded in earnings; unrealized gains or losses
are recorded directly in shareholder’s equity as part of accumulated other comprehensive income. Any
dividends or interest income received from both types of securities are recognized in earnings (e.g.,
other income) in the period in which it is earned.
If there is not a public market for the security, the cost method is used to account for the investment.
Under this method, the investment is recorded on the balance sheet as an asset at its initial cost. It is
not marked to fair value on the balance sheet in each period but the amount is tested for permanent
impairment at least annually. Similar to a trading/available-for-sale security, dividend and interest
income is recorded in earnings each period as it is earned.
Circumstances change and there may be a public market valuation available for a less than 20% owned
equity investment. In this scenario, a company would change from cost to market value accounting for
the investment. Mechanically, in the first period in which the investee company goes public, the
investment on the balance sheet (heretofore at amortized cost) is marked to fair value. Assuming there
are no shares sold by the investee in the initial public offering, the resulting unrealized gain or loss is
recorded directly in equity in the period in which the market value became available (other
comprehensive income (net of a deferred tax liability)).

ACCOUNTING FOR EQUITY INVESTMENTS: 20% TO 50% OWNERSHIP
Ownership interests in investees of between 20% and 50% are accounted for under the equity method
of accounting unless specific circumstances dictate otherwise. The equity method is typically used to
account for 50%/50% joint ventures. Below we explain the equity method of accounting.
On the balance sheet under the equity method, a long-term asset is recorded at the amount paid for the
initial investment in the equity of the entity. In each period after that, the investment account is increased
(decreased) by the parent’s percentage ownership of the investee net income (loss). Notably, dividends
received from the investee are not recorded in earnings of the parent company, but rather reduce its
balance sheet equity investment account as they are viewed as a return of capital under GAAP. On the
consolidated income statement, the parent company records a line item often entitled “equity income.”
This amount is equal to its percentage ownership in the income of the investee (e.g., 25% of the
investee’s net income).
It isn’t well known that this equity income amount is adjusted for elimination of inter-company profits and
depreciation/amortization due to the hypothetical step-up of the investee’s net assets to fair market
value on the date of the initial investment. In effect, on date the equity investment occurs, a company will
fair value all of the assets and liabilities of the investee and any intangible amortization or
increased/decreased depreciation is recorded as an adjustment to the equity income amount that is
recorded by the parent company. This is often why the equity income amount reported by a parent
company does not equal the parent company’s percentage ownership interest multiplied by the
investee’s net income that may be separately reported to the investee’s shareholders. Inter-company
profits arising from sales between the parent and subsidiary are eliminated based on the parent
company’s ownership percentage. Further, as a matter of convenience, GAAP and SEC rules allow
companies to record the equity method investee’s reported results of operations in the arrears by up to 3
months.
The cash flow statement reports the equity income (loss) amount as a non-cash item that is subtracted
(added) to operating cash flow unless this equity amount was distributed as a dividend to the parent
company. In the latter situation, there is no subtraction or, only a partial subtraction, reflecting the
amount of equity income not received as dividends.
In certain extreme scenarios, significant losses at the investee level may reduce the parent company’s
equity investment to zero on the balance sheet. In this scenario, the parent company ceases recording
equity investment losses in their income statement unless there are additional debt guarantees and/or
other commitments for additional financial support or profitability was expected to re-occur soon. The
parent company would begin recording equity income again once it reached the watermark on its
investment (i.e., the unrealized losses were recouped).

MERGERS & ACQUISITION ACCOUNTING: RED ALERT FOR ACCOUNTING ABUSE
Currently, the accounting for mergers and acquisitions is an area of high accounting abuse, in our view.
The most concerning issue is how companies allocate the purchase price of the acquisition to the fair
market value of the target’s net assets. In this respect, companies are highly incentivized to allocate a
significant portion of the purchase price to goodwill and non-amortizable intangible assets. Since neither
goodwill nor non-amortizable intangible assets are expensed, all else being equal, the combined
company reports higher earnings after the acquisition (companies do expense amortizable intangible
assets but may choose long asset lives to reduce the yearly amortization).
Therefore, we advise investors to carefully read the M&A purchase accounting disclosure. It is typically
found in one of first few financial statement footnotes and GAAP and SEC rules require a company to
disclose the amount of the purchase price allocated to the specific assets and liabilities of the target
company. It is the amounts assigned to individual asset and liabilities that require a careful review and
proper context.
Briefly, by way of background, in 2001, pooling of interests merger accounting was disallowed upon the
issuance of FAS No. 141(R) Business Combinations. Now U.S. and IFRS GAAP allow only purchase
accounting for M&A transactions. The overall concept of FAS No. 141(R) is to mark all of the acquired
company’s assets and liabilities to fair market value on the acquisition date. Commonly, a target
company is purchased at an equity value exceeding the fair market value of its net tangible assets. In
this scenario, intangible assets and goodwill are recorded on the balance sheet. The “day 2” accounting
for intangible assets depends on if they are finite or indefinite life intangible assets. If intangible assets
have a finite life they are expensed as amortization over each asset’s expected life. Examples of such
assets include customer lists, contract backlog, trademarks, and patents. By contrast, intangible assets
with indefinite lives and goodwill are not expensed in earnings. Rather these amounts are tested for
impairment at least annually. Prior to the issuance of FAS 141(R), both goodwill and all intangibles
assets were amortized as expenses in earnings.
THREE HOT AREAS OF POTENTIAL ACQUISITION ACCOUNTING ABUSE

1. HIGH PERCENTAGE OF THE PURCHASE PRICE WAS ALLOCATED TO GOODWILL
Since both U.S. and IFRS GAAP no longer require goodwill to be amortized, companies have an
incentive to allocate a large portion of the acquisition price to goodwill on the balance sheet. If the
acquisition doesn’t pan out, goodwill is written off as a one-time impairment charge to earnings
and typically excluded from analysts’ net income calculations. Under GAAP, goodwill is, in effect,
a “plug” number recorded after the fair market value of net assets acquired are recorded.
However, we believe that this “plug” contains informational content. First, a high level of goodwill
as a percentage of the total purchase price amount indicates that the company is assigning a
large amount to synergy value, signaling overpayment. Second, since goodwill is not amortized,
the company may be under allocating the purchase price to tangible and intangible assets to
increase earnings by avoiding higher post-acquisition depreciation / amortization expense. As a
rule of thumb, we become concerned when a company allocates more than 70% of the purchase
price to goodwill. This suggests that the company may have overpaid or is under allocating
expenses, neither of which are positive signals.
2. HIGH PERCENTAGE OF THE PURCHASE PRICE ALLOCATED TO INDEFINITE LIVED INTANGIBLE

ASSETS
GAAP identifies two types of intangible assets: finite and indefinite life. An indefinite life intangible
asset is defined as one extending “beyond the foreseeable horizon” and used as a default if a

MERGERS & ACQUISITION ACCOUNTING: RED ALERT FOR ACCOUNTING ABUSE (CONTINUED)
company cannot ascertain an intangible asset’s useful life. Such assets are not amortized as a
periodic expense, but instead tested at least annually for impairment. Similar to goodwill, since
indefinite life intangible assets are not amortized as an expense, there is an incentive for
management to allocate a substantial portion of the intangible purchase price allocation to these
assets. Therefore, we suggest analysts closely review the M&A disclosures for large and
unreasonable purchase price allocations to indefinite life intangible assets. As an example, we
would review and determine if a company allocated a portion of the purchase price to a “brand”
indefinite life intangible asset that one does not expect to have longevity. Additionally, when
material, GAAP requires a separate footnote disclosure for expected intangible asset amortization
amounts and asset lives for both indefinite and finite intangible assets.
3. LONG (AND STRAIGHT LINE) AMORTIZATION PERIOD FOR INTANGIBLE ASSETS

Finite life intangible assets are required to be expensed over their useful life and, as such, we
suggest carefully reviewing their assigned amortization life for reasonableness. To reduce the
annual amortization expense charged against earnings, a company might use a very short period
(1-2 years and try and classify the expense as non-recurring) or a very long period (more than 15
years). Unfortunately, we have found no average period or benchmark against which to compare
company amortization periods since they vary by industry group. However, assigning a useful life
amortization period to a finite life intangible asset exceeding 15 years is very aggressive, in our
view. Amortization periods for customer lists has been a SEC hot button in recent years as there
is a view that companies should be expensing customer list/relationship intangible assets over an
accelerated time period rather than using a straight line amortization period. We view customer
list/relationship amortization periods exceeding 5-10 years as aggressive. Amortization
information is found in the 10-K either in a separate section, the acquisition/business
combinations footnote, or in the significant accounting policies section.
Below is an excerpt of Ecolab’s10-K wherein they discuss the amortization periods for intangible
assets. Based on a reading of this disclosure, Ecolab uses a 15 straight line amortization period
for customer relationships, which is less conservative, in our view.
Ecolab (2011 Form 10-K): ($ in thousands)

Goodwill and Other Intangible Assets
The merger with Nalco resulted in the addition of $4.4 billion of goodwill, which will ultimately be maintained in separate reporting units.
Subsequent performance of these reporting units relative to projections used in the purchase price allocation could result in an impairment if
there is either underperformance by the reporting unit or if the carrying value of the reporting unit were to fluctuate due to working capital
changes or other reasons that did not proportionately increase fair value..
As part of the Nalco merger, the company added the “Nalco” trade name as an indefinite life intangible asset. The carrying value of this asset will
be subject to impairment testing beginning in 2012.
Other intangible assets subject to amortization primarily include customer relationships, trademarks, patents and other technology. The fair value
of identifiable intangible assets is estimated based upon discounted future cash flow projections and other acceptable valuation methods. Other
intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of other intangible
assets was 14 years as of December 31, 2011 and 13 years as of December 31, 2010.
The weighted-average useful life by type of amortizable asset at December 31, 2011 is as follows:
NUMBER OF YEAR
Customer relationships 15
Trademarks 17
Patents 14
Other technology 8

Ecolab (2011 Form 10-K): ($ in thousands) (continued)
The straight-line method of amortization reflects an appropriate allocation of the cost of the intangible assets to earnings in proportion to the
amount of economic benefits obtained by the company in each reporting period. The company evaluates the remaining useful life of its intangible
assets that are being amortized each reporting period to determine whether events and circumstances warrant a change to the remaining period
of amortization. If the estimate of an intangible asset’s remaining useful life is changed, the remaining carrying amount of the intangible asset will
be amortized prospectively over that revised remaining useful life.
OTHER IMPORTANT ITEMS TO WATCH FOR IN M&A DISCLOSURES

Below and on the next page are several things to focus on when reviewing the purchase accounting
disclosures:
ARE INTANGIBLE ASSETS AND GOODWILL TAX-DEDUCTIBLE?

There may be different accounting for goodwill and intangibles under GAAP and the Internal Revenue
Code (IRC). GAAP requires companies to disclose whether acquisition related goodwill and/or intangible
assets are tax deductible under the tax code. Specifically, for asset acquisitions, IRC Section 197 allows
goodwill and intangible assets to be deducted (amortized) as expenses ratably over a 15 year period
even if such amounts are not expensed under GAAP. This has implications for a company’s prospective
cash tax rate and the tax shield is a hidden asset that may not be fully reflected in the share price of the
company. To be sure, our experience is that companies and their bankers incorporate such assets into
the valuation of the target company. This often manifests itself when investors are comparing the prices
paid for acquisitions as a buyer would be in a position to pay more in a transaction structured as a
taxable purchase of assets (goodwill and intangible assets are tax deductible). To compare the
purchase price multiples across companies, we suggest separately valuing this tax shield (similar to a
NOL valuation) on a net present value basis and reducing the target’s enterprise value by this amount.
Apart from tax net operating loss carryforwards, some acquisitions are structured to create future tax
deductible goodwill and intangible amortization expense (goodwill/intangibles are amortizable over 15
years under IRC Section 197). The next exhibit is Generac’s disclosure of tax deductible goodwill, the
asset of which is not reflected on the company’s balance sheet or in 10-K tax footnote table of deferred
tax assets. We suggest valuing this asset separately and treating it similar to a NOL for valuation
purposes. Later in this report, we explain how to value NOLs.
Tax Deductible Goodwill (Generac 2011 Form 10-K)
Factors influencing provision for income taxes. Because we made a Section 338(h)(10) election in connection with the CCMP Transactions,
we have $1.2 billion of tax-deductible goodwill and intangible asset amortization remaining as of December 31, 2011 that we expect to
generate cash tax savings of $470 million through 2021, assuming continued profitability and a 39% tax rate. The amortization of these
assets for tax purposes is expected to be $122 million annually through 2020 and $102 million in 2021, which generates annual cash tax
savings of $48 million through 2020 and $40 million in 2021, assuming profitability and a 39% tax rate.

HAVE THERE BEEN MATERIAL CHANGES IN PURCHASE PRICE ALLOCATIONS?
GAAP allows companies up to one year after the acquisition date to adjust the recorded fair market
valuations of the target company’s balance sheet. We suggest reviewing the business combinations
footnote for any large changes in the fair market value amounts allocated to the acquired net assets
since the initial purchase price allocation. To be sure, initial estimates may be tentative as asset
valuations may take many months to complete and yet quarterly and annual financial statements must
be filed. GAAP requires amounts to be trued-up in the following quarter(s) as valuations are finalized.
Review large changes in purchase price allocations for reasonableness and the possible underlying
cause(s). Large purchase price accounting adjustments are rare and we view them as a red flag,
particularly if they benefit future earnings. Mechanically, when a subsequent purchase price accounting
adjustment is recorded, the other entry of the adjustment is to increase or decrease goodwill (assuming
goodwill was recorded).
WERE COSTS PREPAID AT THE TIME OF THE MERGER?

The M&A footnote disclosures should be reviewed to see if the target company prepaid costs prior to
acquisition’s closing date. Such a maneuver may provide an unsustainable increase to operating cash
flow. Mechanically, if a cost is prepaid prior to the merger, it appears on the target company’s balance
sheet as a prepaid asset and there is a cash outflow in the period in which the cost is prepaid. When the
merger closes, the prepaid asset carries over to the acquired company’s balance sheet. In turn, as the
prepaid asset is recorded as an expense in earnings, the reduction in the prepaid asset increases
operating cash flow. However, if the prepaid costs at closing are recurring costs of the company, in a
subsequent period after the prepaid asset is drawn down, there will need to be a replenishment of the
asset. This will necessitate a cash outflow as the cost is paid again in cash.
HOW MUCH WAS PP&E UNDERVALUED ON THE TARGET COMPANY’S BALANCE SHEET?
The amount of the purchase price allocated to PP&E and operating leases may provide detail into the
amount by which they were undervalued. One quick way to analyze the undervaluation would be to
compare the amount allocated to PP&E from the purchase accounting disclosure to the standalone
target companies’ PP&E amount. It’s also not well understood that operating leases are marked to fair
value in purchase accounting, so rent expense reflects current market rents existing at the acquisition’s
closing date. Under purchase accounting, if the lease is undervalued, an operating lease intangible
asset (“favorable lease”) is recorded. Conversely, if the lease is overvalued, an accrued lease liability is
recorded. In turn, after the acquisition closes, the operating lease asset or (liability) recorded in purchase
accounting increases or (decreases) future GAAP rent expense. This non-cash item is added back to
operating cash flow, so the cash rental expense amount is unchanged.
PURCHASE ACCOUNTING DISCLOSURES: EXAMPLES

As an example of M&A disclosures, the next exhibit is the purchase accounting disclosure of the Ecolab-
Nalco acquisition. The disclosure identifies the fair values at which the assets/liabilities of Nalco were
recorded and how much of the acquisition was allocated to goodwill and intangible assets. Based on a
reading of this disclosure, a significant portion of the purchase price was allocated to goodwill ($4.4
billion) and intangible assets and the asset lives determined for intangibles were longer than average.
Unfortunately, some companies do not disclose the actual mark-up/mark-down amounts to fair value (as
is the case in Ecolab’s disclosure). Therefore, to determine how much the target company’s
assets/liabilities were written-up/down, review its pre-acquisition balance sheet from the 10-Q/10-K in
the period immediately prior to the acquisition.

Ecolab’s Purchase of Nalco: Purchase Accounting Disclosure
4. ACQUISITIONS AND DISPOSITIONS
Nalco merger
On December 1, 2011, the company completed its merger with Nalco, the world’s leading water treatment and process improvement
company. Based in Naperville, Illinois, Nalco offers water management sustainability services focused on industrial, energy and
institutional market segments. Nalco’s programs and services are used in water treatment applications to prevent corrosion,
contamination and the buildup of harmful deposits and extend asset life, among other functions, and in production processes to enhance
process efficiency, extend asset life and improve customers’ end products.
The following table summarizes the values of Nalco assets acquired and liabilities assumed as of the
merger date. To the extent previously discussed, such amounts are considered preliminary:
MILLIONS
Current assets $ 1,869.6

Property, plant and equipment 1,069.2
Other assets 97.3
Identifiable intangible assets:
Customer relationships 2,160.0
Patents 321.0
Trade names 1,230.0
Trademarks 79.0
Other technology 91.0
Total assets acquired 6,917.1
Current liabilities 1,105.5

Long-term debt 2,858.4
Pension and postretirement benefits 505.7
Net deferred tax liability 1,188.7
Noncontrolling interests and other liabilities 167.7
Total liabilities and noncontrolling interests assumed 5,826.0
Goodwill 4,403.9
Total consideration transferred $ 5,495.0
The customer relationships, patents, finite-lived trademarks and other technology are being amortized
over weighted average lives of 15, 14, 15 and 8 years, respectively. The Nalco trade name has been
determined to have an indefinite life.

Below is the purchase accounting fair value disclosure for J&J’s purchase of Synthes. J&J recorded $6.0
billion of goodwill, $12.9 billion in intangible assets, and $1.3 billion of property, plant, and equipment.
Johnson & Johnson (2012 Form 10-K): Purchase Accounting Disclosure Under FAS No. 141(R)
During the fiscal second quarter, the Company completed the acquisition of Synthes, Inc., a global developer and manufacturer of
orthopaedics devices, for a purchase price of $20.2 billion in cash and stock. The net acquisition cost of the transaction is $17.5 billion
based on cash on hand at closing of $2.7 billion.
Under the terms of the agreement, each share of Synthes, Inc. common stock was exchanged for CHF 55.65 in cash and 1.717 shares
of Johnson & Johnson common stock, based on the calculated exchange ratio. The exchange ratio was calculated on June 12, 2012 and
based on the relevant exchange rate and closing price of Johnson & Johnson common stock on that date, the total fair value of
consideration transferred was $19.7 billion. When the acquisition was completed on June 14, 2012, based on the relevant exchange rate
and closing price of Johnson & Johnson common stock on that date, the total fair value of the consideration transferred was $20.2 billion.
Janssen Pharmaceutical, a company organized under the laws of Ireland and a wholly-owned subsidiary of Johnson & Johnson, used cash
on hand to satisfy the cash portion of the merger consideration.
The following table presents the amounts recognized for assets acquired and liabilities assumed
as of the acquisition date, as well as the adjustments made up to December 30, 2012:
(Dollars in Millions) June 14, 2012 December 30, 2012
Cash & Cash equivalents $ 2,749 2,749
Inventory 889 1,194
Accounts Receivable, net 738 738
Other current assets 249 238
Property, plant and equipment 1,253 1,253
Goodwill 5,371 6,011
Intangible assets 12,929 12,861
Other non-current assets 46 46
Total Assets Acquired 24,224 25,090
Current liabilities 825 1,053
Deferred Taxes 2,731 3,471
Other non-current liabilities 431 329
Total Liabilities Assumed 3,987 4,853
Net Assets Acquired $ 20,237 20,237
The adjustments made since the date of acquisition were to account for changes to inventory, based on the results of the physical
inventory counts and deferred taxes, to reflect the statutory tax rate that is being applied to the intangible assets. The revisions to the
purchase price allocation were not material to the Statements of Consolidated Earnings for the prior fiscal quarters of 2012.
The assets acquired are recorded in the Medical Devices and Diagnostics segment. The acquisition of Synthes, Inc. resulted in $6.0
billion of goodwill. The goodwill is primarily attributable to synergies expected to arise from the acquisition of Synthes, Inc. The
goodwill is not expected to be deductible for tax purposes.

JNJ Intangibles from Synthes acquisition
The purchase price allocation to the identifiable intangible assets included in the June 14, 2012 and December 30, 2012 balance sheets
were as follows:
(Dollars in Millions) June 14, 2012 December 30, 2012

Intangible assets with definite lives:
Customer relationships $ 9,950 9,870
Patents and technology 1,495 1,508
Total amortizable intangibles 11,445 11,378
Trademark and Trade name 1,420 1,420
In-process research and development 64 63
Total intangible assets $ 12,929 12,861
The weighted average life for the $11.4 billion of total amortizable intangibles is approximately 21 years.
The trade name asset values were determined to have an indefinite life based on a number of factors, including trade name history, the
competitive environment, market share and future operating plans. The intangible assets with definite lives were assigned asset lives
ranging from 7 to 22 years.

As an illustration of the purchase accounting disclosures within the financials sector, we present 1st
United Bancorp’s acquisition of Old Harbor Bank of Florida.
1st United Bancorp (2011 Form 10-K): Acquisition of Old Harbor Bank of Florida ($ in thousands)
The Company accounted for the transaction under the acquisition method of accounting which requires purchased assets and assumed
liabilities to be recorded at their respective acquisition date fair values. The estimated fair values are considered preliminary and are
subject to refinement as additional information relative to the closing date fair values becomes available during the measurement period,
not to exceed one year. Specifically, additional information related to the fair value over loans, other real estate and the FDIC loss share
receivable are preliminary and may change as new information becomes available. Preliminary valuation and purchase price allocation
adjustments are reflected in the table below.
The acquisition of Old Harbor is consistent with the Company’s plan to enhance both its footprint and competitive position. This
acquisition provided for the initial expansion into the West Coast of Florida markets specifically Pasco and Pinellas counties. The Company
believes it is well-positioned to deliver superior customer service, achieve stronger financial performance and enhance shareholder value
through the synergies of combined operations, all of which contributed to the resulting goodwill associated with the transactions.
On the date of acquisition, the Company did not immediately acquire the furniture or equipment or any of the owned facilities of Old
Harbor. Management assessed each banking location and determined not to assume three banking facilities, two of which were leased
and one was owned. The Company has purchased two banking facilities and related furniture and equipment for $2,200 and assumed two
leased banking facilities.

ACQUISITION ACCOUNTING ANTICS: THE PERFECT STORM
Acquisitions create the pressure for management teams to show pro forma earnings accretion of the
combined company and justify the financial terms of the transaction. This creates the perfect storm for
earnings management and low earnings quality. Under the GAAP purchase accounting rules,
companies are required to mark the entire balance of the target company (not parent) to fair value on
the acquisition date. Intangible assets are also typically created as part of this process. The amount paid
for the target company in excess of the net assets’ fair value (including intangibles) is recorded as
goodwill and there is no amortization of goodwill for GAAP purposes. This amount remains on the
balance sheet and is tested at least annually for impairment. There are several other items to watch in
acquisitions and each is discussed in turn:
• Excess write-down of the target’s property, plant and equipment = lower future depreciation;
• Big bath restructuring charges taken by the target company prior to acquisition;
• Movement to “pro forma” earnings reporting for acquisition related items;
• Disguising future compensation as earn-outs or other one-time payments;
• Cherry picking accounting policies: choosing the more favorable accounting method of the two
companies; and
• Managing the target company’s working capital levels prior to the acquisition.
A few acquisition accounting antics center on lowering post-acquisition costs by incurring them prior to
the closing date of the acquisition or by recording big bath accounting write-downs when valuing the
target company’s net assets. One way of increasing a company’s post-acquisition earnings is by
excessively writing down the target company’s property, plant and equipment in purchase accounting. In
so doing, annual depreciation expense is lowered since the PP&E balance, subject to annual
depreciation, is lower. One way of spotting this is to review the company’s purchase price allocations’
financial statement footnote. Another related way of lowering post acquisition depreciation expense is to
simply change the depreciation method or life in purchase accounting. Still another way of lowering the
annual expense is recording significant pre-acquisition restructuring costs by the target company. These
expenses would be accrued as a liability on the balance sheet of the target company prior to the
acquisition and, therefore, treated as an assumed liability in purchase accounting.
Switching to the use of pro forma earnings after the acquisition is another way to boost earnings. There
may be justifiable reasons for reporting under an earnings measure that excludes certain non-recurring
costs, such as restructuring. For example, beginning in 2009, GAAP now requires the expensing of all
restructuring costs post-acquisition during the period in which they are incurred. If a company is
expected to report only several quarters of restructuring costs, viewing an earnings metric excluding
such costs is most appropriate, in our view. However, since the costs chosen to be excluded are subject
to significant management judgment and there is pressure to show post-acquisition earnings accretion,
earnings quality deteriorates as the frequency and amount of such excluded items increases.
Some acquisition structures include future “earn-out” payments to prior shareholders or employees
based on targets of future sales, earnings or other operating performance metrics. This structure tends
to be used in the acquisition of a private company in which there are only a few shareholders. Often, the
senior management of the acquired company will move to the acquired firm and assume similar roles.
One way of reducing subsequent compensation cost of these employees is to try and structure their
future compensation in the form of an earn-out since these payment amounts are not expensed through
earnings (some are marked up or down through earnings if their initial value changes).

ACQUISITION ACCOUNTING ANTICS (CONTINUED)
Last, acquisitions provide the opportunity for companies to change to more favorable accounting
policies. Under the ruse of “harmonizing” different policies, there may be a switch (benign or otherwise)
in depreciation policies, classification of expenses, taxes, revenue recognition and cost capitalization,
among other items. Any changes may fall under the radar given the acquisition.
Given the aforementioned numerous ways to manage post acquisition earnings, it’s logical to conclude
that highly acquisitive companies should be analyzed based on cash flow. However, cash flow isn’t a
great measure either as companies may materially alter working capital. A simple illustration is to push
off collecting receivables until after the transaction closes (high days sales outstanding “DSOs” when
transaction closes) and then decrease to a “normal level”. Alternatively, on the liability side of the
balance sheet, a company might choose to reduce accounts payables (low days payable ratio) prior to
an acquisition (a cash outflow) and then rebuild accounts payable amounts (a cash inflow) after the
acquisition closes.

GOODWILL IMPAIRMENTS (ASC 805, 350, AND 360; FORMERLY FAS 141R, 142, AND 144)
THE MECHANICS
GAAP requires goodwill to be recorded at the reporting “unit” level. GAAP defines a reporting unit as an
operating segment or one level below an operating segment. This leaves management discretion in
assigning goodwill to a reporting unit since one company might assign goodwill at the higher segment
level while another company might assign goodwill to a lower business unit level. Assigning goodwill to a
higher segment level leaves more room for a buffer in avoiding a potential future write-down as an
increase in a business value in one area of an operating segment might offset weakness in another.
After goodwill is recorded, it is required to be tested at least annually for impairment or if circumstances
warrant, more frequently (should be tested at the same time each year).
Beginning in 2012, companies may use a preliminary qualitative assessment first to determine the need
for a quantitative impairment test. Based on qualitative events or circumstances (e.g. macroeconomic
conditions, industry considerations, changes in input cost factors, financial performance, entity specific
events, sustained decrease in share price), management will use more likely than not threshold (50%+)
as to whether the fair value of a reporting unit is greater than the carrying value. If not, the quantitative
test must be performed. There are two steps in GAAP’s quantitative goodwill impairment test:
1. Compare the reporting unit’s fair market value to its carrying amount (book value). If the fair
market value of the reporting unit is greater than its book value, the impairment test is finished
and there is no goodwill impairment.
To complete Step 1 of the test of goodwill impairment, a company must calculate the fair market
value of the reporting unit using fair value accounting guidance contained in ASC 820, Fair Value
Measurement and Disclosures (formerly FAS No. 157). There’s usually no readily available
market value for a reporting unit. As a result, management will hire an external valuation firm to
calculate fair value and/or use an internal valuation model based on DCF or multiplies of
comparable companies, if available.
2. In Step 2, if the fair value of the reporting unit is less than its book value, a company must
estimate the new fair market value of goodwill or what is known as the implied goodwill amount.
To calculate this amount, the company completes a hypothetical purchase accounting allocation
under which the newly calculated reporting unit’s fair market value is allocated to the individual
tangible and intangible assets (excluding goodwill). The amount by which the reporting unit’s fair
market value amount exceeds the fair market value of its net assets is goodwill’s implied fair
market value. In the last calculation, the calculated implied goodwill amount is compared to the
goodwill amount recorded on the balance sheet at that same unit level. The resulting goodwill
impairment charge is the reporting unit’s existing goodwill amount less its newly calculated
implied fair market value.

GOODWILL IMPAIRMENTS (CONTINUED)
In the following exhibit, we walk through the mechanics of a goodwill impairment test. In this example,
we assume book value of assets of $350, goodwill of $450, liabilities of $275, and equity of $525.
Step 1 of a goodwill impairment test compares the fair market value of a reporting unit to its carrying
value. The fair market value is determined using various valuation methodologies such as discounted
cash flow analysis, market multiples, or the cost approach. The assumed $450 fair value of the reporting
unit is less than its $525 carrying value, indicating that an impairment exists. Since the reporting unit’s
fair value is less than its carrying value, proceed to Step 2.
In Step 2 of a goodwill impairment test, the fair market value of tangible and intangible assets is
calculated and the implied fair value of goodwill becomes apparent. Goodwill’s implied fair market value
of $375 is calculated based on an assumption of $475 of assets (the sum of all tangible and identifiable
intangible assets) and $325 of liabilities. A $75 goodwill impairment charge (fair market value of $375
less book value of $450), runs through the income statement as a loss.
Goodwill Impairment Testing Example
Assets 350 Liabilities 275

Goodwill 450 Book value of equity 525
Total assets 800 Total liabilities + equity 800
Step 1: Compare the fair value of reporting unit to the carrying amount
Fair value of reporting unit(1) 450

Book value of reporting unit 525
Excess carrying value (75)
Since the reporting unit's fair value is less than its book value, proceed to Step 2.
Step 2: Compare the implied value of goodwill to the carrying amount of goodwill
Book value of reporting unit 525

Less: fair value of tangible and identifiable
intangible assets 475
Less: fair value of liabilities (325)
150 150
Implied value of goodwill (a) 375

Carrying value of goodwill (b) 450
Goodwill impairment (a) - (b) (75)
(1) Fair value based on a reasonable valuation methodology such as DCF analysis, market multiples, cost to recreate, etc.

GOODWILL IMPAIRMENTS (CONTINUED)
GOODWILL IMPAIRMENT CHARGE INDICATOR: GOODWILL / MARKET CAPITALIZATION
We have found that a high ratio of goodwill to a company’s market capitalization is a leading indicator of
a future goodwill impairment charge. That is, the higher the level of goodwill as a percentage of market
capitalization, the greater the probability that the implied fair value calculation of goodwill will be less
than its current balance sheet amount. This is a useful ratio to screen for goodwill impairments at the
aggregate company level since we don’t have enough detail to calculate the goodwill amounts at the
“reporting unit” level. Historically, we’ve found that the goodwill-to-market capitalization ratio in the
quarter before a goodwill impairment charge occurred averaged 39% with a median ratio of 22%.
HOW TO ESTIMATE POSSIBLE GOODWILL IMPAIRMENT CHARGES

GAAP requires goodwill to be recorded and analyzed for impairment at the reporting unit level. However,
there is often limited disclosure on a reporting unit level available in public filings. As a result, in order to
assess the possibility and size of a potential goodwill impairment charge, we must make a number of
assumptions. In the first step of the goodwill impairment test, the fair value of the reporting unit is
compared to its book value. If the fair value is greater than the book value, the impairment testing
ceases. If it is not, the test proceeds to Step 2. As a substitute for the reporting unit value, we use the
fair value of the company’s market capitalization to the company’s shareholder’s equity balance.
In Step 2, the fair value of all tangible and identifiable intangible assets and liabilities are allocated to the
fair value of the reporting unit. In this part of the analysis, we assume the asset and liability amounts
recorded on the GAAP balance sheet are equal to their fair values. The book value of the non-goodwill
assets (“net identifiable assets”) is calculated by subtracting goodwill from shareholder’s equity. The
implied fair value of goodwill is, in turn, calculated by comparing the company’s market capitalization
(our proxy for fair value of the reporting unit) to the book value of the net identifiable assets (our estimate
of net identifiable assets’ fair value). Next, the implied goodwill fair value amount is compared to the
amount of goodwill on the company’s balance sheet. If the implied fair value of goodwill is less than the
balance sheet amount, there company is at high risk of an impairment charge. An impairment charge
would be recorded in earnings as a noncash charge, reducing equity at its tax-effected amount.
LONG LIVED ASSET IMPAIRMENT TESTING: THE RULES AND MANAGEMENT’S SUBJECTIVITY
ASC 360, Property, Plant, and Equipment (formerly FAS No. 144), requires companies to test long lived
assets, such as PP&E for impairment when indicators exist. Under the accounting guidance in ASC 360,
the impairment test is performed when “events or changes in circumstances indicate that its carrying
amount may not be recoverable”. Indicators would include items, such as significant decreases in the
asset’s market price, adverse changes in the extent or manner that the assets are being used, a change
in legal factors or the business climate that may impact asset’s value, or recent cash flow and/or
operating losses.
A two-step test is performed if an impairment test is necessary. In Step 1, the company compares the
total undiscounted estimated future cash flows of the asset to its carrying value. If the asset’s carrying
value exceeds the undiscounted cash flows, there is an impairment loss. This loss is measured as the
difference between the asset’s carrying value and fair value (where fair value would be measured on a
discounted cash flow basis or through other fair value measurements). Readers will recognize that in
light of the inherent management subjectivity in this impairment test, companies have lots of flexibility in
the amount and timing of long-lived asset write-downs.

LOOK FOR RELATED PARTY TRANSACTIONS
Related party transactions are a required GAAP disclosure. The accounting literature broadly defines a
related party as including:
1. A parent company and its subsidiaries;

2. Subsidiaries of a common parent company;
3. Affiliates;
4. An enterprise and trust for the benefit of employees;
5. An enterprise and its principal owners (owners or beneficial owners of at least 10% of voting
interest), management (Board of Directors, CEO, COO, SVPs, or immediate family members);
6. Other parties if one party controls or can significantly influence management or operating policies
of the other inasmuch as one of the transacting parties might be prevented from fully pursuing its
own separate interests.
In assessing the disclosure requirements, there is not a dollar amount materiality threshold per se and
companies must also evaluate qualitative factors. Related party transactions are not required
disclosures in situations where the transactions are eliminated in the consolidated financial statements.

WHEN ARE SEGMENT DISCLOSURES REQUIRED?
GAAP requires disclosure of operating segment information under ASC 280, Segment Reporting
(formerly FAS No. 131). The framework for identifying segments under ASC 280 is a “management
approach” based on the way management organizes the company in making operating decisions and
evaluating operating results. Segments may be organized by line of business, division, geography, end
markets, customer, etc. As a result, this information is often disparate across companies since it’s
disclosed based on how management organizes the company for decision making.
Under GAAP, an operating segment is a component of a business when:
1. It engages in business activities from which it may earn revenues and incur expenses;
2. Its operating results are regularly reviewed by the enterprise’s chief operating decision maker to
make decisions about resources to be allocated to the segment and assess its performance; and
3. For which discrete financial information is available.
GAAP further classifies a segment as a “reportable segment” (that must be disclosed) if it meets the
aforementioned operating segment definition and at least one of the three following quantitative
thresholds.
a. Its assets are 10% or more of the combined assets of all operating segments.
b. Its reported revenue, including both sales to external customers and intersegment sales or
transfers, is 10% or more of the combined revenue (internal and external) of all reported
operating segments; and/or
c. The absolute amount of its reported income or loss is 10% or more of the greater, in absolute
amount, of (1) the combined reported profit of all operating segments that did not report a loss or
(2) the combined reported loss of all operating segments that did report a loss.
If a segment is a reportable segment, GAAP requires certain disclosures. First, a measure of income or
loss and total assets is a required disclosure for each reportable segment. Second, disclosure of the
following items is required if it is included in the company’s measure of segment profit or loss reviewed
by the company’s chief operating decision maker:
1. Revenue from external customers;

2. Revenue from transactions with other operating segments of the same company;
3. Interest income;
4. Interest expense;
5. Depreciation, depletion, and amortization expense;
6. Equity income/loss;
7. Income tax expense/benefit;
8. Impact of items in earnings that are unusual in nature or occur infrequently but not both;
9. Extraordinary items;
10. Significant non-cash items other than depreciation, depletion, and amortization expense;
11. Type of product or service from which each reportable segment derives its revenues; and
12. Factors used to identify the enterprise’s reportable segments, including the basis for organization
(products, services, geographic).

WHEN ARE SEGMENT DISCLOSURES REQUIRED? (CONTINUED)
Additionally, GAAP requires several reconciliations in the segment disclosures:
1. The total of the reportable segment’s net revenues to the company’s consolidated net revenues;
2. A reconciliation of the total of the reportable segments’ measures of profit or loss to the
company’s consolidated income from continuing operations;
3. The total of the reportable segment’s assets to the enterprise’s consolidated assets; and
4. The total of the reportable segments’ amounts for every other significant item of information
disclosed to the corresponding consolidated amount.
Besides segment disclosures, geographical disclosures are required for the following items:
1. Total domestic revenues;

2. Total revenues from all other foreign countries;
3. Revenues from individual countries, if material (materiality not defined in ASC 280); and
4. Long-lived assets (i.e., PP&E) in the company’s home country, in all other foreign countries, and
in individual countries, if material.
GAAP also requires disclosure of large customers if a customer is 10% or more of the company’s
revenues. The customer’s percentage of the firm’s total revenues and the identity of the segment or
segments reporting the revenues must be disclosed. Notably, the specific customer is not required to be
disclosed, so sometimes companies will list the disclosure as Customer A, B, C, etc. along with the
customer’s specific percentage of the total firm’s revenues. The customer percentage of a certain
segment’s revenue is not required to be disclosed.
Unfortunately, ASC 280 does not define the profit or loss measure required to be disclosed (e.g.,
operating income, EBIT, EBT, net income, etc.). Therefore, any measure is allowed to be used as the
segment measurement of profit or loss insofar as it’s used by management for internal decision making.
GAAP also allows segment information to be reported under different accounting methods than is used
in the consolidated GAAP financial statements (e.g., LIFO vs. FIFO). However, the amount reported for
each segment item must be the same amount reported to the chief operating decision maker used to
allocate resources and measure the segment’s financial performance.
Any adjustments, eliminations and allocations of revenues, expenses, gains, and/or losses are included
in the segment’s earnings only if they are included in the earnings measure used by the chief operating
decision maker. These items could vary. For example, a company reports LIFO inventory for external
reporting purposes and uses the FIFO inventory costing method for internal performance measurement
purposes. If amounts such as corporate overhead and other costs are allocated to reported segments,
GAAP requires such items to be allocated to segments on a “reasonable basis.” To be sure, this is open
for management’s interpretation and, thus, we often find different cost allocations across companies. We
are also cautious in how allocations are calculated across companies since the information is used by
the chief decision maker internally and is a likely input into evaluating the performance and
compensation of company management. This creates a large financial incentive among internal
managers to report high segment profits.
If segments change, GAAP requires restatement of prior-period comparative information for the new
segments unless it is impracticable. If segment information for earlier periods is not restated, companies
are required to disclose the segment information in the current year on both its current year segment
basis and its old segment basis unless it is impracticable. Notwithstanding comparable restated segment
information, the newly reorganized segment disclosures may still be used to mask slowing growth.
ARE THERE CHANGES TO SEGMENTS?
Management has discretion in choosing if, or when, they change their internal organizational structure
and how the chief operating decision maker analyzes the segment’s operating performance. While
changing segments is often undertaken for a specific business purpose, such as a change in customer
patterns or recent acquisitions, it still may be used as an artifice to mask slowing growth. As an example,
a highly acquisitive company acquires another business and consolidates the acquired business into an
existing operating segment, boosting revenues.
Fortunately, GAAP requires companies to disclose if they change segments and we view this alone as a
yellow flag. To provide an example of the different types of GAAP segment disclosures, in the next
exhibit, we present Microsoft's operating segment and geographical disclosures.

Microsoft (2012 Form 10-K): Segment and Geographic Information

Microsoft (2012 Form 10-K): Segment and Geographic Information (continued)

EXCESSIVE COST CAPITALIZATION ON THE BALANCE SHEET?
A careful reading of the 10-K footnotes is important in searching for signs of improper cost capitalization
and accounting policy choices that may impact earnings comparability across companies. Improperly
capitalizing normal operating costs on the balance sheet has been one of the most common areas of
accounting fraud. The incentives are large. By capitalizing costs and expensing them over time in
earnings, a company reports higher earnings in the short-term. One of the classic illustrations of
improper cost capitalization was WorldCom. The company improperly capitalized “line costs” as capital
expenditures in PP&E on the balance sheet instead of expensing them as operating costs. In turn, the
line costs were depreciated as an expense over a longer period of time. On the cash flow statement,
these “line costs” were shown as capital expenditures and “other” amounts within the investing section
of the cash flow statement. This resulted in permanently overstated operating cash flow since the capital
expenditures are expensed as depreciation and the latter is added back to operating cash flow when it
occurs.
COST CAPITALIZATION: COMPARABILITY

Expenditures for long-lived assets are typically “capitalized” into the asset’s cost on the balance sheet if
they are expected to provide future benefits more than one year. The accounting theory behind this
concept is the matching principle, which attempts to match revenues with costs incurred to generate the
revenues. Cost capitalization does not need to be improper to impact comparability and GAAP actually
requires cost capitalization in certain situations. However, there are grey areas where companies may
have a choice of cost capitalization.
Mechanically, capitalizing a (accumulating) cost on the balance sheet increases an asset account, such
as PP&E or other current/non-current assets. By capitalizing costs, the company’s reported earnings are
higher since all these costs are not expensed through earnings in the current period. The cash outflow
associated with the asset increase is reported on the cash flow statement as a cash outflow either in the
operating, investing, or financing section. If the cash outflow for the capitalized cost is classified in
operating cash flow, cost capitalization does not distort operating cash flow (another reason to analyze
cash flow rather than earnings). On the other hand, if the cash flow effect of the asset increase is shown
as an investing cash outflow on the cash flow statement, this classification permanently overstates
operating cash flow.
Subsequently, when capitalized costs are expensed (as depreciation or other costs), this lowers
earnings but the expense is non-cash in the current period and is added back to operating cash flow.
Therefore, operating cash flow remains unchanged. This is one of the shortcomings with alternative
measures of cash flow, such as EBITDA or even operating cash flow. Free cash flow is the only
measure correcting for different cost capitalization practices across companies. Even with free cash flow
measures, analysts need to be careful in deducting other investing cash outflows that may be cap-ex
substitutes or other recurring investing cash outflows (e.g., software capitalization).
COST CAPITALIZATION: EXAMPLE

The next exhibit is an illustration of the financial statement impact of improperly capitalizing costs in
PP&E instead of expensing them. We illustrate this with the scenario of a $500 expense capitalized as a
5-year asset, assuming straight line depreciation.
In Year 1, expense capitalization increases earnings and operating cash flow compared to the company
immediately expensing costs. However, free cash flow is the same under either scenario.
EXCESSIVE COST CAPITALIZATION ON THE BALANCE SHEET? (CONTINUED)
In Year 2, under the cost capitalization scenario, earnings are lower from $100 of non-cash depreciation
expense compared with $0 of depreciation expense under the immediate expensing scenario (the entire
amount was expensed in Year 1). Both operating cash flow and free cash flow are the same in Year 2
under both scenarios. The same dynamic will occur through Years 3 through 5 (not shown).
Example: Cost Capitalization vs. Immediate Expensing
CAPITALIZE EXPENSE
Year 1 Year 2 Year 1 Year 2
Income Statement
Revenue $1,000 $1,000 $1,000 $1,000
Expenses 0 0 500 0
Depreciation 100 100 0 0
Net income 900 900 500 1,000
Statement of Cash Flow

Depreciation 100 100 0 0
Cash flow from operations $1,000 $1,000 $500 $1,000
PP&E (500) 0 0 0
Cash flow from investing ($500) $0 $0 $0
Free cash flow $500 $1,000 $500 $1,000
Balance Sheet
Retained earnings $900 $1,800 $500 $1,500
COST CAPITALIZATION DISCRETION FOR CERTAIN EXPENSES: WATCH OUT!

In the next several sections, we discuss situations in which GAAP requires cost capitalization and where
management has flexibility in capitalizing costs:
INTEREST COST
GAAP (ASC 835, Interest - Capitalization of Interest [formerly FAS No. 34]), requires interest from debt
used to finance long-term assets to be capitalized into the asset’s cost on the balance sheet (e.g.,
PP&E). Since cash is fungible, there is subjectivity is specifically assigning debt to long-term projects
and, thus, its capitalization. Further, some companies may choose to fund projects with internally
generated cash flow or finance the assets differently. This impairs comparability across companies.

There are several financial statement impacts from capitalizing interest. First, capitalized interest
expense is never recognized under the interest expense caption on the income statement. Since the
interest expense amount is included in the asset’s cost, it is subsequently expensed as depreciation
expense over the life of the long-term asset. On the cash flow statement, the initial cash interest
expense outflow is shown in the section of the related asset’s cash cost outflow. Since capitalized
interest usually relates to PP&E assets, it is included as part of capital expenditures in investing cash
flow. This is why creditors also focus on cash interest expense in calculating debt coverage ratios since
reported interest expense in the income statement is understated if interest cost is capitalized. When
using operating cash flow or net income metrics, there will also be non-comparability across companies
when one company chooses to finance long-term assets with debt while another company finances
assets with equity or cash. Using Verizon’s 2012 10-K disclosure, in the next exhibit, we illustrate
capitalized interest expense.
Verizon (2012 Form 10-K): Interest Expense / Capitalized Interest
Total interest costs on debt balances decreased during 2012 compared to 2011 primarily due to a $2.7 billion decrease in average debt
(see "Consolidated Financial Condition") and a lower effective interest rate. Capitalized interest costs were lower in 2012 primarily due to
our ongoing deployment of the 4G LTE network.
Total interest costs on debt balances decreased during 2011 compared to 2010 primarily due to a $1.6 billion decrease in average debt
(see "Consolidated Financial Condition") and a lower effective interest rate. Capitalized interest costs were lower in 2011 primarily due to
our ongoing deployment of the 4G LTE network.
SOFTWARE DEVELOPMENT FOR EXTERNAL SALE

GAAP requires capitalization of internal software development once so-called technological feasibility is
reached (ASC 985-20, Costs of Software to be Sold, Leased, or Marketed [formerly FAS No. 86]). While
this may sound simple, there is considerable discretion in identifying the point at which technological
feasibility is reached.

We find this dynamic currently among the video game companies. Electronic Arts (EA) expenses all
software development costs and discloses that technological feasibility occurs very late in the software
development process. Other competitors maintain that they reach technological feasibility earlier in the
video game development phase and capitalize a larger amount of software development costs. This
impacts the comparability of earnings across the industry group. Since the changes in software
development assets are shown in operating cash flow, cash flow is comparable across the companies.
However, not all companies classify changes in the software development cost asset in operating cash
flow. In the next exhibit, we show how Synopsys’ capitalized software development costs are classified
in investing cash flow. We believe such costs should be reclassified as a cash operating cost in
operating cash flow.
Synopsys (2012 Form 10-K): Statement of Cash Flows – Investing Section
INTERNAL USE SOFTWARE

GAAP requires internal use software costs to be capitalized as an asset and amortized over their useful
life typically 3 to 5 years (ASC 350-40, Internal-Use Software [formerly Statement of Position 98-1]).
Training costs are always immediately expensed. ASC 350-40 classifies internal use software
development costs into three separate stages:
(1) Preliminary Project Stage: The first stage includes the conceptual formulation and evaluation of
alternatives leading up to the determination that the development of the software will begin. Costs
incurred during this stage are expensed immediately.
(2) Application Development Stage: Once the second stage begins, costs are capitalized on balance
sheet. Such costs/activities include but are not limited to design, coding, hardware installation,
and testing. Once the software is ready for its intended use and substantial testing is completed,
companies move to the Post-Implemental Operating Stage.
(3) Post-Implementation Operation Stage: When the Post-Implementation/Operation Stage begins,
maintenance costs are expensed while upgrades that add functionality are capitalized into the
asset account.
LOSS RESERVES
A company may encounter an uncertain loss or other potential liability and, therefore, a careful reading
of the 10-K’s loss contingency footnote disclosures may highlight potential future legal and other losses.
This footnote is typically qualitative and vague. Under GAAP, the loss is recorded as an accrued liability
(reserve) if it is both probable (generally interpreted to mean at least a 70% chance of occurring) and
reasonably estimable (FAS No. 5, Accounting for Contingencies). We find that unexpected negative
surprises occur more often when a loss reserve isn’t recorded because it is not probable and estimable.
In this scenario, GAAP requires the following:
• If a loss is only reasonably possible, GAAP requires a qualitative disclosure of the loss and an
estimate or range of the potential loss. No loss reserve is recorded on the balance sheet.
• If a range of possible losses exists, the most probable loss is recorded as an expense and
accrued liability.
• In a scenario when losses are not estimable with any certainty or contain an equal probability of
occurring, GAAP requires an accrued liability to be recorded for the lowest contingency amount
within the range of possible outcomes.
• If amounts are not estimable, a company must disclose this fact.
Management teams try to shift blame and don’t often record losses until a lawsuit is resolved. Therefore,
this section should be reviewed for unexpected, large cash outflows associated with unfavorable lawsuit
outcomes.

OTHER THAN TEMPORARY IMPAIRMENTS
In this next section, we review the accounting rules for other than temporary impairments of underwater
marketable debt securities. First, we review the accounting rules for marketable securities. FAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities categorizes investments in debt and
equity securities into: (1) trading, (2) available-for-sale (“AFS”), and (3) held-to-maturity (“HTM”). AFS is
the largest category on corporate balance sheets. Under GAAP, trading and AFS securities are
recorded at fair value on the balance sheet. Conversely, HTM securities are recorded on the balance
sheet at amortized cost. GAAP requires an additional stipulation for a security to be classified as HTM
as a company must have both the intent and ability to hold the security until maturity. Equity securities
by their very nature cannot be classified as HTM. Since trading and AFS securities are marked to
market each period even though they may not have been sold, GAAP requires different classification of
unrealized gains and losses. Trading securities’ unrealized gains and losses are recorded in earnings
each period. Available-for-sale securities’ unrealized gains or losses are not recorded through earnings,
but instead recorded in shareholder’s equity in the other comprehensive income (“OCI”) account. Held-
to-maturity securities’ unrealized gains or losses are not recorded on the balance sheet since they are
not marked to fair value.
GAAP requires companies to assess AFS and HTM investments for other-than-temporary impairments
(“OTTI”) each period. This also includes any cost and equity method investments. While many
companies hold debt securities, this issue is most germane to financial institutions holding large
securities’ portfolio. The rules governing GAAP OTTI rules changed in April 2009 when FASB issued
new accounting guidance on determining if an underwater debt security should be impaired as a loss
through earnings (FSP FAS No. 115-2 and FAS No. 124-1). The OTTI rules require an unrealized loss
to be recognized as a permanent write-down through earnings if any of the following conditions are met:
(a) The company has the intent to sell the debt security;
(b) There is a greater than 50% chance that the company will be required to sell the debt security
before its anticipated recovery in value; or
(c) The company does not expect to recover the security’s entire amortized cost basis (credit loss).
Under the OTTI impairment model, a company will always record an impairment loss related to the
credit component of the marketable debt security’s unrealized loss in earnings. The other portion of the
unrealized market security loss (that is due to non-credit, such as liquidity) is recorded in earnings only if
either (a) or (b) of the aforementioned criteria is met. Otherwise, the unrealized loss stays in equity in
other comprehensive income until the security is sold or otherwise disposed of.
The GAAP test for ascertaining if there is a credit loss is expected cash flow. Under this test, FASB rules
require the company to compare the present value of the cash flows that are expected to be collected
from the security to its amortized cost basis. The expected cash flows are discounted at the effective
interest rate implicit in the security at acquisition date. Under GAAP (FSP FAS No. 115-2), the difference
between the present value of cash flows expected to be collected and the security’s amortized cost
basis is recorded as the credit loss. This test is highly subjective and difficult for auditors to assess since
it’s based on management’s expectations of future cash flow. Consequently, this allows companies wide
latitude in pushing out impairment losses into future periods.

OTHER THAN TEMPORARY IMPAIRMENTS (CONTINUED)
To assist companies in evaluating possible OTTI losses, GAAP includes guidance on factors companies
should use in assessing whether a credit loss exists:
• The length of time and extent to which fair value of the investment has been below its cost basis.
• Adverse conditions specifically related to the security, a geographic area or an industry.
• Historical and implied volatility of the security’s fair value.
• The debt security’s payment structure.
• Any changes in the security’s credit rating.
• Failure of the issuer of the security to make scheduled interest or principal payments.
• Recoveries or additional declines in the security’s fair value after the most recent balance sheet
date.
If a company determines that an OTTI has occurred, the security is written down to fair value and a loss
is recognized in earnings (or recognized partially in OCI as previously discussed). If events change and
the security later recovers in value, GAAP does not allow it to be written-up to its new fair market value.
Instead, the loss is “recycled” through income as the written down amount is accreted up to its par value
amount through higher (non-cash) interest income.
As an example of other than temporary impairment losses and related disclosures for marketable debt
securities, the next exhibit is FBL Financial Group’s 2012 OTTI disclosure. There were $26.4 million of
OTTI charges in 2012, of which $9.4 million were recorded in AOCI as non-credit, and the remainder in
earnings (net ~$17 million).
First Financial Holdings (2011 Form 10-K): Other-Than-Temporary Impairment Disclosure
Realized Gains (Losses) on Investments
Year ended December 31,

2012 2011 2010
(Dollars in thousands)
Realized gains (losses) on investments:
Realized gains on sales $ 18,047 $ 5,818 $ 21,918

Realized losses on sales (568 ) (463 ) (526 )
Total other-than-temporary impairment charges (26,399 ) (20,206 ) (30,637 )
Net realized investment losses (8,920 ) (14,851 ) (9,245 )
Non-credit losses included in accumulated other comprehensive income (loss) 9,372 6,555 20,821
Total reported in statements of operations $ 452 $ (8,296 ) $ 11,576

OTHER THAN TEMPORARY IMPAIRMENTS (CONTINUED)
MARKETABLE SECURITIES: REVIEW UNDERWATER AMOUNTS TO AVOID SURPRISES
A quick review of a company’s underwater marketable security disclosure is helpful in avoiding any
unexpected future security write-downs. GAAP requires at least annual tabular disclosure of investments
that have been in a continuous unrealized loss position for less than 12 months and investments in a
continuous unrealized loss position greater than 12 months. The schedule is usually classified by the
type of security, such as treasury bonds, corporate bonds, MBS, municipal bonds, etc. Companies are
further required to provide commentary on why they view these losses as only temporary and do not
necessitate an OTTI.
In the next exhibit, we illustrate Allstate’s 2012 disclosure of marketable securities’ unrealized losses.
Based on an analysis of this disclosure, Allstate had $76 million of continuous unrealized losses on
marketable securities less than 12 months old and $488 million in continuous unrealized losses of 12
months or longer.
Allstate (2012 Form 10-K): Unrealized Losses on Marketable Securities
($ in millions)
Less than 12 months 12 months or more
Total
Number Fair Unrealized Number Fair Unrealized Unrealized
of issues value losses of issues value losses losses
December 31, 2012
Fixed income securities

U.S. government and agencies 6$ 85 $ — — $ — $ — $ —
Municipal 130 1,012 (13) 80 717 (95) (108)
Corporate 133 1,989 (33) 70 896 (94) (127)
Foreign government 22 190 (1) — — — (1)
ABS 12 145 (1) 77 794 (106) (107)
RMBS 117 50 (1) 336 638 (109) (110)
CMBS 11 68 — 44 357 (77) (77)
Redeemable preferred stock — — — 1 — — —
Total fixed income securities 431 3,539 (49) 608 3,402 (481) (530)
Equity securities 803 284 (27) 96 69 (7) (34)
Total fixed income and equity securities 1,234 $ 3,823 $ (76) 704 $ 3,471 $ (488) $ (564)
Investment grade fixed income securities 387 $ 3,141 $ (39) 409 $ 2,172 $ (217) $ (256)
Below investment grade fixed income securities 44 398 (10) 199 1,230 (264) (274)
Total fixed income securities 431 $ 3,539 $ (49) 608 $ 3,402 $ (481) $ (530)

WATCH FOR LARGE RESERVES AND RESERVE REVERSALS
10-K footnotes provide detail on the composition and changes in reserve accounts. A careful review of
these disclosures is warranted as companies have been known to use reserves to manage earnings in
what is known as “cookie jar” accounting. This occurs when a company reverses an accrued liability or
contra asset account (e.g. bad debt reserve which is netted against accounts receivable) as a gain in
earnings. Another variation of this is “big bath” accounting in which a company records a very large
charge in earnings by writing down assets and recording various reserves. If the charge is excessive, in
a subsequent period, GAAP requires the reserve to be reduced / eliminated and companies have
discretion in choosing when to reverse it as a gain in earnings. Common reserves include bad debts,
restructuring, warranty, sales discounts, worker’s compensation, taxes, and legal. Mechanically, GAAP’s
matching principal requires an expense to be recorded in the same period in which revenue is
recognized and a loss recorded when both probable and estimable even though there is still uncertainty
over the exact timing and amount of the loss.
We suggest reviewing the reserve accounts footnote disclosure for:
(1) Reserve Reversal Gains: Check to make sure a material amount of excess reserves were not
reversed as a gain in earnings. The SEC now requires quarterly and annual detailed activity of
restructuring reserves, frequently presented in a reconciliation table as we illustrate in the next
exhibit.
(2) Under Reserving To Boost Earnings in the Current Period: A company might choose to under
expense recurring costs such as warranty or sales returns to boost current period earnings. Since
this account will need to be replenished in a future period, the company may encounter higher
costs in future years. We suggest reviewing the current period expense amount and comparing it
to historical trends. This analysis isn’t as applicable to restructuring accruals since, by definition,
they should be episodic.

WATCH FOR LARGE RESERVES AND RESERVE REVERSALS (CONTINUED)
One specific disclosure is the restructuring reserve table. We suggest reviewing it for material reserve
reversals into earnings. While GAAP technically requires excess reserves to be recorded as a gain in
earnings, they are low quality. Therefore, we suggest excluding them from normalized earnings. We also
find this specific disclosure useful in assessing future cash restructuring costs for severance, closing
facilities, etc. As an example of the restructuring 10-K disclosure, we reproduced Goodyear Tire’s
disclosure in the next exhibit. During 2012, $178 million of new charges were recorded in earnings while
$3 million was reversed. $107 million is reported as incurred, which means that the related cash was
paid to settle the previously accrued liability.
Goodyear Tire (2012 Form 10-K): Restructuring Disclosure
(In millions) Associate-related Costs Other Costs Total
Balance at December 31, 2009 $ 120 $ 25 $ 145
2010 charges 237 24 261

Incurred (129 ) (26 ) (155 )
Reversed to the Statement of Operations (16 ) (5 ) (21 )
2011 charges 60 46 106

Incurred (104 ) (45 ) (149 )
2012 charges 142 36 178

Incurred (77 ) (30 ) (107 )

WARRANTY RESERVES MAY BE A SOURCE OF EARNINGS GROWTH
Accounting for warranty reserves is an area of significant management judgment. A company might
choose to under-accrue warranty expense in the current period to increase earnings. However, if
warranty costs haven’t economically changed, the company will need to replenish the reserve and face
higher costs in future periods. Since this account is very subjective, we find it to be a relatively easy area
with which for management to make changes.
GAAP requires companies to disclose a roll forward of the warranty balance, if material. The disclosure
should be analyzed in a similar way as any other reserve account. To that end, we compare the ending
warranty reserve balance to revenues and would expect a fairly constant ratio unless something
significant has changed in the business. We also look for any warranty reserve gains (reversals) that
would have increased EPS (changes in estimates and other). Further, we compare the accruals for
product warranties (the amount expensed in earnings) to the payments on a current year basis and with
a one year lag (current year expense to prior year payments). If a company has been consistently
expensing higher warranty cost than payments, it may reflect a management tone of conservatism. As
an example of the warranty reserve disclosure, below is Cummins.
Cummins (2012 Form 10-K): Warranty Reserve
NOTE 11. PRODUCT WARRANTY LIABILITY
We charge the estimated costs of warranty programs, other than product recalls, to income at the time products are shipped to
customers. We use historical claims experience to develop the estimated liability. We review product recall programs on a quarterly basis
and, if necessary, record a liability when we commit to an action or when they become probable and estimable, which is reflected in the
provision for warranties issued line. We also sell extended warranty coverage on several engines. The following is a tabular reconciliation
of the product warranty liability, including the deferred revenue related to our extended warranty coverage and accrued recall programs:
December 31,
In millions
2012 2011
Balance, beginning of year $ 1,014 $ 980
Provision for warranties
issued 415 428
Deferred revenue on
extended warranty
contracts sold 210 124
Payments (416) (409)
Amortization of deferred
revenue on extended
warranty contracts (103) (95)
Changes in estimates for

pre-existing warranties (33) (7)
Foreign currency
translation 1 (7)
Balance, end of year $ 1,088 $ 1,014

ARE THERE UNDERREPORTED ACCRUED EXPENSES / ACCOUNTS PAYABLE
Are part of a 10-K footnote review and balance sheet analysis, we think it’s important to analyze accrued
expenses and payables for possible signs of business issues. Below is a summary checklist of items.
 Read the MD&A section of the 10-K for changes in accrued expense policies.
 Calculate the change in accrued expenses to the change in revenue. Detail of accrued expenses
is typically disclosed annually, or more frequently, if the account is large and there have been
large changes. The best method is to compare the most granular account changes year-over-
year or period-over-period (salary accrual, marketing accrual, warranty, accrual, etc.). We
suggest comparing each detailed accrued expense item, if available, to its underlying driver (e.g.,
bonus accrual to sales).
 Calculate and analyze the days payable ratio (payables / cost of goods sold x 365 days). This
ratio calculates the number of days required to pay vendors based on cost of goods sold.
 Compare the percentage change in inventory to the percentage change in accounts payable.
Over the long-term, the two accounts should move in tandem since the growth in payables should
match the growth in inventory. Any large differences in this relationship may signal issues. The
relationship of inventory growing and payables declining is most concerning to us as it may signal
finished goods have been piling up while the company has reduced the purchase of new raw
material inputs (the latter of which would drive the decrease in accounts payable).

ACCOUNTING FOR LEASES
The economics of “operating” and “capital” leases are similar, but the accounting for each type of lease
differs under GAAP accounting. ASC 840, Leases (formerly FAS No. 13), outlines four bright line rules
to determine whether a lease should be classified as a capital lease or not. If a lease meets at least one
of the following four tests, then it should be classified as a capital lease:
1. The lease conveys ownership to the lessee at the end of the lease term;
2. The lessee has the option to purchase the asset at a bargain price at the end of the lease term;
3. The term of the lease is 75% or more of the asset’s economic life; and
4. The present value of the minimum lease payments is 90% or more of the asset’s fair market
value.
Due to operating and capital lease accounting differences, most management teams decide to structure
leases as off-balance sheet operating leases (we’ve estimated that <10% of all leases are classified as
capital leases), resulting in lower leverage ratios for the company.
Below, we’ve reproduced Discover’s lease commitments footnote disclosure.
Discover Financial Services (2012 Form 10-K): Commitments, Contingencies, and Guarantees
Lease commitments. The Company leases various office space and equipment under capital and non- cancelable operating leases which
expire at various dates through 2022. At November 30, 2012, future minimum payments on leases with original terms in excess of one
year consist of the following (dollars in millions):
Occupancy lease agreements, in addition to base rentals, generally provide for rent and operating expense escalations resulting from
increased assessments for real estate taxes and other charges. Total rent expense under operating lease agreements, which considers
contractual escalations, was $18 million, $16 million and $14 million for the years ended November 30, 2012, 2011 and 2010, respectively.

ACCOUNTING FOR LEASES (CONTINUED)
CAPITALIZING OPERATING LEASES FOR FINANCIAL ANALYSIS
With regard to going concern companies, we treat leases as debt-like given their contractual nature. The
rating agencies also consider and treat leases as debt. The future minimum lease payments for non-
cancelable operating leases must be disclosed by companies at least annually. There are two methods
to approximate lease payments as debt:
1. Calculate the NPV of the leases’ future minimum payments, discounted at the company’s
marginal borrowing rate; or
2. Multiply the total lease payment by 7 or 8 to approximate the debt and asset amounts, which was
developed by the rating agencies in the 1980s.
Below, we’ve reproduced Starbucks’ lease commitments footnote disclosure, and follow with an
example of adjusting the financial statements by capitalizing leases.
Starbucks (2012 Form 10-K): Rental Expense and Future Minimum Lease Payments Disclosures
Rental expense under operating lease agreements (in millions):
Fiscal Year Ended Sep 30, 2012 Oct 2, 2011 Oct 3, 2010
Minimum rentals $ 759.0 $ 715.6 $ 688.5
Contingent rentals 44.7 34.3 26.1
Total $ 803.7 $ 749.9 $ 714.6
Minimum future rental payments under non-cancelable operating leases as of September 30, 2012 (in millions):
Fiscal Year Ending
2013 $ 787.9
2014 728.5
2015 640.4
2016 531.5
2017 403.4
Thereafter 968.5
Total minimum lease payments $ 4,060.2

Below we present the alternative calculations to capitalize operating leases for financial statement
analysis. For the first approach, the NPV of Future Minimum Lease Payments (NPV method), the
disclosed schedule of non-cancelable minimum lease payments will be used as a basis. Using the
company’s marginal cost of debt (we assume 10% for presentation purposes) the net present value of
each year’s payment is calculated. As only the first five years of payments are required to be discretely
disclosed, the “thereafter” amount is allocated to future years based on an assumed run-off keeping the
value of the most recent discretely disclosed year (we use the $403 million disclosed for 2017 to assume
2018-2020). These calculations result in an estimated net present value of future minimum lease
payments of $2.9 billion.
The alternative method is the 8x approach. This approach is somewhat more simple as it is calculated
by taking an 8x multiple of the next year’s rental expense. A 7x multiple is also commonly used which
would infer a slightly higher discount rate. Additionally, the methodology may be adjusted to include
contingent rentals or other recurring, but technically not “non-cancelable” or “minimum” lease payments
that should be capitalized. In the example below, this method results in a capitalized lease amount of
$6.1 billion.
Starbucks Capitalization of Leases Alternatives
NPV of Future Minimum Lease Payments Approach

Discount Factor
Fiscal Year Rent Expense Assuming 10% Rate NPV
2013 788 1.10 716
2014 729 1.21 602
2015 640 1.33 481
2016 532 1.46 363
2017 403 1.61 250
Thereafter 969
2018 403 1.77 228

2019 403 1.95 207
2020 162 2.14 75
Net Present Value of Future Minimum Lease Payments 2,923
8x Rent Expense Approach

2013 Rent Expense (Present Value) 716
Assumed contingent rentals (same as 2012 amount) 45
Total 2013 Rent Expense 761
8x 2013 Rent Expense 6,088
Note: assumes year-end rental payment date for NPV purposes.


Analytically, the capitalized leases amount calculated above would be considered debt and asset like,
and the financial statements can be adjusted. In doing so, new leverage ratios and enterprise value
ratios can be calculated using the adjusted debt and assets amounts. Below, we compare the adjusted
debt and PP&E levels using the lease capitalization alternatives.
Starbucks Capitalization of Leases Alternatives
NPV Approach 8x Approach

2012 2012
Total short-term and long term debt reported 550 550
Add: Capitalized operating leases 2,923 6,088
=Total adjusted debt 3,473 6,637
Reported Property, Plant and Equipment 2,659 2,659

Add: Capitalized operating leases 2,923 6,088
=Total adjusted P,P&E 5,582 8,747
2012 EBITDA 2,382 2,382

Add: 2012 Rent Expense 804 804
2012 EBITDAR 3,185 3,185
Future minimum lease payments, which are often based on revenue, do not include cancelable leases
or contingent rentals, and therefore, will be understated if a company uses renewable short-term leases
or contingent rentals based on future revenue. These nuances make minimum lease payment
comparability an issue; different companies with different types of leases may report vastly different
minimum lease payment numbers in their footnotes. Since future minimum lease payment disclosures
exclude contingent rentals and don’t assume lease renewal options, we usually use the second method
of capitalizing leases (7-8x total rent expense) on the balance sheet as debt.
CAPITAL LEASES UNDERSTATE CAPITAL EXPENDITURES

Under capital lease accounting, the lease obligation and related asset are recorded at inception, but
there is no cash flow / cash flow statement impact. The capital leased asset is depreciated over its
useful life as a non-cash depreciation expense. There is a corresponding obligation payment each
period consisting of interest expense and reduction in lease obligation principal (similar to a typical
amortizing loan payment). The principal portion of the lease obligation is recorded as a cash outflow
from financing, while the interest expense lowers a company’s earnings and cash flow from operations.
Compared to companies traditionally buying assets as capital expenditures, capital leases skew
reported EBITDA and free cash flow metrics because interest and depreciation are added back to
EBITDA. Capital leases are more similar to an asset purchase financed with debt, resulting in a
financing cash inflow.
Since GAAP understates capital expenditures (no cash outflow shown on the cash flow statement) for
companies using capital leases, we suggest adding new capital leases to capital expenditures. In doing
this, we believe that the cash flows will be more comparable, irrespective of a company’s financing
policy, and that you arrive at a better free cash flow number.

Next we compare Amazon.com's new capital leases versus the company’s capital expenditures and
calculate the adjusted cap-ex numbers over the past seven years.
Amazon.com (2012 Form 10-K): Capital Leases vs. Capital Expenditures from the Cash Flow Statement ($ in millions)
2006 2007 2008 2009 2010 2011 2012

Capital expenditures $216 $224 $333 $373 $979 $1,811 $3,785
New capital leases 69 89 220 335 577 1,012 831
Adjusted capital expenditures 285 313 553 708 1,556 2,823 4,616
New capital leases / cap-ex 32% 40% 66% 90% 59% 56% 22%
To further demonstrate the effects of including capital leases as capital expenditures, we adjust
Amazon.com’s free cash flow to the firm (“FCFF”) by deducting new capital leases signed over the same
six year time period.
Amazon.com (2012 Form 10-K): Adjusted Free Cash Flow to the Firm Calculations ($ in millions)
Amazon.com 2006 2007 2008 2009 2010 2011 2012
Operating cash flow $702 $1,405 $1,697 $3,293 $3,495 $3,903 $4,180
Less: cap-ex 216 224 333 373 979 1,811 3,785
Reported free cash flow 486 1,181 1,364 2,920 2,516 2,092 395
Add: after-tax interest expense 51 50 46 22 24 42 60

Reported free cash flow to the firm 537 1,231 1,410 2,942 2,540 2,134 455
Less: new capital leases 69 89 220 335 577 1,012 831

Adjusted free cash flow to the firm 468 1,142 1,190 2,607 1,963 1,122 (376)
Adj. FCFF / Reported FCFF 87% 93% 84% 89% 77% 53% -83%
CAPITAL LEASES BOOST CASH FLOWS AND REDUCE CAP-EX

Given the four bright line tests for lease accounting, it is fairly simple for companies to structure new
leases as either capital or operating without altering the economics of the lease much. Therefore, some
management teams may choose to increase cash flow from operations and free cash flow by using
capital leases instead of operating leases. We believe that analysts should be wary of companies that
switch operating leases to capital leases given the resulting higher on-balance sheet leverage reported
from capital leases.
Assuming that one company’s operating lease payments (sometimes referred to as rent expense)
approximate another company’s capital lease payments, their operating cash flows are not comparable
since a different amount of expense is recorded under each scenario. Only the interest portion of a
capital lease payment reduces operating cash flow, whereas, under an operating lease, operating cash
flow is reduced by the entire lease payment.

NEW FASB AND IASB LEASE ACCOUNTING PROPOSALS
In August 2010, the FASB and IASB jointly issued an Exposure Draft proposal to overhaul lease
accounting, which we believe will capitalize most leases on balance sheet as an intangible asset (right to
use property) and debt and eliminate off-balance sheet operating lease accounting. The FASB and IASB
were hoping to issue a final standard in 2011; however, they did not do so and are currently in re-
deliberations. We believe that a final standard won’t be effective any time before 2014, at the earliest.
Under this proposal, a lessee who enters into a lease agreement would record a “right of use” lease
asset and a corresponding lease obligation on the balance sheet. These journal entries would occur
upon inception of the lease. The asset amount would be calculated as the present value of the future
lease payments plus any initial direct costs incurred by the lessee. The discount rate used to calculate
the lease’s present value would be based on the company’s incremental borrowing rate on the date of
the lease or the rate the lessor charges the lessee, if it can be readily determinable.
Incremental borrowing rate is defined as the interest rate that, on the day of inception, the lessee would
pay to borrow the funds necessary to purchase a similar underlying asset, over a similar time period.
Under the proposals, if the discount rate changes in a subsequent period, no remarking of the
asset/liability would occur. The right of use asset would be classified as if it were a tangible asset within
PP&E and evaluated for impairment at least annually. The liability to make lease payments would be
presented as a liability on the balance sheet.
LEASE ACCOUNTING PROPOSALS: FINANCIAL STATEMENT IMPACT

The financial statement impact of the proposed accounting changes for leases is summarized below.
Operating Leases Under Current and Proposed Accounting Rules
Financial Statement Current Accounting Proposed Accounting

Balance Sheet
Assets Nothing recorded Right of use lease asset recorded
Liabilities Nothing recorded Lease obligation recorded
Deferred Taxes No deferred taxes Deferred tax asset recorded (in general)
Income Statement Rent expense Amortization/depreciation expense

Interest expense
Statement of Cash Flows All operating outflows Amortization expense - operating outflow
Interest expense - operating outflow
Decline in lease obligation - financing outflow
Total change in cash Minimum lease payment (rent exp.) Minimum lease payment (principal + int.)

LEASE ACCOUNTING PROPOSALS: KEY FINANCIAL RATIO IMPACTS
Under current lease accounting, companies that use operating leases appear less levered than in reality
since their contractual lease payments are not captured as liabilities on the balance sheet. Not only do
companies using operating leases appear less levered, they also typically report better profitability ratios
(ROA, asset turnover ratio, etc.).
Operating cash flow, EBITDA, and EBIT would all most likely be higher under the new proposals than
currently reported numbers because rental expense would become separated into amortization and
interest expense.
The proposed lease accounting changes would impact financial ratios, measures of earnings, and cash
flow in the following manner:
Financial Ratio Impacts Under Current and Proposed Accounting Rules
Financial Statement Current Accounting Proposed Accounting

Enterprise value Lower Higher
ROA Higher Lower

ROE Typically higher Typically lower
Asset turnover Higher Lower
EBITDA Lower Higher

EBIT Lower Higher
Net income Typically higher Typically lower
Debt / Equity Lower Higher

Interest coverage Higher Lower
Cash from operations Lower Higher

Capital expenditures Understated Understated
Unlevered free cash flow Lower Higher
LEASE ACCOUNTING PROPOSALS: LOWER EARNINGS

Under the current treatment for operating leases, total lease expense includes the current period’s
minimum rental expense plus any amount of contingent rental expenses. The proposal suggests that the
total rental expense should instead be composed of interest expense on the lease obligation and the
amortization expense (similar to depreciation) on the right of use asset.
The total aggregate lease expenses recognized over the lease term would be the same as a current
operating lease. However, due to higher interest expense in the early years of a purchased asset, net
income would be lower in the earlier years under the proposal, reversing to a higher net income number
in later years.

LEASE ACCOUNTING PROPOSALS: MATERIAL IMPACT ON GROWTH COMPANIES’ EARNINGS
For most companies, the net income difference of a single operating lease based on current operating
lease accounting and the proposal reverses over time, usually a very long time (many years). This is
especially the case for growth companies adding new leases every year or companies that frequently
renew expiring leases.
It’s extremely difficult to generalize any possible earnings impact since it truly depends on what point
along the following graph a company is at. But due to the proposals, we believe that growth companies’
earnings could be 10-25% lower. The net income effect is smaller for mature companies or companies
with slowing growth and might actually be higher for companies that are shrinking. In the next exhibit, we
compare lease expense under the proposal and current accounting, using straight-line rent expense /
amortization.
Recorded Expenses Under Current and Proposed Accounting Rules
150
Proposed accounting:
Interest Exp. + Amortization
100
50
Interest Expense
Current accounting:
0 lease ~ rental expense
2000.05 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
-50
-100
-150
Time
Source: Wolfe Trahan Accounting & Tax Policy Research; FASB; IASB.
LEASE ACCOUNTING PROPOSALS: SUBSEQUENT ACCOUNTING FOR RENTAL EXPENSE

Operating lease rental payments are recorded as rent expense on a pay-as-you-go basis under current
accounting rules, whereas rent expense will become amortization and interest under the proposal. The
amortization will be calculated on the “right of use” asset and interest will be calculated on the lease debt
obligation.
The “right of use” asset will be amortized, straight-line, as an expense over the lease’s term and the
lease obligation will be reduced each period using the effective interest method, similar to a typical
mortgage amortization schedule. Besides this change, companies will continue paying their rental lease
expenses under the lease agreements with no changes to the leases’ economics.

LEASE ACCOUNTING PROPOSALS: SIMPLIFIED RETROSPECTIVE TRANSITION
Prior period financial statements would not be restated, but upon the new accounting standard’s initial
adoption date, the right of use asset and related lease liability would be measured as the present value
of remaining lease payments. These remaining lease payments would be discounted using the lessee’s
incremental borrowing rate on the adoption date.

CONVERTIBLE DEBT
Convertible bond accounting has become complicated in recent years due to increasingly complex
instruments and a desire to massage the terms of the instruments to achieve a favorable accounting
result (i.e., avoid including shares in EPS calculations). Two economically similar instruments may be
accounted for in different ways across companies depending on how the convertible debt is settled upon
conversion. Convertible bonds are now accounted for in one of two ways depending on their terms,
specifically how the convertible bond is settled upon conversion:
1. Plain vanilla straight convertible bonds. Bonds that are solely convertible into stock or may be
converted into stock and/or cash at the company’s option are accounted for under the “if
converted” method for diluted EPS calculations. We discuss the EPS treatment for convertible
bonds later in this section. For balance sheet purposes, the convertible debt is recorded on the
balance sheet at its issuance price (generally par) and interest expense is recorded in earnings at
the convertible bond’s coupon rate. This was fairly simple accounting until a new innovation
appeared in the convertible bond market in 2005 as discussed next.
2. Cash settled (net-share settled) principal convertible bonds. In 2005, a new innovation
appeared in the convertible bond market as companies began issuing cash-settled principal
convertible bonds (also referred to as treasury stock bonds or net share settled bonds). Cash
settled principal convertible bonds’ indenture require that, upon conversion or at maturity, the
bond’s principal amount must be settled in cash and the excess amount of the conversion value
(stock price x # shares convertible into) over the bond’s principal amount may be settled in either
stock or cash at the company’s option. One of the reasons for their increased usage was the
favorable accounting EPS benefits afforded to them as the more favorable “treasury stock
method” is used to calculated diluted EPS rather than the “if-converted” method.
Over concerns that companies were issuing these instruments at low interest rates due to the
conversion feature and including no shares in diluted EPS until the bond was converted, FASB changed
the accounting rules for cash settled principal convertible bonds at the beginning of 2009. The rules did
not change for convertible bonds that are solely convertible into stock. New FSP APB 14-1 changed the
accounting treatment for cash-settled principal convertible debt by requiring “bifurcation accounting”.
The new rules require GAAP interest expense to be calculated based on a company’s non-convertible
debt interest rate (straight rate). The old GAAP and plain vanilla convertible bond accounting records
interest expense at the cash (effective) interest rate. The rules did not change the diluted share count
treatment for convertible bonds or change the accounting for convertible preferred stock. Also, the
change more closely aligns with International Financial Reporting Standards (“IFRS”), which already
require convertible debt to be bifurcated and accounted for as debt and equity on the balance sheet.
The mechanics of “bifurcation” accounting for cash-settled principal convertible bonds are as follows:
1. A convertible bond’s value is calculated excluding its equity conversion feature (considering all
other embedded features, such as other calls and puts by the company). Simplistically, the value
of debt is calculated based on the company’s non-convertible debt borrowing rate on the date
upon which the convertible bond is issued. Since a company’s straight debt rate is invariably
higher, the net present value of the bond’s cash flows and other conversion features results in a
value lower than the convertible bond’s principal amount. This amount is recorded as discounted
debt on the company’s balance sheet.

CONVERTIBLE DEBT (CONTINUED)
2. In the next step, the company must calculate its prospective interest expense, which will include
both non-cash accretion and cash interest. The debt discount amount is accreted up to the bond’s
par amount over the expected life of the bond as additional non-cash interest expense. Interest
expense is calculated using the effective yield method. (Multiply the beginning of the period debt
balance by the bond’s effective yield that was calculated on the issuance date. The non-cash
accretion increases the debt amount. In the next period, this higher debt amount is multiplied by
the same effective interest rate and so forth.). By using the effective yield method, interest
expense is recorded in earnings at the company’s straight date rate. In the event that the bond is
redeemed early, the un-accreted bond discount is accounted for as a loss on debt
extinguishment.
3. The equity conversion option is calculated as the difference between the bond’s issuance price
(e.g., par) and the calculated straight debt value (step 1 value). This equity amount is recorded in
additional paid-in-capital in shareholder’s equity and is not changed until the bond matures or is
redeemed.
The next exhibit illustrates and compares the plain vanilla convertible bond and cash settled principal
convertible bond accounting. Assume a company issues a $1,000 convertible bond for cash and the
equity conversion option is $226 (pre-tax). Under cash settled principal bond accounting, on the balance
sheet, there is a $136 ($226 x (1 – 40% tax rate)) increase in shareholder’s equity, $226 lower total debt
and a $90 deferred tax liability. On the income statement, the company reports reports $27 higher
interest expense. Cash flow from operations is the same under both methods of accounting since the
non-cash portion of interest expense is added back to operating cash flow.
Example: Issuing $1,000 in Convertible Debt for Cash
Balance Sheet: Convertible Bond Issuance Date
Plain Vanilla Cash Settled
Debit: Cash 1,000 Debit: Cash 1,000

Credit: Convertible debt 1,000 Credit: Convertible debt 774
Credit: Deferred tax liability(1) 90
Credit: Equity conversion feature (net of taxes)(2) 136
Income Statement: Year 1
Operating income (assumption) 150 Operating income (assumption) 150

Interest expense 20 Interest expense 47
Taxes 52 Taxes 41
Net income 78 Net income 62
Statement of Cash Flows - Cash from Operations: Year 1
Net income 78 Net income 62

Interest expense 0 Interest expense 27
Deferred taxes 0 Deferred taxes (11)
Cash from operations 78 Cash from operations 78
(1) The tax effected amount of $226 allocated to equity at 40%.; (2) $226 allocated to equity less deferred taxes of $90.
Note: Assumed the deduction of interest expense on the tax return at the cash coupon rate.

In the next exhibit, we illustrate a typical convertible bond disclosure for cash settled principal bond’s
using Intel’s 10-K. Both the coupon and effective interest rate are disclosed. The latter of which is used
to calculate interest expense in earnings (i.e., the straight debt rate). Recall that the effective interest
rate is based on the date on which the bond is issued and does not change each period.
Intel (2012 Form 10-K): Long-Term Debt Excerpt
Convertible Debentures
In 2009, we issued $2.0 billion of junior subordinated convertible debentures (the 2009 debentures). In 2005, we issued $1.6 billion of
junior subordinated convertible debentures (the 2005 debentures). Both the 2009 and 2005 debentures pay a fixed rate of interest
semiannually.
2009 2005
Debentur Debentur
es es
Annual coupon interest rate 3.25% 2.95%
Annual effective interest rate 7.20% 6.45%
Maximum amount of contingent interest that will accrue per year 0.50% 0.40%
The effective interest rate is based on the rate for a similar instrument that does not have a conversion feature. Both the 2009 and 2005
debentures have a contingent interest component that requires us to pay interest based on certain thresholds or for certain events,
commencing on August 1, 2019 for the 2009 debentures. As of December 29, 2012, we have not met any of the thresholds or events
related to the 2005 debentures. The fair values of the related embedded derivatives were $6 million and zero as of December 29, 2012
for the 2009 and 2005 debentures, respectively ($10 million and zero as of December 31, 2011 for the 2009 and 2005 debentures,
respectively).
CONVERTIBLE DEBT AMOUNT ON BALANCE SHEET OFTEN NOT THE TRUE LIABILITY
In light of newer accounting for cash settled principal convertible bonds, the liability reported on the
balance sheet for convertible debt will not be the true liability due at redemption. The next exhibit is a
continuation of Intel’s long-term debt footnote wherein they disclose the outstanding principal, equity
component, and net debt carrying amounts. The balance sheet amount for their 2009 convertible debt
was $1 billion at 12/29/12 compared to $2 billion of principal amount outstanding and the conversion
feature of $613 million was recorded in equity. For valuation and financial analysis, we believe the
outstanding principal amount should be used as debt rather than the balance sheet value.
Intel (2012 Form 10-K): Long-Term Debt Excerpt
Both the 2009 and 2005 debentures are convertible, subject to certain conditions, into shares of our common stock. Holders can surrender the
2009 debentures for conversion if the closing price of Intel common stock has been at least 130% of the conversion price then in effect for at
least 20 trading days during the 30 consecutive trading-day period ending on the last trading day of the preceding fiscal quarter. Holders can
surrender the 2005 debentures for conversion at any time. We will settle any conversion or repurchase of the 2009 debentures in cash up to the
face value, and any amount in excess of face value will be settled in cash or stock at our option. However, we can settle any conversion or
repurchase of the 2005 debentures in cash or stock at our option. On or after August 5, 2019, we can redeem, for cash, all or part of the 2009
debentures for the principal amount, plus any accrued and unpaid interest, if the closing price of Intel common stock has been at least 150% of
the conversion price then in effect for at least 20 trading days during any 30 consecutive trading-day period prior to the date on which we
provide notice of redemption. We can redeem, for cash, all or part of the 2005 debentures for the principal amount, plus any accrued and
unpaid interest, if the closing price of Intel common stock has been at least 130% of the conversion price then in effect for at least 20 trading
days during any 30 consecutive trading-day period prior to the date on which we provide notice of redemption.

Intel (2012 Form 10-K): Long-Term Debt Excerpt (continued)
If certain events occur in the future, the indentures governing the 2009 and 2005 debentures provide that each holder of the debentures can,
for a pre-defined period of time, require us to repurchase the holder’s debentures for the principal amount plus any accrued and unpaid
interest. Both the 2009 and 2005 debentures are subordinated in right of payment to any existing and future senior debt and to the other
liabilities of our subsidiaries. We have concluded that both the 2009 and 2005 debentures are not conventional convertible debt instruments
and that the embedded stock conversion options qualify as derivatives. In addition, we have concluded that the embedded conversion options
would be classified in stockholders’ equity if they were freestanding derivative instruments. As such, the embedded conversion options are not
accounted for separately as derivatives.
2009 Debentures 2005 Debentures

Dec. 29, Dec. 31, Dec. 29, Dec. 31,
(In Millions, Except Per Share Amounts) 2012 2011 2012 2011
Outstanding principal $ 2,000 $ 2,000 $ 1,600 $ 1,600
Equity component carrying amount $ 613 $ 613 $ 466 $ 466
Unamortized discount $ 922 $ 933 $ 656 $ 669
Net debt carrying amount $ 1,063 $ 1,052 $ 932 $ 919
Conversion rate (shares of common stock per $1,000 principal amount of
debentures) 45.05 44.55 33.86 32.94
Effective conversion price (per share of common stock) $ 22.20 $ 22.45 $ 29.53 $ 30.36
In the preceding table, the remaining amortization periods for the unamortized discounts for the 2009 and 2005 debentures are
approximately 27 and 23 years, respectively, as of December 29, 2012.
Below we discuss the EPS accounting treatment for convertible bonds. The EPS accounting is
predicated on how the convertible bond’s principal amount is required to be settled and, accordingly, is
calculated under one of two methods:
1. If-Converted Method: Used when the convertible bond’s principal amount is not required to be
settled in cash.
Mechanics:
Under the if-converted method, the bond is assumed to have been converted at the beginning of
the quarter, year, or, if later, the issuance date. Since it is assumed to be converted into shares,
there is both a numerator and denominator adjustment in the diluted EPS calculation (note that
this diluted EPS calculation is disclosed in the financial statement footnotes). First, the total
number of shares underlying the convertible bond is added to the diluted share count. Second,
there is also an adjustment to net income since if the bond converted, the company would not be
paying interest expense. Accordingly, net income is adjusted higher by the after-tax interest
expense on the convertible bond. In some extreme scenarios, doing the aforementioned
adjustment actually increases EPS and the convertible bond is not dilutive if converted. If this
occurs, GAAP requires the company to exclude the shares and not make the related after-tax
interest expense adjustment.
One common belief is that a convertible bond needs to be in the money to be included in the
diluted share count. This is simply not true as the calculation is mechanical. If the above
calculation results in a dilutive EPS effect, the adjustments are made.

2. Treasury stock method: This method is used when the convertible bond’s principal amount
must be cash-settled at the company’s option (note that the terms may be such that amounts
above the bond’s principal amount may be settled in cash or shares at the company’s option).
Mechanics
Under the treasury stock method, there is only EPS dilution from the convertible bond when it’s
in-the-money since the principal amount must be cash-settled. The number of shares included in
the company’s share count is the number of shares of stock required to settle the in-the-money
amount of the convertible bond’s conversion spread (convertible bond – par value). There are no
shares included in the share count if the bond is not in the money.
To illustrate this method, assume a share price of $10 and that a $1,000 convertible bond is convertible
into 200 shares of stock. The current conversion value of the bond is equal to the $10 current share
price multiplied by 200 shares or $2,000.
Under the treasury stock method, diluted EPS is calculated as follows:
Conversion value amount: $2,000 ($10 x 200 shares)

Less: bond’s par value: 1,000 (assumed)
Excess 1,000
Divided by average share price $10 (assumed)
Equals: 100 shares included in diluted EPS share count

CONVERTIBLE DEBT: INCORPORATING INTO VALUATION
Accounting for convertible debt is far from perfect and, therefore, analysts should consider several
adjustments for financial analysis and valuation.
For a plain vanilla convertible bond, if the current stock price or the analyst’s target share price is greater
than the convertible bond’s exercise (strike) price, we believe the underlying shares into which the bond
may be converted should be included in the diluted share count. Conversely, if the convertible bond is
currently out-of-the-money and the analyst believes that it is unlikely to become in-the-money (a true
busted convertible), we suggest that the convertible bond be treated similar to straight debt and,
accordingly, do not include any shares (underlying the convertible) in the diluted share count. If a bond
is out of the money and is never likely to be in the money again, we believe that current GAAP does not
reflect the real economics of the transaction. This is a situation where the if converted method of
accounting is overly conservative and arrives at the wrong economic answer.
Analysts should also remember to not double count items in valuation. That is, be careful to not treat the
convertible as 100% debt while at the same time including all the shares in the share count. The
company’s share count may not include the economically correct number of shares, but a quick review
of the diluted share count 10-K disclosure will assist in making sure the correct number of shares is
included.
For cash-settled principal convertible bonds, we advise classifying the principal amount as debt and the
amount in excess of the principal, if any, as equity. If the bond is out-of-the-money and the analyst does
not expect the bond to increase in price to be in-the-money, we suggest treating the convertible debt’s
par amount as debt. This reflects the company’s obligation to pay the debt off at par value or, if it’s
higher, we use the put value (e.g., bonds may be puttable at 102%, etc.).

DEBT AND DEBT COVENANTS
After reading through a company’s 10-K debt disclosures for customary items such as debt covenants,
debt terms, and debt maturities we suggest reviewing it for the following items:
 Does the company account for its debt under fair value accounting? GAAP requires revaluation of
the target company’s debt to fair value at the acquisition date. As part of this process, a new
effective interest rate on the debt is calculated on which interest expense is calculated. This
creates a scenario where the cash interest expense on the debt may be materially different than
the GAAP interest expense. Separately, companies have the option to account for their debt at
fair value under GAAP with changes in fair value reported in earnings each period. We find this
more common in financial institutions than in other industries.
 Does the debt contain a cross payment default provision? Under this provision, creditors of a
material amount of debt may elect to declare that a default has occurred under their debt
indenture and, therefore, accelerate the principal amounts due to creditors.
 Does the debt contain a cross accelerated provision? This provision permits a bondholder to
declare default on a second debt instrument only if a default on the first debt instrument occurs
and the first debt instrument is, in fact, accelerated.
 Does the debt have a subjective acceleration clause? This debt term allows bondholders to
accelerate the maturity of debt if certain events occur that are not objectively determinable (or
defined).
FLOATING RATE DEBT?

In today’s low short-term interest rate environment, many companies have swapped fixed rate debt into
floating rate debt. If interest rates ever rise again, companies would be faced with higher borrowing
costs. To assess the amount of debt swapped into floating rates, we suggest a review of the interest rate
risk disclosure, which is found either in the MD&A section or in financial instruments/derivative footnote.
Companies are required to disclose the amounts of interest rate swap agreements designated as fair
value hedges and the related swap maturity dates (an interest rate swap from fixed to floating is
categorized as a “fair value” hedge under the accounting rules since it hedges the debt face amount
outstanding). The exhibit below is an excerpt from Honeywell’s 2012 Form 10-K indicating that the
company has swapped $1.4 billion of 4.09% fixed rate debt to LIBOR based floating rate debt.
Honeywell (2012 Form 10-K): Long-Term Debt Excerpt
Note 16—Financial Instruments and Fair Value Measures

Interest Rate Risk Management—We use a combination of financial instruments, including long-term, medium-term and short-term
financing, variable-rate commercial paper, and interest rate swaps to manage the interest rate mix of our total debt portfolio and related
overall cost of borrowing. At December 31, 2012 and 2011, interest rate swap agreements designated as fair value hedges effectively
changed $1,400 million of fixed rate debt at a rate of 4.09 to LIBOR based floating rate debt. Our interest rate swaps mature at various
dates through 2021.
Note: Emphasis added.


ACCRUED CAPITAL EXPENDITURES UNDERSTATE TRUE CAP-EX
Although not very common, there are situations in which a company purchases capital expenditures, but
has not yet paid for them in cash. The balance sheet impact is to increase property, plant, and
equipment and increase an accrued liability. Since no cash has been expended for the property, there is
not a cash outflow shown for such expenditures under capital expenditures on the cash flow statement.
Rather, the company records capital expenditures on the cash flow statement (an investing cash
outflow) when the amounts are actually paid in cash in a subsequent period.
This timing difference may under/over state capital expenditures in a particular period and would be one
method for a company to temporarily reduce capital expenditures on the cash flow statement.
Supplemental disclosure of accrued purchases of property, plant, and equipment is a required GAAP
disclosure and either shown at the bottom of the cash flow statement (under “non-cash investing and
financing activities”) or in the financial statement footnotes. In the next exhibit, we provide an illustration
of a footnote with this information from Macquarie Infrastructure Group’s 2012 Form 10-K filing.
Macquarie Infrastructure Group (2012 Form 10-K): Cash Flow Statement Excerpt ($ in thousands)
Supplemental disclosures of cash flow information for continuing operations:

Non-cash investing and financing activities: 2012 2011 2010
Accrued purchases of property and equipment $ 9,623 $ 3,201 $ 3,593
Acquisition of equipment through capital leases $ 3,117 $ 2,663 $ 139
Issuance of LLC interests to manager for performance fees $ 23,509 $ — $ —
Issuance of LLC interests to manager for base management fees $ 19,821 $ 14,467 $ 4,083
Issuance of LLC interests to independent directors $ 571 $ 450 $ 450
Taxes paid $ 4,870 $ 2,913 $ 1,655
Interest paid $ 58,916 $ 72,949 $ 78,718

OTHER ASSETS AND LIABILITIES
SEC rules require additional disclosure of certain balance sheet accounts if materiality thresholds are
met. We suggest reviewing these disclosures for large or unusual increases and/or decreases. In
particular, a careful review of the other current or non-current assets is warranted as a company might
capitalize costs into a non-current asset account rather than expensing such amounts. Annual
disclosure of the following is required:
• Any other current assets greater than 5% of total current assets;
• Any other non-current assets greater than 5% of total assets;
• Deferred costs greater than 5% of total assets;
• Any other current liabilities greater than 5% of total current liabilities; and
• Any other non-current liabilities greater than 5% of total liabilities.

ACCUMULATED OTHER COMPREHENSIVE INCOME
In order to avoid what it deemed unnecessary earnings volatility, the FASB decided to exclude certain
items from current period earnings. To that end, accumulated other comprehensive income (“AOCI”)
was created to “hold” certain gains or losses within shareholder’s equity. AOCI has no other conceptual
basis or theoretical justification except to smooth earnings.
Analysts should review AOCI activity in the current period for large and unusual changes. Given the
nature of the items accounted for in AOCI, we expect to see volatile year-over-year changes. The four
items included in AOCI include (1) pensions, (2) unrealized gains/losses on marketable securities, (3)
unrecognized gains/losses on cash flow hedges, and (4) foreign currency translation effects. Below we
discuss each of these AOCI items and how it relates to Honeywell’s 2012 Form 10-K disclosure.
1. Pensions and OPEB: Under ASC 715, Compensation - Retirement Benefits (formerly FAS No.
158), companies must record the economic funded status of pension and other post-retirement
plans (“OPEB”) as either an asset (if overfunded) or liability (if underfunded). Since GAAP allows
(and most companies choose to) defer actuarial gains/losses and smooth investment
gains/losses on pension plans, the change in a company’s unfunded pension amount is recorded
as an decrease/increase to AOCI.
Most pension plans are underfunded due to a decline in discount rates the last several years and
significant asset losses incurred during 2008. Companies with defined benefit plans usually have
large unrecognized balances in AOCI (the balance sheet impact is to reduce equity, net of a
deferred tax asset, while increasing the pension liability). Since pension plans are generally only
marked-to-market once a year, this section of AOCI should not change on a quarterly basis.
The pension impact in 2012 on AOCI was $198 million as shown in Honeywell’s disclosure. The
unrecognized pension amount in the company’s AOCI balance at 2012 year-end was $1.85
billion. Note that Honeywell adopted a form a pension “mark to market” accounting in 2010 that
will limit the volatility of AOCI pension amounts.
2. Unrealized gains/losses on available-for-sale marketable securities: Under ASC 320, Investments

– Debt and Equity Securities (formerly FAS No. 115) unrealized gains/losses on a company’s
marketable security portfolio are recorded in AOCI. In 2009, all else being equal, unrealized gains
on company portfolios increased the AOCI balance. If management decides to sell all or a portion
of its marketable securities, the unrealized gain/loss is removed from this account and recognized
as income/expense in earnings.
As shown in Honeywell’s 2012 Form 10-K AOCI disclosure, the marketable securities’ current
year unrealized loss was approximately $6 million after tax, resulting in a net cumulative $157
million in unrecognized gains held in the company’s securities portfolio.
3. Unrecognized gains/losses from cash flow hedges of forecasted transactions: Under ASC 815,
Derivatives and Hedging (formerly FAS No. 133), all derivatives are recorded at fair market value
on the balance sheet. The two typical types of derivative transactions temporarily recorded in
AOCI include (1) unrealized gains/losses on cash flow hedges of forecasted transactions and (2)
hedging cash flows of a recorded balance sheet asset or liability (e.g., derivative to hedge floating
rate debt that is swapped into a fixed rate). Gains or losses on these hedging transactions are
temporarily held in AOCI until the hedged transaction is recorded into earnings. Hedge
ineffectiveness is recognized immediately in earnings.

ACCUMULATED OTHER COMPREHENSIVE INCOME (CONTINUED)
This portion of AOCI should be reviewed any large unrealized or unsettled derivative losses or for
large year-over-year changes, suggesting new hedging policies and/or risk management
practices. But be aware that companies may close out hedges at quarter-end or year-end to
minimize the amount of unrealized gains or losses at period-end.
Honeywell’s 2012 Form 10-K AOCI disclosure shows that the company had a $4 million loss on
its derivatives and hedging at year-end (due to a net $27 million unrealized gain in 2012).
4. Impact of foreign currency translation of foreign subsidiaries balance sheet under the current rate
method of foreign currency accounting (“currency translation adjustment”): Under ASC 830,
Foreign Currency Matters (formerly FAS No. 52), companies may translate their balance sheet
under the (1) current rate method (majority of companies use) or (2) temporal method.
The current rate method translates all foreign subsidiary balance sheet assets and liabilities at the
end of period exchange rate. The cumulative impact of translating foreign subsidiaries’ balance
sheets from a foreign currency into U.S. dollars under the current rate method is recorded directly
into AOCI. Under the temporal method, the impact of translating foreign balance sheets is
recorded in earnings.
In a period of substantial exchange rate volatility, this account may experience a material year-
over-year change. The amount of the gain/loss from currency translation depends on the
company’s net exposure (i.e., equity balances) and the change in exchange rates. The translation
gain/loss is calculated as the foreign subsidiary’s equity balance multiplied by the change in
exchange rate, and the current year change represents the net gain or loss.
As shown in Honeywell’s AOCI disclosure, the impact of translating foreign subsidiaries in 2012
was approximately a $282 million gain, resulting in a cumulative unrecognized translation gain at
year-end of $356 million.

ACCUMULATED OTHER COMPREHENSIVE INCOME (CONTINUED)
Honeywell (2012 Form 10-K): AOCI Disclosure ($ millions)
Note 19—Accumulated Other Comprehensive Income (Loss)

Total accumulated other comprehensive income (loss) is included in the Consolidated Statement of Shareowners’ Equity.
Comprehensive Income (Loss) attributable to noncontrolling interest consisted predominantly of net income. The changes in Accumulated
Other Comprehensive Income (Loss) are as follows:
Pretax Tax After Tax

Year Ended December 31, 2012
Foreign exchange translation adjustment $ 282 $ — $ 282
Pensions and other postretirement benefit adjustments (285) 87 (198)
Changes in fair value of available for sale investments 54 (60) (6)
Changes in fair value of effective cash flow hedges 35 (8) 27
$ 86 $ 19 $ 105

Foreign exchange translation adjustment $ (146) $ — $ (146)
Pensions and other postretirement benefit adjustments (317) 108 (209)
Changes in fair value of available for sale investments 12 — 12
Changes in fair value of effective cash flow hedges (41) 7 (34)
$ (492) $ 115 $ (377)

Foreign exchange translation adjustment $ (249) $ — $ (249)
Pensions and other postretirement benefit adjustments 26 18 44
Changes in fair value of available for sale investments 90 — 90
Changes in fair value of effective cash flow hedges (6) 2 (4)
$ (139) $ 20 $ (119)
Components of Accumulated Other Comprehensive Income (Loss)

December 31,
2012 2011
Cumulative foreign exchange translation adjustment $ 356 $ 74
Pensions and other postretirement benefit adjustments (1,848) (1,650)
Change in fair value of available for sale investments 157 163
Change in fair value of effective cash flow hedges (4) (31)
$ (1,339) $ (1,444)

FAIR VALUE MEASUREMENTS
ASC 820, Fair Value Measurements and Disclosures (formerly FAS No. 157), provides a framework to
record the fair market values of financial assets and liabilities. This is the “mark-to-market” standard of
accounting that created significant controversy in recent years.
Central to this framework is the fair value hierarchy, commonly referred to as the Level 1, 2, and 3
assets and liabilities. The type of inputs used to determine the fair values of a company’s financial
instrument determine which level the asset (or liability) should be disclosed under. According to ASC
820, below is the basis for fair value hierarchy classification:
• Level 1: Inputs based on “quoted prices in active markets for identical assets or liabilities” are
Level 1 assets. The most common example would be determining a fair value based on an
exchange traded stock price.
• Level 2: Observable inputs other than quoted prices for identical instruments are Level 2 assets.
Observable inputs include items such as quoted prices for similar assets or pricing formulas
based on commonly quoted inputs (e.g. interest rates).
• Level 3: Unobservable factors in the market are Level 3 assets, the most subjective of the three
categories. Fair values of these assets consist primarily of management assumptions and can
take the form of DCF models or comparable company analyses (i.e., mark to model).
Companies must provide a disclosure that shows the amount of their assets and liabilities within each of
these levels. In the following exhibit, we present Travelers Companies’ disclosure of its Level 1, 2, and 3
assets. At December 31, 2012, $284 million of the company’s assets held at fair value (<1% of total)
were valued based on Level 3 inputs.

FAIR VALUE MEASUREMENTS (CONTINUED)
Travelers Companies (2012 Form 10-K): Fair Value Measurement Disclosure
(at December 31, 2012, in millions) Total Level 1 Level 2 Level 3

Invested assets:
Fixed maturities
U.S. Treasury securities and
obligations of U.S.
government and
government agencies and
authorities $ 2,222 $ 2,205 $ 17 $ —
Obligations of states,
municipalities and political
subdivisions 38,681 — 38,653 28
Debt securities issued by
foreign governments 2,257 — 2,257 —
Mortgage-backed securities,
collateralized mortgage
obligations and pass-
through securities 2,997 — 2,992 5
All other corporate bonds 19,203 — 19,006 197
Redeemable preferred stock 33 32 1 —
Total fixed maturities 65,393 2,237 62,926 230
Equity securities
Common stock 510 510 — —
Non-redeemable preferred stock 135 92 43 —
Total equity securities 645 602 43 —
Other investments 100 46 — 54
Total $ 66,138 $ 2,885 $ 62,969 $ 284
Note: The Company did not have any material transfers between Levels 1 and 2 during the year ended December 31, 2012.
Companies are required to disclose a summary of Level 3 asset changes over the year. This disclosure
is interesting and important to analyze because the determination of fair value is dynamic and the inputs
used to determine the fair value may have changed year-over-year. Since Level 3 asset fair values are
the most open to management subjectivity, investors should watch out for large transfers from Level 1 or
2 into Level 3. It is also important to inquire about any large increases into the Level 2 category as there
is relatively more subjectivity in valuing these types of assets than Level 1 assets.
Analysts should inquire with management about the type of valuation techniques and methods used to
determine their assets’ fair values. The next step would be determining the viability and applicability of
management’s valuation assumptions.
It is important to note that being classified as a Level 3 (or 2) asset doesn’t necessarily mean that the
asset is more or less risky than another. The key difference is the type of inputs used to arrive at the
recorded fair value. The following exhibit is Travelers Companies disclosure of Level 3 assets and
activities.

FAIR VALUE MEASUREMENTS (CONTINUED)
Travelers Companies (2012 Form 10-K): Fair Value Measurement Disclosure
Fixed Other
(in millions) Maturities Investments Total

Total realized and unrealized
investment gains (losses):
Reported in net realized
investment gains(1) 4 5 9
Reported in increases
(decreases) in other
comprehensive income 5 2 7
Purchases, sales and
settlements/maturities:
Purchases 79 3 82
Sales — — —
Settlements/maturities (94) — (94)
Gross transfers into Level 3 10 — 10
Gross transfers out of Level 3 (24) — (24)

Balance at
December 31, 2012 $ 230 $ 54 $ 284
Amount of total realized

investment gains (losses)
for the period included in
the consolidated statement
of income attributable to
changes in the fair value of
assets still held at the
reporting date $ — $ — $ —

BALANCE SHEET RELATIONSHIPS
When a company chooses to overstate reported earnings, a corresponding overstatement of an asset
account (or understatement of a liability account) is also created. The following relationships are critical
in analyzing a company’s 10-K and detecting potential earnings management tactics.
Inventory:
To lower cost of goods (and increase earnings), management might choose to understate inventory
purchases or the company’s ending inventory balance.
Beginning Inventory
+ Purchases
- Ending Inventory
= Cost of Goods Sold
Companies can increase inventory, and thereby reduce COGS, by:

o Failing to write-down inventory;
o Overstating inventory quantities;
o Adding amounts and overstating to the inventory account; and/or
o Overproducing inventory to absorb fixed overhead costs.
Best detection metric: Days of Inventory (Inventory / COGS x 365 days) analyzed over time.
Accounts Payable:
Inventory and accounts payable are inter-connected (accounts payable is generally linked to
inventory purchases) and changes to these balance sheet accounts should be reviewed together.
Movement in these two accounts should, more or less, happen in tandem.
To increase current reported earnings, management may under-report accounts payable and
inventory purchases at the same time, resulting in a low cost of goods sold number and higher
reported earnings.
Accrued Expenses (unpaid expenses):

Accrued liabilities are balance sheet amounts related to expenses already recognized on the income
statement 1. To increase current earnings, a company may understate accrued expenses on the
balance sheet, tempting management to draw-down and reduce existing accrued liability accounts
instead of recording an expense through earnings and increasing the accrued liabilities further.
Although management may temporarily increase earnings, the benefit is transitory if the expenses
are actually recurring costs since the one-time earnings benefit will reverse as higher costs in the
future as the account is replenished.
Two examples:
o Reducing accrued warranty liabilities. If warranty costs are recurring in nature, the company
will be recording a higher expense through earnings in the following period.
o Requiring employees to use their accrued vacation at year-end. Instead of recording a
compensation expense in the current period, the accrued liability is decreased along with a
corresponding cash outflow.
1
Exception: As PP&E is purchased and recorded on the balance sheet, an accrued liability exists for any unpaid amounts.

Income Statement

REVENUE RECOGNITION
Historically, the largest number of financial restatements has resulted from improper revenue
recognition. Disclosures about revenue recognition in the 10-K can glean information about potential
risks due to aggressive accounting policies. Some business models lend themselves to more flexibility in
recognizing revenue. For example, consider a sell-in versus sell-through business model where there is
a distributor or other vendor as the “middle man”. In a sell-in revenue recognition practice, revenue is
recognized when shipped to the distributor and, from the company’s perspective, there is clearly more
discretion in the timing and amount of inventory shipped and, therefore, recognized. This is often known
as “stuffing the channel”.
Conversely, in a sell-through model, revenue is recognized upon final shipment to the end customer
(distributor to the customer). There is less (but still some) flexibility to stuff the channel in this scenario
as revenue is recognized based on end demand from the customer. Improper revenue recognition under
a sell-through model may still occur if a company is using “bill and hold” type sales or shipping inventory
to a related party or vendor with close ties.
Below is an example of the revenue recognition policy for Snap-On from the Critical Accounting section
of the MD&A.
Snap-On (2012 Form 10-K): Critical Accounting Policies – Revenue Recognition
Revenue Recognition: Snap-on recognizes revenue from the sale of tools, diagnostics and equipment solutions when contract terms are met, the
price is fixed or determinable, collectability is reasonably assured and a product is shipped or risk of ownership has been transferred to and
accepted by the customer. For sales contingent upon customer acceptance, revenue recognition is deferred until such obligations are fulfilled.
Estimated product returns are recorded as a reduction in reported revenues at the time of sale based upon historical product return experience
and gross profit margin adjusted for known trends. Provisions for customer volume rebates, discounts and allowances are also recorded as a
reduction of reported revenues at the time of sale based on historical experience and known trends. Revenue related to maintenance and
subscription agreements is recognized over the terms of the respective agreements.
Snap-on also recognizes revenue related to multiple element arrangements, including sales of hardware, software and software-related services.
When a sales arrangement contains multiple elements, such as hardware and software products and/or services, Snap-on uses the relative selling
price method to allocate revenues between hardware and software elements. For software elements that are not essential to the hardware’s
functionality and related software post-contract customer support, vendor specific objective evidence (“VSOE”) of fair value is used to further
allocate revenue to each element based on its relative fair value and, when necessary, the residual method is used to assign value to the delivered
elements when VSOE only exists for the undelivered elements. The amount assigned to the products or services is recognized when the product is
delivered and/or when the services are performed. In instances where the product and/or services are performed over an extended period, as is
the case with subscription agreements or the providing of ongoing support, revenue is generally recognized on a straight-line basis over the term
of the agreement, which generally ranges from 12 to 60 months.
Franchise Fee Revenue: Franchise fee revenue, including nominal, non-refundable initial fees, is recognized upon the granting of a franchise, which
is when the company has performed substantially all initial services required by the franchise agreement. Franchise fee revenue also includes
ongoing monthly fees (primarily for sales and business training and marketing and product promotion programs) that are recognized as the fees
are earned. Franchise fee revenue totaled $9.9 million, $8.8 million and $9.0 million in fiscal 2012, 2011 and 2010, respectively.
Financial Services Revenue: Snap-on also generates revenue from various financing programs that include (i) loans to franchisees’ customers and
Snap-on’s industrial and other customers for the purchase or lease of tools, equipment and diagnostics on an extended term payment plan; and
(ii) business loans and vehicle leases to franchisees. These financing programs are offered through Snap-on’s finance subsidiaries. Financial
services revenue consists primarily of finance loan receivable revenue and installment contract revenue. Revenue from interest income on the on-
book financing portfolio is recognized over the life of the contracts, with interest computed on the average daily balances of the underlying
contracts. Financial services revenue also includes servicing fee income received from CIT. Prior to July 2009, SOC substantially sold all of its loan
originations to CIT on a limited recourse basis, and SOC retained the right to service such loans for a contractual servicing fee. Contractual
servicing fees from CIT were $1.4 million, $2.3 million and $4.9 million in fiscal 2012, 2011 and 2010, respectively.

REVENUE RECOGNITION (CONTINUED)
Below we discuss the primary ways in which revenues may be managed.
1. Bill and hold sales. The existence of bill and hold type sales are a red flag, in our view. Sunbeam
and Diebold are two examples of large historical accounting restatements due in part to improper
bill and hold accounting. Bill and hold sales are where a company “sells” a product to its
customer, title is transferred, collectability of payment is reasonably assured, but the product
hasn’t shipped. Certainly, there may be legitimate means for such sales. However, since the
product hasn’t shipped and isn’t consuming space on the customers’ premises, there is incentive
for companies to use it as a means to pull forward sales into a current quarter. A discount may
even be offered as terms for its use. The way to spot this artifice is through a careful 10-K/10-Q
reading and comparison of the company’s accounting policy section and/or the questioning of
company management.
2. Extended payment terms. In a like vein to bill and hold sales, a company might grant extended
payment terms to customers as an inducement for sales, in effect, financing the purchase with a
longer-term receivable.
3. Sales return / discounts reserves. Revenues are recorded in earnings net of estimated sales
return and discount reserves. Since these amounts are estimated, a company may use a
reduction (drawdown) of these reserves as a gain to boost revenues. An alternative means to
boost current period revenues is to under reserve for sales returns and discounts. In this
scenario, since a lower amount is deducted from gross sales, earnings improve. However, this is
unsustainable if returns/discounts turn out to be higher as the company will need to replenish the
reserve in a future period (reducing earnings). Furthermore, if a product experiences a changing
pattern of returns or discounts, there may be a surprise increase in this reserve and a
corresponding reduction in net revenues. Further, a new policy of sales’ right of returns may
suggest sales returns/reserves could be understated. As we discuss elsewhere in this report, the
10-K Schedule II is an important item to review for the existence and amount of any sales return
and discount reserves. In the past, retailers and some drug companies have experienced issues
with sales returns/discount reserves. One example of a company restating earnings as a result of
this process is Medicis Pharmaceutical Corporation.
4. One-time gains recorded as revenue. Although not common, a company may choose to record a
gain on the sale of a business in revenue. Earlier this decade, GM recorded a gain on the sale of
their defense business in revenues.
5. Contract accounting/percentage of completion accounting. Some business models lend

themselves to more revenue recognition flexibility. For complex and multi-period/year projects,
revenue is often recognized under the percentage of completion (POC) accounting method. The
POC method records revenues based on the percentage of costs incurred in the current period
relative to total estimated costs or based upon certain project milestones. At the onset of the
project, revenues, expenses, and a related project margin are estimated. In turn, revenue is
recognized each period based on these assumptions. If a companies’ estimate of costs and
related revenues are inaccurate, there may be a one-time charge to write-off accumulated costs.
Even if costs are not written off, there is still significant flexibility to manage reported revenues
and margins under this type of accounting. We view changes to this form of accounting very
skeptically. As an example, before the housing bust, WCI Communities and Toll Brothers began
using percentage of completion accounting for condo development sales based on a cost
incurred to total cost method.
REVENUE RECOGNITION (CONTINUED)
6. Material decreases/changes in deferred revenue. GAAP requires a deferred revenue liability to be
recorded in situations where cash is received prior to when revenue is allowed to be recognized.
A simple example is a 2 year newspaper subscription. On the balance sheet, there is an increase
in cash and an increase in the short and/or long term deferred revenue liability. Assuming no new
subscriptions, the deferred revenue liability decreases each period as papers are delivered and
revenue is recognized in earnings. For an ongoing business growing sales, the deferred revenue
liability should grow each period and be a source of cash in operating cash flow. Since deferred
revenue represents a pool of future revenue, a company may change how deferred revenue is
recognized or improperly draw down from this account. Therefore, we review this account for
material year-over-year and sequential declines. The ProQuest case study later in this report is
an illustration of improper use of deferred revenue accounting. A deferred revenue decrease or a
deceleration in this account is a possible warning sign of a deteriorating underlying business
since it represents revenue to be recognized in future periods.
FINANCIAL RATIO WARNING SIGNS

Apart from reviewing the financial footnote for changes in revenue recognition policies, existence of sell-
in revenue recognition and bill and hold practices, we’ve found a few simple ratios to be the best at
signaling aggressive revenue recognition:
I. Days Sales Outstanding (DSOs). We calculate this ratio as ending accounts receivable divided by
sales (annualized if quarterly) multiplied by 365 days. Average accounts receivable may also be
used, but we prefer to use ending as average smooths out the possible effects of such practices
as stuffing the channel at quarter-end. We also recommend reviewing the debt footnote to ensure
there is no securitization of accounts receivable. Selling receivables would artificially lower this
ratio and, therefore, decrease its efficacy in detecting aggressive revenue recognition.
II. Days Deferred Revenue (DDR). If a company’s business model uses deferred revenue, we
calculate a days deferred revenue metric similar to a days sales outstanding metric. It is
calculated as the total deferred revenue divided by sales (annualized if quarterly) multiplied by
365 days. A declining ratio may suggest a move to a more aggressive revenue recognition policy,
a slowing overall business, or a change in policies.
III. Sales Return Reserves / Discounts. If disclosures exist, we calculate the sales return/discounts
reserve to sales and review for material decreases in this ratio. A company may dip into these
reserves as a means to boost earnings and this is unsustainable if the sales return/discount
reserves are actually higher. We also compare the sales return/discount provision to current
period revenues.
IV. Large Increases in Other Receivables or Other Assets. As an enticement to boost current period
sales, long-term financing may be used. An increase in balance sheet accounts such as other
receivables, financing receivables or other assets are areas in which long term receivables may
be recorded. In this scenario, days sales outstanding would not necessarily be a reliable red flag
indicator.
V. Related Party Sales or Sales to Off-Balance Sheet Joint Ventures. Review financial statement
footnotes for the existence of these items.

NON-RECURRING ITEMS?
Analysts should pay particular attention to any accounting changes or non-recurring items reported, no
matter how innocuous they may appear on the surface. Below we discuss the GAAP treatment for
certain one-time items:
• Extraordinary items. Extraordinary items are defined by GAAP as infrequent in occurrence and
unusual in nature. There is a very high threshold for classification as “extraordinary”. If a company
has an extraordinary gain or loss, it will be shown discretely on the income statement, net of tax,
and below discontinued items. Given the very high threshold to be classified as extraordinary,
these items may generally be treated as true “one-time” items.
• Unusual or infrequent items. GAAP requires unusual or infrequent items that are not
extraordinary to be classified within continuing operations. Restructuring and impairment charges
are common examples. As we explain later in this section, our historical tests have found that
companies that consistently report these special items tend to underperform.
• Accounting changes. A company may choose to change their accounting policy or method for
certain items. Reasons for the change may vary, primarily being the FASB changing the rules or
a company voluntarily choosing to change its accounting policy. Unless it is impractical to do so,
the change in accounting will generally be applied retrospectively, meaning that all prior periods
reflected in the current statements will be changed as if the new accounting was always in place.
The scenario when a company voluntarily makes a change in accounting policy should be viewed
cautiously, as it may be used as a mechanism to improve earnings optically. One recent popular
change is companies changing the method of actuarial loss recognition for their pension plans.
Notably, companies will obtain a preferability letter from their auditors to change from one
permissible accounting standard to another (e.g., moving from LIFO to FIFO inventory method).
Generally, these letters are difficult to obtain from auditors.
• Changes in estimates. Another type of change is an accounting estimate change – changes in

estimates are accounted for only prospectively. One such example is changing the depreciable
life of PP&E. These changes should be viewed skeptically, particularly if a company increases the
useful life estimate, which would have the impact of increasing earnings through lower
depreciation expense.
COMPANIES REPORTING CONSISTENT SPECIAL CHARGES UNDERPERFORM

In our December 6, 2011 report “Earnings Quality”, we performed a share price return analysis of
companies reporting “special items” - include restructuring charges, impairments, settlements, inventory
write-downs, etc. These special items are generally deemed to be “non-recurring”. We found that
companies consistently reported these special items underperformed.
When companies continually report “non-recurring” items, we believe that the market at some point will
begin to view the charges as “recurring”. These charges may be symptomatic of underlying business
issues, therefore impacting growth prospects, multiples and company valuation.
We assessed the frequency of charges on a four quarterly trailing basis based on how many quarters
out of the previous four quarters a special charge occurred, using two different thresholds to assess the
charges’ materiality: 0.25% and 1% of revenue.

NON-RECURRING ITEMS? (CONTINUED)
Companies that reported special charges at least 1% of revenue in 4 out of the last 4 quarters
underperformed the index by 300 basis points on average with 67% of the companies failing to match
the performance of the index (the inverse of a 33% “hit ratio”). Using a lower 0.25% of revenue
threshold, there was 198 basis points of underperformance with 67% of the companies failing to match
the performance of the index (the inverse of a 33% “hit ratio”).
Special Charges: Historical Returns (# of Quarters out of Trailing Four)
Relative Return of Companies Reporting Special Items

> .25% of Revenues
Relative Return % Hit Ratio
1 70
60
0
Relative Return %
50
Hit Ratio %
40
-1
30
20
-2
10
-3 0
0 1 2 3 4
No. of Quarters Special Items Reported
Relative Return of Companies Reporting Special Items

> 1% of Revenues
Relative Return % Hit Ratio
1 70
60
0
50
Relative Return %
Hit Ratio %
-1 40
-2 30
20
-3
10
-4 0
0 1 2 3 4
No. of Quarters Special Items Reported
Note: Number of quarters of special items reported out of the previous four quarters. Hit ratio is the percentage of companies outperforming the index.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poor’s; FactSet.

COMPARABILITY OF MARGINS
Analysts should review the MD&A and footnote disclosures to ascertain whether any classification
issues exist that would impact the comparability of one company’s margins to its peers. For example,
certain types of income or expenses may be classified in different line items within the financial
statements. For many items, no clear accounting guidance exists on where to classify certain costs on
the income statement. Current practice has been established through SEC guidance and industry
practice.
One common point of non-comparability is the classification of distribution expenses. Items such as
inbound freight charges, inspection costs, warehouse costs, and other distribution network costs may be
in either in cost of sales or SG&A. For a retailer, rent expense and shipping and handling costs could
potentially be included as either cost of sales or SG&A. Depreciation and amortization expense may be
classified in SG&A or alternatively, capitalized into inventory and eventually expensed by way of in cost
of sales. Intangible asset amortization will typically be classified based on the intangible asset’s function.
Although less common, certain gains may be classified in a manner where an analyst may want to
adjust for multiple, growth or margin purposes. For example, a company might include equity income
from an unconsolidated subsidiary or interest income in revenue. The SEC does require that product
and service revenue that is at least 10% of total revenues to be separately disclosed on the income
statement.
In the next exhibit, we illustrate Whirlpool’s classification of gains on certain asset dispositions in cost of
sales. While gains and losses have been “nominal” in recent years, amounts may be included in future
years that would require adjustment.
Whirlpool (2010 Form 10-K): Gain on Asset Sale Classifications
We classify gains and losses associated with asset dispositions in the same line item as the underlying depreciation of the disposed asset in
the Consolidated Statements of Income. We retired approximately $600 million and $80 million of machinery and equipment no longer in
use during 2011 and 2010. Net gains and losses recognized in cost of products sold were nominal for 2011, 2010 and 2009.

CHANGES IN ESTIMATE DRIVEN EXPENSES
Recognition of operating expenses in earnings is another area requiring significant management
estimates and assumptions. To boost earnings, a company may defer current period expenses to a
future quarter (cost capitalization), lower (understate) current period expenses, classify normal operating
expenses as non-recurring items or use pro forma earnings.
Changes in estimate driven expenses generally fall into one of six categories:
I. Cost capitalization;
II. Depreciation changes (discussed earlier in the PP&E section)
III. Reserves;
IV. Accrued expenses;
V. Pension Expected Rate of Return (see pensions section)
VI. Recurring costs / pro forma earnings (see Non-recurring items section above)
COST CAPITALIZATION
Improper capitalization of costs on balance sheet has been an area historically rife with aggressive
accounting. Its form varies from a change in an accounting policy, to an outright fraud, or even to a new
business model under which it is permitted since there are no clear accounting rules. Cost capitalization
is required in certain circumstances, but it still may impair comparability across companies. In its true
form, cash is expended in the current period for business items (marketing, contract costs), but
management must reasonably allocate the costs to future period(s) expected to benefit under the
matching principle. Estimating the future benefit period of such costs is rife with assumptions. What’s
more, cost capitalization is relatively easy to do. As an example, to shift current period expenses out of
earnings to the balance sheet, a company might adopt a voluntary change in their cost capitalization
policy.
Expenses related to long life assets (e.g., PP&E) are capitalized on the balance sheet as an asset if they
are expected to provide future benefits typically greater than 1 year. This allows the matching of costs
incurred with related revenues. By capitalizing costs, earnings are higher since the costs are deferred to
an expense in a future quarter. On the cash flow statement, the increase in the asset is reported as a
cash outflow in operating, investing or financing cash flow. If the cost capitalization is reported in
operating cash flow, it will be comparable to other companies. Conversely, if the capitalization of asset is
reported in investing or financing, operating cash flow will be permanently overstated. Over time, as the
capitalized costs are expensed, earnings are lower, but operating cash flow is unchanged since the
expense is non-cash and added back to operating cash flow. As an example, WorldCom improperly
capitalized normal recurring costs as property, plant and equipment and reported the cash outflow in
investing cash flow.

CHANGES IN ESTIMATE DRIVEN EXPENSES (CONTINUED)
Classifying Costs as Investing Cash Outflows – WorldCom
WorldCom
($ in millions) Year ended December 31,
2000 Reported 2000 Restated 2001 Reported 2001 Restated
Cash flow from operations $7,666 $4,227 $7,994 $2,845
Cash flows from investing activities

Capital expenditures (11,484) (11,668) (7,886) (6,465)
Acquisitions and related costs (14) 0 (206) (171)
Increase in intangible assets (938) 0 (694) 0
Decrease in other liabilities (839) 0 (480) 0
All other investing activites (1,110) 505 (424) 514
Cash used by investing activies ($14,385) ($11,163) ($9,690) ($6,122)
As two examples of where cost capitalization is required consider interest cost and software
development. Under FAS 34, interest cost on borrowings used to construct long term assets is
capitalized as part of the asset’s cost. Since the interest cost is included in PP&E, it never appears as
interest expense on the income statement. Rather, it is included as part of the asset and, therefore,
depreciation expense over time. It also never appears as a cost in operating cash flow as the interest
paid is encapsulated in the cash outflow shown for capital expenditures in investing cash flow.
Therefore, this is why credit rating agencies calculate cash interest paid to measure debt servicing
capabilities. Reported interest expense may be artificially low.
Software development cost is another area where capitalization is allowed. FAS No. 86 requires
capitalization of internal software development costs once technological feasibility is reached and then
such costs are amortized over their expected benefit period. There is inherent subjectivity in the
estimated cost amortization period and the determination of when technological feasibility is reached.
This illustrates how even if an accounting principle requires a certain practice, different management
assumptions may lead to different reported expense amounts, all else being equal. For internal use
software, capitalization is required once the “application development stage” begins and this is defined
as the stage in which the design, coding, hardware installation and testing occur.
HOW TO SPOT COST CAPITALIZATION

Insofar as there is not fraud involved, aggressive cost capitalization may come to light by reading the
company's accounting policies section and reviewing several balance sheet accounts. First, if costs are
capitalized, what is the period of time over which such costs are expensed and is it reasonable? It may
appear that a company has calculated a proper amortization period with precision; nevertheless, it is
highly subjective and variable. Therefore, we prefer to find short amortization periods for capitalized
costs (<3 years) as technological obsolescence or product displacement may occur over longer periods
of time. It is also useful to review changes in other current assets and other assets as these accounts
may be the repository for a company capitalizing costs. In more aggressive accounting historical cases,
routine costs were placed in property, plant and equipment. Therefore, it’s useful to review the historical
progression of a few ratios within the same sector or industry group: revenue to PP&E and depreciable
life (gross PP&E / depreciation expense).

We also recommend a quick review of large changes in other balance sheet accounts for possible
excessive cost capitalization. Companies are required to annually disclose:
• Any other current assets greater than 5% of total current assets;

• Any other noncurrent assets greater than 5% of total assets;
• Any deferred costs greater than 5% of total assets;
• Any other current liabilities greater than 5% of total current liabilities; and
• Any other noncurrent liabilities greater than 5% of total liabilities.
ACCRUED EXPENSES: UNDERREPORTING / DRAW DOWNS

Understating accrued expenses on the balance sheet is one less known tactic to increase current period
earnings. An accrued expense liability is an unpaid expense for which there has already been a GAAP
expense recognized. As an example, consider an employee vacation accrual. During the year in which
the employee earns vacation, an expense is recorded along with a vacation accrued liability as the
employee works during the year. When the employee takes vacation, the accrued liability is reduced but
there is no income statement impact. To boost current period earnings, a company may draw down the
accrued expense liability and avoid a current period expense in earnings. Continuing the vacation
accrual example, an employer could institute a policy of requiring employees to take two weeks of
vacation at the end of December. During those two weeks in which the employee is off, the accrued
liability is drawn down instead of recording employee compensation cost in earnings since vacation days
are drawn down. This benefit is temporary if the accrued expenses are recurring as the accrued
compensation cost will increase in the following period.
The best ways we've found to detect these items are by comparing the ratio of the change in accrued
expenses to the change in revenue and by reading through Management's Discussion and Analysis
section (MD&A) for any changes in accrual accounting policies. Changes (decrease) in the accrued
liability balance at year-end are also red flags.
RESERVES
Balance sheet reserve liabilities are another category of accrued expenses that may be drawn down to
lower current period expenses. Examples of balance sheet reserves include warranty, restructuring, bad
debts, taxes and litigation. Reserve accounts should be reviewed for gains from excess reserve
reversals (i.e., the cookie jar) and under-reserving (expensing) in the current period. Since reserves are
management estimates, GAAP provides significant flexibility in the timing and amount expensed in
earnings or reversed as a gain in earnings. A common abuse over the years is to incur a large one-time
excessive restructuring charge (shown as an accrued liability on the balance sheet) and then slowly
reverse this as a gain into earnings. The large restructuring charge itself may improve future earnings as
assets are written down (lower depreciation expense) and future operating expenses are pulled forward
into a charge in earnings. Abuse in the 1990's caught the attention of the SEC and now companies are
required to include a quarterly restructuring reserve roll forward. This has improved the transparency of
spotting restructuring reserve reversals. However, quarterly (or even annual) roll forward tables are not
required for other reserves. Another reserve reversal is taxes. Companies maintain a material tax
reserve liability for uncertain tax positions. Management may reverse part of the reserve as an offset
against reported income tax expense to lower the current period effective tax rate. This is a typical
reason a company "beats" earnings due to a lower than expected income tax rate.

A less well known tactic used to boost current period earnings is under expensing a recurring cost such
as warranty or bad debts. This will benefit current earnings, but without a sustainable improvement in
quality or collection efforts, the company will need to replenish the reserve through higher warranty/bad
debt expense in future periods. To match costs in the same periods revenues are recognized, the
company must expense its estimate of the cost of returns, product quality issues, bad debt, etc. in the
period in which the sale occurs. In calculating the current period expense amount, companies generally
use their historical experience and expectations based on current market conditions. This provides the
flexibility to manage the expense amount. To detect possible under accruing of expenses, we compare
the reserve amount to the related cost driver (warranty to sales, bad debt expense to accounts
receivable, inventory reserves to inventory, sales returns to sales and inventory). A low reserve
percentage relative to the historical ratio is one indicator of possible under-expensing current period
costs. As an example, a company begins the quarter with a warranty accrued liability to sales of 3%. To
reduce current period expenses, the company might expense only 1% of sales as warranty expense. As
a result, the ending reserve declines to 2% of sales. If reserves really are 3% of sales, the company will
need to increase warranty expense even higher than 3% of sales in future periods to make up for the
current period shortfall. The next exhibit is an illustration of Ericsson's material reserve reversals. After
the telecom bust, the company recorded substantial "big bath" restructuring and other charges. In
hindsight, the charges were excessive and, therefore, part of this accrued liability was reversed as a
gain in earnings over time. Based on the table below, there was at least a two year pattern of
approximately 4.8 billion SEK reserve reversals into earnings each year.
Illustration of Reserve Reversals: Ericsson
Ericsson’s 2006 20-F Filing: Provisions (SEK Millions)

Warranty Total
commitments Restructuring Other1)2) provisions
2006
Opening balance 4,821 2,314 11,533 18,668
Additions 2,561 2,765 5,420 10,746
Costs incurred -3,471 -2,308 -4,561 -10,340
Reversal of excess amounts -1,100 -416 -3,231 -4,747
Balances regarding divested/acquired businesses 224 20 -24 220
Reclassification 15 19 -121 -87
Translation difference for the year -89 -117 -372 -578
Closing balance 2,961 2,277 8,644 13,882
2005
Opening balance 6,424 3,598 14,756 24,778
Additions 2,858 1,323 5,564 9,745
Costs incurred -3,181 -1,983 -6,894 -12,058
Reversal of excess amounts -1,390 -480 -2,923 -4,793
Balances regarding divested/acquired businesses 6 — — 6
Reclassification 3 -322 224 -95
Translation difference for the year 101 178 806 1,085
Closing balance 4,821 2,314 11,533 18,668
1) Both current and non-current provisions.

2) Off-balance customer financing is included in other provisions.

RESTRUCTURING COSTS
The accounting rules for recording restructuring charges lay out a framework that attempts to prevent
the abuse of “big bath” charges or “cookie jar reserves”. Stemming from perceived abused in the 1990s,
when many companies previously took large charges in advance of actually incurring related
restructuring costs, FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities was
issued. This standard set a higher hurdle to recognize restructuring costs in that a liability must be
incurred in a manner where there is little or no discretion to avoid (a probable future sacrifice of
economic benefits arising from present obligations). No charges can be taken “below the line” - all costs
must be included as part of operating income. A company simply having a restructuring plan will not be
sufficient to meet the hurdle to recognize the charges – additional steps must be taken. The following is
a description of the accounting for several common restructuring items.
• One-time Termination Benefits: For one-time benefits provided to terminated employees, the
following must occur in order for the company to record a restructuring expense:
1. Management commits to a termination plan.
2. The plan identifies the number of employees to be terminated, their job classifications or
functions, and the expected completion date.
3. The termination plan includes and establishes specific termination benefits so employees may
ascertain the type and amount of benefits to be received.
4. It is unlikely that significant change will be made to the plan or that the plan will be withdrawn.
5. Communicated to the impacted employees.
The charges are recorded on the date the plan is communicated to the employees when
employees are not required to render service until their termination date or if they will not be
retained beyond a minimum retention period. The charges are recorded over the employee’s
remaining service period in the scenario that the employee is required to provide service until
their termination date and required to stay beyond the minimum retention period. (Note that the
minimum retention period may not exceed the legal notification period or, if none, 60 days.)
• Contract Termination Costs: When a company restructures, certain contracts or operating leases
may be terminated. These terminations will result in a restructuring charge and related accrued
liability to account for contract termination costs on the termination date. Additionally, there may
be other ongoing costs expected to be incurred under terminated contracts when the company
ceases using the rights under the contract (e.g., leased property). These amounts will also be
included in the charge and liability. The charges may be incurred on the same date as the
contract termination date or on a later date.

RESERVE REVERSAL GAINS INCLUDED IN EARNINGS - DO NOT OVERLOOK THE “SCHEDULE II”
Due to its location, typically near the end of the 10-K filing, the Schedule II (“Valuation and Qualifying
Accounts”) of reserve accounts is often overlooked. Although sometimes inconsistent and not
standardized, the schedule provides a very useful summary of a company’s critical reserve accounts.
Common items included on the Schedule II include inventory reserves, sales return reserves, deferred
tax valuation allowance, and bad debt reserves.
If a reserve account is disclosed elsewhere in the 10-K, it is not required to be disclosed in the Schedule
II (common with restructuring reserves). A review of the Schedule II is important to determine whether
the company reversed reserves or had another unsustainable benefit to earnings. For example, to boost
earnings in the current period, a company might reduce the expense amount of a recurring reserve,
such as warranties. Unless there is a sustainable trend whereby the lower reserve amount will not need
to be increased in a future period, this will be only a temporary earnings boost. The company will
subsequently record higher warranty expenses in future periods to build the account again. Likewise, the
company may be over-reserving in the current period so that the reserve may be reversed as a gain into
earnings at some future date (cookie jar reserves) when earnings are slowing.
To assess the reasonable of reserves, provisions and reversals, it’s important to standardize these
amounts. Companies use historical experience to calculate reserve amounts - the reserve amount
should be compared to the driver of the cost (e.g. warranty to revenues, bad debt expense to accounts
receivable, sales returns to sales and inventory) and contrasted with prior years. If the reserve
percentage is low compared to historical periods, this may presage future reserve increases as an
expense to earnings. The additions to the reserve account (the expense/provision) should be compared
with the subtractions from the reserve account. This can be done on a current year basis but we also
suggest a one-year lag (subtractions from the current year vs. the additions from the prior year). This is
due to the fact that the expensing of costs in the current period matches those costs with revenues, but
charge-off amounts and payout amounts will occur in subsequent period(s) as the balance sheet asset
is deemed worthless (receivables / inventory) or actual cash payments are made (warranties).
As an illustration and analysis of Schedule II, in the next exhibit we highlight Hewlett-Packard’s 2012
disclosure. The schedule reconciles the beginning and ending reserve balances. The “Addition of bad
debt provision” and “Additions to allowance” rows represent the amount of expense recognized in
earnings during each respective year. On the balance sheet, a corresponding allowance account is also
increased and netted against the related asset account (accounts receivable, inventory, tax assets, etc.).
Next, the deduction row is the amount written-off or utilized in the current period. As amounts are
written-off, there is generally no earnings impact — the accounts are removed from the balance sheet.
For example, if an accounts receivable amount is written-off for which there is a bad debt reserve, both
the accounts receivable account and the bad debt reserve is reduced by the same amount. For sales
returns, this may represent a cash outflow as products previously sold were refunded to customers.
There is generally no income statement impact. Similarly, when inventory is written-off, the inventory
and inventory reserve account are both reduced.

RESERVE REVERSAL GAINS INCLUDED IN EARNINGS (CONTINUED)
Next, we compare the amounts charged to expense in the current period to the “deductions” amounts.
The charges to expenses for financing receivables have been relatively stable over the last few years,
but the accounts receivable deductions has been lumpy. In 2010 and 2011, perhaps the company was
drawing down its bad debt allowance to more normalized levels from higher post-financial crisis bad
debt expense assumptions.
We then compare the prior year bad debt expense to the current year “deductions” since bad debt
amounts written off in the current year (called “deductions” in this situation) would have been expensed
to earnings in the prior year. Ideally, we would prefer observing charges to earnings slightly higher than
deductions. Due to their nature, they may be more “lumpy” on a year-over-year basis if there are larger
receivables reserved for and subsequently written-off. We would be skeptical of large decreases in bad
debt reserves relative to receivables or sales from the prior year, depending on the economic
environment.
To assess the reasonableness of the allowance for doubtful accounts, we compare the ending balance
to the receivables balance. Based on accounts receivable of $16.4 billion at 10/31/2012 and $18.2 billion
at 10/31/2011, the ending allowance balances seem consistent at around 2.6-2.8% each year.
Hewlett-Packard Schedule II

STOCK BASED COMPENSATION
Now known as ASC 718, companies have been required to record stock based compensation as an
expense in the earnings since the implementation of FAS No. 123(R), Share Based Repayment, in
2006. The primary forms of stock-based compensation include stock options, restricted stock and stock
appreciation rights. We describe each briefly below.
Types of Stock-Based Compensation
• Stock options: Stock options provide the employee with a right to purchase a share of company
stock at a stated exercise price. This right becomes effective upon vesting and has a limited
timeframe until expiration. Common vesting conditions include service time, meeting a
performance condition or being subject to a market condition. The most common vesting
condition is the service period, which is typically 3-4 years of service time. Option expiration is
typically 7-10 years from the date of grant. The exercise price is typically set by the company as
the market price of the stock on the day the option is granted (“at the money”). When the option is
vested and the option is in the money (market price>exercise price), the employee may exercise
the option resulting in a cash payment from the employee to the company and an issuance of a
share of stock to the employee. Employee stock options may expire worthless to the employee if
the share price declines below the exercise price and remains lower through expiration date. Prior
to the required expensing of stock options in earnings, stock option grants were the preferred
form of stock-based compensation, but have since given way to restricted stock grants.
• Restricted shares/stock or restricted stock units (“RSUs”): A company may also issue shares of
restricted stock to employees as compensation. They are typically subject to similar vesting
conditions to stock options that will be lifted upon meeting the terms. RSUs are promises made
by the company to issue the share of stock upon vesting. Restricted shares and RSUs are
essentially stock options with a $0 exercise price. Both restricted stock and RSUs may or may not
have dividend and voting rights, depending on the company. We have noticed a trend towards
companies moving towards more restricted stock grants (away from options). The advantage to
the employee of a restricted share grant is that some value is realized by the employee upon
vesting, even if the share price has declined since the grant date, due to the $0 exercise price.
• Stock Appreciation Rights (“SARs”): Stock Appreciation Rights are stock based compensation
instruments that are net settled in either cash or stock. Similar to a stock option, employees
participate in any increases in the stock price between the grant date and the exercise date.
However, no actual exercise proceeds will be paid to the company. Instead, the employee is
either directly paid in cash or shares based on the net increase in share price upon exercise.
From a company perspective, less dilution occurs as full shares are not issued. There will be
different accounting treatment based on whether the SARS are cash settled (and, thus, marked to
market through earnings each period based on the change in stock price) or share settled (similar
treatment to stock options and restricted stock).

STOCK BASED COMPENSATION (CONTINUED)
Expensing of Stock-Based Compensation
Companies must expense the grant date fair value of stock based compensation. This expense is
recognized over the service period, or the period the compensation is being earned by the employee.
The service period is typically the same as the vesting period, which is usually three to four years.
Depending on the actual vesting schedule, the grant date fair value will be recognized either straight line
or under an accelerated amortization method. Regardless of the subsequent changes in stock price and
intrinsic value of the option, the grant date fair value is a fixed compensation amount (no mark to market
or “true-up”). As a result, there may be scenarios where the GAAP cost does not reflect the true
economic cost of stock based compensation.
Stock-based compensation expense is not typically a discrete line-item in the income statements.
Instead, it’s defined as a compensation cost and will be classified where the remainder of that particular
employee’s compensation cost resides. For example, stock-based compensation for executives will be
recorded in SG&A. For manufacturing companies, a portion of stock-based compensation may be
capitalized into inventory and eventually recognized as cost of goods sold upon sale. As an example,
below we present Cisco’s disclosure that shows the allocation of total stock based compensation
expense throughout the income statement line items.
Cisco (2012 Form 10-K): Stock Based Compensation Summary
Summary of Share-Based Compensation Expense

Share-based compensation expense consists primarily of expenses for stock options, stock purchase rights, restricted stock, and restricted
stock units granted to employees. The following table summarizes share-based compensation expense (in millions):
Years Ended July 28, 2012 July 30, 2011 July 31, 2010
Cost of sales—product $ 53 $ 61 $ 57
Cost of sales—service 156 177 164
Share-based compensation expense in cost of sales 209 238 221
Research and development 401 481 450

Sales and marketing 588 651 602
General and administrative 203 250 244
Share-based compensation expense in operating expenses 1,192 1,382 1,296
Total share-based compensation expense $ 1,401 $ 1,620 $ 1,517

MEASUREMENT OF STOCK-BASED COMPENSATION GRANT DATE FAIR VALUE
The income statement expense amount for the next several years will be driven by the grant date fair
value of the stock based compensation. For restricted shares or RSUs, the fair value is rather
straightforward as it is set as the market price of the stock at that date. (If the employee cannot
participate in dividends before vesting, there may be some discount to the market price for the expected
dividends).
Management will have additional judgment in setting grant date fair value amounts for options and share
settled SARs. Typically, they will use a Black-Scholes, Binominal-Lattice, or some other type of option
pricing model. Companies are required to disclose the material assumptions used in their option pricing
models. It is important to assess these assumptions for reasonableness as well as any year to year
changes. The primary input assumptions for the Black-Scholes model include exercise price, expected
life, volatility, dividend rate, and risk-free rate.
The volatility assumption in an option pricing is the most subjective. Analysts should pay particular
attention to this assumption as management can use it to reduce future earnings impact. Due to SEC
guidance, companies typically use a market based assumption (may come from the implied volatility on
the company’s market traded equity options) as opposed to the historical volatility of their stock price.
Analysts should review the disclosure of option assumptions and ascertain whether any changes in the
volatility assumption are reasonable given the underlying volatility of the stock.
FORFEITURES
Due to employee turnover, not all share based compensation that is granted will ultimately vest.
Companies assume a forfeiture rate, or an amount that will not vest, and are only required to record an
expense for the amount expected to vest. This rate is not always disclosed and varies by company. An
annual forfeiture rate in the two to ten percent range is most common. The higher forfeiture rate
assumed, the lower the expense. However, at the end of each vesting period, companies will make a
“true-up” to include actual vested amounts.

DISCLOSURES
In the next series of exhibits, we provide examples of what to look for in the common stock-based
compensation related disclosures, using Cisco as an example. Cisco grants both restricted stock units
and stock options to its employees. Note that some companies also offer employee stock purchase
plans, which may be included in the similar exhibits. These plans typically afford employees a
discounted purchase price on company stock (usually 10-20%). While also expensed based on fair
value, the size of these plans is typically small relative to option or RSU programs.
FAIR VALUE ASSUMPTIONS

Below we show Cisco’s assumptions for determining the fair value of its stock option grants. Cisco did
not grant any options in 2012 or 2011 as the company has moved to granting more restricted shares.
For their 2010 option grants, the company used a lattice binomial model and disclosed that they use the
expected volatility of their stock based on the implied volatility of market traded options of 30.5%.
Cisco (2012 Form 10-K): Stock Option Valuation Assumptions

The valuation of employee stock options and the underlying assumptions being used are summarized as follows:
Year Ended July 31, 2010

Weighted-average assumptions:
Expected volatility 30.5%
Risk-free interest rate 2.3%
Expected dividend 0.0%
Kurtosis 4.1
Skewness 0.20
Weighted-average expected life (in years) 5.1
Weighted-average estimated grant date fair value per option $ 6.50
The valuation of employee stock purchase rights and the related assumptions are for the employee stock purchases made during the
respective fiscal years. The valuation of employee stock options and the related assumptions are for awards granted during the indicated
fiscal year.
The Company uses third-party analyses to assist in developing the assumptions used in, as well as calibrating, its lattice-binomial and
Black-Scholes models. The Company is responsible for determining the assumptions used in estimating the fair value of its share-based
payment awards.
The Company used the implied volatility for traded options (with contract terms corresponding to the expected life of the employee stock
purchase rights) on the Company’s stock as the expected volatility assumption required in the Black-Scholes model. The implied volatility is
more representative of future stock price trends than historical volatility. The risk-free interest rate assumption is based upon observed
interest rates appropriate for the term of the Company’s employee stock purchase rights. The dividend yield assumption is based on the
history and expectation of dividend payouts at the grant date. Prior to the initial declaration of a quarterly cash dividend on March 17,
2011, the expected dividend yield was 0% as the Company did not historically pay cash dividends on its common stock. For awards granted
on or subsequent to March 17, 2011, the Company used an annualized dividend yield based on the then current per-share dividend
declared by its Board of Directors.
The use of the lattice-binomial model requires extensive actual employee exercise behavior data for the relative probability estimation
purpose, and a number of complex assumptions as presented in the preceding table. The estimated kurtosis and skewness are technical
measures of the distribution of stock price returns, which affect expected employee stock option exercise behaviors, and are based on the
Company’s stock price return history as well as consideration of various academic analyses. The expected life of employee stock options is
a derived output of the lattice-binomial model, which represents the weighted-average period the stock options are expected to remain
outstanding.

GRANT AND EXERCISE TABLES
Below, we show the tabular format typically used to disclose the activity (number outstanding, number
granted, number exercised, etc.) of stock based compensation grants. Based on the company’s
disclosures, Cisco granted 65 million restricted shares/RSUs in 2012 at a weighted average value of
$17.45. As shown in an earlier section, Cisco did not grant any stock options in 2011/2012 but the table
is still disclosed showing that 66 million were exercised and 36 million were canceled/forfeited/expired.
Cisco (2012 Form 10-K): RSU Awards
(e) Restricted Stock and Stock Unit Awards

A summary of the restricted stock and stock unit activity, which includes time-based and performance-based or market-based restricted stock, is as follows (in
millions, except per-share amounts):
Weighted-Average
Restricted Stock/ Grant Date Fair Aggregated Fair
Stock Units Value per Share Market Value
BALANCE AT JULY 25, 2009 62 $ 21.25
Granted and assumed 54 23.40
Vested (16) 21.56 $ 378
Canceled/forfeited (3) 22.40
BALANCE AT JULY 31, 2010 97 22.35

Vested (27) 22.54 $ 529
BALANCE AT JULY 30, 2011 116 21.50

Vested (35) 21.94 $ 580
BALANCE AT JULY 28, 2012 128 $ 19.46
Cisco (2012 Form 10-K): Stock Option Awards

(f) Stock Option Awards
A summary of the stock option activity is as follows (in millions, except per-share amounts):
STOCK OPTIONS OUTSTANDING
Number Weighted-Average
Outstanding Exercise Price per Share
BALANCE AT JULY 25, 2009 1,004 $ 24.29
Exercised (158) 17.88
Canceled/forfeited/expired (129) 47.31
BALANCE AT JULY 31, 2010 732 21.39

BALANCE AT JULY 30, 2011 621 21.79

Assumed from acquisitions 1 2.08
BALANCE AT JULY 28, 2012 520 $ 22.68
The total pretax intrinsic value of stock options exercised during fiscal 2012, 2011, and 2010 was $333 million, $312 million, and $1.0 billion, respectively.

TOTAL STOCK-BASED COMPENSATION GRANTED
Our view is that the economic cost of stock-based compensation is the normalized total fair value that is
granted. This can be attained from the disclosures in the previous two exhibits. Generally, multiply the
number of grants (options/RSUs/restricted shares) by the fair value per item granted. Restricted shares
are straightforward as both items are disclosed in the grant table. For options, it is important to use the
fair value of the options granted (which is disclosed in the table with the model assumptions) as opposed
to the weighted average exercise price that was disclosed in the roll-forward table.
Below we calculate the 2012 fair value of stock based comp. granted using the disclosures above. There
were 65 million shares of restricted stock / RSUs granted at a fair value of $17.45 per share and no
options were granted. The total stock based compensation granted in 2012 was $1.1 billion.
Fair Value Calculation of Cisco’s Total Stock-Based Compensation Granted

Compensation
Amount Granted Weighted Ave. Granted
(millions) Fair Value ($) ($ in millions)
Restricted shares / RSUs 65 $17.45 $1,134
Stock options 0 NA 0
Total Value of 2012 Stock Based Compensation Grants $1,134
DILUTION OVERHANG & OUTSTANDING OPTION TRANCHE TABLE

To account for the outstanding restricted shares and options (that haven’t been issued or exercised) in
the diluted share count, the treasury stock method is used. Only options that are in the money are
considered to be included in the diluted share count. For Cisco, in 2012, stock-based compensation
resulted in 34 million additional shares included in the diluted EPS calculation. Additionally, Cisco
discloses that there were 591 million employee share based awards that have not been included in the
diluted share count at period end. This is likely the result of options being out of the money, and careful
attention should be paid to such outstanding options for possible future EPS dilution (as discussed in the
following paragraphs).
Cisco (2012 Form 10-K): EPS Calculation

The following table presents the calculation of basic and diluted net income per share (in millions, except per-share amounts):
Years Ended July 28, 2012 July 30, 2011 July 31, 2010
Net income $ 8,041 $ 6,490 $ 7,767
Weighted-average shares—basic 5,370 5,529 5,732
Effect of dilutive potential common shares 34 34 116
Weighted-average shares—diluted 5,404 5,563 5,848
Net income per share—basic $ 1.50 $ 1.17 $ 1.36
Net income per share—diluted $ 1.49 $ 1.17 $ 1.33
Antidilutive employee share-based awards, excluded 591 379 344
Employee equity share options, unvested shares, and similar equity instruments granted by the Company are treated as potential common shares outstanding in
computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options, unvested restricted stock, and restricted stock
units. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the
treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has
not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are collectively
assumed to be used to repurchase shares.

To be aware of potential large increases in the dilutive impact of stock options, analysts should pay
attention to the tranches of outstanding options. If provided, this table will disclose a breakout of
outstanding options based on ranges of various exercise prices. Both the total options outstanding are
shown as well as the subset of those that are vested (“exercisable”). Keep in mind that whether the
options are actually vested or exercisable has no bearing on whether the options are included in diluted
EPS under the treasury stock method.
An increase in the market price of a company’s stock can cause a large dilution impact if there are a
large number of options with exercise prices at or slightly below the current stock price. This is due to
the mechanics of the treasury stock method. For example, given a stock price in the period of $20, a
tranche of options with a weighted average exercise price of $30 would not be included in calculating
diluted EPS. However, if in the following period, there is a large increase in the stock price to
somewhere above $30, these options will begin to be included in the diluted share count, reducing EPS.
While many companies continue to disclose it, this table is no longer a required GAAP disclosure. Next,
we present the table provided in Cisco’s 10-K. The company had 143 million outstanding options (of
which 141 million are vested) with exercise prices between $20.01 and $25.00.
Cisco (2012 Form 10-K): Outstanding Options by Tranche
The following table summarizes significant ranges of outstanding and exercisable stock options as of July 28, 2012 (in millions, except years
and share prices):
STOCK OPTIONS OUTSTANDING STOCK OPTIONS EXERCISABLE
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Contractual Exercise Aggregate Exercise Aggregate
Number Life Price per Intrinsic Number Price per Intrinsic
Range of Exercise Prices Outstanding (in Years) Share Value Exercisable Share Value
$ 0.01 – 15.00 10 4.10 $ 6.95 $ 92 9 $ 7.18 $ 82
15.01 – 18.00 83 2.12 17.79 — 83 17.79 —
18.01 – 20.00 150 0.93 19.31 — 150 19.31 —
20.01 – 25.00 143 2.87 22.75 — 141 22.76 —
25.01 – 35.00 134 4.08 30.64 — 129 30.67 —
Total 520 2.53 $ 22.68 $ 92 512 $ 22.65 $ 82
The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s closing stock price
of $15.69 as of July 27, 2012, which would have been received by the option holders had those option holders exercised their stock
options as of that date. The total number of in-the-money stock options exercisable as of July 28, 2012 was 10 million. As of July 30, 2011,
575 million outstanding stock options were exercisable and the weighted-average exercise price was $21.37.

ECONOMIC COST OF STOCK BASED COMPENSATION
The true economic cost of stock based compensation is the transfer of value from the company to
employees. We would calculate this as the difference in the exercise price and the stock price at
exercise date. For restricted stock, the exercise price is $0 and the exercise date is the vesting date.
The net economic cost of stock-based compensation is calculated as follows:
Fair value of stock options exercised and restricted shares/ RSUs vested during the period:
Fair value of options exercised = number of stock options exercised times the average stock value during
the period.
Fair value of restricted shares/ RSUs = number of restricted shares/ RSUs vested times the average stock
value during the period.
Less: Cash received from stock option exercises (calculated as number of stock options exercised times the
weighted average exercise price). No exercise proceeds from restricted stock/ RSUs.
Less: Cash tax benefit of stock options exercised and restricted shares / RSUs vested. For statutory stock
options (most plans) the company does not receive a tax deduction until the option is exercised. The cash tax
benefit should be disclosed by the company, typically in the narrative of the stock compensation footnote.
Equals: Net cash cost of stock options exercised / restricted shares vesting during the period.
In the following exhibit, we calculate Cisco’s 2011 net cash cost of stock-based compensation. Cisco
actually provides the intrinsic value of option exercises ($312 million) and fair value of restricted stock
vested ($529 million). These amounts are disclosed in the roll-forward table exhibit previously discussed
and the related narrative. The cash tax benefit is estimated at a 35% tax rate. We estimate the net cash
cost of stock-based compensation in 2011 was $547 million.
Economic Cash Cost of Cisco’s Stock-Based Compensation ($ in millions)
Aggregate intrinsic value of options exercised in 2012 (1) $ 333

Aggregate fair falue of restricted stock vested in 2012 (2) 580
Less: Tax benefits from stock option exercises and other awards (3) (320)
Equals: Net cash cost of stock option exercises & restricted stock vesting $ 593
(1) Explicitly disclosed by company. If not disclosed this amount can be estimated as (# of
options exercised X average stock price) less (# of options exercised x average exercise
price).
(2) Explicitly disclosed by company. If not disclosed this amount can be estimated as # of
restricted shares vested X average stock price during period.
(3) Estimated at 35% tax rate.
Note: Excludes employee purchase plans. For fiscal year ending July 31, 2012.

ECONOMIC COST OF STOCK BASED COMPENSATION (CONTINUED)
ARE SHARE REPURCHASE PROGRAMS ACTUALLY A RETURN OF CAPITAL?
To offset the dilution from share based compensation, companies will typically utilize their share
buyback programs. We compare the net cash cost of stock based compensation to the shares
repurchased during the period to determine if the buyback program really is returning capital to
shareholders, or is merely being used as an offset to dilution from stock-based compensation (wealth
transfer to employees). When compared to $4.8 billion of “gross” share repurchases in 2012 and after
accounting for $593 million of stock repurchased to offset the economic cost of options/shares
exercised/vesting, Cisco repurchased a net $4.2 billion in stock in its fiscal year ending July 31, 2012.
Economic Cash Cost of Cisco’s Stock-Based Compensation
Net cash cost of stock option exercises & restricted stock vesting 593
Offset by: Value of shares repurchased (per Cash Flow Statement) (4,760)
Equals: Cash cost of stock options exercises - actual shares repurchased $ (4,167)
Note: Excludes employee purchase plans. For fiscal year ending July 31, 2012.

INCORPORATING STOCK BASED COMPENSATION INTO CASH FLOWS AND VALUATION
GAAP treats stock based compensation cost as a non-cash item that is added back to net income in the
statement of cash flows in calculating cash flow from operations. Therefore, any free cash flow
calculations that use reported operating cash flow figures do not include stock-based compensation.
Relatedly, some companies view stock based compensation expense as a “non-cash” item. We
disagree.
In our view, stock based compensation costs should be thought of in two distinctive components:
(1) Choosing to compensate the employee in a specific amount (an operating decision); and
(2) The issuance of options or shares directly to the employee instead of cash (a financing decision)
Analytically, we view the amount of compensation paid to the employee as a cash cost and, therefore,
reduce cash flow from operations for this cost. Our view is that this is akin to the company selling the
options or shares to some outside party and paying the employee in cash - an economically identical
transaction with very different accounting impacts.
The cash cost of stock based compensation as an adjustment to operating cash flow may be calculated
in a variety of ways, none of which are perfect. One method is to simply use the reported stock-based
compensation expense that GAAP adds back to net income in calculating cash flow from operations.
This is relatively simple with likely as much accuracy as the methods discussed next.
However, due to changes in compensation policies, sometimes this reported stock-based compensation
amount is not representative of future stock compensation amounts. In this case, we suggest using the
normalized fair value of stock-based compensation grants. This amount is calculated by using the value
granted in the most recent year (or an average of recent years) similar to how we calculated it previously
in the fair value calculation of total stock based compensation granted. In turn, adjustments can be
made for any expected changes in company stock compensation policies.
Another alternative is to use the aforementioned calculated economic cost of stock based
compensation. Again, there may be a historical bias in this amount as it reflects a compensation policy
when the options were issued in the past (sometimes up to ten years ago), and may not be
representative of the current stock-based compensation practices.

MODIFICATIONS TO OPTIONS AND VESTING PERIODS
When stock prices declined in 2008 and 2009, many previously granted stock options were left
significantly out of the money. As a response to help employees maintain some of their original value,
some companies have modified underwater stock options and accelerated the vesting of stock options
and restricted stock. These modifications can have an impact on future expense amounts reported in
earnings and EPS.
For example, companies may choose to modify/cancel/accelerate awards and recognize a large
expense in bad quarters. This is a type of “big bath” technique used as way to increase future earnings
when the economy recovers. These types of tactics generally have accounting implications of increasing
expenses in the current period and/or causing a “ramp up” effect portending higher future stock
compensation expenses.
There is a specific accounting treatment for modification of previously granted stock based
compensation. Typically, an additional expense often must be recognized if stock-based compensation
(options, restricted stock, etc.) awards are modified or their vesting is accelerated. Companies must
compare:
1. The revalued original (“cancelled”) stock-based compensation award (using updated assumptions
for volatility, interest rate, term, etc.) as of the modification date with
2. The value the newly modified/granted stock-based compensation award using current
assumptions.
If the value of the newly modified award exceeds the value of the cancelled stock/option, the company
must recognize additional stock-based compensation expense over the remaining employee service
period, which is usually the vesting period. The company would still recognize any stock-based
compensation expense related to the original award. If the value of the newly modified award is less
than the cancelled award (not typical), the expense related to the original option is still recognized.
Completely cancelling older stock options and simultaneously replacing them with new options is
considered a modification and treated as described above. If no replacement award is granted any
unrecognized compensation cost of that award is immediately expensed upon cancellation.

MODIFICATIONS TO OPTIONS AND VESTING PERIODS (CONTINUED)
BEWARE OF OPTION VESTING ACCELERATION REDUCING NORMALIZED COMPENSATION EXPENSE
When options are deeply out of the money, some companies may accelerate the vesting of options as a
means to keep some form of incentive for the employees. When vesting is accelerated, all of the
unrecognized future stock option expense for those particular options will be recognized immediately.
Therefore, the normalized stock based compensation expense over the remaining vesting period that
would have otherwise been recorded ratably over the vesting period will no longer occur. If new stock
based compensation is granted, there will be a “ramp-up” effect the year after the acceleration as the
company makes its way back to a normalized stock compensation amount. In the past, Dell accelerated
the vesting of 20.9 million options with an average exercise price of $22.03. This resulted in a $106
million charge for the fiscal year ended February, 2009. Therefore, this $106 million was effectively
pulled forward from recognition in future years.
Dell (2011 Form 10-K): Accelerated Vesting of Stock Options

Stock Option Accelerated Vesting Charges — Certain stock-based compensation charges incurred during Fiscal 2009 related to the
accelerated vesting of unvested “out-of-the-money stock options” (options that have an exercise price greater than the current market
stock price) are excluded from the non-GAAP financial measures. Stock-based compensation costs unrelated to the accelerated vesting of
out-of-the-money stock options are not excluded from the non-GAAP financial measures. We exclude charges related to the accelerated
vesting of out-of-the-money stock options because we believe they do not contribute to a meaningful comparison of our past operating
results to our current operating results.
LARGE SHARE COUNT CHANGES? QUANT. WORK SUGGESTS OUT/UNDER PERFORMANCE

Analysts should also review the overall change in a company’s share count over the past two years as
we’ve found large changes therein to be predictive of future stock performance. Based on our historical
research, companies with the largest increase in share count over the past two years underperformed
their sectors by the widest margin (bottom 10%) as shown in the chart below. We use this item as one of
the “additional factors” in our earnings quality framework discussed later in this report.
Stock Price Performance of Share Count Increasing Companies - Historical Return Study Results
Relative Return based on 2 Year Share Count Change

1 year Relative Return (L) Hit Ratio % (R)
3.0 80
2.0 70
1-Year Excess Return %
1.0 60
0.0 50
Hit Rate %
-1.0 40
-2.0 30
-3.0 20
-4.0 10
<-------Inc. in Share Count----------------------------Dec. in Share Count----->
-5.0 0
1 2 3 4 5 6 7 8 9 10
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Bloomberg; Standard & Poor’s; FactSet.

INCOME TAXES
The income tax footnote is one of the most complex notes in a 10-K. However, we feel it is one of the
most important items to thoroughly review, particularly this year in light of the frameworks for corporate
tax reform proposed by both the GOP and the Obama administration, the potential for the existence of
tax loss carry-forwards generated in the recent recession, and the expiration bonus tax depreciation in
2014.
Assessing the sustainability of a company’s effective and cash tax rates is essential for company
analysis. In reviewing the disclosures, look for the main drivers of the current GAAP effective tax rate
(income tax expense divided by pre-tax GAAP income) and the cash tax rate (cash taxes as disclosed /
pre-tax GAAP income). These rates must be taken in context with industry peer companies and
geographic segments and incorporation.
Income taxes are one of the areas where we have witnessed low earnings quality recently. A low or high
tax rate is a classic reason companies may beat or miss earnings expectations. Unexpected tax rates /
provisions may occur for three reasons:
• Quarterly tax rates are based on the estimated annual tax rate. Using a higher annual
effective tax rate assumption in an early quarter in the year allows the company to true-up the tax
rate in any particularly quarter. If the company deems the prospective tax rate to be lower, a
“catch-up” gain is recorded in earnings.
• Tax reserve accounts. Companies must maintain an accrued liability for uncertain tax positions
(i.e., when a company deducts an expense on their tax return (saving cash taxes), but does not
record the tax benefit in its GAAP financial statements due to potential audit risk). These reserve
accounts have significant management discretion. Part of the liability could be reversed as a gain
offsetting income tax expense for a variety of reasons, such as a settlement with the IRS or some
other judgmental determination that the accrued tax liability is no longer necessary.
• The presence of historical net operating losses often causes significant volatility in a
company’s tax rate. If a company is in a 3 year cumulative loss position, it may have recorded a
valuation allowance on its net deferred tax assets. When this occurs, the company will report a
very low GAAP effective tax rate. However, once the company returns to reporting consistent
GAAP profitability (6-8 quarters), the tax rate will increase to a more normalized level. The
auditors will require the company to reverse the deferred tax asset valuation allowance as a one-
time gain offsetting income tax expense in earnings and then report a normal tax rate going
forward. This increase in tax rate may present a potential source of negative earnings surprise.
LOW TAX RATES UNDERPERFORM

As a group, our quantitative work has shown that companies with low effective tax rates historically
underperformed their sector, while the historical performance for low cash tax rate companies was
inconclusive. This is most likely due to the fact that there is significant volatility in cash tax payments on
a quarterly basis. Regardless, it is our view that a low cash tax rate is red flag of future problems and
therefore still closely monitor companies’ cash tax rates.
Perhaps the most glaring example was Enron. In 2000, Enron reported $1.4 billion in GAAP earnings.
However, the company reported a very low cash tax rate during periods where it was later found that
there was fraud. What this suggests is that the IRS did not deem the income reported by Enron as real

INCOME TAXES (CONTINUED)
taxable income subject to taxes. The IRS uses a definition of taxable income closer to a cash basis
income, meaning that companies overstating earnings through non-cash means will generally pay lower
cash taxes since the tax authorities don’t deem the GAAP income as real income.
A Low Cash Tax Rate Was a Sign at Enron
ENRON
Calculated Cash Tax Rate
($ in millions) Year ended December 31,
1998 1999 2000
Income before taxes $878 $1,128 $1,413
Cash taxes, net of refunds 73 51 62
Cash tax rate 8% 5% 4%
WHAT ARE THE DRIVERS OF A LOWER EFFECTIVE INCOME TAX RATE?

Compared to the U.S. federal tax rate of 35%, many companies report materially lower effective income
tax rates for GAAP. The income tax footnote contains a reconciliation disclosure that will show in tabular
format the reasons the GAAP rate is different from the statutory rate. It will be reported in either tax rate
percentage terms or in absolute dollar terms. Over the long run, we view a low effective tax rate relative
to the higher corporate federal rate as generally unsustainable. For a U.S.-based company with mainly
domestic revenues, a typical effective income tax rate is between 35% and 40%, including state taxes.
Depending on the state, income tax rates range from 0% to 9% (companies receive a deduction on their
corporate tax return for state income taxes paid. Therefore, the state tax amount shown on this
reconciliation schedule is net of the federal income tax benefit).
Common reasons for a lower than statutory (35%) effective income tax rate include:
1. Net operating losses / valuation allowances;

2. Income earned in foreign countries that have lower tax rates;
3. Tax credits; and
4. Changes in uncertain tax positions / settlements with IRS.
Next, we show WhiteWave Food’s (“WW”) 2012 income tax rate reconciliation. In 2012, WW reported an
effective income tax rate of 33.6%. The largest item that causes the lower effective tax rate is “Foreign
Taxes versus U.S. statutory rate” of 3.5% in 2012, which is due to earnings in lower taxed foreign
countries. Most countries have a lower statutory tax rate compared to the 35% U.S. rate. The U.S. will
collect the difference in that 35% rate and the actual taxes already paid to the jurisdiction where the
profits were earned only when the funds are brought back to the U.S. If a company makes the assertion
that the foreign income taxed at a lower rate is “permanently reinvested” abroad, GAAP does not require
companies to record U.S. income taxes on foreign earnings in the income statement (or the
corresponding deferred tax liability) and, therefore, the company uses the foreign tax rate in calculating
its overall GAAP effective tax rate. Most companies make this assertion. If the permanently reinvested
assertion is not made for foreign earnings, the effective income tax rate would approximate the 35-40%
U.S. corporate and state blended income rate.

Typically, in order to use the profits generated overseas for returning capital to shareholders or domestic
M&A, the foreign profits must be repatriated, causing a taxable event. In our view, the lower effective tax
rate from foreign earnings may be unsustainable. We would prefer to see a normalized income tax rate
recorded in earnings along with a deferred income tax liability for future foreign taxes owed upon
repatriation.
WhiteWave Foods (2012 Form 10-K): Statutory to Effective Income Tax Rate Reconciliation
The following is a reconciliation of income tax expense computed at the U.S. federal statutory tax rate to income tax expense
reported in our consolidated statements of operations:
Year ended December 31,
2012 2011 2010
Amount Percentage Amount Percentage Amount Percentage
(In thousands, except percentages)

Tax expense at statutory rate of 35% $ 59,280 35.0% $ 58,248 35.0% $ 40,080 35.0%
State income taxes 6,757 4.0% 5,809 3.5% 3,857 3.4%
Foreign taxes versus U.S. statutory rate (6,008) (3.5)% (7,710) (4.6)% (4,272) (3.7)%
Transaction costs 4,489 2.7% — 0.0% — 0.0%
U.S. manufacturing deduction (3,603) (2.1)% (1,082) (0.7)% (942) (0.8)%
Audit settlements and statute of limitation lapses (1,419) (0.8)% (3,413) (2..1)% (2,885) (2..5)%
Deferred tax rate adjustments (1,942) (1.1)% (234) (0.1)% (2,902) (2.5)%
Other (696) (0.6)% 471 0.3% 223 0.1%
Total $ 56,858 33.6% $ 52,089 31.3% $ 33,159 29.0%
As previously mentioned, some companies present their reconciliation of statutory and effective tax rate
differently than WhiteWave’s disclosure, using instead the actual dollars of income tax provision.
Interestingly, disclosing in this manner may somewhat mask a low tax rate as an additional step must be
performed to translate the dollar amounts into percentage terms. In this method of disclosure, each line
item can be converted to a percentage by dividing by the “earnings before income taxes” (pre-tax GAAP
income) line found in the income statement.
Using Apple’s disclosure below, we would divide each of the 2012 amounts in Apple's disclosure below
by the pre-tax income amount of $55.8 billion (from Apple’s income statement). Dividing the total tax
provision of $14 billion by $55.8 billion results in an effective tax rate of 25.2% compared to the 35%
statutory corporate income tax rate.

Apple (2012 Form 10-K): Statutory to Effective Tax Rate Alternative Calculation ($ in millions)
A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate
(35% in 2012, 2011 and 2010) to income before provision for income taxes for 2012, 2011, and 2010, is as follows (in millions):
2012 2011 2010
Computed expected tax $19,517 $11,973 $ 6,489
State taxes, net of federal effect 677 552 351
Indefinitely invested earnings of foreign subsidiaries (5,895) (3,898) (2,125)
Research and development credit, net (103) (167) (23)
Domestic production activities deduction (328) (168) (48)
Other 162 (9) (117)
Provision for income taxes $14,030 $ 8,283 $ 4,527
Effective tax rate 25.2% 24.2% 24.4%
ARE THERE LARGE UNREPATRIATED FOREIGN EARNINGS?

Unrepatriated earnings are profits that the company earned in international jurisdictions on which
foreign, but not U.S., taxes have been paid. U.S. taxes will not be due until those profits are repatriated
by way of a dividend or deemed distribution from the foreign subsidiary to the U.S. parent company.
When this occurs, U.S. taxes must be paid at the 35% tax rate (the company will receive a foreign tax
credit for foreign taxes paid). Companies are not required to record GAAP U.S. income tax expense on
foreign earnings if they deem them permanently reinvested overseas. This allows companies to report
lower effective income tax rates. In this scenario, there is an off-balance sheet deferred tax liability for
any foreign taxes that would be owed upon the repatriation of foreign earnings.
The next exhibit is Procter & Gamble’s disclosure of the company’s permanently reinvested
(unrepatriated) earnings from foreign subsidiaries.
Procter & Gamble (2012 Form 10-K): Unrepatriated Foreign Earnings
We have undistributed earnings of foreign subsidiaries of approximately $39 billion at June 30, 2012, for which deferred taxes have not
been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional
tax expense may result, although the calculation of such additional taxes is not practicable.
During the 2005 tax year, the American Jobs Creation Act of 2004 (“Jobs Act”) allowed a one-time
repatriation holiday. The Jobs Act provided companies with the ability to repatriate foreign earnings at an
effective tax rate of 5.25%. While many large multinational companies are hoping for another
repatriation holiday, we do not believe any legislation will be passed in 2013.

Note that the unrepatriated earnings amounts are not necessarily equivalent to foreign cash. They may
represent something of an upper bound on the amount of cash that is actually held in foreign
subsidiaries, though in reality they are more akin to an untaxed retained earnings figure. As previously
highlighted, it may be difficult for companies to use “trapped” foreign cash for larger share repurchase
programs or dividend payments. To access this foreign cash for U.S. investment or corporate actions,
companies may incur incremental U.S. taxes generally equal to the difference between the 35% U.S.
corporate tax rate and the foreign effective tax rate paid.
FIN 48 UNCERTAIN TAX POSITIONS — ARE THERE LARGE POTENTIAL TAX LIABILITIES?
Companies record a reserve (accrued liability or often referred to as “tax reserves”) for tax positions
taken on their tax return that may not hold up under an IRS audit. Analysts should pay particularly close
attention to this portion of the income tax footnote as it is both a way to manage earnings and can also
result in a large cash tax outflow for income taxes. The accounting standard that sets forth this guidance
and the related disclosures is FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in
Income Taxes. While companies calculate their current year GAAP and IRS income tax amounts
annually, a long potential audit cycle (3 years, perhaps longer once IRS contesting occurs), causes
uncertainty about the actual tax amounts that will be ultimately owed to the tax authorities. FIN 48 also
requires increased annual disclosure of the company’s uncertain (i.e., aggressive) tax positions.
FIN 48 provides guidance on how to calculate GAAP income tax expense when there is uncertainty in
the allowable amount of a tax deduction (taken on the company’s tax return). FIN 48 uses a two-step
model in accounting for uncertain tax positions. First, determine if there is a greater than 50% chance
that the tax position taken by the company would be allowed upon a tax audit. If yes, then a GAAP tax
benefit is recorded (in the income statement by way of lower income tax expense) equal to the largest
amount that has a greater than 50% chance of being realized. The remaining amount is treated as an
uncertain tax position. If the answer is no in this two-step model, then none of the tax benefit is
recognized in the income statement (through lower income tax expense) and the entire amount is
recorded as an uncertain tax position (in the language of accountants: debit income tax expense, credit
income tax accrued liability). Importantly, in this determination of an uncertain tax position, companies
are required to assume that the tax position will be reviewed by the IRS/tax enforcers and such
authorities will have complete knowledge and all relevant facts with respect to the tax position.
FIN 48 Reconciliation Disclosure
Analysts should pay attention to the reconciliation of unrecognized tax benefits. In tabular format, it
provides a beginning to end of year activity rollforward for the “tax reserve”. What this tax reserve
represents is the reserve for “uncertain tax positions” as follows:
• The entirety of tax positions that would have less than a 50% chance of being sustained upon an
audit.
• Portions of tax positions that have an at least 50% chance of being sustained upon an audit, but
not 100%. When this occurs, the company records the tax benefit only up to the amount likely to
be sustained. For example, if a company received a $1,000 tax benefit from a tax deduction taken
and the highest probable amount likely to be sustained upon audit is $600, the remaining $400
would be recorded as the unrecognized tax benefit on the FIN 48 schedule.

The next exhibit is an excerpt of Apple’s unrecognized tax benefit (uncertain tax positions) liability
reconciliation. It shows the balance of $1.4 billion at the beginning of the year and activity within the
account during the year that resulted in an ending balance of $2.1 billion.
In 2012, there was a $687 million increase in the total amount of unrecognized tax benefits due to
uncertain tax positions of prior years (increase in estimate of possible taxes owed) and new tax positions
taken in FY 2012 on the company’s tax return, but not recognized for GAAP (as a reduction in income
tax expense) increased the reserve by $467 million. The current period “additions” in this table provides
insight into the amount of uncertain tax positions recognized on the tax return in the current year. Large
year-over-year increases may suggest more aggressive tax planning in the current year. Last, in
reviewing Apple’s footnote, there was a small decrease in the tax reserve of $10 million due to the
expiration of the tax statute of limitations (a reduction in the reserve is recorded as an offset (gain) to
income tax expense in the income statement).
Apple (2012 Form 10-K): Income Taxes – Reconciliation
Uncertain Tax Positions

Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax
position will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then
measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest
amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest
and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one year as non-
current liabilities in the Consolidated Balance Sheets.
As of September 29, 2012, the total amount of gross unrecognized tax benefits was $2.1 billion, of which $889 million, if
recognized, would affect the Company’s effective tax rate. As of September 24, 2011, the total amount of gross unrecognized tax
benefits was $1.4 billion, of which $563 million, if recognized, would affect the Company’s effective tax rate.
The aggregate changes in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2012, 2011, and
2010, is as follows (in millions):
2012 2011 2010
Beginning Balance $1,375 $ 943 $ 971
Increases related to tax positions taken during a prior year 340 49 61
Decreases related to tax positions taken during a prior year (107) (39) (224)
Increases related to tax positions taken during the current year 467 425 240
Decreases related to settlements with taxing authorities (3) 0 (102)
Decreases related to expiration of statute of limitations (10) (3) (3)
Ending Balance $2,062 $1,375 $ 943
There are a few important items to keep in mind when analyzing this schedule:
1. The balance is not the maximum expected cash payments from unfavorable tax audits, is not
an expected value of future taxes owed on uncertain tax positions and it does not include any
interest or penalties that might be owed to the IRS upon an unfavorable settlement (e.g., there
is a 20% annual penalty for substantial underpayment of taxes and companies are charged
accrued interest on the amounts owed since the tax return filing date).

2. There are many other tax positions that, upon audit, might be disallowed (e.g., aggressive
transfer pricing). At the time of the GAAP financial statements, these positions may have met
the FIN 48 threshold for recording the tax benefit in the income statement and, therefore, are
not recorded as an uncertain tax position.
3. It is very difficult to accurately estimate the expected future cash payments with respect to
uncertain tax positions and the liability often includes hundreds of different tax positions taken
over multiple years.
HOW TO ANALYTICALLY ASSESS UNCERTAIN TAX POSITIONS

We suggest analysts assess, standardize, and compare uncertain tax risk across companies by using
several metrics:
1. Compare the uncertain tax position balance to free cash flow and current market capitalization
of the company. Keep in mind that the ending balance represents at least several years of tax
positions that have not yet been audited or where the tax statute of limitations remains open.
And it is not an expected cash outflow.
2. Compare the current year additions to total income tax expense (taken from the income
statement), an average of the prior 3 to 5 years’ total income tax expense (to remove potential
one year volatility in income tax expense) and cash income taxes paid in the current year.
Recording an uncertain tax position reduces a company’s cash tax rate, but not the GAAP tax
rate. Therefore, a high ratio of uncertain tax positions to the aforementioned items suggests
that a company’s low cash tax rate (and, therefore, higher operating cash flow) may be driven
by aggressive/uncertain tax positions and unsustainable. Changes in unrecognized tax
benefits are recorded through GAAP income tax expense in earnings.
There are two other items found in the uncertain tax position table that warrant mention. First,
the balance is often reduced during the year by settlements. Most tax issues do not go to
court and the company and IRS often agree on an allowable amount for the uncertain tax
position taken. There is also statute of limitation lapses. The IRS has a three year statute of
limitations period to open an audit. The clock begins to tick when the company’s tax return is
filed. It is not uncommon for a company and the IRS to agree to waive the statute of
limitations. As tax returns are audited and settlements/adjustments made or when the statute
of limitation period ends, any remaining uncertain tax position for that item is released as a
non-cash reduction to the company’s GAAP income tax expense. This is one of the reasons a
company may have an unexpected reduction in the income tax rate in a particular quarter.
LARGE NET OPERATING LOSS CARRYFORWARDS?

Large tax net operating loss (“NOL”) carryforwards may be a “hidden asset” on balance sheets. When a
company experiences a loss on its tax books, there is no refund or credit given unless the loss can be
carried back to the 2 immediately prior years when taxes were paid. Instead, an NOL carryforward is
created. This NOL carryforward can be used in a later year to offset positive taxable income, thus,
reducing a company’s tax liability. Outside of an acquisition (and even then with some limitations), NOLs
are not easily monetizable. However, for a going concern company that once again becomes profitable,
NOLs represent a significant source of value if utilized. NOLs are disclosed in the table of deferred tax
assets and liabilities at their tax effected amount.
The next exhibit is GM’s 2012 table of deferred tax assets and liabilities. At a high level, deferred tax
assets and liabilities represent timing differences between when an item is deducted/recognized as
income on the GAAP financial statements and the company’s tax return. This is due to the fact that
GAAP is based on the accrual accounting concept and the tax code is generally based on cash
accounting. The recording of a deferred tax asset/liability bridges this timing difference and allows a
normal tax rate to be recorded on the GAAP financial statements.
The table discloses that the company has $20.2 billion operating loss and tax credit carryforwards which
are detailed in a separate table below (this is the amount that would offset taxes dollar-for-dollar; to
calculate the amount that would offset pre-tax income, divide by the respective tax rate [e.g., 35%]). In
addition, there are several other items that warrant a discussion. There is a $3.4 billion and $8.5 billion
deferred tax asset for postretirement benefits and pensions, respectively. This is due to the timing of
when the pension/OPEB expense is recognized on the GAAP financial statements as an expense
(earlier) and deductible for tax purposes (when the cash is paid to the pension trust or OPEB
benefits/trust). Similarly, the warranty deferred tax asset is due to the existence of warranty reserves
and that warranty costs are only deductible as paid in cash (a 35% tax rate multiplied by warranty
reserves should approximate this balance). Again, to calculate the amount applicable to pre-tax income,
divide the deferred tax asset/liability balance by the applicable tax rate. In reviewing this table, we also
look for large deferred tax liability balances. Such items represent a possible future cash outflow from
higher cash taxes, the timing of which is uncertain and a question for management. In analyzing GM’s
table of deferred tax assets/liabilities, we find no large deferred tax liabilities that raise concerns.
GM (2012 Form 10-K): Deferred Tax Asset/Liability Table with Large NOL Carryforwards
Deferred Income Tax Assets and Liabilities
Deferred income tax assets and liabilities at December 31, 2012 and 2011 reflect the effect of temporary differences between amounts
of assets, liabilities and equity for financial reporting purposes and the bases of such assets, liabilities and equity as measured by tax laws,
as well as tax loss and tax credit carryforwards.
The following table summarizes the components of temporary differences and carryforwards that give rise to deferred tax assets and
liabilities (dollars in millions):
December 31, 2012 December 31, 2011
Deferred tax assets
Postretirement benefits other than pensions $ 3,494 $ 3,672
Pension and other employee benefit plans 8,536 8,357
Warranties, dealer and customer allowances, claims and discounts 4,277 4,015
Property, plants and equipment 2,225 1,547
Capitalized research expenditures 6,106 5,152
Operating loss and tax credit carryforwards 20,220 21,199
Miscellaneous U.S. 2,865 3,017
Miscellaneous non-U.S. 578 243
Total deferred tax assets before valuation allowances 48,301 47,202
Less: valuation allowances (10,991) (45,191)
Total deferred tax assets 37,310 2,011
Deferred tax liabilities
Intangible assets 724 1,933
Total deferred tax liabilities 724 1,933
Net deferred tax assets $ 36,586 $ 78

GM (2012 Form 10-K): NOL Carryforwards Table
The following table summarizes the amount and expiration dates of our operating loss and tax credit carryforwards at December 31,
2012 (dollars in millions):
Expiration Dates Amounts
U.S. federal and state loss carryforwards 2013-2030 $ 6,642
Non-U.S. loss and tax credit carryforwards Indefinite 1,472
Non-U.S. loss and tax credit carryforwards 2013-2031 4,961
U.S. alternative minimum tax credit Indefinite 669
U.S. general business credits(a) 2017-2031 1,914
U.S. foreign tax credits 2013-2022 4,562
Total operating loss and tax credit carryforwards $ 20,220

Important items to keep in mind when reviewing 10-K income tax footnote disclosures for NOLs:
(1) Within the deferred tax asset table, the amounts shown are the company’s tax effected NOL
amounts. It is not net present valued. As an illustration, if an NOL carryforward of $1,000 is
available to a company, this NOL could be used to offset $1,000 of pre-tax income. Within the
deferred tax asset table, the NOL line item would be $350 ($1,000 NOL multiplied by the U.S.
federal (or foreign/state income tax rates) statutory income tax rate of 35%). This $350 is the
amount that can offset taxes owed. In reality, the actual value of the NOL in the deferred tax
asset table is somewhat lower as no present value factors based on expected utilization are
taken into account (if used, the NOLs would likely be used over a number of forthcoming years
when pre-tax profit is generated). Also, the NOL deferred tax asset amount is often an aggregate
of all NOLs available to the company, which may include federal, state, foreign NOLs, and
possibly tax credits. Each of these may have different expiration periods and varying ease of use.
Below, we present a summary table of the carry forward periods and expiration of various tax
NOLs and credits.
NOL and Tax Credit Summary
Type of NOL or Tax Credit Expiration Period

U.S. federal NOL 2 years carryback and 20 years carryforward; losses are carried back to the earliest period first
U.S. state NOL Varies by state, but often 10-20 years; some states do not allow any carryback
U.S. capital losses 3 years carryback and 5 years carryforward; may only off-set against capital gains
U.S. AMT credit Indefinite
U.S. foreign tax credit Typicially 10 years
Foreign NOL Varies by jurisdiction; some countries allow indefinite carryforward
Source: Wolfe Trahan Accounting & Tax Policy Research; Internal Revenue Code.
(2) Amounts listed in the narrative annual report disclosures before or after the table of deferred tax
assets and liabilities typically represent the amount that may be used to offset pre-tax income and
is not the NOLs’ value. In the previous example, a $1,000 NOL would likely be described in the
narrative.
(3) Certain limitations on the ability to use the NOLs may exist. For example, IRC Section 382 places
an annual limitation on the amount of NOLs that can be used to offset pre-tax income. Designed
to prevent the trafficking of NOLs, Section 382 will kick in if there has been an “ownership
change” in the corporation. Under IRC Section 382, an ownership change occurs when there has
been a more than 50% change in ownership of a company within any three-year period. When
this ownership change occurs, there will be a ceiling placed on the annual amount of NOLs that
may be used to offset taxable income. The limitation amount is formulaic and is calculated as the
acquired company’s common and straight preferred equity value immediately prior to the
ownership change multiplied by the monthly long-term tax exempt rate published by the Treasury
(~2.77% for acquisitions occurring in March 2013). The long-term tax exempt interest rate may be
found at www.irs.gov/irb.

NOL INTERNAL REVENUE CODE SECTION 382 LIMITATIONS
Our experience is that it is not uncommon to find companies with market capitalizations below their net
cash and NOL balances. The annual use of an acquired company’s NOLs may be limited due to IRC
Section 382, which was enacted by lawmakers to prevent “trafficking” of NOLs (purchasing a company
for its NOL value and thereby reducing the acquiring company’s taxes owed). Without any restrictions,
an “NOL-rich” company may be appealing to a profitable acquirer who might be looking to use the
acquisition to immediately reduce its taxes owed.
Trafficking NOLs is prevented by IRC Section 382 if there has been an “ownership change” in the
corporation, defined by the IRC as a more than 50 percentage point change in ownership of the target
company within the prior three-year period. Specifically, an ownership change occurs when:
1. The percentage of stock of the corporation owned by one or more 5% shareholders has
increased by more than 50 percentage points over,
2. The lowest percentage of stock owned by the 5% shareholder during the prior three-year period
(prior to the ownership change).
For purposes of the ownership change test, each 5% or more shareholder is tested individually. The less
than 5% shareholders are typically aggregated and treated as one 5% shareholder under the so-called
“aggregation rules.” In a merger, there is usually a change in ownership, as defined by the IRC above,
for at least one of the corporations involved.
When an ownership change occurs, IRC Section 382 places a ceiling on the annual amount of the
target’s NOLs usable to offset the taxable income of the combined company. The limitation amount is
calculated as the acquired company’s common and straight preferred equity value immediately prior to
the ownership change (in-the-money options and warrants may also be included) multiplied by the
monthly long-term tax exempt rate published by the Treasury (currently 2.77% for acquisitions occurring
in March 2013). Immediately prior to the ownership change is construed to mean the market cap. of the
target company on the day the acquisition closes.
Below we illustrate the IRC Section 382 limitation calculation, assuming that a $500 market
capitalization company, immediately prior to the ownership change (the date of acquisition), is acquired.
The calculated Section 382 limitation amount ($13.9) is the maximum allowable annual deduction to
offset taxable income of the combined company in the years following the acquisition. This NOL
limitation amount may be increased in certain years by built-in gains and the “338 Approach,” which are
discussed in more detail in our May 2, 2012 report, “Hidden Value in Net Operating Losses”.
Example: Section 382 Limitation
Acquired company’s equity market cap. x Long-term tax exempt rate = Annual NOL limitation
$500 x 2.77% = $13.9 (annual amount of NOL allowed against pre-tax income)
Source: Wolfe Trahan Accounting & Tax Policy Research; Internal Revenue Code.

NOL INTERNAL REVENUE CODE SECTION 382 LIMITATIONS (CONTINUED)
The IRC Section 382 limitation combined with the 20 year U.S. Federal NOL carryforward period limits
the amount of usable NOLs for some companies, explaining why our research identified companies with
NOLs and net cash balances that exceed their current market capitalizations. A few other IRC Section
382 items that we consider to be important when analyzing companies with material NOLs are detailed
below:
• Continuity of business required: The acquired NOL business must continue in existence during
the two year period after the ownership change date. If the acquiring corporation does not
continue the business of the acquired company at all times during the two year period after the
change in ownership date, the IRC Section 382 limitation amount is reduced to $0 under IRC
Section 382(c).
• Second ownership changes: If another greater than 50% “ownership change” occurs, a company
must re-calculate its IRC Section 382 annual limitation amount based on then current long-term
tax exempt rate multiplied by the change in control company’s equity and preferred market value
immediately prior to the second ownership change date. This renewed IRC Section 382 limitation
amount is applicable to all NOLs created after the first ownership change. Furthermore:
o If the second IRC Section 382 limitation amount is lower than the first IRC Section 382
limitation amount, the company must use the lower of the two amounts for all existing NOLs;
and
o If the second IRC Section 382 limitation amount is higher than the first Section 382 limitation
amount, the company must continue using the first IRC Section 382 limitation amount for
NOLs existing as of the first ownership change date.
• Unused Section 382 amounts are additive to the next year: If a company under the IRC Section
382 limitation rules doesn’t use all of the NOLs available to it, any unused amount may be used to
offset losses in the subsequent year plus that current year’s IRC Section 382 amount. Based on
the prior example, if the company experiences an ownership change resulting in an annual IRC
Section 382 limitation of $13.9, but only reports $10 in taxable income, using $10 of NOLs, $3.9
of the IRC Section 382 amount remains ($13.9 – $10) and is carried forward to the subsequent
year. Thus, in the following year, the company may use $17.8 of NOLs ($3.9 + $13.9 = $17.8).

HOW TO VALUE NOLS
To value NOLs, we suggest the following:
1. Project GAAP pre-tax income and estimate the amount of NOLs that will be usable in each year,
offsetting pre-tax income and keeping in mind any IRC Section 382 limitations;
2. Multiply the amount of NOLs used in each year by the company’s marginal tax rate in the same
jurisdiction as in which the NOLs exist; and
3. Calculate the NPV of the tax effected NOL amounts at the company’s weighted average cost of
capital (“WACC”), representing the present value of tax savings. We use the company’s WACC
(instead of a Treasury rate) as it reflects the riskiness of the company’s cash flows (i.e., taxable
income) necessary to utilize the NOL.
Once the NOLs are valued, an analyst may calculate the company’s earnings at a normalized effective
tax rate assuming no NOLs. A target price can then be determined by multiplying the company’s tax-
effected normalized earnings by its expected P/E multiple and adding the NOL value per share.
Similarly, we believe the aggregate value of a company’s NOLs, as calculated above, should be added
to the equity value derived from a DCF model or treated as a reduction in enterprise value (similar to
cash) for comparable company analysis.
NOL VALUATION EXAMPLE

Below we walk through an example of how to value a company’s NOLs, using the net present value
(“NPV”) approach described above. Assuming that a company’s NOL beginning balance in 2012 is $1.5
billion, we then assume that it generates $450 million of pre-tax income, which would be the amount of
NOLs used in that year. At an assumed tax rate of 35%, there is $70 of tax value from 2012 NOL usage.
We then carry forward the remaining unused NOL amount, and assume that the pre-tax income
available for NOL usage grows by 10% annually. Each year’s NOL usage tax amount is calculated
based on the 35% tax rate and the NPV of all years equals $432 million based on an assumed discount
rate of 10%.
Example: Valuing NOLs ($ in millions)
NOL Valuation Example 2012 2013 2014 2015

Beginning NOL balance $1,500 $1,500 $1,050 $555 $10
Assumed usage 450 495 545 10
Tax rate assumption 35% 35% 35% 35%
= NOL DTA amount used 158 173 191 4
Present value, discounted at 10% $432 $143 $143 $143 $3

OFF-BALANCE SHEET HIDDEN TAX VALUE: ARE THERE OTHER TAX SHIELDS?
Apart from tax net operating loss carryforwards, some acquisitions are structured to create future tax
deductible goodwill and intangible amortization expense (goodwill/intangibles are amortizable over 15
years under IRC Section 197). Below is Generac’s disclosure of tax deductible goodwill, the asset of
which is not reflected on the company’s balance sheet or in 10-K tax footnote table of deferred tax
assets. We suggest valuing this asset separately and treating it similar to a NOL for valuation purposes.
Tax Deductible Goodwill: Off-Balance Sheet Asset (Generac 2011 Form 10-K)
Factors influencing provision for income taxes.

Because we made a Section 338(h)(10) election in connection with the CCMP Transactions, we have $1.2 billion of tax-deductible goodwill
and intangible asset amortization remaining as of December 31, 2011 that we expect to generate cash tax savings of $470 million through
2021, assuming continued profitability and a 39% tax rate. The amortization of these assets for tax purposes is expected to be $122 million
annually through 2020 and $102 million in 2021, which generates annual cash tax savings of $48 million through 2020 and $40 million in
2021, assuming profitability and a 39% tax rate.
Source: Wolfe Trahan Accounting & Tax Policy Research. Company filings.
ARE DEFERRED TAX VALUATION ALLOWANCES REQUIRED?

Deferred tax assets and liabilities are due to timing differences between GAAP and cash taxes. For
example, a deduction may be taken on the tax return, but not yet recorded as an expense for GAAP.
This is common due to accelerated depreciation methods used for tax purposes but straight-line for
book purposes and will result in a deferred tax liability as future additional cash will be required to pay
taxes. A deferred tax asset will arise when an expense is taken for GAAP book purposes, but the
corresponding deduction is not yet taken for tax purposes. The DTA is essentially a future cash savings
as lower taxes will be due in a future period when compared to the GAAP tax expense. Accounting rules
require that companies evaluate their net tax assets for realizability. A company must actually have
positive pre-tax income in the future in order to utilize / realize the value of these deferred tax assets.
When a company is valued on book value metrics, the evaluation of tax asset realizability and assessing
potential valuation allowances is critical. This is particularly true for financial institutions like banks and
insurers. In the last several years, deferred tax asset write-down issues have arisen for homebuilders (in
2007 after large impairment and inventory losses); Fannie Mae’s (in 2008 when deferred tax assets
represented a significant portion of reported GAAP shareholder’s equity balance), and banks more
recently (large deferred tax asset balances were built from loan losses with little visibility into future
profitability).
A deferred tax asset write-down, or valuation allowance, must be recorded if, based on available
evidence, there is a more than 50% chance that some portion or all of the deferred tax assets will not be
realized by the company. The accounting standards on valuation allowances are set forth in ASC 740
(formerly FAS No. 109, Accounting for Income Taxes). In determining whether tax assets should be
written-down to their realizable value, the rules require both positive and negative evidence to be
considered. In order to justify the realizability of the tax assets, the company must demonstrate the
ability to generate a specific type of taxable income that is of the same character as the tax asset’s
attributes (i.e., same jurisdiction and type [e.g. capital loss vs. ordinary income]).

The recording of a valuation allowance, or deferred tax asset write-down, is recorded as an increase to
income tax expense in the income statement with a corresponding increase to the deferred tax asset
valuation allowance account. There will be a direct impact on GAAP shareholders equity due to the
write-down. For reporting purposes, the deferred tax valuation account is netted against the net deferred
tax asset amount on the balance sheet (a contra-asset account akin to bad debt allowance netted
against accounts receivable). It’s important to note that despite any deferred tax asset valuation
allowance, the actual tax attributes (e.g. NOLs) continue to exist and may be utilized so long as the
taxable income generated allows for it. GAAP tends to be overly conservative in this area in writing
down DTA’s.
LOW CASH TAX RATE?

The amount of cash taxes paid is a required annual disclosure. The location may vary - either at the
bottom of the cash flow statement as a supplemental item or in the financial statement footnotes
narrative. Analysts should pay close attention to these disclosures and calculate a cash tax rate. We
believe that a consistently low cash tax rate may suggest aggressive tax planning or aggressive GAAP
reporting. Certain circumstances (e.g., NOLs, large foreign earnings, etc.) may be exceptions. We
believe that one sign of early problems at Enron was a very low income tax rate.
Cash taxes may vary from the GAAP income tax expense as the latter is based on an accrual basis
using pretax income reported to shareholders. Cash taxes paid represent what is actually paid to the
IRS. Cash flow from operations will reflect the cash taxes paid. U.S. calendar year-end companies
generally make federal quarterly estimated tax payments to the Treasury on April 15th, June 15th,
September 15th, and December 15th. Any final payment is payable on the tax return’s due date, which
is March 15th (of the subsequent year) for calendar year-end companies. International country
estimated tax payment dates vary by country. We suggest two primary methods to calculate cash tax
rates:
1. Cash taxes paid / GAAP income before taxes. This cash tax rate reflects the actual cash tax
payments made during the current year. However, this calculation may be skewed by the timing
of cash tax payments which can be lumpy due to estimated tax payments and income tax
refunds.
2. Current income tax provision / GAAP income before taxes. To correct for the timing issues
discussed in Method #1 above, this is an alternative measure of the cash tax rate. We prefer this
method when cash tax payments are abnormally high or low in the current year. It’s an
improvement as it’s based on taxes related to the current year’s earnings. In the annual tax
footnote, the total reported income tax provision is comprised of two parts: current and deferred.
The current year income tax expense is the amount of taxes owed as calculated on the
company’s income tax return (corporate 35% tax rate multiplied by the company’s tax return pre-
tax income).

Next, we calculate Humana’s cash tax rates using both of the methods described above. The two
different methods of calculating cash tax rates have been relatively similar the last several years.
Humana (2012 Form 10-K): Cash Tax Rate Calculations ($ in millions)
2012 2011 2010 2009

1 Cash paid for income taxes 745 874 874 785
Earnings before provision for taxes 1,911 2,235 2,235 1,750
Cash tax rate using cash taxes paid 39% 39% 39% 45%
2 Current tax expense 769 794 849 589

Earnings before provision for taxes 1,911 2,235 2,235 1,750
Cash tax rate using current tax expense 40% 36% 38% 34%
THE IMPACT OF BONUS DEPRECIATION ON CASH TAX RATES

At 2012 year-end, bonus depreciation was scheduled to expire. The American Taxpayer Relief Act
extended 50% bonus depreciation by 1 year to the end of 2013 (end of 2014 for certain longer-
production and transportation assets). Interestingly, over the past year, the administration has been
questioning the need for any accelerated depreciation overall, much less bonus depreciation. Therefore,
the extension was not widely anticipated and we suspect many companies likely pulled forward some
capital expenditures into 2012 year-end. Sectors most impacted are utilities, telecommunications, and
industrials.
When bonus depreciation ends in 2014, analysts should be prepared for the cash tax rates of
companies in cap-ex intensive industries to potentially spike higher in the coming years due to the
reversal of these benefits. Below is a historical synopsis of bonus depreciation allowed under the U.S.
tax law.
Periods of Bonus Depreciation Availability
Bonus Depreciation Allowed Under U.S. Tax Law for Corporations
2001 2002 2003 2004 2005 2006 2007

0% 30% 50% 50% 0% 0% 0%
2008 2009 2010 2011 2012 2013 2014

50% 50% 50% 100% 50% 50% 0%
Note: No known periods of bonus depreciation prior to above.

Source: Wolfe Trahan Accounting & Tax Policy Research; IRS.

SHARE REPURCHASES
In addition to the gross share repurchase amount shown in the statement of cash flows (within the
financing section), analysts may also look for more information on the buybacks within the company’s
annual report filing. In either Item 5 of the 10-K or within the notes to the financial statements, share
repurchase activity must be disclosed in tabular format.
Detailed information will be included pertaining to the total number of shares repurchased, average price
paid per share, total number of shares purchased as part of publicly announced plans, and the
approximate amount of the shares remaining under approved stock repurchase plans. Either the fourth
quarter or full-year share repurchase activity may be disclosed (also required to be disclosed quarterly in
a tabular format).
Below we present CCE’s share repurchase disclosures from the company’s 2012 Form 10-K.
Coca-Cola Enterprises (2012 Form 10-K): Share Repurchase Disclosure

SHARE REPURCHASES
The following table presents information about repurchases of Coca-Cola Enterprises, Inc. common stock made by us during the fourth
quarter of 2012 (in millions, except average price per share):
(A) During the fourth quarter of 2012, 0.2 million of the total number of shares repurchased were attributable to shares withheld for taxes
upon the vesting of employee share-based payment awards. The remainder of the shares repurchased were attributable to shares
purchased under our publicly announced share repurchase programs and were purchased in open-market transactions.
(B) In October 2010, our Board of Directors approved a resolution to authorize the repurchase of up to 65 million shares, for an aggregate
purchase price of not more than $1 billion, as part of a publicly announced program. This program was completed at the end of 2011, and
resulted in the repurchase of $1 billion in outstanding shares, representing 37.9 million shares at an average price of $26.35 per share. In
September 2011, our Board of Directors approved a resolution to authorize additional share repurchases for an aggregate purchase price
of not more than $1 billion, subject to the cumulative 65 million share repurchase limit. This program was completed at the end of 2012,
and resulted in the repurchase of $780 million in outstanding shares at an average price of $28.81 per share. In December 2012, our Board
of Directors approved a resolution to authorize additional share repurchases for an aggregate price of not more than $1.5 billion.

EARNINGS PER SHARE AND DILUTED SHARE COUNT
A separate table in the footnotes must be disclosed showing the numerator and denominator
components of basic and diluted earnings per share calculations. This is an important section to review
for future potential EPS dilution. More information may also be found in the stock-based compensation
and debt footnotes (if convertible debt is outstanding).
The diluted share count will only include the impact of outstanding stock options to the extent they are in
the money. However, there may be a dilution overhang from at or out of the money options (see the
stock based compensation section of this report). Unvested restricted shares of stock are not fully
included in the diluted share count; therefore, beware of large recent grants that may begin to impact the
share count in future years. Yet another variation of stock based compensation is performance based
shares (e.g. subject to meeting EPS, ROE targets). These will not be included in the diluted share count
until the performance threshold has been met (considered to be contingently issuable shares).
On the other hand, a company's share count may not include the analytically correct number of shares.
This may occur most often with convertible debt outstanding. Plain vanilla convertible bonds will be
included in diluted EPS under the “if converted” method. This method assumes that the bond will always
be converted into stock, regardless of where the conversion price is relative to the market price of the
underlying stock. In some cases, this may result in too many shares being included in the diluted share
count from an economic perspective. If the convertible bond is out of the money or the company plans
on redeeming the bond in cash, no shares would be issued. Analytically, this convertible debt instrument
should be treated as debt rather than equity and the shares should not be included in the diluted share
count. Keep in mind that if a convertible bond's principal amount is required to be settled in cash, the
treasury stock method may apply. Within the EPS footnote, some companies may disclose the number
of shares excluded from the diluted share count due to their anti-dilutive effect. This helps frame the
possible forward EPS dilution existing at the balance sheet date.
Cisco Systems (2012 Form 10-K): EPS Calculation
The following table presents the calculation of basic and diluted net income per share (in millions, except per- share amounts):
Employee equity share options, unvested shares, and similar equity instruments granted by the Company are treated as potential common shares
outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in- the- money options, unvested
restricted stock, and restricted stock units. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal
period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the
amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded
in additional paid- in capital when the award becomes deductible are collectively assumed to be used to repurchase shares.

Statement of Cash Flows

STATEMENT OF CASH FLOWS
Generally we find that cash flows are a better indicator of company prospects than earnings as the
amounts are subject to less management discretion and accounting leeway. Most accounting
maneuvers are non-cash in nature so will be shown as a negative adjustment to operating or investing
cash flow. The balance sheet, income statement, and statement of cash flows are all inter-related. It is
important to note that the statement of cash flows is not without its shortcomings as accounting
deficiencies (e.g. capital leases) and other novel ways to increase reported operating cash flow do exist.
Below and on the next few pages, we discuss 13 items that result in non-comparable cash flows across
companies. Analysts should check these items and keep in mind that many items on the cash flow
statement may be netted together – items that an analyst would not consider recurring operating cash
flow may not be obvious at first glance. Throughout the 10-K in the related footnotes, you may discover
clues for unsustainable or “buried” cash flow benefits.
1. Extension / Delaying Payments of Accounts Payable or Accrued Expenses

By delaying actual cash payments for accounts payable or accrued expenses until after the
period end, operating cash flow will receive a temporary boost.
2. Inventory Draw Downs

Many companies drew down their inventory balances in the prior recession when production and
customer demand slowed. This improved operating cash flows; however, upon recovery of the
markets, inventory balances will again rise, reversing this trend and creating a cash flow
headwind. This dynamic has made it difficult to obtain the “normalized” operating cash flow (and
free cash flow measures) of many companies.
3. Prepaid Expenses
A prepaid expense will impact cash flow negatively in the period the payment is made. For certain
recurring costs such as advertising or marketing, companies may prepay them in a year when
cash flows are increasing. This increase in prepaid assets results in an operating cash outflow in
the current period. However, the following period, the company will receive an operating cash
flow tailwind as no cash payments will be necessary. This is a temporary benefit for cash flow that
cannot likely be sustained.
4. Accelerated Cash Receipts

Receiving cash before the related revenue is recognized will result in deferred revenue (a
balance sheet liability) being recognized. Many examples of this accelerated cash receipt occur in
areas where there is a longer time horizon, such as subscription software or a long-term supply
agreement. The recording of the deferred revenue account will be shown as an operating cash
inflow in the current period. If more than a one period cycle of cash flows have been collected on
an accelerated basis, future periods will have a cash flow headwind.
As an example of front-loading cash, a company may require cash deposits or encourage

customers to pay in advance. Some companies may lengthen the duration of certain contracts.
Take the example of a subscription license that is fully paid up-front. If the company begins
switching customers to minimum 2 year contracts from one-year contracts, reported cash flow
would appear to be growing. However, the increase in cash flow would be solely due to changes
in the contractual term, not the volume of subscriptions sold.

STATEMENT OF CASH FLOWS (CONTINUED)
5. Accounts Receivable Securitization
Many lower-rated companies utilize accounts receivable sales as a form of low-cost financing
(interest rate is typically based on short-term LIBOR or commercial paper rate). Some
securitizations will meet the criteria for sale accounting (A/R removed from the balance sheet and
recorded as operating cash inflow) and some will be required to be recorded as a secured
borrowing (A/R remains on balance sheet, securitized debt balance recorded - under the FAS No.
166 rules, Accounting for Transfers of Financial Assets, if material recourse exists it’s likely that
the sale of the receivables would not qualify for sale accounting).
No matter the actual accounting treatment that the securitization receives under GAAP, we feel
that economically (irrespective of the non-recourse nature of receivable sales), the transaction is
a financing decision and should analytically treated as such. The incoming cash flow is occurring
outside the normal cash flow collection process.
To adjust, operating cash flow should be reduced by the change in the uncollected receivables
balance. This balance is the amount of accounts receivable that has been sold but not collected
by the third party (bank or securitization trust). Correspondingly, financing cash flow is adjusted
by the same amount. Assuming the uncollected accounts receivable balances have increased
year-over-year, there is a negative adjustment to operating cash flow (from the change in the
uncollected balance) and a positive adjustment to financing cash flow.
Aside from potentially boosting operating cash flow, A/R securitizations will also mask
deterioration in DSOs and less conservative revenue recognition policies.
6. Cost Capitalization (Operating vs. Investing Cash Flow)

When costs are capitalized on balance sheet, the increase in the asset account must be shown
as a cash outflow somewhere on the cash flow statement. Some items may be shown as an
operating cash flow - there would be no overstatement of operating cash flow. More concerning
would be when the amount is reported as an investing cash outflow. Operating cash flow will be
permanently increased. The capitalized amount will eventually be expensed through earnings, but
as they would be “non-cash” at that point, the costs will be an add-back to the operating cash flow
amount. Note that this scenario will occur whether costs are properly or improperly capitalized.
7. Large Cash Outflows in From Investing Activities

Similar to the cost capitalization section above, any cash flow analysis should pay particular
attention to the amounts in the investing section, looking for amounts that should actually be
“operating”. Most traditional measures of cash flow focus on operating cash flow and capital
expenditures, so companies are incentivized to classify items as other investing cash outflows.
This leads us to WorldCom's 2000 and 2001 reported and restated cash flows. Among other
things, WorldCom improperly capitalized recurring costs as capital expenditures and other costs
and classified them as investing cash outflows. A quick review of WorldCom's cash flow
statement revealed large unexplainable investing cash outflows.

WorldCom: Classifying Costs as Investing Cash Outflows
Year Ended December 31,

2000 2000 2001 2001
Reported Restated Reported Restated
Statement of Cash Flow
Cash flow from operations $7,666 $4,227 $7,994 $2,845
Cash flow from investing

Capital expenditures (11,484) (11,668) (7,886) (6,465)
Acquisitions and related (14) 0 (206) (171)
Increase in intangibles (938) 0 (694) 0
Decrease in other liabilities (839) 0 (480) 0
All other investing activities (1,110) 505 (424) 514
Cash used by investing activities ($14,385) ($11,163) ($9,690) ($6,122)
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Bloomberg; Standard & Poor’s; FactSet as of 11/2/2011.
8. Lease Accounting a Source of Potential Cash Flow Management

As we discuss in the leases section of this report, new capital leases are not recorded as capital
expenditures on the cash flow statement. This is a shortcoming in GAAP that should be adjusted
for analytically by adding the amount of new capitalized leases entered into in the year (a
required supplemental disclosure) to reported cap-ex.
Similarly, a mix shift from operating leases to more capital leases will boost operating cash flows.
Given the bright line accounting rules for classifying a lease, structuring the leases to fit
accounting conventions is relatively easy. Capital leases are recorded on balance sheet and the
primary related expenses will be interest costs and non-cash depreciation. Operating leases’
rental expense is fully recorded in operating cash flow, so a switch to capital leases will result in
only the interest expense portion of a capital lease remaining in operating cash flow.
9. Taxes Impact Cash Flows

Income tax payments are included in operating cash flow. A temporary boost may be received in
periods of low cash tax payments, which may not be sustainable. Substantial differences may
occur due to the timing of cash tax payments when compared to the normalized tax rate. Items
resulting in this divergence include net operating losses, special tax credits, the timing of tax
payments or other items. We suggest observing a cash tax rate and assessing the sustainability
(we view a low cash tax rate as generally unsustainable over the long-run). Analysts may utilize a
normalized long-term tax rate for valuation and cash flow purposes and separately value any tax
benefits such as NOLs or tax credits.
10. Company Stock Contributions to Pension Plans

Many companies have been contributing stock in lieu of cash contributions in recent years. While
this will result in cash savings in any given year, a company that has a materially unfunded plan
cannot permanently avoid cash contributions. Only up to 10% of a company’s pension plan
assets are allowed to be in company stock. If the company is contributing stock at a time when
their share price is depressed, it only serves to further dilute existing shareholders.

11. Stock Based Compensation
As discussed in the stock-based compensation section of this report, stock option and restricted
stock expenses are technically “non-cash” and are add-backs to arrive at operating cash flow. We
feel that operating cash flow should be adjusted to include the impact of stock based
compensation costs as the payment in stock options / restricted stock is a financing choice and
the compensation costs are actually cash costs. Additionally, to avoid dilution from these
programs, many companies choose to repurchase stock in the market, which is classified as a
financing cash outflow and this amount is often overlooked by the investment community. We
believe that GAAP overstates analytical operating cash flow for companies with significant stock
based compensation plans.
12. Working Capital Benefits After an Acquisition

Analysts should skeptically view any large working capital benefits in the quarters after a material
acquisition. Companies may undertake certain actions in an acquisition to increase subsequent
reported operating cash flow. The target company may either increase non-cash current assets
(slower collection of accounts receivable) or decrease current liabilities (faster payment of
accounts payable or accrued expenses). Upon acquisition on the parent company’s cash flow
statement, the cost of acquired working capital is shown as a financing cash outflow for cash
acquisitions (will never appear on the cash flow statement for stock acquisitions). In subsequent
periods, if and when working capital levels return to normal levels, the consolidated company will
show the positive impact as operating cash flow. In this sense, for highly acquisitive companies,
earnings may actually be the preferred measure of operating performance over cash flow.
13. Include M&A Transactions as Cap-Ex

Companies may be described as serial acquirers if acquisitions are frequent and deemed
necessary to maintain revenue growth. For these companies free cash flow should be calculated
by including acquisition amounts akin to capital expenditures. When compared to other
companies that internally develop new products/markets resulting in current period cash
marketing/R&D costs, acquisitive companies will otherwise appear less expensive if adjustments
are not made. The acquisition costs can be treated as cap-ex in full or over a number of years
depending on the size and frequency of M&A.
Cash Flow Ratios to Monitor:
• Operating cash flow / net income

• Cash flow margin: Operating cash flow / revenue
• Cash conversion margin: (operating cash flow – net income) / revenue
• Cash flow from operations / EBITDA
• (EBITDA - operating cash flow) / revenue

MATERIAL NON-CASH ACTIVITIES / SUPPLEMENTAL CASH FLOW INFORMATION
Companies are required to disclose supplemental cash flow information in their 10-K, otherwise known
as significant non-cash activities. This schedule may be found either at the bottom of the cash flow
statement or in the 10-K footnotes, and can be used as a quick way to find the cash paid for interest and
income taxes. It includes such items as new capital leases initiated during the year, conversions of debt
into equity, stock acquisitions, and debt/liability assumptions. We use Amazon.com’s 2012 10-K to
illustrate this disclosure in the next exhibit.
We carefully review this schedule for large transactions that are accounted for as non-cash under
GAAP, but may analytically be cash expenses. As an example, assets acquired under capital leases
during the year are disclosed. As we explain in the lease section of this report, we believe capital leases
are capital expenditures and, as such, should be deducted from free cash flow calculations. Additionally,
we find this schedule useful in assessing earnings quality as it provides an input into assessing if a
company is capitalizing interest expense or has an unsustainably low cash tax rate.
Amazon.com (2012 Form 10-K): Supplemental Cash Flow Information

Pension Accounting
and Disclosures

PENSION AND POSTRETIREMENT PLAN DISCLOSURES
Pension and other postretirement benefits (“OPEB”) plan accounting and disclosure is one of the more
complex areas to understand when reviewing a 10-K. For specific company impacts and analysis please
refer to our related pension report published on January 3, 2013.
The following discussion focuses on defined benefit pension and OPEB plans. Defined contribution
plans (e.g. 401(k) plans) are typically very simple as they are expensed on a pay as you go basis.
Generally, there are three primary impacts analysts should consider when analyzing defined benefit
pension and OPEB plans:
1) Balance sheet. The net Funded Status (Pension Assets – Pension Liability) is recorded on the
balance sheet and is only “marked to market” annually. We consider any unfunded amount as the
economic equivalent of debt. In the long-term, this unfunded amount will need to be funded in
some way, by way of contributions from the company or outsized asset returns from the pension
plan.
2) The periodic pension cost. Pension cost is the amount related to pensions that is included in
earnings. It is a non-cash expense and reported on the income statement in the function area in
which the employee works (cost of sales, SG&A, R&D, etc.). In a later section, we walk through
the main components of pension cost.
3) Contributions. This is the actual cash impact of pensions, as determined by either the related
regulatory rules, union agreements, or other discretionary choices made by the company. Cash
contributions would be made either to the pension asset trust for a funded plan or directly to the
plan beneficiaries in an unfunded plan. These amounts would be included in the operating
sections of the cash flow statement.
In the pension footnote, pension plans are aggregated together for combined funded status. There may
actually be individually separate plans underlying the combined amounts, each of which may have
varying funded levels. For example, there may technically be separate plans for union employees,
salaried employees, or executives. The combined disclosures may show a net overfunded pension plan,
but one plan may be overfunded while other smaller plans may be underfunded. Therefore, the
aggregate disclosure amounts may understate certain individual pension plan’s funding level.
GAAP VS. REGULATORY RULES

The funded status of a pension plan is typically very different on a GAAP basis compared to a regulatory
basis. Regulatory rules are used to determine the required cash contributions, which may be very
different than the periodic pension cost reported under GAAP. Regulatory pension funded status is
generally not disclosed. In some cases, investors may find that no cash regulatory pension funding
requirement is due despite a large underfunded pension plan for GAAP purposes.
Only certain plans, so-called “qualified” plans, are subject to the ERISA regulatory funding rules. Other
plans, such as some executive plans (“non-qualified plans”) may not be subject to the specific ERISA
cash funding requirement rules. Additionally, plan disclosures may segregate U.S. and international
pension plans. International plans typically follow the cash funding rules of their respective domiciles,
which vary greatly.
For defense contractor cos., certain cash pension costs/funding amounts may be indirectly reimbursed
by the gov’t through negotiated contract rates under CAS accounting (Cost Accounting Standards).

KEY PENSION ITEMS: FUNDED STATUS = PENSION PLAN ASSETS – PENSION LIABILITY
Unless specifically noted, the majority of the following discussion pertains to the GAAP accounting rules
(see the subsequent pension Q&A section for a short primer on the regulatory rules).
Funded Status
The funded status of the pension plan is calculated as the plan assets less the pension liability (PBO).
An overfunded status would be included on the company’s balance sheet as an asset or the
underfunded status (more typical in today’s environment) would be included as a liability. If not
specifically broken out, amounts would typically be included on the balance sheet under some “Other”
assets or liabilities line item caption.
Pension Plan Assets

Pension assets are recorded and measured at fair value at year-end. The assets are not specifically
consolidated on the company’s balance sheet, but rather as part of the funded status as discussed
above. The assets are typically held in a trust separate from the remainder of the company’s assets.
Pension Liability - Projected Benefit Obligation (PBO) and Accumulated Benefit Obligation (ABO)
Corporate pension benefit payments are typically tied to a predetermined formula. Several inputs are
used in the calculation, notably, an average of the employee’s average salary and the number of years
of employment. From a GAAP perspective, the pension liability is a series of future cash outflows
(benefit payments) that are discounted back to today using an assumed discount rate. Many equate the
pension liability to a series of zero coupon bonds with maturities equal to the individual future benefit
payment date.
The reported GAAP pension liability is also known as the PBO or “projected benefit obligation”. The
PBO makes assumptions about future compensation increases and what salary levels may ultimately be
at the time current employees reach retirement. An alternative measure that is disclosed (but not used
for funded status recorded in the balance sheet) is the ABO or “accumulated benefit obligation”. The
primary difference is the treatment of assumed future compensation increases. The ABO is a measure
of the present value of the future benefit payments based on the employee’s current salary. The PBO
will always be larger than the ABO. The ABO represents the liability required if the pension were settled
today and is closer to the liability used for regulatory purposes.

KEY PENSION ASSUMPTIONS
DISCOUNT RATE
The discount rate is one of the primary assumptions companies use to calculate the PBO when the
pension liability is marked to market each year-end. As a result, the discount rate assumed at the end of
one year will impact the service and interest cost for the following year. Management has some, but
generally not a significant amount of input into determining the discount rate as it is generally market
based. It is the spot Aa corporate bond yield at year-end.
Actuaries hired by the company will calculate the rate based on Aa corporate interest rates that match
the duration of the company’s pension plan liabilities. We monitor several Aa indexes that track the level
of corporate Aa rates. One publicly available index that we’ve found to be highly correlated is the
Citigroup Pension Curve Discount Rate – which is available on a monthly basis at the following location:
http://www.soa.org/files/xls/pen-discount-curve.xls. While the Moody’s Aa rate has not been a highly
reliable proxy for the discount rate in several years, some analysts may follow it at least for directional
purposes due to its ease of availability (Bloomberg ticker = MOODCAA Index).
For our analysis, we use the Merrill Lynch 15 year Aa corporate spot yield curve, which is published
daily. Based on our actuary contacts, we have found this yield to most closely track that used by pension
plans in valuing their pension liabilities.
Discount Rate Proxy: Merrill Lynch 15+ year Aa Corporate Index Yield
Merrill Lynch 15+ Yr Aa Corporate Yield

6.5
6.0
ML 15+ Yr Aa Corporate Yield (%)
5.5
5.0
4.5
4.0
December 31, 2010: 5.40%

December 31, 2011: 4.55%
December 31, 2012: 4.07%
3.5
Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12
Source: Wolfe Trahan Accounting & Tax Policy Research; Bank of America-Merrill Lynch.

KEY PENSION ASSUMPTIONS (CONTINUED)
IMPACT OF DISCOUNT RATE
As a function of present value, lower discount rates will increase the calculated pension liability. The
year-end assumed discount rate is used to mark the pension liability to fair value at year-end. It is also
used to determine the following years’ service and interest cost. The impact of discount rates on service
and interest cost include:
• Higher discount rate — lower service cost;
• Higher discount rate — higher interest cost (higher rate reduces the projected benefit obligation,
but the impact of a higher interest rate on a lower benefit obligation is typically larger); and,
• The net impact of a higher discount rate on the combined service and interest cost typically
reduces pension expense, as the effect of the lower service cost amount exceeds that of the
higher interest cost. However, if a pension plan has a large proportion of retirees or older
employees, as measured by a high interest cost relative to service cost, a higher discount rate
may increase pension expense.
RATE OF COMPENSATION INCREASE (SALARY INFLATION RATE)

As discussed earlier, the primary measurement of the pension liability is the PBO, which incorporates
assumptions about future salary levels. The rate of compensation increase or salary inflation rate will be
disclosed by the company. The salary inflation rate acts as a pension benefit obligation growth rate.
Along with the employee’s expected retirement date and mortality, the company’s actuary will use the
current salary amount and assumed salary inflation rate to calculate future pension benefit payments.
Lower salary inflation rate assumptions may be considered less conservative since they will result in
lower pension liabilities. Based on our reviews, a salary inflation rate of 4.00% to 4.25% is typical and
assumptions do not frequently change.
EXPECTED RATE OF RETURN ASSUMPTION

The expected rate of return assumption is a direct input into the calculation of periodic pension cost. As
discussed later, the expected return on plan assets is a component of pension cost and is a direct offset
to the other components in that it will lower the overall expense since it is a return measure. The
expected long-term rate of return on plan assets is an assumption reflecting 1) the current or target
asset allocations and 2) the anticipated average rate of return on the company’s pension assets over the
long-term. It is typically based on a long-term historical average of actual fund performance (anywhere
from 10-30 years is possible based on discussions with fund managers and actuaries). Therefore, year
to year volatility in the performance of the pension fund’s actual returns will not immediately portend a
change in the expected rate of return assumption.
The reported pension expense in earnings is directly impacted by the expected rate of return. A higher
expected rate of return reduces pension cost and thus increases earnings. Conversely, a lower
expected rate of return would increase pension cost and lower earnings.

KEY PENSION ASSUMPTIONS (CONTINUED)
GAAP Guidance on the Expected Rate of Return Assumption:
ASC 715-30-35-47:
“The expected long-term rate of return on plan assets shall reflect the average rate of earnings
expected on the funds invested or to be invested to provide for the benefits included in the PBO. In
estimating that rate, appropriate consideration shall be given to the returns being earned by the plan
assets in the funds and the rates of return expected to be available for reinvestment. The expected
long-term rate of return on plan assets is used (with the market related value of assets) to compute
the expected return on assets.”
Over the last several years, the median expected rate of return assumption was 8.0%. Given the lower
equity returns over the last several years and the fact that many companies are allocating pension
assets into historically lower yielding fixed income assets, we were not surprised to see the 2011 median
rate of return fall to 7.75%. It is possible that we will see further declines in the expected rate of return
assumption at 2012 year-end and believe that the median rate will trend down to around 7.0% over the
next several years.
Historical Median Discount Rate and Expected Rate of Return Assumptions for Russell 3000 Companies
Median Discount Median Expected

Year Rate (%) Rate of Return (%)
1996 7.50 9.00
1997 7.25 9.00
1998 6.75 9.00
1999 7.50 9.00
2000 7.50 9.00
2001 7.25 9.00
2002 6.75 8.75
2003 6.25 8.50
2004 5.75 8.50
2005 5.50 8.25
2006 5.75 8.00
2007 6.25 8.00
2008 6.25 8.00
2009 5.85 8.00
2010 5.40 8.00
2011 4.75 7.75
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Bloomberg; Standard & Poor’s; FactSet.

PENSION COST
Pension cost includes seven primary components:
1 Service cost: This cost is the ongoing expense due to new benefits being earned by current
employees for working during the current year and increasing their future benefit payments under
the pension benefit formula structure. It is, in effect, compensation cost. These incremental
benefits are being “earned” now, but will be paid out during retirement. Therefore, additional
future amounts due are calculated, discounted back to present values, and expensed as service
cost in the current period. This amount increases the projected benefit obligation.
2 Interest cost: Interest cost is calculated on the pension benefit obligation as a function of the
deferred nature of the pension benefit payments. A defined benefit pension plan is essentially a
deferred compensation arrangement. It is calculated as the end-of-prior-year benefit obligation
(“PBO”) multiplied by the year-end discount rate. This amount will be included within periodic
pension cost and the projected benefit obligation.
3 Expected return on pension plan assets: Due to smoothing mechanisms in GAAP pension
accounting, actual returns on pension plan assets are not used in determining periodic pension
cost. As discussed previously, a company must assume an expected rate of return on pension
plan assets when calculating pension expense. This is the return on the plan assets that the
company assumes will be achieved over the long-term on a smoothed basis. The expected return
on plan assets is an offset (“income”) amount to other pension costs and calculated as the assets
x the expected rate of return on plan assets. Companies can choose to use the fair value of plan
assets or up to a 5-year smoothed value (called the market-related value).
4 Amortization of gains/losses: The increase or decrease in the PBO from a change in the discount
rate or differences between the actual and expected returns on plan assets are directly reflected
in the balance sheet, but are not directly reflected in pension cost / earnings in the current period.
These items are the result of changes in actuarial assumptions that are smoothed into pension
expense over time and will dampen earnings volatility. When an actuarial mark occurs that
changes amounts on the balance sheet, instead of immediately expensed through earnings, they
are accumulated in AOCI (within equity) in an account called “unrecognized net gain or loss”. The
accumulated unrecognized net gains or losses are then recognized into earnings over time under
a complex calculation commonly referred to as the “corridor”. While overall EPS volatility is
understated through use of this smoothing technique, the impact of using the corridor may still
result in large swings in pension expense year-to-year.
5 Amortization of prior service cost: Particularly with union negotiated pension plans, companies
may amend their pension plan benefit terms to retroactively increase or decrease (less likely)
employee pension benefits. When a company makes an amendment to a pension plan that
changes future benefits, the costs / savings associated with the amendment are calculated by an
actuary and then recognized straight line over the remaining service life of the impacted
employees.

PENSION COST (CONTINUED)
6 Curtailments: The FASB pension rules define a plan curtailment as “an event that significantly
reduces the expected years of future service of present employees or eliminates for a significant
number of employees the accrual of defined benefit payments for some or all of their future
services” (FAS No. 88). Essentially, employees will not continue to accrue future benefits in the
amount originally estimated. Freezing a pension plan is a typical example of a curtailment (the
discontinuing of accruals for any future benefit increases based on service life or salary increase).
Another example is a restructuring event, such as the closing of a facility or a division of the
company. Curtailments will typically result in a reduction of the PBO as the value of future benefit
payments will be less than previously estimated. Based on the specific events, actuaries will
calculate the costs/savings associated with the action and the company will record a one-time
gain or loss in earnings.
7 Settlements: A settlement occurs when there is some irrevocable action taken by the company to
relieve a portion of its future pension liability. Common examples include: 1) making a lump sum
cash payment to the employee/retiree that relieves any obligation to pay the future benefit
payments or 2) the purchase of a nonparticipating annuity contract that will exactly offset the
future cash flows due for the benefit payments. Simply investing in high quality fixed income
securities with maturities similar to the benefit payment dates would not be considered a
settlement. Based on the specific events, actuaries will calculate the costs/savings associated
and the company will record a one-time gain or loss.

PENSION FOOTNOTE EXAMPLE – ILLINOIS TOOL WORKS
On the next several pages, we will walk through some of the common pension and OPEB footnote
disclosures using Illinois Tool Works (ITW) as an example.
ASSUMPTIONS
The first part of the disclosure includes assumptions used to calculate the pension plan liability – these
are 2012 year-end assumptions that are used to calculate the year-end funded status and will also be
used to calculate the following year’s (2013) pension expense. For example, ITW calculated the present
value of its pension projected benefit obligation at December 31, 2012 using a discount rate of 3.85%.
This rate will also be used to calculate 2013 pension interest expense (prior year-end PBO multiplied by
the discount rate at prior year-end).
The bottom part of the table lists the assumptions that were used to calculate ITW’s 2012 pension
expense. As shown below, the 2011 year-end discount rate of 4.64% was used for the 2012 net pension
cost. The expected rate of return on plan assets was 7.23%. The assumed rate of compensation
increases (salary inflation rate) is also shown at 3.86%.
Illinois Tool Works (2012 Form 10-K): Pension & OPEB Assumptions
Assumptions
The weighted-average assumptions used in the valuations of pension and other postretirement benefits were as follows:
Pension Other Postretirement Benefits

2012 2011 2010 2012 2011 2010
Assumptions used to determine benefit
obligations at December 31:
Discount rate 3.85 % 4.64 % 5.05 % 4.15 % 4.95 % 5.45 %
Rate of compensation increases 3.86 % 3.86 % 3.94 % —% —% —%
Assumptions used to determine net
periodic benefit cost for years ended
December 31:
Discount rate 4.64 % 5.05 % 5.57 % 4.95 % 5.45 % 5.80 %
Expected return on plan assets 7.23 % 7.39 % 7.63 % 7.00 % 7.00 % 7.00 %
Rate of compensation increases 3.86 % 3.94 % 4.18 % —% —% —%
PENSION COST
The pension cost disclosure in the following exhibit details the individual components of pension cost
and OPEB cost. The drivers of changes in pension cost include discount rates, salary inflation rates,
company contributions, actuarial changes, and the inherent smoothing mechanisms in GAAP pension
accounting (i.e., deferring some gains and losses). ITW reported 2012 pension and OPEB cost of $122
million and $24 million, respectively. This is the amount of expense generally recorded in the income
statement (allocated to cost of sales, SG&A, and R&D) although some of the costs may be capitalized
into inventory.

PENSION FOOTNOTE EXAMPLE – ILLINOIS TOOL WORKS (CONTINUED)
These amounts are non-cash and the only pension cash “cost” is the current year’s cash contribution to
the company’s pension plan. The cash contribution amount is shown as an operating cash outflow on
the cash flow statement (pension expense, net of cash contributions are typically shown as one line item
in the operating section of the cash flow statement) and may be an inflow or outflow depending on if the
GAAP expense is higher or lower than the actual cash contribution. The amount may also be buried
within “other” operating cash flow.
Illinois Tool Works (2012 Form 10-K):Pension & OPEB Cost ($ in millions)

In millions 2012 2011 2010 2012 2011 2010
Components of net periodic benefit cost:
Service cost
$ 100 $ 94 $ 94 $ 13 $ 14 $ 14
Interest cost
107 116 110 27 30 30
Expected return on plan assets (157 ) (157 ) (150 ) (20 ) (21 ) (18 )
Amortization of actuarial loss
57 39 26 1 — —
Amortization of prior service cost
1 1 1 3 6 6
Settlement/curtailment loss
14 — 1 — — —
$ 122 $ 93 $ 82 $ 24 $ 29 $ 32
FUNDED STATUS, PLAN ASSETS & LIABILITY ROLLFORWARDS

The next exhibit includes the two parts of the funded status for the pension & OPEB plans. It includes a
“rollforward” of 2012 activity and items impacting ending balances for each of the pension & OPEB plan
assets and liabilities.
At December 31, 2012, ITW’s fair market value of pension plan assets was $2.3 billion, while the
company’s PBO was approximately $2.7 billion. Therefore, ITW’s pension plan was underfunded by
approximately $367 million at December 31, 2012. There was an additional amount $58 million of “other
immaterial plans” (presumably, unfunded nonqualified pension plans) for a total unfunded status of $425
million. Also, keep in mind that these disclosures aggregate pension plans as most companies have
multiple pension plans (salaried, union, etc.).
The pension footnote rollforwards discloses the line-by-line changes in the pension & OPEB benefit
obligation and the fair market value of pension & OPEB plan assets. In 2012, the pension plan’s PBO
increased from $2.5 billion to $2.7 billion primarily due to $100 million of service cost, $107 million of
interest cost, $200 million actuarial loss (primarily due to a decline in discount rate), offset by $196
million of benefit payments made and $74 million of divested plans. Pension plan assets increased from
$2.0 billion to $2.3 billion due to $240 million in actual market gains, $190 million in company
contributions offset by $196 million of benefit payments made and $38 million of divested plan assets.

Illinois Tool Works (2012 Form 10-K): Pension & OPEB Assets, Liabilities, Funded Status ($ in millions)
The following tables provide a rollforward of the plan benefit obligations, plan assets and a reconciliation of funded status for the
years ended December 31, 2012 and 2011:

In millions 2012 2011 2012 2011
Change in benefit obligation:
Benefit obligation at January 1 $ 2,465 $ 2,301 $ 569 $ 559
Service cost 100 94 13 14
Interest cost 107 116 27 30
Plan participants’ contributions 6 8 15 15
Amendments 5 — — —
Actuarial loss 204 79 45 —
Acquisitions/divestitures (74 ) 16 — —
Benefits paid (196 ) (142 ) (45 ) (48 )
Medicare subsidy received — — 3 3
Liabilities from (to) other immaterial plans — 2 — (4 )
Settlement/curtailment loss (gain) 5 — (38 ) —
Foreign currency translation 33 (9 ) — —
Benefit obligation at December 31 $ 2,655 $ 2,465 $ 589 $ 569
Change in plan assets:

Fair value of plan assets at January 1 $ 2,054 $ 1,941 $ 297 $ 294
Actual return on plan assets 240 108 31 3
Company contributions 190 131 30 33
Plan participants’ contributions 6 8 15 15
Acquisitions/divestitures (38 ) 15 — —
Benefits paid (196 ) (142 ) (45 ) (48 )
Foreign currency translation 32 (7 ) — —
Fair value of plan assets at December 31 $ 2,288 $ 2,054 $ 328 $ 297
Funded status $ (367 ) $ (411 ) $ (261 ) $ (272 )
Other immaterial plans (58 ) (63 ) (7 ) (7 )
Net liability at December 31 $ (425 ) $ (474 ) $ (268 ) $ (279 )

BALANCE SHEET LOCATION
The actual funded status of a company’s pension (and OPEB) plan is recorded on the company’s
balance sheet. However, the actual balance sheet location of the net pension (under)/over-funded
amount may differ among companies as shown in the next exhibit.
For example, at 2012 year-end, ITW’s approximately $425 million underfunded pension plan is recorded
on the balance sheet primarily in non-current liabilities as $470, but smaller portions are also recorded in
other assets and accrued expenses.
Illinois Tool Works (2012 Form 10-K): Pension & OPEB Funded Status Balance Sheet Location ($ in millions)

In millions 2012 2011 2012 2011
The amounts recognized in the statement of financial
position as of December 31 consist of:
Other assets $ 57 $ 41 $ — $ —
Accrued expenses (12 ) (21 ) (7 ) (7 )
Liabilities held for sale — (13 ) — —
Other noncurrent liabilities (470 ) (481 ) (261 ) (272 )
Net liability at end of year $ (425 ) $ (474 ) $ (268 ) $ (279 )
UNRECOGNIZED ACTUARIAL AMOUNTS

While GAAP requires the pension plan’s economic funded status to be shown on the balance sheet,
actuarial gains/losses are still smoothed into earnings over time. The cumulative unrecognized actuarial
gains/losses and unrecognized prior service cost are recorded in equity in AOCI.
As shown in the exhibit below, ITW had gross unrecognized pension actuarial losses of $892 million at
2012 year-end. These amounts will be recognized as pension expense in the future years based on a
complex amortization method known as the corridor approach. Prior service costs of $7 million will be
recognized on a straight line basis.
Illinois Tool Works (2012 Form 10-K): Pension & OPEB Unrecognized Actuarial Losses ($ in millions)
In millions 2012 2011 2012 2011
The pre-tax amounts recognized in accumulated

other comprehensive income consist of:
Net actuarial loss $ 892 $ 848 $ 10 $ 15
Prior service cost 7 4 2 5
$ 899 $ 852 $ 12 $ 20

FUTURE RECOGNITION OF ACTUARIAL GAINS/LOSSES
Due to the overly complex corridor approach and smoothing of pension costs, actuarial gains and losses
are perhaps the most variable pension cost components on a year-to-year basis. Therefore, companies
are required to disclose the subsequent years’ expected recognition of net actuarial gains/losses
(currently held in AOCI as shown above). These amounts will be recognized into pension cost (income)
in the upcoming fiscal year. As shown below, ITW expects to recognize $76 million of actuarial losses
into pension cost in 2013. This disclosure may not always be in the pension footnote or in tabular format.
It may be found elsewhere in financial statements in the narrative - we found the following ITW
disclosure in the AOCI footnote.
Illinois Tool Works (2012 Form 10-K): Pension & OPEB Expected Next Year Actuarial Gain/Loss Recognition ($ in millions)
The estimated unrecognized benefit cost that will be amortized from accumulated other comprehensive income into net periodic benefit
cost in 2013 is $76 million for pension and $2 million for other postretirement benefits.
FUTURE BENEFIT PAYMENTS

Companies must disclose the upcoming future benefit payments to be paid to pension and OPEB plan
beneficiaries. As shown below, ITW expects to pay $213 million in benefit payments for its pension plan.
While these amounts typically are funded from pension trust assets for U.S. qualified plans, this may not
be the case for certain non-qualified, international pension, or OPEB plans (amounts may need to be
funded from operating cash flow).
Illinois Tool Works (2012 Form 10-K): Pension & OPEB Future Benefit Payments ($ in millions)
The Company’s portion of the benefit payments that are expected to be paid during the years ending December 31 is as follows:
Other
Postretirement
In millions Pension Benefits
2013 $ 213 $ 38
2014 195 39
2015 174 39
2016 180 40
2017 188 41
Years 2018-2022 974 210

PLAN ASSET DISCLOSURES
The next exhibit includes the allocation of pension plan assets at 2012 year-end for ITW. In reviewing
the disclosures, it is helpful to ascertain where the company’s “target” allocation is and if it has changed
(e.g. due to reduction of risk tolerance, more liability matching, etc.). Also, it is important to look at these
asset allocations in conjunction with the company’s expected return on asset assumption to assess their
reasonableness.
Illinois Tool Works (2012 Form 10-K): Pension Asset Allocation ($ in millions)
The Company’s overall investment strategy for the assets in the pension funds is to achieve a balance between the goals of growing plan
assets and keeping risk at a reasonable level over a long-term investment horizon. In order to reduce unnecessary risk, the pension funds
are diversified across several asset classes, securities and investment managers. The target allocations for plan assets are 50% to 65%
equity securities, 30% to 45% debt securities and 0% to 10% in other types of investments. The Company does not use derivatives for the
purpose of speculation, leverage, circumventing investment guidelines or taking risks that are inconsistent with specified guidelines.
2012
In millions Level 1 Level 2 Level 3 Total
Pension Plan Assets:
Cash and equivalents $ 26 — — $ 26
Equity securities:
Domestic 56 — — 56
Foreign 85 — — 85
Fixed income securities:
Government securities — 245 — 245
Corporate debt securities — 263 — 263
Mortgage-backed securities — 12 — 12
Investment contracts with insurance companies — — 75 75
Commingled funds:
Mutual funds 387 — — 387
Collective trust funds — 1,055 — 1,055
Partnerships/private equity interests — — 84 84
$ 554 1,575 159 $ 2,288
Other Postretirement Benefit Plan Assets:
Cash and equivalents $ 34 — — $ 34
Life insurance policies — — 294 294
$ 34 — 294 $ 328
Cash and equivalents include cash on hand and investments with maturities of 90 days or less and are valued at cost, which approximates
fair value. Equity securities primarily include common and preferred equity securities covering a wide range of industries and geographies
which are traded in active markets and are valued based on quoted prices. Fixed income securities primarily consist of U.S. and foreign
government bills, notes and bonds, corporate debt securities, asset-backed securities and investment contracts. The majority of the assets
in this category are valued by evaluating bid prices provided by independent financial data services. For securities where market data is
not readily available, unobservable market data is used to value the security. Commingled funds include investments in public and private
pooled funds. Mutual funds are traded in active markets and are valued based on quoted prices. The underlying investments include small-
cap equity, international equity and long- and short-term fixed income instruments. Collective trust funds are private funds that are valued
at the net asset value, which is determined based on the fair value of the underlying investments. The underlying investments include both
passively and actively managed U.S. and foreign large- and mid-cap equity funds and short-term investment funds. Partnerships/private
equity interests are investments in partnerships where the benefit plan is a limited partner. The investments are valued by the investment
managers on a periodic basis using pricing models that use market, income and cost valuation methods. Life insurance policies are used to
fund other postretirement benefits in order to obtain favorable tax treatment and are valued based on the cash surrender value of the
underlying policies.

MARK-TO-MARKET PENSION ACCOUNTING CHANGES
In a trend that we expect to accelerate, some companies have adopted an accounting policy change to
mark their pension assets and liabilities to market at year-end and immediately recognize the net impact
in earnings in ‘Q4 (companies are already doing the former, but not the latter). Currently, almost all
companies smooth the net impact of marking pension assets and liabilities to market at year-end and
amortize the net loss/gain over a longer period of time (in the meantime, the losses are held in an
account in equity called Accumulated Other Comprehensive Income). As interest rates have moved
lower over the last several years coupled with a range bound stock market, companies have been
reporting higher pension expense due to recognizing the effects of lower interest rates in earnings as
“actuarial losses”. In an effort to “flush out” the losses sitting in equity, some companies have adopted
MTM pension accounting changes. Adopting MTM eliminates most if not all of the actuarial losses in
equity, transforming them into a ‘Q4 charge or gain (depending on asset returns and the direction of
interest rates). Below we list the companies voluntarily adopting MTM pension accounting:
Albermarle Fortune Brands Home & Security PerkinElmer* UPS

Ashland* Graftech International* Polyone* Verizon
AT&T Honeywell Reynolds American* Windstream*
ConAgra Foods IHS* SAIC
Eastman Chemical* Johnson Controls* TCF Financial*
First Energy Kellogg Teradyne
A MOVE TO “PRO FORMA” PENSION COST

A few other companies not formally adopting a pension MTM accounting policy change, but reporting a
form of “adjusted” earnings that excludes certain pension and OPEB costs include:
• GE reports operating EPS and only includes pension service cost in EPS. The company excludes
non-operating retirement related costs from operating earnings.
• IBM reports operating and non-operating results that only include pension service cost in
operating earnings. Other items are included in non-operating income.
• Other companies that have chosen to report an adjusted earnings number by adding-back
pension cost include: Boeing, Brinks*, DuPont*, NCR*, JCPenney*, Ryder* and Unisys*.
Unimprovident allocates actuarial losses to “corporate” non-operating segment.
* Qualified U.S. pension plan is either frozen or closed to new employees.

PENSION FUNDING RELIEF PROVISIONS ENACTED INTO LAW IN JULY 2012
Pension funding requirements are based on a different set of rules established under the Pension
Protection Act (For detail of these rules, see the Pension Q&A section later in this report). The pension
funding relief legislation enacted into law on July 6, 2012 includes a minimum (and maximum) corridor
used to determine the discount rate companies’ use in calculating the required regulatory pension
contributions. Traditionally, the discount rate used in calculating a company’s pension liability is a 24
month trailing average of corporate Aaa-A rates published monthly by the Treasury / IRS. Under the new
legislation, the corridor percentages are applied to the 25 year trailing average of segment rates. The
rate used will be set at the corridor threshold if the current rate they would otherwise use falls outside of
it. That is, if the rate that companies use on 1/1/13 (currently based on the 24 month trailing average) is
below 85% of the 25 year trailing average rate, then the rate will just be the 85% number.
The applicable corridors are below. Keep in mind that pension plan years begin on January 1st (e.g.
2013 plan year valuation was 1/1/13).
Plan Year Minimum Maximum

2012 90% 110%
2013 85% 115%
2014 80% 120%
2015 75% 125%
After 2015 70% 130%
Current regulatory discount rates:

http://www.irs.gov/Retirement-Plans/Funding-Yield-Curve-Segment-Rates
Based on IRS published rates, we estimate the discount rate that was used under this new legislation
(for funding purposes) in the 2012 and 2013 plan years was ~175 basis points higher than what
otherwise would have been used under a 2 year AAA-A 24 month trailing rate.
Typically, the average pension plan’s duration is approximately 12, so for every 100 basis point increase
in the discount rate, the pension liability (used for calculating funding purposes) would decline by roughly
12% (ignoring convexity). There were no “strings” attached to the legislation, so we expect general
adoption of the funding relief, but with varying financial impacts. Our checks indicated that some
companies were likely to adopt the relief beginning for plan year 2013 rather than in 2012 as actuarial
calculations were nearly finalized by the time legislation was passed. Further, since overall pension
funding hasn’t improved year-over-year, healthier companies will likely choose to continue making large
contributions to their pension plans — a reduction in pension contributions has a negative impact on
EPS as cash contributed to a pension plan is assumed to earn the expected rate of return (7.75%
median rate for U.S. companies currently).
Note there is no GAAP balance sheet impact from funding relief as only the rules that determine a
company’s required U.S. pension contributions are changing. The GAAP underfunded pension liability
remains the same. Further, FASB has no intention in changing their rules to match the new regulatory
ones.

OTHER PENSION MEASURES INCLUDED IN THE PENSION FUNDING RELIEF LEGISLATION
The other MAP-21 pension related provisions are increases in pension benefit guarantee flat and
variable rate premiums. Under the legislation, single-employer plan flat rate premiums will increase from
$35 to $42 per participant in 2013 and to $49 per participant in 2014. Variable rate premiums (currently
$9 per $1,000 of unfunded vested benefits divided by the number of participants) will increase by $4 in
2014 and another $5 in 2015. They will be subject to a $400 limit in 2013 and thereafter (per-participant
variable rate premium). Multi-employer plan flat-rate premiums will increase by $2 per participant in
2013. Overall, we expect the increase in premiums to have a negligible impact on companies’ EPS.
PENSION FUNDING RELIEF: FINANCIAL STATEMENT IMPACTS

The financial statement impact of pension funding relief will be primarily on a company’s cash flow.
Companies keep separate records of their pension liabilities for GAAP accounting and regulatory
(ERISA) accounting and it is the regulatory rules that determine required U.S. pension contributions.
Only the latter rules are changing. A higher discount rate under the ERISA regulatory calculations will
reduce the pension liability and thereby improve the underfunding amount that is used in calculating
required pension contributions. In turn, this newly calculated regulatory pension underfunding amount
must still be funded ratably over the next 7 year period (seven year required funding of the pension
shortfall amount did not change). The impact will be lower required contributions as pension funding
relief allows companies to contribute less to their pension plan than previously required and, thus, would
improve operating cash flow and free cash flow.
There were no “strings” attached to the legislation, so we expect widespread adoption. Airlines do not
benefit from the pension funding relief, either. The airline industry already “enjoys” pension funding relief
passed in the Pension Protection Act of 2006 that is more lenient than the new legislation (they received
discount funding relief). The funding relief will also not impact companies’ non-U.S. pension plans as
they are subject to funding regulations of each particular country.
Importantly, the GAAP reported pension liability on the balance sheet will not change. Nor would there
be any direct change to the earnings impact from pensions. There may be a small indirect impact on the
income statement/EPS based on the reinvestment assumption/actions from a higher cash balance (i.e.,
pay down debt) versus foregone income that would have been earned from contributing to the pension
plan. Additionally, lower contributions to the pension plan could raise cash taxes as companies receive
tax deductions at the time of the pension contribution insofar as the company is a current taxpayer in the
U.S. Some of the most impacted companies are in a tax NOL position, so we wouldn’t expect higher
cash taxes for such companies.

UNFUNDED MULTI-EMPLOYER PENSION PLANS
Some companies participate in multi-employer pension plans, but they are most popular amongst
grocery stores and transportation companies. Companies account for these multi-employer pension
plans under a “pay-as-you-go” system and only expense the annual contribution amounts through
earnings and cash flow.
A company's true liability from participating in a multi-employer pension plan has always been shrouded
in secrecy, with underfunded amounts largely unknown. Further, while a typical defined benefit pension
plan’s unfunded liability is disclosed and on the balance sheet, an unfunded multi-employer pension plan
is neither.
As a first step in addressing this significant shortcoming, in the Fall of 2011, FASB issued ASU 2011-09
requiring new disclosures for companies with multi-employer pension plans in 2011 10-K footnotes.
Heretofore, disclosures typically lacked meaningful information other than recent years’ contributions.
The new disclosures are meant to be both quantitative and qualitative in nature. No changes were
required to the recognition and measurement of multi-employer pension plans (no balance sheet liability,
remains to be expensed on a pay-as-you-go basis). Disclosures for each significant multi-employer plan
are required in a tabular format if possible to include the following:
1) Name and identifying EIN number;

2) Level of employer’s participation (whether the employer’s contribution represents >5% of total
contributions to the plan);
3) Financial health of the plan based on the “risk zone” as indicated by the Pension Protection Act;
any funding improvement plans pending or implemented; any surcharges imposed; and
4) Expiration date and information about the collective bargaining agreements underlying the
required contributions to the plans.
Using the EIN number, investors may view the source document Form 5500 IRS pension plan filing for
more information on the pension plan (filed on a delayed basis at www.freeerisa.com).
Importantly, certain information about plan withdrawal liabilities will still not be required. This information
may prove useful when analyzing companies with multiemployer pension plans, if attainable by
voluntary disclosure, company inquiry, or otherwise. Below and on the next page are the new 10-K
disclosures for Safeway.
Multi-Employer Plan 10-K Disclosures - Safeway ($ in millions)
2011 2010 2009
United States plans $ 262.7 $ 245.4 $ 236.8
Canadian plans 49.5 46.9 41.3
Total $ 312.2 $ 292.3 $ 278.1

Additionally, the Company has incurred a partial withdrawal from the United Food and Commercial Workers Unions
and Employers Midwest Pension Plan to which it contributes on behalf of Dominick's. During 2011, the Company
expensed the withdrawal liability assessment of $6.6 million and began paying monthly installments of $0.3 million in
September 2011.

UNFUNDED MULTI-EMPLOYER PENSION PLANS (CONTINUED)
Multi-Employer Plan 10-K Disclosures – Safeway ($ in millions) (continued)
The following two tables contain information about Safeway's U.S. multiemployer pension plans.
Pension Protection Act Safeway 5% of total

zone status plan contributions FIP/RP status
Pension fund EIN - PN 2011 2010 2010 2009 pending/implemented
UFCW-Northern California 946313554 -
Red Red Yes Yes Implemented
Employers Joint Pension Trust Fund 001
Western Conference of 916145047 -
Green Green No No No
Teamsters Pension Plan 001
Southern California United Food &
951939092 - Red Red Yes Yes
Commercial Workers Unions and Food Implemented
001 3/31/2012 3/31/2011 3/31/2010 3/31/2009
Employers Joint Pension Plan
Food Employers Labor Relations
526128473 -
Association and United Food and Red Red Yes Yes Implemented
001
Commercial Workers Pension Fund
United Food and Commercial Workers
366508328 - Red Red Yes Yes
Unions and Employers Midwest Pension Implemented
001 11/30/2011 11/30/2010 11/30/2010 11/30/2009
Plan
Bakery and Confectionery Union and 526118572 -
Green Green Yes Yes No
Industry International Pension Fund 001
Rocky Mountain UFCW 846045986 -
Green Red Yes Yes No
Unions & Employers Pension Plan 001
Sound Retirement Trust (formerly Retail 916069306 - Red Green Yes Yes
Implemented
Clerks Pension Trust) 001 9/30/2011 9/30/2010 9/30/2010 9/30/2009
Desert States Employers & UFCW Unions 846277982 -
Green Yellow Yes Yes No
Pension Plan 001
Denver Area Meat Cutters and Employers 846097461 -
Green Red Yes Yes No
Pension Plan 001
936074377 -
Oregon Retail Employees Pension Trust Red Red Yes Yes Implemented
001
362407063 - Green Green Yes Yes
Chicago Area I.B.of T. Pension Plan No
001 1/31/2012 1/31/2011 1/31/2011 1/31/2010
Total Safeway
contributions to U.S.
multiemployer pension
plans $ 262.7 $ 245.4 $ 236.8
At the date the financial statements were issued, Forms 5500 were generally not available for the plan years ending in 2011. Additionally,
for the plan year ending January 31, 2009, Safeway contributed more than 5% of the total contributions to the Chicago Area I.B. of T.
Pension Plan.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. Note: Above disclosure is excerpt of entire multiemployer plan table in the 10-K.

PENSION Q&A
In this section, we discuss commonly received questions on pensions.
How Does Pension Underfunding Affect a Company’s Balance Sheet?

GAAP requires companies to mark their pension plan assets and liabilities to market at year-end and
‘true-up’ the respective balance sheet asset or liability. The actual over or under funded amount of the
pension plan is shown on the balance sheet either as a long term asset (if over-funded) or a liability (if
under-funded). For companies where underfunding worsened at year-end 2012, they will record an
increase in the pension liability on the balance sheet with a corresponding charge to equity (net of a
deferred tax asset).
For example, assume Company Alpha reported a $100 pension liability at 2011 year-end. Market
returns and a decline in Aa corporate bond rates results in a $120 pension liability at 2012 year-end
when assets and liabilities are marked to market. At 2012 year-end, the balance sheet is adjusted by
recording a $20 increase in the pension liability with a corresponding charge to equity for $12 ($20 x [1-
0.40 assumed tax rate). A deferred tax asset for $8 ($20 x 40% assumed tax rate) is recorded and will
unwind as an actual tax deduction and cash tax savings when the company actually makes the $20
pension contribution.
Are Stock Contributions Allowed to a Pension Plan?

Yes, stock contributions are allowed, but cannot exceed 10% of the value of the total pension plan
assets. Generally, we've observed that if pension plan stock contributions are made, the pension plan
will sell down the stock over time.
Xerox (2012 Form 10-K): Company Stock Pension Contributions
In March 2012, we elected to make a contribution of 15.4 million shares of our common stock, with an aggregate value of approximately
$130 million, to our U.S. defined benefit pension plan for salaried employees in order to meet our planned level of funding.
United Technologies (2011 Form 10-K): Company Stock Pension Contributions
The funded status of our defined benefit pension plans is dependent upon many factors, including returns on invested assets and the level
of market interest rates. We can contribute cash or company stock to our plans at our discretion, subject to applicable regulations. Total
cash contributions to our global defined benefit pension plans were $551 million and $1.3 billion during 2011 and 2010, respectively.
During 2011 and 2010, we also contributed $450 million and $250 million, respectively, in UTC common stock to our defined benefit
pension plans. As of December 31, 2011, the total investment by the domestic defined benefit pension plans in our securities was
approximately 5% of total plan assets. We expect to make contributions of approximately $100 million to our foreign defined benefit
pension plans in 2012. Although our domestic defined benefit pension plans are approximately 87% funded on a projected benefit
obligation basis and we are not required to make additional contributions through the end of 2012, we may elect to make discretionary
contributions in 2012. Contributions to our global defined benefit pension plans in 2012 are expected to meet or exceed the current
funding requirements.

PENSION Q&A (CONTINUED)
What is the Cash Cost of a Pension Plan?
The pension expense amount recognized on the income statement is non-cash and calculated under the
GAAP rules. The current year cash cost of pensions is the actual amount of cash contributed to the
company’s pension trust(s). The GAAP and the cash contribution number are calculated under a
different set of rules and often are materially different. We explain these rules in a subsequent Q&A
section of this report.
Is There an Earnings Benefit (or Carry) from Contributing Cash to the Pension Plan?
In today’s low interest rate environment, contributing money to a pension plan generally provides a non-
cash EPS benefit as there is a significant positive carry between the interest rate at which the cash
balance is earning (or debt interest rate paid) and the return at which the contributed cash is assumed to
earn in the pension plan (7.75% median rate expected pension plan rate of return for all companies). If a
company contributes to its pension plan, the contribution amount is assumed to earn the company’s
pension plan expected rate of return. The pre-tax income impact is equal to the pension contribution
amount multiplied by the expected pension plan rate of return less the cost of funds/foregone interest
income.
Will Companies Change their Expected Rate of Return Assumption?

The current 7.75% median pension plan expected rate of return assumption is too high considering the
current overall pension plan asset mix is 50% stocks, 40% bonds, 9% other, and 1% real estate. Absent
a more immediate push by the regulatory bodies, we believe companies will decrease the return
assumption in decrements over a number of years to mitigate the possible EPS headwind. As a point of
reference, between 2001 and 2006 the median expected rate of return assumption declined from 9% to
8%.

Primer on the Regulatory U.S. Pension Funding Rules
The regulatory pension funding rules are promulgated by the Pension Protection Act of 2006 and
originally promulgated under ERISA rules. The rules have changed several times over the past 20 years
which only adds to their complexity. The rules are complex and materially different than the GAAP rules,
so companies will value their pension plans under two different calculations. Invariably, a third-party
actuary calculates a company’s pension liability and asset amounts under the rules based on detailed
company data. Most defined benefit pension plans are so-called qualified plans and, therefore, subject
to regulatory funding requirements. A company may also have a non-qualified pension plan. These
plans are not subject to the regulatory pension funding rules (plans are often called a SERP or
supplemental executive retirement plan).
Under the ERISA rules, the pension assets and liabilities are valued on the first day of each plan year
(GAAP values on the last day of the year). Therefore, for a calendar year-end company, 1/1/13 was the
most recent pension valuation date. For plan assets, a company either uses the actual fair market value
of plan assets on the valuation date or a 24 month smoothed asset value (used by most companies to
mitigate year-to-year asset volatility) and switching methods is not allowed unless IRS approval is
obtained (very difficult to do). If a smoothed asset value is used, it is calculated based on the trailing 24
months’ average pension assets value adjusted for an assumed expected return. This smoothed value
may not be less than 90% or greater than 110% of the pension plan’s actual fair market value. The
pension liability is calculated as the present value of all pension benefits earned or accrued as of the
pension plan’s valuation date and is calculated by an actuary. It is most comparable to the accumulated
benefit obligation (ABO) under the GAAP rules.
Companies are allowed to use one of two discount rate options in calculating the pension liability: (1)
three segment 24 month trailing average Aaa-A corporate bond yield curve as listed monthly in the IRS
Internal Revenue Bulletin (www.irs.gov/irb) or (2) a spot corporate Aaa-A yield curve based on the
average of the daily corporate bond rates for the prior month (the rate used for a January 1st pension
valuation date is the average daily Aaa-A corporate bond for December). The IRS publishes this rate
monthly at the beginning of the month and our experience is that it approximates the average daily ML
Aaa-A yield curve for the month. Similar to the asset smoothing option, companies are not allowed to
move back and forth between the more favorable discount rate without IRS approval (very difficult to
obtain). As an added twist, if a company uses the 24 month trailing average Aaa-A corporate rate, it may
use the rate for the month in which the pension plan valuation is completed (January 2013) or any of the
four proceeding months (September 2012, October 2012, November 2012 or December 2012).
However, once a certain month is elected to be used, it may not be changed in a subsequent year (e.g.,
once November, always November). Note that as discussed in the pension funding relief section of this
report, MAP-21 pension legislation passed in July 2012 allows the use of a 25 year trailing average
discount rate in lieu of either of the aforementioned rates.
The company then calculates if the pension plan is underfunded based on the difference between the
pension plan assets and liabilities. The shortfall amount, if any, must be ratably funded over 7 years The
annual minimum required pension contribution amount consists of:
1. Service cost: net present value of pension benefits that were accrued by employees in the current
year (very similar to the GAAP service cost); and,
2. Seven year ratable funding of the pension plan’s underfunded amount (pension assets – pension
liabilities).

Until 2011, companies were required to only fund up to a certain percentage based on an upward sliding
scale (in 2010: 96% - lower underfunded amount (if any) over 7 years). However, since 2011 pension
plan years, the entire difference between the pension assets and liabilities must be funded ratably over 7
years. Importantly, the pension funding amounts are trued-up each year. For example, if the pension
plan is underfunded in one year and favorable market returns eliminate the underfunding in a
subsequent year, no contributions would be required in the subsequent year.
Another complicating factor in assessing minimum required pension contributions is the existence of
credit balances, which are not generally disclosed in the GAAP financial statements. A company may
have accumulated credit balances in prior years from pension contributions in excess of the minimum
required amount. Companies are allowed to use these credits to reduce their minimum pension plan
contributions. However, credits are not allowed to be used if the pension funding percentage for the prior
plan year is below 80% (1/1/12 for the 1/1/13 pension valuation). Further, in calculating the current
funding ratio (assets divided by liabilities), credit balances created after the Pension Protection Act was
enacted are subtracted from pension assets. In turn, the pension liability is divided into this adjusted
pension asset amount to calculate the current funded ratio.
Required pension contributions are due by 8.5 months after the pension plan year-end. To illustrate, the
last required pension valuation date for calendar year-end companies was January 1, 2013 since
pensions are valued on the first day of each pension plan year. Using the 8.5 months after plan year-end
timeline, the mandatory pension plan contributions are not due until September 15, 2014. However, the
pension rules require quarterly contributions if a pension plan was not at least 100% funded in the
previous year (1/1/12 in our example and the majority of pension plans were underfunded on this date)
and such amounts are due on 4/15, 7/15, 10/15 and the following 1/15 (for non-calendar year-end
companies such amounts are due on the 15th of the fourth, seventh and tenth months and the 15th day
after year-end). The required quarterly contribution amounts are calculated based on the lower of: (1)
90% of the current year’s minimum pension contribution or (2) 100% of the prior year’s minimum
pension contribution amount.
At Risk Rules
Higher contributions will be required if a pension plan is considered “at-risk”. A pension plan is
considered at-risk if its funded ratio using a one-year lookback (e.g. 1/1/2012 for the valuation date that
took place on 1/1/2013) was less than 80%. An at-risk plan must calculate its funded ratio using the
following formula, which essentially nullifies the potential use of credit balances that would otherwise be
available to reduce required contributions.
1/1/2013 Market value of assets (smoothed or actual FMV)

- 1/1/08 existing credit balance
- Post 12/31/07 credit balance
= Adjusted market value of pension assets
/ 1/1/2013 Pension liability (what the PPA terms “funding target”)
= Pension funded ratio under at-risk rules
Further, if the pension plan was less than 70% funded using the one year lookback period (e.g. as of
1/1/2012), then the current year pension regulatory liability will be calculated differently. The plan will
have to use more stringent actuarial assumptions that will essentially calculate the liability based upon
the maximum potential benefits that could be paid out (e.g. using lump sum payments vs. annuity). If the
current year funded ratio is less than 70%, using this newly calculated pension regulatory liability, then
this will be the funding ratio used to calculate the minimum required contribution.
Benefit Restriction Thresholds
Two important pension funding percentage thresholds are 60% and 80%. If a company falls under these
thresholds, various benefit restrictions are imposed and, therefore, some companies with active pension
plans will endeavor to maintain an at least 80% funded pension plan (based on regulatory rules).
Funded Ratio < 60%

Using the previously discussed at-risk rules, plans with a funded ratio less than 60% will have certain
restrictions enforced. For example, benefits may be required to be frozen (no new benefit accruals) and
payments must be made in annuity form as opposed to lump sum payouts. In order to avoid these
restrictions, companies may choose to waive their credit balance amount if this action would increase
the funding level back to at least 60%. Alternatively, a company may accept the pension plan
restrictions, keep the credit balance, and use it to offset part (or all) of the minimum contribution amount.
We believe many companies would endeavor to keep their plans at least 60% funded under the at-risk
rules to avoid benefit restrictions unless the company itself is in a distressed scenario.
Funded Ratio: 60% to <80%

There are several restrictions placed on a company’s pension plan if it’s 60% or more funded, but less
than 80% funded as calculated under the ‘at-risk’ rules. If a company’s pension plan is still open to
employees, these restrictions may become an HR issue and, therefore, the company may choose to
incrementally and voluntarily fund its pension plan to meet the 80% funding threshold. The restrictions
are as follows:
1. Company is required to file Form 4010. This form notifies pension plan participants of the current
funded status of the pension plan,
2. There are no benefit increases allowed unless this amount is immediately fully funded (an issue
since some union contracts require annual benefit increases),
3. Lump sum benefit payments are limited to 50% of an employee’s accrued pension benefit (most
employees are given an option for a 100% lump sum distribution or an annuity when retiring or
leaving the company).
Assuming a pension valuation date on 1/1/13, the voluntary contributions required to reach an 80%
funding level would need to be made by 9/15/14.

Other Disclosures
and Audit Opinions

MARKET RISK DISCLOSURES
This footnote identifies companies that experienced material changes in market risk exposures and
derivatives. The market risk disclosure section must be disclosed by companies annually and include
both quantitative and qualitative information about the market risks impacting them.
Typical items included in the market risk disclosure section are interest rate risk, equity price risk,
commodity price risk, and foreign currency exchange rate risk. All of a company’s financial instrument
market risks are categorized into (1) instruments entered into for trading purposes and (2) instruments
entered into for purposes other than trading. The quantitative and qualitative information mentioned
above must be provided for each of these two categories.
Within the qualitative section of a company’s market risk footnote, management must disclose at least
the following few items:
1. The company’s primary market risk exposures;

2. The manner in which market risk exposures are managed; and
3. How the primary market risk exposures are managed compared to the prior year and whether
there were any changes in these exposures.
Under the SEC’s disclosure rules, a company’s quantitative disclosure for these exposures may be
presented in one of following three formats:
1. A tabular presentation of instruments sensitive to market risks grouped by similar risk

characteristics. The information included in this table should include the fair market values,
contract terms, and expected maturity dates for each of the exposures, allowing investors to
determine the exposures’ next five years of expected cash flows.
2. A sensitivity table that quantifies potential losses in earnings, cash flows, and fair values from one
or more hypothetical changes in interest rates, commodity prices, exchange rates, and/or other
market prices over a selected time period. The different categories and market risk exposures
may have varying magnitudes of hypothetical rate changes. Management is required to provide a
description of the model, the assumptions used in the sensitivity analysis, and some parameters
to help the investors understand the disclosure.
3. Potential losses in future earnings, cash flows, or fair values may be disclosed using a value at
risk methodology over a selected time period. Probabilities of occurrence from changes in items
such as interest rates, commodity prices, and/or exchange rates must also be disclosed. For
each value at risk disclosure category, companies must include at least one of following three
additional disclosures:
a. The average, high, and low amounts or distribution of value at risk amounts for the reporting
period;
b. The average, high, and low amounts or the distribution of actual change in earnings, cash
flow, or fair value from the market risk sensitive instruments that occurred over the reporting
period; or
c. The number of times or percentage of actual changes in earnings, cash flows, or fair value
from the market risk sensitive instruments exceed the value at risk amounts during the
reporting period.

MARKET RISK DISCLOSURES (CONTINUED)
Given a material disclosure alternative is changed, management must provide the (1) reason(s) for the
change and (2) comparable information for either new disclosure methodology or the current year
disclosure under the prior year’s methodology. In the following exhibit, we present Hewlett-Packard’s
quantitative market risk section.
Hewlett-Packard (2012 Form 10-K): Quantitative Market Risk Disclosure
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk.
In the normal course of business, we are exposed to foreign currency exchange rate, interest rate and equity price risks that could impact
our financial position and results of operations. Our risk management strategy with respect to these three market risks may include the
use of derivative financial instruments. We use derivative contracts only to manage existing underlying exposures of HP. Accordingly, we
do not use derivative contracts for speculative purposes. Our risks, risk management strategy and a sensitivity analysis estimating the
effects of changes in fair values for each of these exposures are outlined below.
Actual gains and losses in the future may differ materially from the sensitivity analyses based on changes in the timing and amount of
interest rate, foreign currency exchange rate and equity price movements and our actual exposures and hedges.
Foreign currency exchange rate risk

We are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, anticipated purchases and
assets, liabilities and debt denominated in currencies other than the U.S. dollar. We transact business in approximately 75 currencies
worldwide, of which the most significant foreign currencies to our operations for fiscal 2012 were the euro, the Japanese yen, Chinese
yuan renminbi and the British pound. For most currencies, we are a net receiver of the foreign currency and therefore benefit from a
weaker U.S. dollar and are adversely affected by a stronger U.S. dollar relative to the foreign currency. Even where we are a net receiver, a
weaker U.S. dollar may adversely affect certain expense figures taken alone. We use a combination of forward contracts and options
designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in our forecasted net revenue and, to
a lesser extent, cost of sales and inter-company lease loans denominated in currencies other than the U.S. dollar. In addition, when debt is
denominated in a foreign currency, we may use swaps to exchange the foreign currency principal and interest obligations for U.S. dollar-
denominated amounts to manage the exposure to changes in foreign currency exchange rates. We also use other derivatives not
designated as hedging instruments consisting primarily of forward contracts to hedge foreign currency balance sheet exposures. For these
types of derivatives and hedges we recognize the gains and losses on these foreign currency forward contracts in the same period as the
remeasurement losses and gains of the related foreign currency-denominated exposures. Alternatively, we may choose not to hedge the
foreign currency risk associated with our foreign currency exposures, primarily if such exposure acts as a natural foreign currency hedge
for other offsetting amounts denominated in the same currency or the currency is difficult or too expensive to hedge.
We have performed sensitivity analyses as of October 31, 2012 and 2011, using a modeling technique that measures the change in the fair
values arising from a hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with
all other variables held constant. The analyses cover all of our foreign currency contracts offset by the underlying exposures. The foreign
currency exchange rates we used were based on market rates in effect at October 31, 2012 and 2011. The sensitivity analyses indicated
that a hypothetical 10% adverse movement in foreign currency exchange rates would result in a foreign exchange loss of $71 million and
$96 million at October 31, 2012 and October 31, 2011, respectively.
Interest rate risk

We also are exposed to interest rate risk related to our debt and investment portfolios and financing receivables. We issue long-term debt
in either U.S. dollars or foreign currencies based on market conditions at the time of financing. We then often use interest rate and/or
currency swaps to modify the market risk exposures in connection with the debt to achieve U.S. dollar LIBOR-based floating interest
expense. The swap transactions generally involve the exchange of fixed for floating interest payments. However, we may choose not to
swap fixed for floating interest payments or may terminate a previously executed swap if we believe a larger proportion of fixed-rate debt
would be beneficial. In order to hedge the fair value of certain fixed-rate investments, we may enter into interest rate swaps that convert
fixed interest returns into variable interest returns. We may use cash flow hedges to hedge the variability of LIBOR-based interest income
received on certain variable-rate investments. We may also enter into interest rate swaps that convert variable rate interest returns into
fixed-rate interest returns.

MARKET RISK DISCLOSURES (CONTINUED)
Hewlett-Packard (2012 Form 10-K): Quantitative Market Risk Disclosure (continued)
We have performed sensitivity analyses as of October 31, 2012 and 2011, using a modeling technique that measures the change in the fair
values arising from a hypothetical 10% adverse movement in the levels of interest rates across the entire yield curve, with all other
variables held constant. The analyses cover our debt, investment instruments, financing receivables and interest rate swaps. The analyses
use actual or approximate maturities for the debt, investments, interest rate swaps and financing receivables. The discount rates we used
were based on the market interest rates in effect at October 31, 2012 and 2011. The sensitivity analyses indicated that a hypothetical 10%
adverse movement in interest rates would result in a loss in the fair values of our debt, investment instruments and financing receivables,
net of interest rate swap positions, of $121 million at October 31, 2012 and $145 million at October 31, 2011.
Equity price risk

We are also exposed to equity price risk inherent in our portfolio of publicly traded equity securities, which had an estimated fair value of
$59 million at October 31, 2012 and $118 million at October 31, 2011. We monitor our equity investments for impairment on a periodic
basis. Generally, we do not attempt to reduce or eliminate our market exposure on these equity securities. However, we may use
derivative transactions to hedge certain positions from time to time. We do not purchase our equity securities with the intent to use them
for speculative purposes. A hypothetical 30% adverse change in the stock prices of our publicly traded equity securities would result in a
loss in the fair values of our marketable equity securities of approximately $18 million and $35 million at October 31, 2012 and 2011,
respectively. The aggregate cost of investments in privately-held companies, and other investments was $59 million at October 31, 2012
and $57 million at October 31, 2011.

HEDGING AND DERIVATIVE DISCLOSURES
Hedge accounting and interpreting the related derivative disclosures is one of the most complex areas of
accounting. At a high level, the accounting is straightforward — record derivatives on the balance sheet
at fair market value. In turn, the changes in fair value each period must be reflected either in earnings or
equity and this is where the accounting guidance becomes complicated and is a function of the
instrument and the related risk it hedges.
Under GAAP, three types of hedges qualify for special accounting treatment:
1. Foreign currency hedge of a net investment: This is when a derivative is used to hedge the
foreign exchange risk in the net assets (book equity) held in a foreign subsidiary in a foreign
currency.
2. Fair value hedge: This is when a company uses derivatives to hedge changes in the fair value of
a balance sheet asset/liability or unrecognized firm commitment. As an example, a company
enters into an interest rate derivative to hedge the fair value of fixed rate debt.
3. Cash flow hedge: This is when a derivative is used to hedge the cash flows of a specific balance
sheet risk (derivative used to hedge interest expense on floating rate debt) or a forecasted
transaction (foreign sales and A/R).
We find that some companies utilize foreign currency derivatives as a means to hedge exchange rate
risk on sales, gross margin, or SG&A, among other items. This type of transaction is usually classified
as a cash flow hedge under GAAP. Under a cash flow hedge, the unrealized gains/losses are recorded
in equity in other accumulated comprehensive income (AOCI) until the forecasted transaction occurs. In
the period when the transaction actually occurs (e.g., revenue is recognized along with accounts
receivable), the derivative unrealized gain or loss held in AOCI is transferred out of AOCI and into the
income statement. It is classified in the income statement in the same line item as the risk that it is
hedging (e.g., as an addition or subtraction to revenue).
To illustrate, a company hedges its foreign subsidiary’s cost of goods sold. During the period in which
the derivative is outstanding, but before the sale transaction occurs, the unrealized losses are assumed
to be $1,000 and, accordingly, recorded in AOCI in equity for $1,000. Next, the sale occurs. If the
company is perfectly hedged, the unrealized losses on the cash flow hedge are transferred from AOCI in
equity and used to offset the “natural” foreign exchange gain reported in cost of sales. Therefore, the net
foreign exchange impact on cost of sales is $0.

HEDGING AND DERIVATIVE DISCLOSURES (CONTINUED)
In the next exhibit, we summarize and describe the different types of hedges under GAAP.
Description of the Different Types of Hedges Based on ASC 815, Derivatives and Hedging (formerly FAS No. 133)
TYPE OF HEDGE DESCRIPTION GAIN/LOSS RECOGNITION

Fair Value Hedge Hedging an exposure to changes in the fair Derivative gain/loss recorded in earnings in each period.
value of a balance sheet asset or liability or an
unrecognized firm commitment attributable to The change in fair value on the hedged item attributable to the hedged risk is
a particular risk. The derivative's FMV is added/subtracted to its balance sheet value with a corresponding gain/loss.
recorded as an asset or liability.
If the derivative's change in fair value is different than the fair value of the
hedged asset or liability, the difference is recorded as a gain or loss in earnings.
Cash Flow Hedge Hedging exposure to variability of all or a Portion of the derivative gain/loss equal to the change in hedged transaction's
specific portion of a balance sheet item cash expected cash flows (the effective portion of the hedge) is deferred and
flows or a forecasted transaction attributable to reported in "other comprehensive income" in equity on the balance sheet until
a particular risk. The FMV of the derivative is the hedged transaction impacts earnings. The ineffective portion of the hedge is
recorded as an asset or liability. recorded in earnings in the current period.
In the period that the hedged transaction is reported in earnings, the deferred
derivative gain/loss in AOCI is reported in earnings.
Hedge of Net Macro type hedge of the change in value of a Changes in fair value of the foreign subsidiaries' net assets are recorded in other
Investment of Foreign company's foreign subsidiary's net assets due comprehensive income in equity in the "cumulative translation adjustment"
Ops. to F/X movements. account until the subsidiary is sold or disposed of.
Hedge Accounting Not Derivative contract recorded on the balance Derivative is market-to-market with the gain or loss reported in earnings during
Met sheet as an asset or liability at fair value. each period.
Source: Wolfe Trahan Accounting & Tax Policy Research. FASB.
If a derivative transaction does not qualify for hedge accounting treatment under FAS 133, then its fair
value change is recorded in earnings each period.

DERIVATIVES: AN 8 POINT CHECKLIST TO ANALYZE DISCLOSURES
Derivative and hedging disclosures provide details on a company’s hedging policies and the financial
statement amount and location of derivative contracts. Companies are required to disclose the balance
sheet and income statement location of the derivatives, their fair value amounts, the impact on earnings,
and the amount of gain/loss deferred from cash flow hedges that are recorded in accumulated other
comprehensive income in equity. Over the next few pages, we provide a methodology to analyze the
disclosures.
It’s important to keep in mind that despite many pages of detailed disclosures in the 10-K, company
derivative disclosures are very high level. Therefore, we suggest using them to assess tail risks of the
company, if the company is actively hedging risks, or is speculating. One common question we receive
is whether these disclosures are useful in estimating the impact of foreign exchange rate changes on
earnings and margins. Oddly, GAAP has no requirement in this area and the best 10-K area in which to
ferret out possible exchange rate translation impacts is in the MD&A section. Disclosure is usually
spotty. However, McDonald’s is an exception and clearly discloses the financial statement impact of
foreign exchange translation as we show in the next exhibit.
McDonald’s Corp (2012 Form 10-K): Foreign Currency Translation Impact on Financial Statements ($ in millions)
IMPACT OF FOREIGN CURRENCY TRANSLATION ON REPORTED RESULTS

While changes in foreign currency exchange rates affect reported results, McDonald’s mitigates exposures, where practical, by financing in
local currencies, hedging certain foreign-denominated cash flows, and purchasing goods and services in local currencies.
In 2012, foreign currency translation had a negative impact on consolidated operating results primarily due to the weaker Euro, along
with most other currencies. In 2011, foreign currency translation had a positive impact on consolidated operating results driven by the
stronger Euro and Australian Dollar, as well as most other currencies. In 2010, foreign currency translation had a positive impact on
consolidated operating results driven by stronger global currencies, primarily the Australian Dollar and Canadian Dollar, partly offset by
the weaker Euro.
Impact of foreign currency translation on reported results

Currency
translation
Reported amount benefit/(cost)
In millions, except per share data 2012 2011 2010 2012 2011 2010
Revenues $ 27,567 $ 27,006 $ 24,075 $ (726) $ 944 $ 188
Company-operated margins 3,379 3,455 3,173 (97) 134 35
Franchised margins 7,437 7,232 6,464 (204) 213 (14)
Selling, general & administrative expenses 2,455 2,394 2,333 40 (55) (12)
Operating income 8,605 8,530 7,473 (261) 301 13
Net income 5,465 5,503 4,946 (178) 195 13
Earnings per common share—diluted 5.36 5.27 4.58 (0.17) 0.19 0.01

DERIVATIVES: AN 8 POINT CHECKLIST TO ANALYZE DISCLOSURES (CONTINUED)
We suggest using derivative disclosures to answer the following the questions about possible risk
exposures and related hedging:
(1) What risks are derivatives used to hedge?
(2) What are outstanding derivatives’ fair market values on the balance sheet? Are they material?
(3) What is the notional amount outstanding for derivative hedges?
(4) What is the derivatives’ duration? Longer-term cash flow foreign currency hedges raise a concern
to us since the forecasted transaction might not occur. To that end, we view long-term hedges
exceeding two years as very uncommon based on our history of reviewing disclosures.
(5) Does the company hold derivatives that don’t qualify for hedge accounting under GAAP? Keep in
mind that there are some derivative contracts not qualifying for hedge accounting since the
derivative is not considered highly effective at hedging the related risk. Instead, the derivative is
marked to fair value on the balance sheet and the changes therein are recorded in earnings each
period. An example of this would be option contracts since an investor initially pays a premium for
the derivative. In an extreme situation, holding derivatives that do not qualify for hedge
accounting may be a sign that the company is inappropriately engaged in currency speculation.
(6) What is the size of the unrealized derivative gain or loss recorded in AOCI in equity from cash
flow hedges (e.g., hedging future sales or gross margins)? We suggest analyzing whether there
have been any large quarterly or year-over-year changes. A large unrealized gain or loss in
equity (from a cash flow hedge) indicates that the company has actively hedged an underlying
risk exposure (commodity, foreign margins) that has yet to occur and impact the income
statement.
(7) Does the company hedge equity in its foreign subsidiaries?
(8) Have there been large realized gains or losses in prior quarters impacting the income statement?
In the exhibits on the next several pages, we use Becton Dickinson’s (BDX) derivative footnote
disclosure to answer our eight questions.

ANALYZING DERIVATIVE DISCLOSURES: BECTON DICKINSON ILLUSTRATION
The exhibit below is Becton Dickinson's general derivative and hedging disclosure of foreign currency
risks and related strategies. Derivatives designated for special hedge accounting treatment under FAS
No. 133 are separately disclosed from those not designated.
(1) WHAT RISKS ARE DERIVATIVES USED TO HEDGE?

The disclosure below describes the general risks the company is hedging.
Becton Dickinson (2011 Form 10-K): Derivative and Hedging Activities
Foreign Currency Risks and Related Strategies
The Company has foreign currency exposures throughout Europe, Asia Pacific, Canada, Japan and Latin America. From time to time, the
Company may partially hedge forecasted export sales denominated in foreign currencies using forward and option contracts, generally
with one-year terms. The Company’s hedging program has been designed to mitigate exposures resulting from movements of the U.S.
dollar, from the beginning of a reporting period, against other foreign currencies. The Company’s strategy is to offset the changes in the
present value of future foreign currency revenue resulting from these movements with either gains or losses in the fair value of foreign
currency derivative contracts. Forward contracts were used to hedge forecasted sales in fiscal year 2010. The Company did not hedge
forecasted sales in fiscal year 2011 and as of September 30, 2011, the Company has not entered into contracts to hedge cash flows for
fiscal year 2012.
The Company designates forward contracts used to hedge these certain forecasted sales denominated in foreign currencies as cash flow
hedges. Changes in the effective portion of the fair value of the Company’s forward contracts that are designated and qualify as cash flow
hedges (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk) are included in Other
comprehensive income (loss) until the hedged transactions are reclassified in earnings. These changes result from the maturity of
derivative instruments as well as the commencement of new derivative instruments. The changes also reflect movements in the period-
end foreign exchange rates against the forward rates at the time the Company enters into any given derivative instrument contract. Once
the hedged revenue transaction occurs, the recognized gain or loss on the contract is reclassified from Accumulated other comprehensive
income (loss) to Revenues. The Company records the premium or discount of the forward contracts, which is included in the assessment of
hedge effectiveness, to Revenues.
In the event that the revenue transactions underlying a derivative instrument are no longer probable of occurring, accounting for the
instrument under hedge accounting is discontinued. Gains and losses previously recognized in Other comprehensive income (loss) are
reclassified into Other income (expense). If only a portion of the revenue transaction underlying a derivative instrument is no longer
probable of occurring, only the portion of the derivative relating to those revenues would no longer be eligible for hedge accounting.
(2) WHAT ARE OUTSTANDING DERIVATIVES’ FAIR MARKET VALUES ON THE BALANCE SHEET? ARE
THEY MATERIAL?
Discussed as part of question 5.
(3) WHAT IS THE NOTIONAL AMOUNT OUTSTANDING FOR DERIVATIVE HEDGES?

As shown in the next exhibit, BDX discloses $2.2 billion of outstanding notional amount of foreign
exchange contracts, primarily used to hedge sales. In turn, we suggest comparing this outstanding
notional amount to the company’s most recently reported or forecasted foreign revenues to calculate
what percentage of future sales are hedged. It’s very uncommon and a concern to us if more than one
year’s future foreign revenues are hedged.

ANALYZING DERIVATIVE DISCLOSURES: BECTON DICKINSON ILLUSTRATION (CONTINUED)
Becton Dickinson (2011 Form 10-K): Derivative and Hedging Activities ($ in thousands)
Transactional currency exposures that arise from entering into transactions, generally on an intercompany basis, in non-hyperinflationary
countries that are denominated in currencies other than the functional currency are mitigated primarily through the use of forward
contracts and currency options. Hedges of the transactional foreign exchange exposures resulting primarily from intercompany payables
and receivables are undesignated hedges. As such, the gains or losses on these instruments are recognized immediately in income. The
offset of these gains or losses against the gains and losses on the underlying hedged items, as well as the hedging costs associated with the
derivative instruments, is recognized in Other income (expense).
The total notional amounts of the Company’s outstanding foreign exchange contracts as of September 30, 2011 and September 30, 2010
were $2,209,780 and $1,776,046, respectively.
(4) WHAT IS THE DERIVATIVES’ DURATION?

Not disclosed.
(5) DOES THE COMPANY HOLD DERIVATIVES THAT DON’T QUALIFY FOR HEDGE ACCOUNTING UNDER
GAAP?
The next exhibit is BDX’s disclosure of derivatives’ fair value amounts and their balance sheet
geography as of September 30, 2011 (fiscal year-end). Recall that all derivatives are recorded on the
balance sheet at fair value. Derivatives that qualify and are designated for hedge accounting are
separately disclosed. A review of this disclosure and consistent with qualitative disclosures previously
analyzed indicates that a majority of derivatives are used to hedge foreign currency risks.
The fair market value of the company's outstanding derivative asset contracts at 9/30/11 was $43.2
million and $39.6 million for outstanding derivative liability contracts. One reason for why there is both an
asset and liability is that contracts may have been initiated at various points in time and, as such, the
amounts are not allowed to be netted on the balance sheet under GAAP unless a right of set-off exists.
Although GAAP requires some of the derivatives to be reported at gross on the balance sheet as assets
and liabilities, for financial analysis, we suggest netting them in assessing the overall outstanding size of
derivative hedges. The net size of the outstanding net derivative asset was $3.6 million at September
30, 2011. In our view, this isn't very material.
Additionally, the disclosure identifies certain derivatives that are not “designated” under FAS No. 133
hedge accounting since they either do not qualify or the company chose not to designate the derivative
for accounting purposes. There are tedious administrative requirements with complying with FAS No.
133 and, to save time and money, some companies simply choose to leave the derivatives
undesignated for accounting purposes. Nonetheless, it’s worth investigating a company with a large
percentage of undesignated derivatives to ferret out if they are used for speculative purposes or, more
appropriately, risk management. BDX discloses a material amount of undesignated derivatives for
hedge accounting purposes and the reasons therefor is a question for company management.

Effects on Consolidated Balance Sheets
The location and amounts of derivative instrument fair values in the consolidated balance sheet are segregated below between
designated, qualifying hedging instruments and ones that are not designated for hedge accounting.
(6) WHAT IS THE SIZE OF THE UNREALIZED DERIVATIVE GAIN OR LOSS RECORDED IN AOCI IN EQUITY
FROM CASH FLOW HEDGES (E.G, HEDGING FUTURE SALES OR GROSS MARGINS)?
This item is discussed as part of another question below.
(7) DOES THE COMPANY HEDGE EQUITY IN ITS FOREIGN SUBSIDIARIES?

BDX did not disclose that it is hedging equity in its foreign subsidiaries and we generally find this type of
hedging to be uncommon. There is a good reason for our caution. In 2003 and 2004, Baxter used long-
term cross-currency swaps as a way to hedge the net equity (book value) in certain foreign subsidiaries
and was caught on the wrong side of an illiquid trade. During this time period, the U.S. dollar weakened
and the net book equity in Baxter’s foreign subsidiaries increased. At the same time, the related
derivative used to hedge the balance sheet exposure was in a loss position. The contract came due and
needed to be settled. There was no offsetting cash flow gain that could be used as payment for the
hedge losses since the “gain” was related to the increase in value of the foreign subsidiary’s net assets.
These assets couldn’t be easily liquidated (such as PP&E and working capital) to pay off the derivative
losses. The company’s pre-tax liability exceeded $1 billion at December 31, 2004 and resulted in
significant cash payments to settle the contract. A careful reading of Baxter’s prior year 10-K would have
identified such hedges. However, the 10-K did not disclose the total amount of outstanding derivatives at
that time. GAAP rules have since changed requiring disclosure.
As an illustration of one disclosure, the following exhibit is an excerpt on net investment hedges from
Bunge’s 2008 10-K.

Bunge – Net Foreign Subsidiary Investment Hedges Disclosure – 2008 10-K
We use net investment hedges to mitigate the translation adjustments arising from remeasuring our investment in certain of our foreign
subsidiaries. For derivative instruments that are designated and qualify as net investment hedges, we record the effective portion of the
gain or loss on the derivative instruments in accumulated other comprehensive income (loss). During 2008, we entered into fixed interest
rate currency swaps with a notional value of $69 million to hedge the net asset exposure in our Brazilian subsidiaries. Under the terms of
these swaps, we pay Brazilian interest rates and receive fixed U.S. dollar interest rates. The exchange of principal at the maturity of the
swap is expected to offset the foreign exchange translation adjustment of our net investment in our Brazilian real functional currency
subsidiaries. These swaps mature in December 2010. At December 31, 2008, the fair value of the fixed interest rate currency swaps was a
loss of $1 million, which was recorded in accumulated other comprehensive income (loss) in the consolidated balance sheet as an offset to
the foreign currency translation gain from the underlying Brazilian real net asset exposure.
(8) HAVE THERE BEEN LARGE REALIZED GAINS OR LOSSES IN PRIOR QUARTERS IMPACTING THE
INCOME STATEMENT?
The next several exhibits are disclosures on the income statement location and impact of derivative
gains and losses. There are separate disclosures for those derivatives classified as hedges of cash
flows, fair values, and undesignated hedges. For cash flow hedges, two tables are disclosed. The first
table discloses the amount of derivative gains/losses due to fair value changes not recognized in
earnings during the period. Becton Dickinson discloses $33.2 million of interest rate swap losses in
AOCI in equity at year-end. The losses remain in equity since the underlying transaction it is hedging
had not yet occurred. The losses would be reclassified out of equity and into the income statement when
the related hedged item was recognized in earnings.
The second table (on the right of the exhibit) discloses the amount of gains and/or losses that were
reclassified from AOCI to earnings during the year. As the related revenues for which the derivative was
hedging were recognized in the current quarter, approximately $1.7 million of foreign currency hedging
losses were removed out of AOCI in equity and reported in revenues. This hedge loss presumably offset
gains from the underlying revenue transactions. For forward looking analysis, we find this disclosure to
be historical and not particularly useful in predicting the future. However, it provides context in assessing
past hedging activities for cash flow hedges. In 2011, the company reported that no gains or loss were
reclassified from AOCI into income suggesting that they weren’t hedging future cash flows related to
revenues or cost of goods sold. This was a change in practices from 2010 and 2009 when there were
material cash flow hedging gains and losses in revenue.
Effects on Consolidated Statements of Income
Cash flow hedges
The location and amount of gains and losses on designated derivative instruments recognized in the consolidated statement of income for
the years ended September 30, consisted of:

The next exhibit is BDX’s disclosure of the amount of cash flow hedges expected to be reclassified from
AOCI in equity to earnings over the next 12 months. This disclosure provides a general sense of the size
of the embedded gain/loss on derivatives from hedging future cash flows, such as sales.
The Company’s designated derivative instruments are perfectly effective. As such, there were no gains or losses, related to hedge
ineffectiveness or amounts excluded from hedge effectiveness testing, recognized immediately in income for the years ended September
30, 2011, 2010 and 2009. The loss recorded in Other comprehensive income (loss) for the year ended September 30, 2011 represents
unrealized losses on interest rate swaps entered into during the fourth quarter of fiscal year 2011 in anticipation of issuing long-term debt
in the first quarter of fiscal year 2012, partially offset by gains realized on interest rate swaps that were entered into in the first quarter of
fiscal year 2011 in anticipation of issuing long-term debt during that quarter. These swaps were designated as hedges of the variability in
interest payments attributable to changes in the benchmark interest rates against which the long-term debt was priced. The amounts
recorded in Other comprehensive income (loss) relative to these swaps will be amortized, over the life of the respective notes, with an
offset to Interest expense.
In the disclosure of fair value hedges, BDX displays the location of the gains/losses recorded under fair
value hedge accounting. In the third quarter, BDX recorded a loss on derivative positions of $2.7 million
which perfectly offset a recorded fair value gain on its hedged fixed rate debt.
Fair value hedge. The location and amount of gains or losses on the hedged fixed rate debt attributable to changes in the market interest
rates and the offsetting gain (loss) on the related interest rate swap for the years ended September 30 were as follows:
The next exhibit is BDX’s disclosure of the amount and location of gains/losses due to its undesignated
hedges. The company classified a $1.4 million loss in other expense in fiscal 2011 from foreign
exchange contracts. The company discloses that these derivatives are used to hedge inter-company
transactions, but they do not qualify for hedge accounting. This seems reasonable to us.
Undesignated hedges. The location and amount of gains and losses recognized in income on derivatives not designated for hedge
accounting for the years ended September 30 were as follows:

WATCH INTERCOMPANY ACCOUNTS PAYABLE AND FOREIGN CURRENCY TRANSACTIONS
Do foreign subsidiaries receive short-term funding from the U.S. parent company?
The foreign currency translation of short-term inter-company obligations, such as accounts payable, is
an area prone to significant management discretion and where non-economic gains may be created. A
shortcoming in FAS No. 52 requires gains and losses from foreign currency translations on short-term
inter-company obligations to be recorded in earnings. An inter-company transaction between a U.S.
company and its foreign subsidiary is rather easy to create (or eliminate) as a company may
conveniently use a gain on intercompany payables to increase earnings. Given the weakening dollar
over the past several years, some companies have received an additional earnings boost from these
inter-company foreign currency translation gains. If the dollar begins to appreciate vis a vis other
currencies in which a company conducts business, this prior source of non-economic earnings would
become an unexpected earnings headwind.
To illustrate how gains on inter-company obligations may be recorded in earnings, consider a U.S.
company loaning $10 to its European subsidiary (1.5 €/$ exchange rate). On its balance sheet, the U.S.
company records a $10 inter-company accounts receivable. On the other side, the European subsidiary
records an inter-company accounts payable of €15 on the date the transaction is initiated. Next, assume
that the exchange rate changes to 1.25 €/$ at the end of the quarter. Given the change in the exchange
rate, there is a new accounts payables balance of €12.50 for a €2.50 exchange rate gain. The European
subsidiary reports a €2.50 gain in earnings in the current period. In turn, when translating the European
subsidiary’s financial statements into U.S. dollars, the gain is also translated into U.S. dollars and
reported in the parent’s consolidated income statement. It is not eliminated as a gain or loss in
consolidation. Meanwhile, the U.S. parent company’s receivable is already in U.S. dollars; therefore,
there is no foreign currency translation gain or loss. Finally, the inter-company balances of accounts
receivable and accounts payable are eliminated and offset each other (once translated into dollars).
Economically, the transaction and gains or losses should cancel out, but they don’t on a reported
consolidated GAAP basis since the accounting rules do not require it (FAS No. 52).
There are several issues with this transaction. First, the inter-company gain/loss is uneconomic and
generates no real cash flows. Second, a company may fully control inter-company balances and require
subsidiaries to repay inter-company amounts at any time. Therefore, it’s relatively easy to create non-
economic gains if currencies are moving in the favorable direction. Third, inter-company short-term
foreign payables (i.e., borrowings) may be turned into long-term inter-company debt. Long-term inter-
company obligations’ foreign exchange gains or losses are not reported in earnings in the current
period. Instead, they are recorded in accumulated other comprehensive income in equity.

SUBSEQUENT EVENT DISCLOSURES
A subsequent event is something of importance that happens after a company’s year-end, but before
the financial statements are issued. Examples of common subsequent events would be a completed
equity/debt offering or an announced JV/partnership with another company. The subsequent event
footnote, commonly found as one of the last disclosures towards the end of a 10-K, is divided into the
following two events based on accounting guidelines:
• Type I Event: A Type I subsequent event is an event relating to something on a company’s

balance sheet at year-end that occurred after the balance sheet date, but prior to the issuing of
financial statements. If a Type I subsequent event occurs, GAAP year-end financial statements
would be adjusted to reflect the subsequent event since the event is deemed to have existed on
the ending balance sheet date. A lot of estimates are made by management to prepare financial
statements, including items such as probable loss accruals, bad debt expense, and PP&E
salvage values, and these estimates/assumptions could change within the aforementioned
timeframe. Type I subsequent events provide useful additional information about a company’s
condition (e.g., bad debt) that existed on the balance sheet date. An example of a Type I event
would be a lawsuit, settled after year-end, but prior to the issuance of the company’s financials.
• Type II Event: Type II subsequent events are related to circumstances that did not exist at year-
end, but occurred prior to issuing financial statements. Material Type II subsequent events are
required GAAP disclosures, but a company’s year-end financial statements are not adjusted to
reflect them since the event occurred after year-end and it was not already included on the
balance sheet. Common examples of Type II events include a stock issuance or JV/acquisition.
In the following exhibits, we provide three examples of subsequent event disclosures, namely
Herbalife’s, Coinstar’s, and Entropic Communication’s.
Herbalife (2012 Form 10-K): Subsequent Events Disclosure Example
14. Subsequent Events

On February 19, 2013, the Company announced that its board of directors approved a quarterly cash dividend of $0.30 per common share
to shareholders of record as of March 5, 2013, payable on March 19, 2013.
Subsequent to the year-ended December 31, 2012, borrowings under the Company’s revolving credit facility, excluding the Term Loan
portion, increased to $500.0 million, and there was approximately $195.2 million of unused available credit as of February 19, 2013. These
borrowed monies were primarily used for common share repurchases under the Company’s share repurchase program described below.
As of February 19, 2013, the Company had approximately $987.5 million of total borrowings outstanding under the Credit Facility,
including the Term Loan and revolving credit facility.
During January and February 2013, the Company repurchased approximately 4.0 million of its common shares through open market
purchases at an aggregate cost of approximately $162.4 million, or an average cost of $40.61 per share.
In February 2013, the Venezuela government announced it is devaluing its Bolivar currency. They announced that the current 5.3 SITME
rate will be eliminated and that the CADIVI rate will be devalued from 4.3 Bolivars to 6.3 Bolivars per U.S. dollar. As of December 31, 2012,
Herbalife Venezuela’s net monetary assets and liabilities denominated in Bolivars was approximately $82.9 million and included
approximately $99.2 million in Bolivar denominated cash and cash equivalents which were remeasured at the published SITME rate of 5.3
Bolivars per U.S. dollar. This new 6.3 CADIVI rate is 16% less favorable than the previously published 5.3 SITME rate. If during 2013, this
new 6.3 CADIVI rate or an alternative unfavorable exchange rate is used for remeasurement purposes, then the Company will have to
record a foreign exchange loss to its fiscal year 2013 consolidated statement of income to the extent this exchange rate is less favorable
than the previously published 5.3 SITME rate, and the Company’s Bolivar denominated cash and cash equivalents will have to be reduced
accordingly. The Company continues to monitor the current exchange restrictions in Venezuela and is assessing what exchange rate it
should use prospectively for remeasurement purposes. See Note 2, Basis of Presentation , for a further description of currency restrictions
in Venezuela.

SUBSEQUENT EVENT DISCLOSURES (CONTINUED)
Coinstar (2011 Form 10-K): Subsequent Events Disclosure Example
NOTE 19: SUBSEQUENT EVENTS

Joint Venture On February 3, 2012, Redbox and Verizon Ventures IV LLC (“Verizon”), a wholly owned subsidiary of Verizon
Communications Inc., entered into a Limited Liability Company Agreement (the “LLC Agreement”) and related arrangements. The LLC
Agreement governs the relationship of the parties with respect to a joint venture (the “Joint Venture”) formed for the primary purpose of
developing, launching, marketing and operating a nationwide “over-the-top” video distribution services providing consumers with access
to video programming content, including linear content, delivered via broadband networks to video-enabled viewing devices and offering
rental of physical DVDs and Blu-ray Discs® from Redbox kiosks. Redbox is initially acquiring a 35.0% ownership interest in the Joint Venture
and will make an initial capital contribution of $14.0 million in cash. The Joint Venture board may request each member to make additional
capital contributions, on a pro rata basis relative to its respective ownership interest. If a member does not make any or all of its requested
capital contributions, as the case may be, the other contributing member generally may make such capital contributions. So long as
Redbox contributes its pro rata share of the first $450.0 million of capital contributions to the Joint Venture, Redbox’s interest cannot be
diluted below 10.0%. In addition, Redbox has certain rights to cause Verizon to acquire Redbox’s interest in the Joint Venture (generally
following the fifth anniversary of the LLC Agreement or in limited circumstances, at an earlier period of time) and Verizon has certain rights
to acquire Redbox’s interest in the Joint Venture (generally following the seventh anniversary of the LLC Agreement, or, in limited
circumstances, the fifth anniversary of the LLC Agreement). Redbox’s ownership interest in the Joint Venture will be accounted for using
the equity method of accounting.
Acquisition of NCR Entertainment Business On February 3, 2012, Redbox entered into a purchase agreement with NCR Corporation
(“NCR”) (the “NCR Agreement”), to acquire certain assets of NCR related to NCR’s self-service entertainment DVD kiosk business. The
purchased assets include, among others, self-service DVD kiosks, DVD inventory, intellectual property, and certain related contracts. The
purchase price includes a $100.0 million cash payment, as adjusted if certain contracts are not transferred at closing, and the assumption
of certain liabilities of NCR related to the purchased assets. We expect the transaction will be recorded as a business combination. Closing
of the transaction is subject to certain customary closing conditions, including appropriate governmental approval under the Hart Scott
Rodino Antitrust Improvements Act, as amended (“HSR”). If the NCR Agreement is terminated under certain circumstances relating to
failure to obtain appropriate antitrust approvals, Redbox is required to pay NCR a $10.0 million break fee within five days of such
termination. In addition, in connection with the NCR Agreement, we intend to enter into a strategic arrangement with NCR for
manufacturing and services during the five-year period post-closing. At the end of the five-year period, if the aggregate amount paid in
margin to NCR for manufacturing and services delivered equaled less than $25.0 million, we would pay NCR the difference between such
aggregate amount and $25.0 million. Assuming HSR approval, we expect the transaction to close no later than the third quarter of 2012.
Entropic Communications (2011 Form 10-K): Subsequent Events Disclosure Example
11. Subsequent Events

On January 4, 2012, we announced that we agreed to become a “stalking horse bidder” to acquire the assets of Trident Microsystems, Inc.
and certain of its subsidiaries, or Trident, used in or related to Trident's set-top box business, or STB Business, for a purchase price of $55.0
million, subject to a working capital adjustment, or the Acquisition, pursuant to an Asset Purchase Agreement, or Purchase Agreement.
Trident filed the Purchase Agreement with the United States Bankruptcy Court for the District of Delaware along with Trident's motion
seeking the establishment of bid procedures for an auction that allows other qualified bidders to submit higher or otherwise better offers,
as required under Section 363 of the U.S. Bankruptcy Code. On Jan. 18, 2012, the Court approved the bid procedures and Trident and
Entropic executed the Purchase Agreement. The closing of the Acquisition, which is expected to occur in the ‘Q1 2012, remains subject to
higher or otherwise better offers approval by the U.S. Bankruptcy Court and customary closing conditions. If Trident accepts an offer other
than our Purchase Agreement, we will be entitled to be paid a break-up fee and a reimbursement of certain of our transaction expenses.
Pursuant to the Purchase Agreement, we will acquire all of Trident's specific STB Business products, patents and other intellectual property
owned by Trident, certain contracts and prepaid expenses, certain tangible assets, accounts receivable, inventory and equipment. Trident
will retain its digital television, PC television, audio and terrestrial demod businesses. We will also acquire leased facilities in Austin, Texas,
San Diego, California, Belfast, Northern Ireland and Hyderabad, India and the right to use other facilities of Trident under short term
Facilities Use Agreements. We will assume certain specified liabilities of Trident.

DATED FINANCIAL STATEMENTS
SUBSIDIARY FINANCIAL STATEMENTS MUST BE LESS THAN 93 DAYS OLD
When consolidating a company’s financial statements, the SEC allows subsidiary financial statements to
be consolidated if they are less than 93 days old. If a company has a consolidation date different than its
subsidiaries, it must disclose:
• The closing date of the subsidiary;

• Why different dates were used; and
• Subsequent events to the subsidiaries’ closing date that would materially affect the consolidated
financial statements.
Companies use dated financial statements for various reasons, but typical reasons relate to
uncompleted JV audits or foreign subsidiaries. Though not a large timing difference, dated financial
statements could cause a material difference in times of great economic uncertainty or high volatility.

INTERNAL CONTROLS
The Sarbanes-Oxley Act of 2002 (“SOX”) requires management teams to assess the effectiveness of
the company’s financial reporting internal controls. The results of management’s assessment are stated
at year-end in “management’s annual report on internal controls over financial reporting.”
There are three degrees of internal control deficiencies: (1) inconsequential deficiency, (2) significant
deficiency, and (3) material weakness. A “material weakness” would be an internal control deficiency
that results in a more than remote likelihood that a material misstatement would not be detected or
prevented.
Management evaluates the effectiveness of its internal controls over financial reporting. Then the
auditors issue two opinions of their own: (1) do they agree or disagree with management’s assessment
on the effectiveness of internal controls and (2) their official opinion. The auditor’s opinion falls into one
of the following three categories:
• Unqualified: No scope limitations and no material weaknesses were identified;

• Qualified or disclaimer opinion: The auditor can’t express an opinion on certain controls due to a
scope limitation; or
• Adverse opinion: Significant internal control deficiencies based on one or more material
weaknesses in its internal controls.
Companies must disclose material weaknesses over internal controls. The severity of internal control
weakness depends on facts and circumstances and should be evaluated holistically along with other
information to discover the existence of larger, unknown problems at the company. That being said,
companies may have significant internal control deficiencies that they choose not to correct due to cost
reasons. Material weaknesses tend often to be precursors to earnings restatements, in our view.

INTERNAL CONTROLS (CONTINUED)
Below we use Ernst & Young’s audit opinion of Netflix’s internal controls as a common example of an
opinion on the effectiveness of internal controls over financial reporting.
Netflix (2012 Form 10-K): Financial Reporting Internal Controls
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Netflix, Inc.
We have audited Netflix, Inc.'s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal
Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”).
Netflix, Inc.'s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the
effectiveness of internal control over financial reporting included in the accompanying Management's Annual Report on Internal Control
over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on
our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Netflix, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31,
2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheet of Netflix, Inc. as of December 31, 2012, and the related consolidated statements of operations,
comprehensive income, stockholders' equity and cash flows for the year then ended of Netflix, Inc. and our report dated January 31, 2013
expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP

San Jose, California
January 31, 2013
Note: Emphasis added


AUDITOR’S OPINION
Investors should always review a company’s audit opinion for an “unqualified” (clean) audit, without any
“going concern” notation. An unqualified audit opinion means that the company’s financial statements
are fairly presented in accordance with GAAP. If a company receives a “going concern” opinion, it
means that there is substantial doubt that it will be able to continue operations over the next year and
that a potential bankruptcy might be around the corner.
Most credit indentures require companies to have unqualified audit opinions, so a “going concern” or
“qualified” opinion would probably technically trigger a debt default. Another debt covenant sometimes
triggered by companies is the timely filing of financial statements.
Audit opinions fall into one of the following categories:
• Unqualified: Financial statements are fairly presented in accordance with GAAP.

• Qualified: A limitation or exception to the accounting standards exists, which must be explained
and disclosed in an additional paragraph within the audit opinion.
• Adverse: Material departures from accounting standards exist and the financial statements are
not fairly presented in accordance with GAAP.
• Disclaimer of opinion: Unable to issue an audit opinion.
In the following exhibits, we present a “going concern” audit opinion for Dynasil Corp. of American and
then a clean audit opinion for Intel based on the companies’ 2012 Form 10-K disclosures.

AUDITOR’S OPINION (CONTINUED)
Dynasil Corp. of America (2012 Form 10-K): “Going Concern” Example
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders

Dynasil Corporation of America and Subsidiaries
Watertown, Massachusetts
We have audited the accompanying consolidated balance sheet of Dynasil Corporation of America and Subsidiaries (the Company) as of
September 30, 2012 and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity, and
cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is
to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material
misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial
reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control
over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for
our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of
Dynasil Corporation of America and Subsidiaries as of September 30, 2012, and the results of their operations and their cash flows for the
year then ended, in conformity with U.S. generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.
As discussed in Note 1 to the consolidated financial statements, as of September 30, 2012, the Company is in default with the financial
covenants set forth in the terms of its outstanding loan agreements (and anticipates entering into a forbearance arrangement with its
lenders) and sustained a substantial loss from operations for the year ended September 30, 2012. These factors, among others, as
discussed in Note 1 to the consolidated financial statements, raise substantial doubt about the Company’s ability to continue as a going
concern. Management’s plan in regards to these matters is also described in Note 1. The consolidated financial statements do not include
any adjustments that might result from the outcome of this uncertainty.
McGladrey LLP
Boston, Massachusetts
January 15, 2013
Note: Emphasis added


AUDITOR’S OPINION (CONTINUED)
Intel (2012 Form 10-K): Example of a Clean Audit Opinion
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Intel Corporation
We have audited the accompanying consolidated balance sheets of Intel Corporation as of December 29, 2012 and December 31, 2011,
and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the three
years in the period ended December 29, 2012. Our audits also included the financial statement schedule listed in the Index at Part IV, Item
15. These financial statements and schedule are the responsibility of the company’s management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Intel
Corporation at December 29, 2012 and December 31, 2011, and the consolidated results of its operations and its cash flows for each of the
three years in the period ended December 29, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion,
the related financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Intel
Corporation’s internal control over financial reporting as of December 29, 2012, based on criteria established in Internal Control—
Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February
19, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP

San Jose, California
February 19, 2013

Earnings Quality

EARNINGS QUALITY SCORE METHODOLOGY
We strongly believe that the balance sheet and cash flow are leading indicators of future income
statement issues (e.g., an earnings miss) and a careful and objective analysis of these two financial
statements generates alpha from avoid underperforming stocks. In order to objectively rank companies
for earnings quality, our EQ methodology calculates an overall “EQ score” based upon the seven
financial metrics identified and explained on the next page. Each metric was empirically tested for
significance at identifying underperforming stocks. The companies are first segregated into their
respective GICS sector. We exclude the financials’ sector as we use more sector specific factors to
interpret the earnings quality of these companies (the earnings quality metrics we use for non-financials
are not applicable to financials companies – see our “Banks: ‘Q3 Earnings/Asset Quality Analysis” report
published on November 20, 2012 for a separate earnings quality analysis, specifically covering banks
over $750 million in market cap.).
For each of the seven factors, we used a ranking system whereby each company is ranked high to low
based on where the metric fell relative to all the other companies within the sector. Based on this
ranking, each company is placed into a decile numbered 1 through 10 (10% buckets). A lower numbered
decile indicates lower earnings quality for that particular factor. For example, for any given factor, if the
company were ranked into the bottom 10%, or decile, of the total sector, it received a “1”. If it placed in
the top 10% of companies, it would receive a “10” and be considered one of the highest earnings quality
in its sector. Each company receives 7 individual decile ranks. Finally, we add the seven decile ranks
together, rank the companies within each sector by this sum, and scale the rankings to 100. This results
in an overall EQ score for each company of 0 to 100.
In order to further identify companies with other negative signals, we qualitatively reviewed additional
factors (such as increasing share count, increase in leverage, pension risk, restructuring charges, and
serial acquisitions). While these factors are not explicitly included in the EQ score due to their binary
nature, we believe that the presence and frequency of these factors is suggestive of lower earnings
quality. Therefore, we include them as “additional factors” separately identified. The more additional
factors separately identified, the lower the overall earnings quality, all else being equal.
Please see our most recent November 28, 2012 Earnings Quality report for more detail on specific
companies scoring in the bottom 10%. We update this analysis quarterly.

EARNINGS QUALITY METRICS
In the exhibit below, we explain the various components of our earnings quality framework. We include
several “additional factors” that are indicative of potential issues (e.g., high number of acquisitions).
However, such items are binary and, therefore, we cannot rank companies within a sector on that basis.
We calculate ratios on a LTM basis as we’ve found this to be more predictive historically.
Earnings Quality Framework Summary Descriptions
SEVEN KEY METRICS Calculation Description

(1) Current Accruals (NI - CFFO) / LTM Revenue Measures the level of non-cash net current assets on the
(↑ ratio = ↓ earnings quality) balance sheet and whether earnings are supported by cash flow
(2) Change in Net Operating Assets Changes in Net Operating Asset Accounts per Cash Measures the growth in net operating assets on the balance
(NOA) Flow Statement / LTM Revenue sheet
(↑ ratio = ↓ earnings quality)
(3) Total Accruals (NI - CFFO - CFFI) / LTM Revenue Measures the level of both net current and non-current assets
(↑ ratio = ↓ earnings quality) on the balance sheet and whether earnings are supported by
cash flow
(4) Tax Rate Tax expense / Earnings Before Taxes A low tax rate is often unsustainable and indicative of low
(↓ rate = ↓ earnings quality) earnings quality
(5) Other Asset Growth Change in Other Total Assets / LTM Revenue Measures other growth in the balance sheet and identifies
(↑ ratio = ↓ earnings quality) possible excess cost capitalization
(6) Change in Cash Margin 1 – (LTM COGS – Δ in AP + Δ in Inventory) / (LTM Measures trends in gross margin on a cash basis to see if margin
(↓ rate = ↓ earnings quality) Revenue – Δ in AR + Δ in Deferred Revenue) changes are supported by strong cash flow
(7) High Cap-Ex LTM Cap-Ex / PP&E Measures the over investment tendency of companies on which
(↑ ratio = ↓ earnings quality) there often are decreasing marginal returns
ADDITIONAL FACTORS Calculation Description

(1) Increasing Share Count Companies with the largest increase in share count We've found that companies with the largest increase in share
over the prior 2 year period (top 10%) count over the prior 2 year period underperformed historically
with a high hit ratio
(2) Serial Restructuring Charges Four Consecutive Quarters of Special Charges of at We find companies reporting special items (restructuring
Least 0.25% of Revenue charges) for four consecutive quarters underperform
(3) High Pension Risk Score 3 Factors: Pension Underfunding to Market Cap > Companies with large unfunded pensions face funding risks in
0.2x; Pension Underfunding to Free Cash Flow > 1.0x; today's low rate environment
Pension + OPEB liability to EV > 0.5x
(4) Increased Leverage At Least a 1 Turn Increase in Debt / EBITDA Ratio Measures companies with increasing proportion of debt in
capital structure
(5) Serial Acquiror At Least 3 Out of 5 Prior Years With a 10%+ Increase in Measures the tendency of companies completing acquisitions
Goodwill & Intangibles to underperform and identify roll-up type situations
SENTIMENT Calculation Description

(1) Earnings Estimate Revisions - 30 Day EPS Revisions Measure of earnings momentum
30 Days
(2) Insider Selling Last 3 Months Net Insider Selling Measure of company sentiment towards its share price
(3) Short Interest Short Interest to Float Measure of sentiment among short sellers

EARNINGS QUALITY FACTORS
Summary of Earnings Quality Factors
Excess Returns of Lowest EQ Companies

High High High Other Increase in
Current Change in High Total Asset Days Increase in Low Tax
Accruals NOA Accruals Growth Inventory High Capex DSOs Rate
0.0
-1.0
1-Year Excess Return (%)
-2.0
-3.0
-4.0
-5.0
-6.0
CURRENT ACCRUALS
One key tenet of our earnings quality analysis is searching for companies with unsustainable growth
rates in their balance sheets. To that end, we believe a company’s balance sheet is a leading indicator
of potential problems on the income statement leading to future negative earnings surprises. Both
statements are intertwined.
Historical Test Results: Current Accruals
Current Accruals: 1-Year Excess Returns %

Decile Excess Return Decile Hit Rate %
2 90
1 80
70
0
60
Hit Rate %
-1
50
-2
40
-3
30
-4 20
-5 10
-6 0
1 2 3 4 5 6 7 8 9 10
Decile

EARNINGS QUALITY FACTORS (CONTINUED)
For example, assume a company is aggressively recognizing revenue. Its earnings will be higher, but
accounts receivable will likely still remain uncollected and on the balance sheet. Cash flow is lower and,
therefore, the balance sheet has grown in size (ex-cash). The operating accruals ratio measures the
growth rate in the balance sheet’s non-cash current assets and liabilities included in the operating
section of the cash flow statement. At a high level, it is a conversion rate as low earnings quality exists
when net income is not supported by a similar high level of operating cash flow. We use net income from
continuing operations in our calculations to eliminate noise from discontinued operations and
restructuring items. All else being equal, the higher the current accruals ratio, the lower the quality of
earnings (e.g., net income is higher than cash flow). We found changes in this ratio to not be as
predictive and we posit this is due to noise and seasonality in the numbers.
In our calculations of current accruals, we use an adjusted net income and operating cash flow number.
We adjust reported net income for non-recurring items, such as goodwill impairments, asset write-
downs, gains/losses on investments and sales of assets, and other unusual items. Cash flow from
operations is adjusted for stock based compensation by treating it as a cash cost. This ensures that
cash flow isn’t artificially high relative to net income.
CHANGES IN NET OPERATING ASSETS

Similar in thinking to the current accruals ratio is a more narrow measure of balance sheet growth-
working capital type changes. In this ratio, we isolate the growth rate in the balance sheet primarily due
to receivables, inventory, payables, accrued expenses, and other asset and liability changes. To
eliminate noise, we use the amount reported on the cash flow statement since it excludes acquisition
related growth and foreign currency translation growth (will not correct for management of the target’s
working capital prior to the acquisition, however). This metric captures three important financial ratios:
days receivable, days inventory and days payable. It assists in identifying companies reporting accrual,
but not cash based earnings with increases in receivable and inventory balances not offset by a similar
increase in payables and/or accrued expenses. All else being equal, the higher the change in net
operating assets’ ratio, the lower the quality of earnings.
Historical Test Results: Change in NOAs
Change in Net Operating Assets: 1-Year Excess Returns %

Decile Excess Return % Decile Hit Rate %
4 100
3 90
2 80
1 70
Hit Rate %
0 60
-1 50
-2 40
-3 30
-4 20
-5 10
-6 0
1 2 3 4 5 6 7 8 9 10
Decile

To calculate the change in net operating assets, we adjust the change in net operating assets on the
cash flow statement for any tax effects, which we don’t consider true operating assets and may be highly
volatile.
TOTAL ACCRUALS
The total accruals ratio is the broadest measure of overall balance sheet growth incorporating both net
current assets and non-current assets. It is used to identify situations where a company is not managing
or growing current net operating assets/liabilities, but rather is excessively growing non-current assets
such as property, plant, and equipment. The ratio assists in finding companies excessively capitalizing
costs into PP&E on the balance sheet. It has been supported by our own research and academic
research that stocks with high levels of total accruals historically underperformed, on average. The ratio
captures investment for cash acquisitions and other investing activity cash outflows.
As we showed in our December 2011 Earnings Quality report, WorldCom reported significant “other”
cash outflows in the investing section of the cash flow statement. All else being equal, a higher working
capital accrual change ratio suggests lower quality of earnings. We also used the same adjusted net
income and adjusted operating cash flow numbers, as discussed in the previous current accruals
section, to calculate each company’s total accruals.
Historical Test Results: Total Accruals
Total Accruals: 1-Year Excess Returns %

4 90
3 80
2 70
1 60
Hit Rate %
0 50
-1 40
-2 30
-3 20
-4 10
-5 0
1 2 3 4 5 6 7 8 9 10
Decile
TAX RATE
We use a low GAAP effective tax rate as an indicator of low earnings quality. Companies may report a
low tax rate for a variety of reasons, including foreign earnings, tax net operating loss carryforwards, and
one time tax benefits. Long-term, we believe few companies may maintain a very low tax rate and,
therefore, a low tax rate may be suggestive of a company over-earning. Our research didn’t find any
strong historical predictability in cash tax rates or changes in tax rates, however. We attribute this to
significant volatility in rates and the difficulty in generalizing rates across a large group of companies. All
else being equal, we believe that a low tax rate is suggestive of low earnings quality.

Not many companies report a cash tax rate on a quarterly basis (and the quarterly information is not
available to derive a cash tax rate, either), so we must rely on GAAP effective tax rates in this situation.
When analyzing companies individually, we advise examining cash tax rates over time and comparing
them to GAAP effective tax rates. A low cash tax rate relative to GAAP tax rate is most concerning to us
if not due to NOLs or unrepatriated foreign earnings.
Historical Test Results: Tax Rate
Effective Tax Rate: 1-Year Excess Returns %

3 80
2 70
1-year Excess Returns %
60
1
Hit Rate %
50
0
40
-1
30
-2
20
-3 10
-4 0
1 2 3 4 5 6 7 8 9 10
Decile
OTHER ASSET GROWTH

When growth is slowing or there are pressures on the underlying business, companies may be tempted
to excessively capitalize costs into other assets on the balance sheet. This ratio isolates excessive
growth in other parts of the balance sheet. All else being equal, higher other asset growth is suggestive
of lower earnings quality.
Historical Test Results: Other Asset Growth
Other Asset Growth: 1-Year Excess Returns %

3 90
2 80
70
1
60
Hit Rate %
0
50
-1
40
-2
30
-3 20
-4 10
-5 0
1 2 3 4 5 6 7 8 9 10
Decile

CHANGE IN CASH GROSS MARGIN
We use the change in cash gross margin as a quality of gross margins measure and follow its trend as
GAAP accrual gross margins may be inflated by non-recurring and one-time non-cash items, such as
sales/inventory reserve reversals and working capital balance sheet growth. The quality of earnings is
lower if gross margins increase as a result of receivables and/or inventory growth. This ratio is
calculated as cash sales less cash cost of goods sold, which measures cash received from selling the
products less the cash paid to produce the product in the current period. Declining cash margins
suggests that more cash is consumed by working capital type items, such as receivables.
HIGH CAPITAL EXPENDITURES

This ratio measures the overinvestment tendencies of companies. While earlier stage growth companies
will naturally be investing heavily in capital expenditures, there is diminishing marginal returns on capital
investment. All else being equal, higher capital expenditures are suggestive of future stock price
underperformance. Academic research has corroborated this tendency for many years.
Historical Test Results: High Cap-Ex
Relative Return based on LTM Capex / Avg. Net PPE

1 year Relative Return (L) Hit Ratio % (R)
2.0 80
70
1.0
60
0.0
Hit Rate %
50
-1.0 40
30
-2.0
20
-3.0
10
<-------Lower Capex/PPE--------------------------------Higher Capex./PPE----->
-4.0 0
1 2 3 4 5 6 7 8 9 10

ADDITIONAL FACTORS
We use additional factors to create an earnings quality mosaic of situations signaling possible stock
price overvaluation. Since these factors are binary (either existing or not), we cannot rank companies
from highest to lowest and separate into deciles. Therefore, we identify whether the factors exist and
consider the number identified as a qualitative measure of earnings quality (the more factors a company
has, the lower the earnings quality).
INCREASING SHARE COUNT

While there are a variety of reasons cited by management for increasing the number of shares
outstanding, our research has found that the share prices of companies with the largest increase in
share count during the prior 2 years underperformed historically with a high hit ratio (i.e., a large
percentage of the stocks with this factor underperformed). A company may choose to issue additional
shares when they believe their share price is overvalued, to compensate employees, and/or to effect an
acquisition. In our view, overall, an increasing share count is a negative management signaling
mechanism and, therefore, we include (companies in the worst decile) it as an additional factor.
SERIAL RESTRUCTURING CHARGES

Historically, we’ve found approximately 200 basis points of 1 year subsequent stock price
underperformance in companies reporting at least four consecutive quarters of “special charges” at least
0.25% of the last twelve months revenues (historical returns don’t materially change if a 1% of revenue
cut-off was used instead). We believe repetitive special charges are often a signal of pressure in the
company’s underlying business fundamentals and, if they occur frequently, should be considered a
normal operating expense in earnings.
HIGH PENSION RISK

In our years of following pension underfunding, historically, we have found pensions to have a negative
impact on company valuation when the pension underfunding to market capitalization ratio was at least
20% (underfunded to enterprise value was considered, but no more accurate). Additionally, we note that
pension underfunding can signify a risk if the underfunded amount is at least equal to the company’s
cash flow. Finally, as an indicator of more structural exposure to retirement liabilities, we identify
companies where the PBO (pension liability) and OPEB liability are at least 50% of the company’s
enterprise value. We identified companies with all three of these indicators present as having high
pension risk.
We view this as a risk factor as the prospect of sub-par equity market returns and/or sustained low
interest rates over the next few years would bring material pressure to bear on these companies’ cash
flows and earnings. Also, high pension risk may simply be an identifier of a bad business and, therefore,
further troubles ahead (AMR and Eastman Kodak scored the worst in our previous pension reports).
INCREASED LEVERAGE
Companies increasing leverage ultimately increase risk to the equity owner. We measure leverage as
the ratio of gross debt to EBITDA. Our increased leverage factor identifies companies with at least a one
turn increase in leverage over the past 12 months.

HIGH ACQUISITIONS (SERIAL ACQUIRORS)
In the past, we’ve found that the share prices of companies completing acquisitions underperform in the
1 year period after the acquisition’s closing date. Further, there are numerous accounting tricks that may
be deployed in acquisitions to unsustainably increase the combined companies’ financial results. These
two issues suggest it’s important to find companies with high acquisitions and use it as a risk factor. In
our analysis, acquisitive companies are separately identified and flagged. We use changes in goodwill
and intangible assets as a proxy for acquisitions, highlighting companies where goodwill and intangibles
have increased 10% or more in at least 3 out of the last 5 years. Usually, most companies will record
goodwill and intangible assets in purchase accounting for acquisitions (fair value all assets and
liabilities), so monitoring increases in these balances is an objective way of finding acquisitive
companies across a large universe.
EARNINGS ESTIMATE REVISIONS

To add a measure of timing or momentum to our accounting ratios, we calculate 30 day earnings
estimate revisions.
INSIDER SELLING
To identify a possible signaling mechanism of stock price overvaluation by company insiders, we use the
last 3 months net insider selling. To be sure, there may be false signals if management owns a
significant number of shares and has been a consistent seller to diversify their wealth. This ratio is
calculated as the net number of shares bought (sold) divided by the total shares outstanding (exercising
stock options and buying the shares is included as a buy and exercising stock options and selling the
shares is included as a sell).
SHORT INTEREST
To measure the sentiment among short sellers, we incorporate the current short interest ratio (shares
currently sold short divided by company float) into our analysis. This assists in gauging the
“crowdedness” of the trade.

Differences Between
U.S. GAAP and IFRS GAAP

BALANCE SHEET: FINANCIAL ASSETS
Summary: IFRS classifies more assets at amortized cost and less OTTI write-downs are recorded on
securities. We believe that these factors lower a company’s overall quality of reported book
value/shareholder’s equity.
Detailed Financial Asset Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Marketable securities: Classified as trading, available-for-sale, or held-to-maturity.
• Non-traded equity investments: Recorded at historical cost, unless elected to be accounted for at fair value under ASC 825 - Financial
Instruments (formerly FAS No. 159).
• OTTI: Occurs based on a two-step test: (1) management does not intend on selling the security and there’s a 50%+ chance that it
wouldn’t have to sell before recovering in value to at least cost and (2) management expects to recover the entire cost basis. If the
answer is “no” to either one of these steps, then an impairment is recorded. Reversals are not allowed.
• Loans: Classified as either held for sale (lower of cost or market) or held for investment (amortized cost). Most loans fall under the
“held for investment” category. Similar to non-traded equity investments, management may elect to record loans at fair market value
under FAS No. 159.
• Loans held for sale: Carried on the balance sheet at the lower of cost or market.
• Classification of debt: Driven by legal form.
• Netting assets and liabilities: Generally allowed when a right of set-off exists under a master netting agreement. Because of this rule,
many items such as off-setting derivatives with the same counterparty are reported net on the balance sheet.
• Transfer of assets between categories: Strict rules for reclassifying securities from available-for-sale to held-to-maturity.
IFRS
• Marketable securities: Classified as trading, available-for-sale, or held-to-maturity.
• Non-traded equity investments: Recorded at fair value.
• OTTI: Only objective evidence of a credit default triggers an impairment (not based on intent or an interest rate change). Things
considered include (1) high probability of bankruptcy, (2) significant financial difficulty, (3) granting of concessions, (4) breach of
contract, (5) disappearance of active market due to financial struggles, and/or (6) measurable decline in future cash flows. Reversals
through the income statement are required.
• Loans: Recorded on the balance sheet at fair market value or amortized cost. Loans are not carried at the lower of cost or market.
• Loans held for sale: This category does not exist. Loans held for sale or securitization are classified as trading and recorded at fair
value.
• Classification of debt: Not driven by legal form. Thus financial assets that are a security in the legal sense are often classified as a
loan/receivable under IFRS, resulting in more “securities” being recorded at historical cost.
• Netting assets and liabilities: Generally allowed when a legally enforceable right to set off exists and the company intends on either
settling on a net basis or realize asset and settle liability simultaneously. Master netting agreements alone are not enough to offset
unless all of the above criteria are met, leading to significantly more presentation at gross on the balance sheet.
• Transfer of assets between categories: More common than under U.S. GAAP. Trading and/or available-for-sale debt instruments
(carried at fair value) may be classified into the loan category (recorded at amortized cost) if the company has both the intent and
ability to hold it for the foreseeable future.

BALANCE SHEET: INVENTORY
Summary: U.S. GAAP allows either FIFO or LIFO accounting methods, but IFRS does not allow LIFO
accounting. Moving from LIFO to FIFO would typically increase a company’s net income and decrease
operating cash flow, during a period of normal inflation. Operating cash flow would decline because the
LIFO tax shield would disappear.
LIFO inventory accounting is most often used in the following industries: retail, industrial, gas, and
pharmaceutical. Approximately 250 companies in the Russell 3000 account for at least a portion of their
inventories using the LIFO method.
Detailed Inventory Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Costing methodology: A few of the commonly allowed inventory methods include LIFO, FIFO, and average cost. The IRS’ “LIFO
book/tax conformity rule” requires companies that use LIFO for tax purposes also use LIFO for GAAP purposes.
• Write-downs: Inventory write-down reversals are not allowed. Recovery in inventory value is captured through higher gross margins
when the written-down inventory is subsequently sold.
IFRS
• Costing methodology: FIFO and weighted average are allowable inventory costing methods. LIFO is not allowed under IFRS.
• Write-downs: Inventory write-down reversals are required to be recorded in COGS, up to the original inventory value, before the
inventory is sold.

BALANCE SHEET: PP&E AND INTANGIBLES
Summary: IFRS allows the revaluation of PP&E to fair market value, which may lead to asset and
equity balance distortions. This could also lead to misleading and/or highly volatile financial ratios such
as ROE and ROIC. Under IFRS, real estate companies may also account for their investment properties
at fair value, with the changes in value recorded into earnings.
Detailed PP&E and Intangible Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Cost: Generally depreciable and recorded at historical cost. PP&E can’t be revalued to fair market value unless the company is
acquired and purchase accounting rules apply.
• Depreciation: Usually depreciated, straight-line, over X number of years. U.S. GAAP does not require a components based approach
for depreciation expense.
• Investment properties: Recorded at historical cost for most real estate companies; no revaluations to fair market value permitted.
• Intangible assets: No revaluations to fair market value permitted.
• Leveraged lease accounting: Permitted. Under leveraged lease accounting, the lessor often recognizes leasing income quicker and the
non-recourse leveraged lease debt amount is netted against the leveraged leased investment asset on the lessor’s balance sheet.
IFRS
• Cost: Generally depreciable and recorded at historical cost. PP&E can be revalued to fair market value with a gain credited to equity
under a “revaluation surplus” account. If a future impairment occurs, the loss may be offset against the revaluation surplus. Historical
cost and depreciated amounts must be disclosed.
• Depreciation: Components based approach used to depreciate assets. Material components of PP&E with different useful lives are
depreciated separately.
• Investment properties: Recorded at fair market value or historical cost. The change in fair market value is recorded in earnings in each
period and investment property is not depreciated. These rules also apply to leased properties.
• Intangible assets: Revaluations to fair market value are permitted, although this is uncommon since the standard requires the fair
market value to be in specific reference to an active market for the specific intangible asset.
• Leveraged lease accounting: Not permitted. Under IFRS, non-recourse debt is recorded at gross on the balance sheet.

BALANCE SHEET: ASSET IMPAIRMENTS
Summary: Due to IFRS’ impairment testing mechanics, companies under IFRS might recognize
impairments before companies in the same situation that report under U.S. GAAP. Furthermore, these
impairments may be reversed back into the income statement as gains if certain criteria are met. These
differences generally result in more volatile earnings.
Detailed Asset Impairment and Lease Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Impairments are tested under a two-step approach (indefinite lived intangibles are now subject to a preliminary qualitative more-
likely-than not impairment test assessment before moving to step 1):
o Initial recoverability test based on an asset’s carrying value vs. total undiscounted future cash flows. If the asset’s carrying value is
greater than the sum of the asset’s undiscounted future cash flows, proceed to step 2.
o In step 2, the asset’s carrying value is written down to fair market value based on FAS No. 157.
• Reversing impairment charges: Not allowed.
IFRS
• Under IFRS, impairments are tested based on a one-step approach:
o If impairment indicators exist, an impairment loss should be calculated. An impairment charge is recorded if an asset’s carrying
value is greater than the future discounted cash flows or the asset’s fair market value, less cost of selling.
• Reversing impairment charges: Allowed if certain criteria are met. The reversal of an impairment charge is recorded and flows
through the income statement as a gain. However, the reversals of goodwill impairment charges are not permitted.

BALANCE SHEET: LEASES
Summary: There are slightly different criteria for lease accounting, but the accounting for leases is very
similar under each standard.
Detailed Asset Impairment and Lease Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Leases: Four bright line criteria to determine whether a lease is classified as a capital lease (on-balance sheet) or operating lease (off-
balance sheet).
IFRS
• Leases: Classification of leases is based on principles and the overall substance of the transaction. It also depends on whether the
lease transfers substantially all of the risks and rewards of ownership to the lessee. Under IFRS, there are no bright line tests or
quantitative breakpoints.

BALANCE SHEET: PENSIONS
Summary: Pension accounting is one of the major differences between U.S. and IFRS GAAP. The most
significant differences with regard to pension accounting relate to underfunding amounts, recording
gains and losses, and treatment of interest cost and actuarial gains and losses.
The International Accounting Standards Board (“IASB”) recently issued revised pension accounting rules
under IAS 19 that was effective for those companies following IFRS beginning January 2013. The rules
require accounting that somewhat resembles some of the mark to market type pension accounting U.S.
companies have been adopting.
Detailed Pension Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Types of plans: Multi-employer plans are typically considered to be defined contribution “pay as you go” plans.
• Terminology: Post-retirement benefits (OPEB) include post-retirement benefits other than pensions and other post-employment
benefits.
• Pension plan asset value: U.S. GAAP permits the use of a smoothed plan asset value (up to 5 years) to calculate expected rate of
return on plan assets. Expected Return on Plan Assets = Market Value x Expected Rate of Return.
• Funded status: The actual economic funded status is recorded on the balance sheet. The pension’s assets minus liabilities (PBO) are
booked as an asset or liability.
• Pension cost component classification: The net pension cost may be allocated to line items such as COGS, SG&A, or R&AD, but
pension expense is reported as one net number on the income statement.
• Actuarial gains/losses: Arise from changes in the discount rate, actuarial table changes, and differences between the pension plan’s
expected rate of return and actual returns. These gains or losses are either recognized over time based on the corridor approach
(common) or immediately recognized through the income statement (uncommon).
IFRS
• Types of plans: Multi-employer plans that are similar in structure to a defined benefit plan are classified as defined benefit plans.
• Terminology: Post-employment includes pension, post-retirement (OPEB), and other post-employment benefits.
• Pension plan asset value: Smoothed market related plan asset values are not allowed. Plan assets used to calculate expected returns
(now part of net interest income / (expense) – see below) must be based on current fair market value.
• Funded status: The balance sheet will be marked-to-market so that the actual funded status of the plan is recorded on the balance
sheet. Previously, economic funded status was only reported in a company’s footnotes, but not on the balance sheet.
• Pension cost component classification: For recognition of periodic pension and OPEB costs, service cost will remain the same, but
there will no longer be specific interest cost and expected return on plan asset components. Instead there will be one amount, “net
interest income/(expense)” that will be recorded. This amount will be based on the discount rate of the plan x the net funded status.
The pension components are disaggregated so that the net interest income or expense will be below operating income in the
financing section of the earnings statement similar to other interest cost items.
• Actuarial gains/losses: “Remeasurements”, or actuarial gains/losses, will be recognized annually directly into Other Comprehensive
Income, an equity holding account. Under the new IFRS rules, these amounts will not be subject to recycling through earnings (e.g.
there will be no amortization or “charges”). Essentially, the only items that will go through earnings on a periodic basis will be the
service cost and the net interest income/(expense).

BALANCE SHEET: JV AND M&A ACCOUNTING
Summary: A company’s net income will be the same irrespective of whether it accounts for its
investments/partnership/acquisitions under the consolidation, equity, or proportional accounting method.
Although net income will be the same under each methodology, a company’s margins and financial
ratios might be skewed depending on whether or not operating metrics are included in EBITDA.
Beginning in 2013, proportionate consolidation is no longer allowed in what IFRS defines as joint
ventures – the equity method will be required instead.
Detailed JV and M&A Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Consolidation: Must be used if a company owns >50% of the voting rights and risks/rewards of an entity (regardless of ownership
interests, is the company the primary beneficiary of the entity and does it have the power to direct its activities?).
• Proportionate consolidation: Not allowed under U.S. GAAP.
• Joint ventures (50-50% ownership): Equity method of accounting is required.
IFRS
• Consolidation: There is greater flexibility under IFRS to issue financial statements that do not consolidate all entities with over a 50%
ownership. More leniency to use the equity method or proportionate consolidation is allowed under IFRS.
• Proportionate consolidation: No longer allowed under IFRS. A new distinction between joint ventures and joint operations will
delineate accounting. See below for joint ventures. The accounting model for a joint operation is a line by line accounting for the
underlying assets, liabilities and income items.
• Joint ventures (50-50% ownership): Equity method of accounting is required beginning 2013.

BALANCE SHEET: RESERVE ACCOUNTS – RESTRUCTURING AND OTHER ACCRUED LIABILITIES
Summary: Based on IFRS, restructuring and other accrued liability charges are typically recorded in
earlier periods and often in larger amounts than U.S. GAAP. These differences arise because of IFRS’
lower probability threshold (~50%) of when the charges are recorded on the books.
We believe that higher reserve account balances and the lack of policing result in a higher probability of
booking excess reserves to manage earnings. We’ve observed that companies under IFRS tend to
reverse accrued liabilities as gains in earnings with greater frequency than companies under U.S.
GAAP.
Detailed Reserve Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Recording reserves/provisions: Based on ASC 450 – Contingencies (formerly FAS No. 5), reserves (accrued liabilities) are recorded on
the books when the liability is both probable and reasonably estimable. “Probable” is generally interpreted to mean at least a 70%
chance of occurring.
• Recorded reserve amounts: The most likely outcome should be recorded on the books. If each outcome has the same probability, the
lowest liability among the range of possible outcomes should be recorded.
• Restructuring cost expensing and timing: Once management decides and commits to a detailed restructuring plan, each cost is
reviewed for when it should be recognized and recorded as an expense in earnings.
• Unfavorable contracts: Recorded once the company stops using the asset.
IFRS
• Recording reserves/provisions: Recorded when “probable,” interpreted to mean “more likely than not” or a greater than 50% change
of occurring. This is a lower threshold than under U.S. GAAP.
• Recorded reserve amounts: Similar to U.S. GAAP, the most likely outcome should be recorded on the books, but when a range of
potential liabilities exist, the mid-point should be selected, resulting in a higher recorded reserve.
• Restructuring cost expensing and timing: Less restrictive, with restructuring charges being recognizable earlier, than U.S. GAAP. IFRS,
specifically IAS 37, only requires that management as “demonstrably committed” to a restructuring (detailed exit plan) and focuses on
an exit plan as a whole rather than individual cost components of the plan. The restructuring does not need to be communicated to
the company’s employees.
• Unfavorable contracts: Recorded for an unfavorable contract, despite the fact that the company is still using its rights under the
contract. Under IFRS, amounts are typically expensed sooner.
• Contingent liabilities: Reduced disclosure for contingent liabilities is allowed if it is severely prejudicial to an entity’s position in a
dispute.

BALANCE SHEET: COST CAPITALIZATION
Summary: Under IFRS, if certain criteria are met, development costs may be capitalized and expensed
over the asset’s life. IFRS tends to lead to higher earnings due to the fact that more costs are capitalized
on the balance sheet instead of being immediately run through the income statement.
Detailed Cost Capitalization Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Advertising: Companies may either expense as incurred or capitalize costs (prepaid asset) and expense through earnings when the
advertising actually happens. Direct response advertising costs may be capitalized and subsequently amortized if certain requirements
are met.
• Research: Expensed as incurred.
• Development: Typically expensed as incurred, unless specific guidance suggests capitalization instead (e.g., ASC 985 – Software
(formerly FAS No. 86)), resulting in the capitalization of certain costs such as software development).
IFRS
• Advertising: Not allowed to defer costs until advertising occurs and must be expensed immediately. Capitalization of direct response
advertising costs as assets is not permitted.
• Research: Expensed as incurred.
• Development: If certain criteria are met, development costs may be capitalized as an intangible asset and amortized over the asset’s
expected life. Does not distinguish between assets developed for internal or external uses.

BALANCE SHEET: CONVERTIBLE BONDS
Summary: IFRS requires companies to allocate convertible debt into debt and equity amounts on the
balance sheet. On the income statement, interest expense is recorded at the company’s straight-debt
interest rate compared to the convertible bond’s cash coupon rate. Only cash settled principal
convertible bonds in the U.S. use “bifurcation accounting.”
Detailed Convertible Bond Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Accounting: In general, the entire amount of a plain vanilla convertible bond is recorded as debt on the balance sheet. FASB Staff
Position No. APB 14-1 changed the accounting for certain types of convertible bonds to a “bifurcation” accounting model, discussed in
depth in the convertible debt section.
• Interest expense: Recorded based on a bond’s effective interest rate, which is typically the cash coupon rate (unless a zero coupon
discount bond for plain vanilla converts) Bifurcated convertible bonds will record interest at the effective interest rate.
IFRS
• Accounting: Recorded as both debt and equity on the balance sheet. IFRS requires bifurcation calculated under the “residual
approach.” The initial debt amount recorded on the balance sheet is the fair value of debt without considering the equity conversion
option and the residual amount (par value less fair value of debt) is recorded as equity.
• Interest expense: Recorded at the bond’s effective interest rate without considering the equity conversion option.

INCOME STATEMENT: REVENUE RECOGNITION
Summary: Conceptually, revenue recognition is similar between U.S. GAAP and IFRS, however U.S.
GAAP tends to be more rules based and standardized within industries whereas IFRS is more principles
based. Due to the somewhat looser revenue recognition definitions and the presence of more
management discretion, we believe that under certain situations, IFRS may lead to earlier recognition of
revenue.
Detailed Revenue Recognition Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Based on: Principles-based, including extensive guidance and rules. Detailed industry rules, common practices, and common
exceptions also exist.
• Example – Percentage of Completion Accounting: Typically only used for construction or production type contracts and disallowed
for service type contracts. Sometimes completed contract revenue recognition accounting is used.
IFRS
• Based on: Principles-based, but unlike U.S. GAAP, there are no extensive guidance, rules, or specific industry practices. Extensive
professional judgment is required.
• Example – Percentage of Completion Accounting: Required for service type contracts. Either straight-line or revenue recognition
milestones may be used to recognize revenue. The completed contract accounting method is generally disallowed.

INCOME STATEMENT: CLASSIFICATION & PRESENTATION
Summary: Analysts should pay extra attention when comparing margins across companies due to the
fact that certain expenses are classified in different areas of the income statement under U.S. GAAP
and IFRS.
Detailed Income Statement Classification & Presentation Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Expenses: Reported based on function (COGS, SG&A, etc.) and may be classified in differing areas of the income statement than under
IFRS.
• Extraordinary items: Unusual and infrequent events reported as a separate line item below the income from continuing operations
line.
• Comparative financial information: The SEC requires at least two years of comparative financial statements, excluding the balance
sheet, which only requires one year.
• Performance measures: The SEC mandates certain presentation requirements such as headings and subtotals.
IFRS
• Expenses: Reported by either function or nature and may be classified in different areas of the income statement than under U.S.
GAAP.
• Extraordinary items: Not allowed.
• Comparative financial information: One year of comparative financial information is required for all numerical financial statement
information.
• Performance measures: Traditional U.S. GAAP concepts such as operating income are not defined, so significantly diverse practices
may exist with regard to income statement headings, subtotals, and line items.

INCOME STATEMENT: STOCK BASED COMPENSATION
Summary: Most of the stock based compensation accounting differences have been eliminated. The
largest remaining difference between U.S. GAAP and IFRS relates to taxes. When comparing a U.S.
and non-U.S. company, the U.S. company’s operating cash flow should be adjusted higher by the
excess tax benefit from stock based compensation deductions reported as a cash financing inflow.
Detailed Stock Based Compensation Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Stock based compensation: Expense recognized on a straight-line or accelerated basis. Accelerated basis is used for options with
graded vesting schedules and front-end loads stock based compensation expense into earlier years of the vesting schedule.
• “Excess” tax benefits: Classified as financing cash flows on the cash flow statement under ASC 718 – Compensation – Stock
Compensation (formerly FAS No. 123(R)). An excess tax benefit is when the option/restricted stock value on the vesting date is higher
than the share price on the grant date. This may be material to heavy option/restricted stock companies with large share price
appreciation.
• Deferred tax accounting: Deferred tax asset grows as non-cash stock based compensation cost is recorded and reversed upon option
exercise / restricted stock vesting. Not adjusted for changes in underlying stock price.
IFRS
• Stock based compensation: Options with graded vesting schedules must be recognized/expensed on an accelerated basis, resulting in
expense amounts being recognized earlier.
• “Excess” tax benefits: Classified as operating cash flows on the cash flow statement.
• Deferred tax accounting: Re-measured each period based on changes in the company’s stock price with the impact typically flowing
through earnings. For example, if a company’s stock price declines, a lower future tax deduction results when the stock vests. The
existing DTA must be written down by increasing income tax expense in the current period, resulting in more volatile quarterly
income tax rates.

INCOME STATEMENT: INCOME TAXES
Summary: Under IFRS, income tax rates may be highly volatile for companies with high stock option
expense. This is due to the fact that stock based compensation deferred tax benefits are recorded
through earnings as they occur. Additionally, due to differing income tax rules, effective tax rates may
not be comparable to a U.S. company.
Other highly technical tax differences exist, but we’ve excluded them from the lists below since they
typically lead to only small differences.
Detailed Income Tax Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Deferred tax assets: Recognized in full on the balance sheet. A valuation allowance is also recoded that reduces the DTA to the
amount that is “more likely than not” (greater than 50% chance) to be realized.
• Stock based compensation DTA: Recorded as the stock awards vest and not trued-up for a stock’s exercise price or changes in a
stock’s intrinsic value until exercise or maturity.
• Balance sheet classification: The DTA/DTL is recorded as either a current or non-current asset or liability based on the related asset or
liability for financial reporting purposes. If this is not available, the DTA/DTL is classified based on the timing of expected reversal.
IFRS
• Deferred tax assets: Recognized only if it is probable (similar to U.S. GAAP’s “more likely than not” standard (>50%)) that the DTA will
be realized, but no valuation allowances are recorded. This is similar to U.S. GAAP, which reports DTAs at gross amounts and records a
valuation allowance for amounts “more likely than not” to be realized.
• Stock based compensation DTA: Only recorded when the stock award is tax deductible and has “intrinsic value.” For stock options, as
the company’s stock price changes, the DTA changes are recorded through earnings via the income tax expense, resulting in a much
more volatile effective tax rate.
• Balance sheet classification: All DTA/DTL classified as a net non-current asset or liability.

STATEMENT OF CASH FLOWS
Summary: The format of a company’s cash flow statement is the same under U.S. GAAP and IFRS, but
there are a few differences in the classification of certain items within the cash flow statement, resulting
in differing operating and free cash flows.
We believe that management teams using IFRS have greater flexibility in the interpretation of cash flows
from operations or investing, resulting in “cash flow arbitrage” (classifying cash outflows as investing and
inflows as operating). Though generally immaterial, the cash balance on a company’s balance sheet
may be different under IFRS depending on where overdrafts are classified.
Detailed Cash Flow Statement Differences Between U.S. GAAP and IFRS
U.S. GAAP
• Interest income: Cash flow from operations.
• Interest expense: Cash flow from operations.
• Dividends received: Cash flow from operations.
• Dividends paid: Cash flow from financing.
• Taxes paid: Typically cash flow from operations.
• Overdrafts: Classified as borrowings within cash flow from financing and not included as a part of cash and equivalents. VIEs and
jointly controlled entities may result in different cash balances.
IFRS
• Interest income: Cash flow from investing or operations.
• Interest expense: Cash flow from financing or operations.
• Dividends received: Cash flow from investing or operations.
• Dividends paid: Cash flow from financing or operations.
• Taxes paid: Typically cash flow from operations, unless it is related to a specific financing or investing activity.
• Overdrafts: May be included in cash balance. Different entities consolidated under IFRS will result in different reported cash amounts
on the balance sheet.
• Note: An accounting policy choice must be made regarding the classification of these items and must be consistently followed.

Appendix:
Accounting Case Studies

PROQUEST (REVENUE RECOGNITION)
In this case study, we review ProQuest’s accounting issues and the financial ratio warning signs.
ProQuest was an information service provider specializing in aggregating, organizing and packaging
licensed data from publishers and selling this information on microfilm, print and electronically to schools
and libraries. From 2001 through the first three quarters of 2005, ProQuest’s financial results were
boosted through decreasing expenses and increasing revenues. The financial impact of the fraud was to
increase pre-tax earnings by $130 million or 31% over the 2001 through ‘Q3 2005 time period.
ProQuest Stock Chart
$40
ProQuest 12
$35 Announces earnings restatement

10
Volume (millions of shares)

$30 Delays 10-K filing
8
$25 Announces more detail
Stock Price
on earnings restatement
$20 6
$15
4
$10
2
$5
$0 0
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FactSet; Standard & Poor’s.
The scheme included several common areas of accounting abuses. First, the company’s deferred
revenue account was understated as the company prematurely recognized revenue from the sale of its
software and learning products. The company sold some products to educational institutions over a
subscription based period. As shown in the exhibit below, one warning sign of this was the continued
decline in the company’s days deferred revenue ratio in 2004 and early 2005. This suggested that the
company was managing the deferred revenue account to inflate earnings. Below we calculate the ratio
before and after the restatement obtaining materially different metrics.
ProQuest: Calculation of Short and Long Term Days Deferred Revenue
'Q1 2004 'Q2 2004 'Q3 2004 'Q4 2004 'Q1 2005 'Q2 2005 'Q3 2005
Short term days deferred revenue 102 87 111 89 76 52 59
Short term days deferred revenue, restated 106 87 111 89 76 350 283
Long term days deferred revenue 35 38 37 26 23 17 13
Long term days deferred revenue, restated 36 38 37 26 23 116 60

PROQUEST (CONTINUED)
Second, the company improperly capitalized software and other costs as assets on the balance sheet.
Third, prepaid assets for royalties were overstated as the company kept the expense of paying royalties
to content creators on the balance sheet rather than recording as an expense through earnings and also
made fictitious entries to increase this account balance. Fourth, acquisition accounting issues occurred
as the company allocated a significant portion of acquisition’s purchase price amounts to goodwill and
did not fair value the intangibles and deferred revenue liability. When they restated earnings for this
issue, they were required to increase PP&E / long-lived assets and decrease goodwill. Below we show
ProQuest’s originally reported and restated cash flow statement and highlight key differences.
ProQuest’s Cash Flow Statement: As Originally Reported and As Restated

ProQuest:
The following table presents the effect of the Restatement on the Consolidated Statements of Cash
Flows: (in thousands) At January 1, 2005 (FY 2004) At January 3, 2004 (FY 2003)
As As
Previously Previously
Reported As Restated Reported As Restated
Operating activities:
Net earnings (loss) $ 66,992 $ (180,051) $ 49,821 $ 18,574
Adjustments to reconcile net earnings (loss) to net
cash provided by operating activities:
Goodwill impairment — 180,503 — —
Gain on sale of discontinued operations (13,484) (16,049) — —
Equity in earnings of affiliate — (908) — (717)
Depreciation and amortization 71,561 71,893 60,696 62,281
Stock-related compensation — 64 — —
Gain on sale of fixed assets (900) (900) — —
Deferred income taxes 21,894 27,722 26,544 3,396
Changes in operating assets and liabilities, net of
acquisitions:
Accounts receivable, net (174) (12,496) 12,729 20,673
Inventory, net (923) 252 167 1,429
Other current assets (8,772) 6,626 (5,733) (6,786)
Long-term receivables (2,911) (2,912) (471) (471)
Other assets (2,916) (269) (623) 1,908
Accounts payable 623 4,060 4,647 9,049
Accrued expenses (2,563) (1,693) (12,368) (1,642)
Deferred income (25,560) 3,267 (12,510) 5,172
Other long-term liabilities 3,692 12,683 37 331
Other, net 1,257 747 (1,858) (204)
Net cash provided by operating activities 107,816 92,539 121,078 112,993
Investing activities:
Expenditures for property, plant, equipment,
product masters curriculum development
costs, and software (66,774) (49,049) (70,819) (63,604)
Proceeds from disposal of fixed assets 900 900 — —
Acquisitions, net of cash acquired (25,767) (23,587) (51,754) (56,354)
Purchase of equity investments available for
sale (7,893) (7,825) (1,978) (1,660)
Proceeds from disposal of equity
investments available for sale 4,261 4,261 490 490
Proceeds from (expenditures associated
with) sales of discontinued operations 32,918 32,918 (2,540) (2,540)
Net cash used in investing activities (62,355) (42,382) (126,601) (123,668)

DIEBOLD (REVENUE RECOGNITION)
In this case study, we review Diebold’s accounting. Diebold is a manufacturer and servicer of ATM
machines. Through various improper accounting schemes, the company overstated pre-tax earnings by
approximately $127 million from 2002 through 2007.
Diebold Stock Chart
$60 Diebold 20
Delays 'Q2 earnings 18
$55

$50 16
14
$45
UTX withdraws
12
Stock Price
$40 bid
10
$35
8
$30
UTX bid to 6
$25 acquire Diebold 4
$20 2
$15 0
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FactSet; Standard & Poor’s.
The scheme included several common areas of accounting abuses. First, the company prematurely
recognized revenue through improper use of “bill and hold” accounting. Second, inventory, revenue and
accrued expense reserves were reversed periodically as a gain in earnings without any justification.
Third, Diebold delayed expenses into future periods by delaying finished goods inventory write-downs
and capitalized expenses related to an Oracle software implementation project. Fourth, the company
wrote up used inventory, reducing cost of goods sold. Fifth, Diebold under-accrued the company’s long-
term incentive plan (“LTIP”) expense in 2002 and 2003 by reducing liability accounts. Instead of
recording the LTIP as compensation expense on the income statement, the company improperly
decreased other balance sheet liability accounts, including accounts payable and deferred revenue.

VERIFONE (INVENTORY RESTATEMENT)
In this case study, we review VeriFone’s accounting issues and the financial ratio warning signs.
VeriFone sells and services automated electronic transaction payment systems. By improperly
overstating ending period inventory balances, the company overstated pre-tax earnings by
approximately $37 million in the first three quarters of 2007. The effect of overstating ending inventory is
to understate cost of goods sold and overstate net income. VeriFone's accounting issues came to light
during annual audit and, on 12/3/07, announced a financial restatement. As shown below, the
company's days inventory outstanding ratio began to spike and trend higher throughout the first three
quarters of 2007 signaling potential problems at the company.
VeriFone
Days Inventory (average)

'Q1 2006 'Q2 2006 'Q3 2006 'Q4 2006 'Q1 2007 'Q2 2007 'Q3 2007
Originally reported 46 49 69 69 87 92 96
As restated 46 49 69 69 73 84 73
$60
VeriFone 60
Announces restatement
$50 of 'Q1-'Q3 2007 earnings 50
and delays 'Q4 results

$40 40
Stock Price
$30 30
$20 20
$10 10
$0 0
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

YELLOW ROADWAY (CHANGES TO DEPRECIATION METHODS)
Changing an asset's depreciable life or residual value is very uncommon and, therefore, we use it a
strong signal of possible deeper issues at a company. In this case study, we review Yellow Roadway's
accounting issues and the financial ratio warning signs. First, the company lowered its 2006 earnings
guidance in March 2006. Next, approximately six months later beginning in ‘Q3 2006, the company
changed equipment depreciable lives from 3 to 14 years to 10 to 20 years and modified certain salvage
values. This change increased EPS $.27 in 2006 ($26 million pre-tax). Yellow Roadway disclosed the
accounting changes in the footnotes of its 'Q3 2006 10-Q. However, the average depreciable life ratio
(gross PP&E divided by LTM depreciation expense) also flagged possible issues. As shown below, this
ratio jumped from 11.1 years to 13.0 years in 'Q3 2006, the quarter in which the depreciable life changes
occurred.
Yellow Roadway's Depreciation Changes
'Q1 2006 'Q2 2006 'Q3 2006 'Q4 2006 'Q1 2007 'Q2 2007
Average Depreciable Life (Yrs) 10.9 11.1 13.0 13.6 14.6 14.6
Yellow Roadway
2,000
$400
Lowers 2006
1,800
earnings guidance
$350 1,600
Stock Price (000s of USD)
1,400
$300
1,200
Volume
$250 1,000
10-Q disclosure of
depr. change (11/9) 800
$200 600
400
$150
200
$100 0
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poor’s; FactSet. Securities and Exchange Commission.

HEALTHSOUTH (COST CAPITALIZATION)
In this case study, we review HealthSouth’s accounting issues and the financial ratio warning signs.
HealthSouth provides outpatient surgery, diagnostic, and rehabilitative healthcare services in facilities
throughout the U.S. The company improperly reversed a revenue reserve account “contractual
adjustment account” as a gain in earnings and correspondingly increased (overstated) PP&E balances.
The contractual adjustment account was a revenue reserve account that is the difference between the
gross amount billed to a patient for a procedure and the amount actually paid by healthcare insurers. As
shown below for the yearly overstatement impacts, this accounting fraud overstated pre-tax earnings by
approximately $1.4 billion between 1999 and 'Q2 2002. Two financial ratios signaling potential problems
at HealthSouth were the increase in PP&E’s average depreciable life and the high level of capital
expenditures relative to property, plant and equipment. In the exhibit below, we show these ratios as
originally reported and after their financial restatement (the company didn’t restate 1998 and 1999
numbers).
HealthSouth
($ in millions)
Six Months
Income before taxes 1999 2000 2001 2002
Reported 230 559 434 340
Actual -191 194 9 157
Difference 421 365 425 183

% 220% 188% 4722% 117%
1998 1999 2000 2001 2002

Average Depreciable Life (Yrs) 8 9 10 10 11
Average Depreciable Life (Yrs), restated in 2000-2003 NA NA 12 12 12
Cap-Ex / PP&E, as originally reported 30% 16% 18% 11% 8%

Cap-Ex / PP&E, as restated NA NA 8% 9% 12%
$100 Healthsouth 16
$90 14
Stock delisted
$80
12
$70
$60 10
Stock Price
$50 8
CEO Scrushy resigns
$40 6
$30 SEC investigation
4
$20
$10 2
$0 0
Jan-99 Oct-99 Jul-00 Apr-01 Jan-02 Oct-02 Jul-03
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. Standard & Poor’s; FactSet; Securities and Exchange Commission.

Two Examples of Companies Changing Depreciation Accounting Policies
Whirlpool 2010 10-K
Property
Property, plant and equipment is stated at cost, net of accumulated depreciation. In 2009, we changed
our method of depreciation prospectively for substantially all long-lived production machinery and
equipment to a modified units of production depreciation method. Under this method, we record
depreciation based on units produced, unless units produced drop below a minimum threshold at which
point depreciation is recorded using the straight-line method. Prior to 2009, all machinery and
equipment was depreciated using the straight-line method. We believe depreciating machinery and
equipment based on units of production is a preferable method as it best matches the usage of assets
with the revenues derived from those assets. For nonproduction assets, we depreciate costs based on
the straight-line method. Depreciation expense for property, plant and equipment was $527 million,
$497 million and $569 million in 2010, 2009 and 2008, respectively.
As a result of this change in method and lower overall production levels, depreciation expense in 2009
decreased by $83 million from what would have been recorded using the straight-line method. Net of
amounts capitalized into ending inventories and income taxes, net earnings increased $48 million for
2009, or $0.64 per diluted share. In addition, the estimated useful lives of our machinery and equipment
was increased from 3 to 10 years to 3 to 25 years. [emphasis added]
Yellow Roadway 2006 10-K
Depreciable Lives of Assets

We perform annual internal studies to confirm the appropriateness of depreciable lives for each
category of property and equipment. These studies utilize models, which take into account actual usage,
physical wear and tear, and replacement history to calculate remaining life of our asset base. We also
make assumptions regarding future conditions in determining potential salvage values. These
assumptions impact the amount of depreciation expense recognized in the period and any gain or loss
once the asset is disposed.
In 2006, the Company revised the estimated useful lives and salvage values of certain classes of property
and equipment to more appropriately reflect how the assets are expected to be used over time. During
2006, the Company increased revenue equipment lives to a range of ten to twenty years from three to
fourteen years and modified certain salvage values. If the Company had not changed the estimated
useful lives and salvage values of such property and equipment, additional depreciation expense of
approximately $26.3 million would have been recorded during the year ended December 31, 2006.
Accordingly, the changes in estimates resulted in an increase in income from continuing operations of
approximately $26.3 million (a $16.0 million increase in net income) for the year ended December 31,
2006. The change in estimate also increased diluted earnings per share by $0.27 for the year ended
December 31, 2006. [emphasis added]

CASE STUDY: LONGTOP FINANCIAL TECHNOLOGIES
As an example of an in-process accounting investigation, we use Longtop Financial Technologies, a
seller of software for the financial services industry in China. Before the investigation, we felt that there
were financial statement warning signs and in this section of the report walk through these red flags.
Similar to certain other Chinese U.S. listed companies, the company has been undergoing an
investigation into accounting irregularities. On May 20, 2011 the CFO resigned followed by resignation
of their auditor Deloitte on May 23, 2011.
Interestingly, in the Deloitte resignation letter, the Chairman of the company called a Deloitte Managing
Partner and informed him that “there were fake revenue in the past so there were fake cash recorded on
the books.” Some reasons Deloitte cited for resigning included: (i) cash at banks and loan balances
appear false, (ii) management’s interference in the audit process, and (iii) detention of Deloitte’s audit
files. There is an ongoing SEC inquiry and the company hasn’t filed its 2010 20-F annual report with the
SEC.
Longtop Financial Technologies: Historical Share Price
$45 Longtop Financial Technologies

$40
$35
$30
Share Price (USD)
$25
$20
$15
$10
$5
$0
Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11
Source: Wolfe Trahan Accounting & Tax Policy Research; Standard & Poor’s.

CASE STUDY: LONGTOP FINANCIAL TECHNOLOGIES (CONTINUED)
On the subsequent pages, we assembled the company’s balance sheet, income statement and cash
flow statement used in our analysis and calculated various financial ratios.
In analyzing the current financial statements, we found several possible red flags. We summarize the
four red flag financial ratios below. First, the company’s cash gross margin was steadily declining over
the several quarters in 2010 and there is a material difference between the company’s reported gross
margin and their cash gross margin. This suggests there has been more non-cash income likely related
to the sharp decline in deferred revenue over this same time period. Lower collections and payments on
accounts receivable and payables may also be a contributor. Second, since the company sells software,
in some situations they receive cash up-front for the sale/license of software. The balance sheet effect of
this is to increase cash and a deferred revenue liability. We closely monitor companies with deferred
revenue balances since it is a possible tool to manage earnings by aggressively recognizing revenue
from this account or reducing it to meet financial forecasts.
Based on our analysis, this account has been wildly volatile over the past eight quarters and steadily
declining. We also calculated days deferred revenue [(deferred revenue / revenue) x 365 days] which
standardizes this account relative to sales of the company. This item has been generally trending
downward. We find this ratio puzzling as it should be stable or growing for a company significantly
growing sales unless there has been a change in the business model. Third, the company has a very
high cash balance to total assets. Usually a high cash balance is an investment positive. However, this
balance is very high and one of the possible areas of accounting issues according to auditor statements.
Furthermore, the timing and amount of $133 million equity offering completed in the quarter ending
12/31/09 raises a red flag in light of an already high cash balance of $226 million at 9/30/09. It appears
that the capital raised was used to fund a $70 million cash acquisition completed in the period ending
March 31, 2010. However, prior to the equity offering, there was already a very high reported cash
balance raising suspicion as to why equity capital was raised. Last, the company maintains a very high
ratio of accrued liabilities to revenue. It is not clear why the balance is so high and atypical to see a ratio
this high based on our experiences.
Longtop Financial Technologies: Financial Ratios
3/31/09 6/30/09 9/30/09 12/31/09 3/31/10 6/30/10 9/30/10 12/31/10

Material Difference Between Reported & Cash Margins
Cash gross margin 62.9% 58.1% 57.9% 55.3%
Gross margin 53.8% 54.9% 62.8% 66.0%
Deferred Revenue Highly Volatile

Deferred revenue / revenue 62% 56% 41% 51% 73% 48% 36% 40%
Days deferred revenue 56 50 40 61 54 40 33 45
High Cash Balance

Cash / total assets 70% 59% 56% 63% 55% 54% 56% 57%
($133 mm equity offering in 'Q4 09)
High Accrued Liabilities

Accrued liabilities / revenue 92% 93% 71% 64% 96% 95% 88% 79%
*Also use of adjusted / pro forma earnings measures
Note: cash gross margin calculated as 1 – (LTM COGS – Δ in AP + Δ in inventory) / (LTM revenue – Δ in AR + Δ in deferred revenue).

Longtop Financial Technologies Balance Sheet
Longtop Financial Technologies

($ in thousands)
3/31/09 6/30/09 9/30/09 12/31/09 3/31/10 6/30/10 9/30/10 12/31/10
Current assets
Cash and cash equivalents 238,295 215,121 226,430 389,699 331,889 342,429 378,960 423,219
Restricted cash 463 38 536 3,745 8,904 2,198 1,952 3,663
Accounts receivable, net 29,861 41,514 56,384 87,625 65,581 72,518 86,963 97,145
Inventories 4,982 4,246 4,520 5,864 6,381 8,191 5,818 6,165
Amounts due from related parties 682 1,181 1,268 681 1,029 485 2,822 564
Deferred tax assets 979 673 1,016 1,449 250 263 273 773
Other current assets 4,712 10,512 12,041 12,549 13,967 18,570 12,500 13,063
Total current assets 279,974 273,285 302,195 501,612 428,001 444,654 489,288 544,592
Fixed assets, net 14,858 20,137 26,169 26,468 26,343 26,330 27,271 27,893
Prepaid land use right 5,167 5,143 5,117 5,090 5,064 5,063 5,103 5,135
Intangible assets, net 11,526 28,081 27,193 27,041 45,676 46,550 47,768 45,040
Goodwill 24,837 38,651 38,531 35,177 96,323 102,063 103,832 106,451
Investment in an associate 0 0 0 0 0 0 4,831 4,639
Deferred tax assets 1,479 1,479 1,479 1,479 1,443 1,443 1,234 1,234
Other assets 632 541 450 17,933 3,334 2,966 2,219 1,929
Total assets 338,473 367,317 401,134 614,800 606,184 629,069 681,546 736,913
Liabilities and equity

Current liabilities
Short-term borrowings 486 4,788 4,709 27,183 169 8,839 16,026 10,570
Accounts payable 3,299 3,995 9,436 22,283 14,963 12,809 16,612 14,302
Deferred revenue 16,010 15,745 19,001 37,240 25,725 21,524 22,370 38,869
Amounts due to related parties 17 36 77 110 156 204 234 2,458
Deferred tax liablities 867 933 935 1,064 1,430 1,680 1,885 1,642
Accrued and other current liabilities 23,810 29,092 31,808 37,892 44,380 48,740 58,088 64,092
Total current liabilities 44,489 54,589 65,966 125,772 86,823 93,796 115,215 131,933
Long-term liabilities
Deferred tax liabilities 1,242 5,554 5,554 3,943 6,842 7,628 7,653 7,389
Other non-current liabilities 384 3,662 3,620 3,872 22,517 19,715 21,940 21,503
Total liabilities 46,115 63,805 75,140 133,587 116,182 121,139 144,808 160,825
Equity
Ordinary shares $0.01 par value 510 513 517 562 562 564 569 571
APIC 243,194 245,811 249,262 378,583 381,262 384,723 474,592 478,061
Retained earnings 29,451 37,835 56,744 82,551 88,542 100,572 32,935 62,691
AOCI 19,203 19,353 19,471 19,517 19,636 22,071 28,642 34,765
Total equity 292,358 303,512 325,994 481,213 490,002 507,930 536,738 576,088
Total liabilities and equity 338,473 367,317 401,134 614,800 606,184 629,069 681,546 736,913

Longtop Financial Technologies Balance Sheet

($ in thousands, except shares)
3/31/09 6/30/09 9/30/09 12/31/09 3/31/10 6/30/10 9/30/10 12/31/10
Revenues:
Software development 21,050 24,717 36,995 46,397 37,091 38,744 55,477 72,498
Other services 4,832 3,776 5,839 8,267 5,975 10,142 4,987 4,429
Total revenue 25,882 28,493 42,834 54,664 43,066 48,886 60,464 76,927
Cost of revenues:
Software development 7,178 8,319 10,825 12,756 13,980 15,567 18,395 22,877
Other services 3,243 3,374 3,767 4,389 5,935 6,477 4,126 3,312
Total cost of revenues 10,421 11,693 14,592 17,145 19,915 22,044 22,521 26,189
Gross profit 15,461 16,800 28,242 37,519 23,151 26,842 37,943 50,738
Operating expenses:
R&D 1,541 1,517 1,962 2,549 2,191 2,220 2,022 2,519
S&M 3,160 3,259 5,304 5,549 6,854 7,268 6,392 8,553
G&A 2,339 2,766 2,734 3,639 4,844 4,017 4,903 5,102
Goodwill impairment 0 0 0 0 1,982 0 0 0
Total operating expenses 7,040 7,542 10,000 11,737 15,871 13,505 13,317 16,174
Income from operations 8,421 9,258 18,242 25,782 7,280 13,337 24,626 34,564
Other income (expense):

Interest income 1,151 1,008 992 1,096 1,219 1,494 1,448 1,802
Interest expense 55 (16) (178) (336) (247) (32) (221) (270)
Other income, net 123 85 220 8 377 63 (1) 239
Total other income 1,329 1,077 1,034 768 1,349 1,525 1,226 1,771
Income before tax 9,750 10,335 19,276 26,550 8,629 14,862 25,852 36,335
Income tax expense 918 1,951 367 743 2,638 2,832 4,317 6,239
Loss from discontinued ops. 0 0 0 0 0 0 0 0
Loss from investment in an associate 0 0 0 0 0 0 48 340
Net income 8,832 8,384 18,909 25,807 5,991 12,030 21,487 29,756
Diluted Shares Outstanding 52,368,317 53,237,958 53,375,287 55,597,313 55,174,468 58,327,801 56,628,591 58,826,842
Diluted EPS 0.17 0.16 0.35 0.46 0.11 0.21 0.38 0.51

Longtop Financial Technologies Cash Flow Statement

($ in thousands)
3/31/09 6/30/09 9/30/09 12/31/09 3/31/10 6/30/10 9/30/10 12/31/10
Operating Cash Flow
Net income 8,832 8,384 18,909 25,807 5,991 12,030 21,487 29,756
Share based compensation 1,443 1,474 1,528 2,196 2,483 2,418 0 2,649
Depreciation 699 703 719 1,253 518 875 856 998
Amortization 724 833 984 1,103 1,704 2,570 2,008 1,906
Loss on partial disposal of subsidiary 0 0 0 0 0 0 858 (241)
Loss from investment in an associate 0 0 0 0 0 0 48 340
Provision for doubtful accounts 33 (26) 57 268 328 154 (550) 150
Impairment of intangible assets 0 0 0 0 2,494 0 0 0
Impairment of goodwill 0 0 0 0 1,982 0 0 0
Change in fair value of contingent consideration 0 0 0 0 447 447 485 485
Loss on disposal of fixed assets 61 5 0 26 54 233 58 (2)
Deferred income taxes (389) 307 (341) (433) 525 248 299 (685)
Accounts receivable 3,751 (11,347) (14,909) (31,339) 22,515 (7,074) (14,746) (9,204)
Inventories (1,505) 816 (272) (1,343) (515) (1,796) 2,447 (278)
Other current assets 1,283 (5,657) (1,569) (474) 1,688 (4,665) 6,707 (741)
Amounts due from related parties (682) (498) (86) 587 (350) 541 (3) (3)
Prepaid land use right 28 27 28 24 31 28 28 27
Other non-current assets (180) 91 91 91 51 53 339 313
Other non-current liabilities (65) 4 57 43 109 (2,996) 473 (880)
Accounts payable (398) (821) 3,529 14,409 (6,805) (2,441) 3,066 (2,069)
Deferred revenue (5,994) (274) 3,250 18,238 (11,521) (4,181) 272 16,148
Amounts due to related parties 17 19 41 33 46 47 0 0
Accrued and other current liabilities 72 (1,968) 6,832 8,671 (8,931) 3,019 7,465 5,231
Net cash from operations 7,730 (7,928) 18,848 39,160 12,844 (490) 31,597 43,900
Investing Cash Flow

Change in restricted cash 710 425 (498) (3,209) (5,159) 6,706 246 (1,711)
Proceeds from sale of fixed assets 0 0 0 0 0 0 0 59
Purchase of fixed assets (2,370) (3,902) (4,929) (3,066) (1,073) (614) (1,850) (1,758)
Purchase of intangible assets (46) (138) (84) (280) (1) (41) (105) (436)
Acquisitions, net of cash acquired (5,577) (16,779) 0 (548) (52,546) (2,899) (7,389) 0
Deposit made on acquisition 0 0 0 (17,574) 14,547 (2,708) 0 0
Proceeds from partial disposal of subsidiary, net of cash 0 0 0 0 0 0 3,669 301
Amounts due from related parties 0 0 0 0 0 0 (1,714) 4,501
Net cash from investments (7,283) (20,394) (5,511) (24,677) (44,232) 444 (7,143) 956
Financing Cash Flow

Proceeds from short-term borrowings 0 4,391 0 22,556 0 8,794 15,951 0
Repayment of short-term borrowings 0 0 0 0 (26,947) 0 (8,954) (5,580)
Proceeds from sale of ordinary shares 0 0 0 132,969 0 0 0 0
Payment of share issuance costs 0 0 0 (6,321) (23) 0 0 0
Dividend paid 0 0 0 0 0 0 0 0
Stock options exercised 1,580 824 1,927 522 541 1,045 750 674
Payment of capital lease obligations (116) (187) (81) (84) (63) (166) (3) 0
Payment of acquisition consideration 0 0 (3,949) (896) 0 (564) 0 0
Amounts due to related parties 0 0 0 0 0 0 0 0
Net cash from financing 1,464 5,028 (2,103) 148,746 (26,492) 9,109 7,744 (4,906)
F/X (48) 120 75 40 70 1,477 4,333 4,309

Net increase (decrease) in cash 1,863 (23,174) 11,309 163,269 (57,810) 10,540 36,531 44,259
Cash at beginning of period 236,432 238,295 215,121 226,430 389,699 331,889 342,429 378,960
Cash at end of period 238,295 215,121 226,430 389,699 331,889 342,429 378,960 423,219

CASE STUDY: KRISPY KREME
In this case study, we review Krispy Kreme’s (“KKD”) accounting issues and the financial ratio warning
signs. Krispy Kreme is a doughnut retailer and franchisor with both company owned stores and
franchised locations, the latter of which resulted in several accounting issues. Management’s incentive
plan was based on achieving a pre-defined EPS growth hurdle and an EBTIDA return on assets ratio.
This created the motive for engaging in aggressive accounting.
There were multiple issues which came to surface when the company surprised the market by lowering
its earnings guidance in the first fiscal quarter of 2005 (beginning in February 2004 and shown in the
next chart). The company’s issues stemmed from improper accrued liability accounting, long depreciable
lives on dough making equipment and aggressive acquisition accounting when buying out its Area
Developers. To a lesser extent, there were issues with overcapitalizing costs on balance sheet and
under-accruing liabilities (vacation pay), among other items.
First, the company used the accrued compensation expense liability to manage earnings by reversing
(reducing) it as a gain in earnings in several periods and, in other periods, increased earnings by under
accruing bonus expense (bonus accrued liability was lower than normal). Second, the company used
long depreciation periods for donut making equipment, thereby increasing EPS. There was negative free
cash flow throughout much of the periods in question.
The franchise business model also lent itself to accounting maneuvers. Operating 183 stores, the
company utilized 26 “Area Developers” (“AD”) to open stores in their territories under a pre-set minimum
store growth schedule. KKD owned a controlling interest in two ADs and a minority equity interest in 15
ADs. Investments were made in the minority equity interests through either capital contributions and/or
notes receivable to KKD. The minority investments were not consolidated onto KKD’s balance sheet and
this understated true leverage levels at KKD since it was a guarantor of certain debt and lease
obligations for some of the joint ventures.
In certain circumstances when the AD’s became profitable or otherwise, the company re-acquired the
majority interest in the franchises. This lead to several franchise re-acquisition accounting issues. KKD
assigned a material portion of the purchase price of AD’s to “reacquired franchise rights”/goodwill. Such
items are accounted for as an indefinite life intangible assets and not expensed. This enhanced the
post-acquisition EPS from the lack of intangible amortization expense. In addition to this item, the
company restated earnings due to: (i) improper accounting for the Dallas, Michigan, and Northern
California franchise re-acquisitions, (ii) there was improper (early) revenue recognition on equipment
sales to franchisees, and (iii) improper incentive compensation accounting after the company completed
the buy-outs of ADs. In this regard, amounts paid subsequently to Area Development managing partners
who continued to work for the company were accounted for as part of the purchase price accounting, in
effect, increasing goodwill.
Since the employees continued to work for the company and the amount paid was dependent upon the
selling owners rendering services to the company after the acquisition, it should have been accounted
for as KKD’s post-acquisition period compensation expense. By improperly accounting for it as an
acquisition related purchase accounting adjustment, it increased goodwill. KKD’s operating expenses
were understated as a result. The next exhibit is a price chart and two possible warning signs of issues
at the company. The company reported a very high total accruals ratio and LTM capital expenditures to
PP&E was high.

CASE STUDY: KRISPY KREME (CONTINUED)
Krispy Kreme
2/3/2002 2/2/2003 2/1/2004
Total Accruals / LTM Revs 11.1% 16.1% 22.5%

LTM
TotalCapex
Asset /Growth
PP&E 33.1%
48.9% 41.1%
60.7% 28.0%
60.9%
$60 Krispy Kreme

25
$50 Lowers full year
earnings estimates

20
$40 Announces informal
inquiry by SEC
Stock Price
15
$30
Announces earnings
restatements
$20 10
$10 5
$0 0
Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poor’s; FactSet; Securities and Exchange Commission.

ACCOUNTING & TAX POLICY RESEARCH LIBRARY
# Report Title Topic Date
1. European Financial Crisis: Mark to Market Maneuvers Financial Institutions 9/23/2011
2. CIT Deep Dive Corporate Actions / Financials [CIT] 9/28/2011
3. Spin-Offs, Post Bankruptcy Equity & Value Opportunities Corporate Actions 10/7/2011
4. Pension Funding Deteriorates $250 Billion Pensions 10/12/2011
5. Synovus Financial: DTA Valued at $500 Million Financial Institutions [SNV] 10/24/2011
6. Companies Initiating Dividends Outperform Corporate Actions 10/31/2011
7. Shareholder Value Creation Stock Ideas: TREE Analysis Capital Allocation 11/8/2011
8. Yahoo! Possible Avenues to Unlock Tax Value Corporate Actions [YHOO] 11/15/2011
9. Banks: Earnings Quality Analysis Earnings Quality / Fin. Institutions 11/21/2011
10. Large Share Repurchases and Deep Value Capital Allocation 11/30/2011
11. Earnings Quality: Ideas and a Guide to Avoid Accounting Pitfalls Earnings Quality 12/6/2011
12. A Dive Into Banks' Off-Balance Sheet Vehicles Financial Institutions 12/16/2011
13. Audio Update: Pension Underfunding with Chris Senyek Pensions 12/20/2011
14. 2012 Pension Outlook Pensions 1/3/2012
15. Verizon Cash Flow Deep Dive: Taxes & Wireless Support Dividend Telecom [VZ] 1/5/2012
16. 2012 Stock Picking Ideas: Capital Creation and Earnings Quality Capital Allocation / Earnings Quality 1/9/2012
17. Audio Update: Key Themes in Financials with Chris Senyek Financial Institutions 1/12/2012
18. Spin-offs, Post Bankruptcy Equity & Value Opportunities Corporate Actions 1/13/2012
19. Dividend Increases Signal Stock Price Outperformance Corporate Actions 1/30/2012
20. Weekly Spin-off Update (Including Post Holdings Analysis) Corporate Actions [POST] 2/3/2012
21. Key Themes: Chart Book Chart Book 2/4/2012
22. Reincorporating: Will Others Follow Aon's Move? Corporate Actions / Taxes [AON] 2/15/2012
23. Audio Update: Corporate Tax Reform Unveiled with Chris Senyek Taxes 2/23/2012
24. 10-K Navigation Guide Primers 2/28/2012
26. Banks: Earnings Quality Analysis Earnings Quality / Fin. Institutions 3/5/2012
27. Apple's Dividend Initiation and Buyback Corporate Actions [AAPL] 3/19/2012
28. Pensions: Restructuring & Mark to Market Adoption Pensions 3/21/2012
29. Audio Update: Pension Restructurings and MTM with Chris Senyek Pensions 3/22/2012
30. New Contrarian Ideas Based on TREE & Earnings Quality Capital Allocation / Earnings Quality 3/23/2012
31. Earnings Quality: Identifying Underperformers Earnings Quality 3/30/2012
33. Financial Institutions' Accounting Themes Financial Institutions 4/9/2012
34. CIT Deep Dive: Lowering Economic Book Value by $5 Corporate Actions / Fin. Institutions [CIT] 4/18/2012
35. Tax Changes in 2013 Likely to Compel Special Dividends in 2012 Corporate Actions / Taxes 4/23/2012
36. Hidden Value in Net Operating Losses (NOLs) Corporate Actions / Taxes 5/2/2012
38. Pro Forma Earnings Earnings Quality 5/9/2012
39. Pensions: State of the Union Pensions 5/11/2012
40. Banks: 'Q1 Earnings/Asset Quality Analysis Earnings Quality / Fin. Institutions 5/16/2012
41. Returning Cash to Shareholders: Who's Next? Capital Allocation 5/21/2012
42. Spin-offs, Post Bankruptcy Equity & Value Opportunities Corporate Actions [ADT, LMCA, VC] 5/31/2012
44. Capital Allocation: Buyback and Dividend Analysis Capital Allocation 6/7/2012
46. Winners From Pension Funding Relief Pensions 6/26/2012
47. Audio Update: Pension Relief with Chris Senyek Pensions 6/29/2012
49. Pension Funding Relief Signed Into Law Pensions 7/9/2012
51. Senyek's Stock Idea Spreadsheet Capital Allocation / Database 7/17/2012
52. Repatriation Transactions and Bills to Extend Bush-Era Tax Cuts Taxes 7/25/2012

ACCOUNTING & TAX POLICY RESEARCH LIBRARY (CONTINUED)
# Report Title Topic Date
57. Capital Allocation: Buyback and Dividend Analysis Capital Allocation 9/5/2012
59. Audio Update: Avoiding Underperforming Stocks with Chris Senyek Earnings Quality 9/7/2012
60. European Stock Ideas: Shareholder Value Creation TREE Analysis Capital Allocation / Europe 9/20/2012
61. Tyco: ADT Deep Dive Corporate Actions [ADT, TYC] 9/26/2012
63. CIT: Four Possible Catalysts in 2013 Financials [CIT] 10/3/2012
64. Pensions: Year-End Outlook Pensions 10/11/2012
65. Spin-offs, Post Bankruptcy Equity & Value Opportunities Corporate Actions [VC, YHOO, LMCA, CPMK] 10/19/2012
66. Earnings Quality: STOXX Europe 600 Earnings Quality / Europe 10/24/2012
68. Post-Election Tax Policy Outlook Taxes 11/9/2012
69. Special Dividend Announcements Set Weekly Record Taxes / Capital Allocation 11/19/2012
73. Special Dividend Announcements Set Another Weekly Record Taxes / Capital Allocation 12/3/2012
74. Stock Ideas From Buyback and Dividend Analysis Capital Allocation 12/13/2012
75. Audio Update: Tax Policy Update and Special Dividends Taxes / Capital Allocation 12/14/2012
76. Key Themes in Dividend Investing Capital Allocation 12/19/2012
78. 2013 Pension Outlook Pensions 1/3/2013
79. American Taxpayer Relief Act: The Truth Hurts Taxes 1/4/2013
80. Financial Institutions: 13 Themes for 2013 Financial Institutions 1/10/2013
81. Spin-offs, Post Bankruptcy Equity & Value Opportunities Corporate Actions [ETFC, VIV.PA, VC, ADT] 1/18/2013
82. CIT: Post-Quarter Update Financials [CIT] 1/29/2013
84. Conference Call: Dividend Strategies: Beyond Value Investing Capital Allocation 2/15/2013
* Every Friday, we send out “Senyek’s Weekly Spin-off Update”, a brief look at new announcements, updates, and activities in spin-off
and post-bankruptcy equities. Monthly, we send out "Senyek's Stock Ideas Spreadsheet" based on three important areas of our
investment analysis and research: capital creation/allocation, earnings quality, and valuation. It may also be used as a simple screening
tool for other factors. We maintain a separate distribution list for these reports. If you would like to be added, please contact
chris@wolfetrahan.com or your Wolfe Trahan salesperson.

DISCLOSURE SECTION
Analyst Certification:
The analyst of Wolfe Trahan & Co. primarily responsible for this research report whose name appears
first on the front page of this research report hereby certifies that (i) the recommendations and opinions
expressed in this research report accurately reflect the research analysts’ personal views about the
subject securities or issuers and (ii) no part of the research analysts’ compensation was, is or will be
directly or indirectly related to the specific recommendations or views contained in this report.
Other Disclosures
The content of this report is to be used solely for informational purposes and should not be regarded as
an offer, or a solicitation of an offer, to buy or sell a security, financial instrument or service discussed
herein. Opinions in this communication constitute the current judgment of the author as of the date and
time of this report and are subject to change without notice. Information herein is believed to be reliable
but Wolfe Trahan & Co. and its affiliates, including but not limited to Wolfe Trahan Securities, makes no
representation that it is complete or accurate. The information provided in this communication is not
designed to replace a recipient's own decision-making processes for assessing a proposed transaction
or investment involving a financial instrument discussed herein. Recipients are encouraged to seek
financial advice from their financial advisor regarding the appropriateness of investing in a security or
financial instrument referred to in this report and should understand that statements regarding the future
performance of the financial instruments or the securities referenced herein may not be realized. Past
performance is not indicative of future results. This report is not intended for distribution to, or use by,
any person or entity in any location where such distribution or use would be contrary to applicable law,
or which would subject Wolfe Trahan & Co. or any affiliate to any registration requirement within such
location. For additional important disclosures, please see www.WolfeTrahan.com/Disclosures.
The views expressed in Wolfe Trahan & Co. research reports with regards to sectors and/or specific
companies may from time to time be inconsistent with the views implied by inclusion of those sectors
and companies in other Wolfe Trahan & Co. analysts’ research reports and modeling screens.
The analyst(s) at Wolfe Trahan & Co. primarily responsible for this research report are affiliated with an
investment advisory firm (the "Investment Adviser") that provides investment advice to clients, including
limited partnerships and other pooled investment vehicles. The Investment Adviser may give advice or
take action with respect to its clients utilizing the quantitative analysis and/or portfolio strategies
described in this research report, and nothing herein shall limit or restrict the Investment Adviser from
utilizing such analysis and strategies or from buying, selling or trading securities or financial instruments
for the accounts of its clients. The clients of the Investment Adviser may at any time have, acquire,
increase, decrease or dispose of the specific securities or financial instruments, if any, discussed herein.
The Investment Adviser may also give advice and take action with respect to its clients that differs from
the analysis, strategies, information, statements, views and opinions included herein.
Copyright © Wolfe Trahan & Co. 2013. All rights reserved. All material presented in this document,
unless specifically indicated otherwise, is under copyright to Wolfe Trahan & Co. None of the material,
nor its content, nor any copy of it, may be altered in any way, or transmitted to or distributed to any other
party, without the prior express written permission of Wolfe Trahan & Co.
This report is limited for the sole use of clients of Wolfe Trahan & Co. Authorized users have received an
encryption decoder which legislates and monitors the access to Wolfe Trahan & Co. content. Any
distribution of the content produced by Wolfe Trahan & Co. will violate the understanding of the terms of
our relationship.


Ccounting AX Olicy: Avigation Uide

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ccounting AX Olicy: Avigation Uide

Uploaded by

Copyright:

Available Formats

ACCOUNTING & TAX POLICY

February 27, 2013

10-K NAVIGATION GUIDE

WolfeTrahan.com Page 4 of 233

SEC Annual Report Filing Deadlines

SEC Classification Definition(1) Form 10-K Filing Deadline

Source: Wolfe Trahan Accounting & Tax Policy Research; SEC.

WolfeTrahan.com Page 5 of 233

Item 10. Directors and Executive Officers of the Registrant

Item 15. Exhibits and Financial Statement Schedules

WolfeTrahan.com Page 6 of 233

Recent FASB / SEC Accounting Pronouncements and Changes

WolfeTrahan.com Page 7 of 233

WolfeTrahan.com Page 8 of 233

Source: Wolfe Trahan Accounting & Tax Policy Research.

WolfeTrahan.com Page 9 of 233

• The SEC’s written comment remains unresolved at the10-K filing date;

PROPERTIES SECTION: LEASED OR OWNED?

Owned Properties: WhiteWave Foods Company

WolfeTrahan.com Page 10 of 233

OFF-BALANCE SHEET EXPOSURES

WolfeTrahan.com Page 11 of 233

Wells Fargo’s MD&A and Footnote Off-Balance Sheet Entities Disclosures

Off-Balance Sheet Transactions with Unconsolidated Entities

Guarantees and Certain Contingent Arrangements

WolfeTrahan.com Page 12 of 233

From footnote 8, Securitizations and Variable Interest Entities:

Carrying value - asset (liability)

Maximum exposure to loss

WolfeTrahan.com Page 13 of 233

CONTRACTUAL OBLIGATIONS AND FIXED CASH FLOW COMMITMENTS

WolfeTrahan.com Page 14 of 233

Contractual Obligations by Year(1)

(in millions) 2013 2014 2015 2016 2017 Thereafter Total

Principal amount $ 1,267 $ 1,420 $ 1,062 $ 1,427 $ 2,144 $ 4,694 $ 12,014

Interest payments 600 540 460 390 300 660 2,950

Other obligations(2) 1,180 330 350 300 170 1,000 3,330

Total $ 8,793 $ 8,461 $ 7,137 $ 6,900 $ 6,961 $ 30,932 $ 69,184

WolfeTrahan.com Page 15 of 233

Whirlpool’s Critical Accounting Policies Excerpt (2012 Form 10-K)

WolfeTrahan.com Page 16 of 233

Goodwill and Intangibles

WolfeTrahan.com Page 17 of 233

WolfeTrahan.com Page 18 of 233

CASH BALANCES ARE OFTEN OVERSTATED IN VALUATION

Apple (2012 Form 10-K): Cash Balance Overseas Example

WolfeTrahan.com Page 19 of 233

LARGE INVENTORY RESERVE CHANGES MAY INFLATE PROSPECTIVE GROSS MARGINS

Inventory Write-Downs Followed by Subsequent Sale

LARGE CHANGES IN THE MIX OF INVENTORY RELATIVE TO TOTAL INVENTORIES?

WolfeTrahan.com Page 20 of 233

Below we present an example of a LIFO liquidation using ConocoPhillips as an example.

ConocoPhillips’ LIFO Liquidation (2012 Form 10-K)

WolfeTrahan.com Page 21 of 233

INVENTORY ACCOUNTING POLICY CHANGES (E.G. LIFO TO FIFO)?

Change of Inventory Method – Eastman Kodak

As of and for the Year As of and for the Year

LIFO Average LIFO Average

Inventory $ 1,140 $ 1,455 $ 1,158 $ 1,506

Cost of goods sold $ 10,617 $ 10,650 $ 9,582 $ 9,601

WolfeTrahan.com Page 22 of 233

IS LOWER PRODUCTION DEPRESSING MARGINS FROM EXCESS OVERHEAD?

IS HIGHER PRODUCTION BOOSTING MARGINS?