CH 01

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis
CHAPTER 1 OVERVIEW OF FINANCIAL REPORTING AND FINANCIAL STATEMENT ANALYSIS

Solutions to Problems and Teaching Notes to Cases 1.1 Effect of Industry Characteristics and Financial Statement Relationships. There are various strategies for approaching this problem. One strategy begins with a particular company, identifies unique financial characteristics (for example, steel companies have a high proportion of property, plant and equipment among their assets), and then searches the common size data in Exhibit 1.13 to identify the company with that unique characteristic. Another approach begins with the common size data in Exhibit 1.13, identifies unusual financial statement relationships (for example, Firm (12) has a high proportion of receivables), and then looks over the list of companies to identify the one most likely to have substantial receivables among its assets. We follow both strategies here. Firm (12) has a high proportion of receivables among its assets and substantial borrowing in its capital structure. This balance sheet structure is typical of the finance company, Household International. We ask students why the capital markets allow a finance company to have such a high proportion of borrowing in its capital structure. The answer is threefold: (1) finance companies have contractual rights to receive cash flows in the future from borrowers; the cash flow tends to be highly predictable, (2) finance companies lend to many different individuals, which diversifies their risk, and (3) borrowers often pledge collateral to back up the loan, which provides the finance companies with an alternative for collecting cash if borrowers default on their loans. Thus, the low risk in the asset structure allows the firm to assume high risk on the financing side. We use this opportunity to ask students how this firm can justify recognizing interest revenue on its loans as it accrues each period when it has an uncollectible loan provision of 20.2 percent of revenues. Two points are noteworthy: (1) the concern with uncollectibles is not with the size of the provision but with how much uncertainty there is in the amount of the provision (a high mean with a low standard deviation is not a concern but a high mean with a high standard deviation is a concern), and (2) revenues represent interest revenues on loans whereas the provision for uncollectibles includes both unpaid principal and interest; thus, the 20.2 percent provision does not mean that the firm experiences defaults on 20.2 percent of its customers each year. The percentage for depreciation and amortization includes the amortization of the cost of establishing loans. Household International capitalizes these costs (included in Other Assets) and amortizes them over the term of the loan. The cash flow from operations to capital expenditures ratio is high because of the low capital intensity of this firm. Firm (11) has a high proportion of cash and marketable securities among its assets and a high proportion of liabilities in its capital structure. This balance sheet structure is typical of the insurance company, Allstate Insurance. Allstate receives cash from policyholders each period as premium revenues. It pays out the cash to
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policyholders as they make insurance claims. There is a lag between the receipt and disbursement of cash, which for a property and casualty insurance company can span periods up to several years. Allstate invests the cash in the interim to generate a return. The high proportion of current liabilities represents Allstates estimate of the amount of future claims arising from insurance coverage in force in the current and previous periods. We ask students at this point to comment on the quality of earnings of an insurance company. Our objective is to get students to see the extent of estimates that go into recognizing claims expenses in a particular period. Claims made from accidents or injuries during the current year related to insurance in force during that year require relatively little estimation. However, policyholders may sustain a loss during the current period but not file a claim immediately. Also, estimating the cost of a claim may present difficulties if the policyholders contest the amount Allstate is willing to pay and the case goes through adjudication. Thus, the potential for low quality earnings is present with insurance companies. We then point out that the amount shown for other assets represents the unamortized portion of the cost of writing a new policy (costs of investigating new policyholders to assess risk levels, commissions paid to insurance agents for writing the new policy, filing fees with state insurance regulators). We ask why insurance companies dont write this amount off in the year of initiating the policy. The explanation is one of matching. Insurance companies recognize premium revenues over several future periods and should match both policy initiation costs and claims costs against these revenues. The cash flow from operations to capital expenditures ratio is high because of the low capital intensity of this firm. Three firms report research and development (R&D) expenditures, Firm (3), Firm (4), and Firm (10). Hewlett-Packard, Merck and Newmont Mining will all have significant expenses to discover new technologies or mineral deposits. (Note that Gillettes expenses on research are included in selling and administrative costs.) Newmont Mining will likely have a higher proportion of property, plant and equipment because of the capital-intensive nature of mining. Hewlett-Packard, on the other hand, outsources many of its computer components and will therefore not have as much property, plant and equipment. In addition, of the three industries represented by these three firms, the pharmaceutical industry historically has been the most profitable. Thus, Firm (3) is Hewlett-Packard, Firm (10) is Newmont Mining, and Firm (4) is Merck. We ask students why Hewlett-Packard has such a small proportion of long-term debt in its capital structure. Computer firms experience considerable technological risk related to the introduction of new products by competitors. Products life cycles are short, approximately one to two years. Hewlett-Packard does not want to add financial risk to its already high business (asset side) risk. Also, computer firms have relatively few assets (other than property, plant and equipment) that can serve as collateral for borrowing. Their most important resources, their technologies and their people, do not show up on the balance sheet. The moderate profit margin evidences the offsetting effects of new technologies on the one hand and the increasingly commodity nature of most computer products and the intense competition in the industry on the other hand. Firm (10) is Newmont Mining. Note that property, plant and equipment dominate the balance sheet and depreciation expense is a major expense on the income statement. Also, its cash flow from operations to capital expenditures ratio is
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low, again symptomatic of a capital-intensive business. Newmont carries substantial business risk with respect to whether it will discover minerals. It also faces the risk of rapid changes in the prices it will receive for minerals mined and sold. Most minerals are commodities and prices respond quickly to changes in supply and demand. Thus, Newmont does not assume a high proportion of long-term debt in its capital structure. Its long-term debt proportion is higher than that for HewlettPackard because of the high proportion of property, plant and equipment that can serve as collateral for borrowing and the longer product life cycles of minerals. Newmont reports a high positive common size percentage for all other items (net) in its income statement. If one netted this percentage of its tax effect, this item comprises a large proportion of its profit margin. Most of its other assets represent investments in joint mining ventures with other firms. Newmont derives equity earnings (discussed in Chapter 9) from these investments. One final clue differentiating Firm (3) and Firm (10) is the higher selling and administrative expense for Firm (3). Hewlett-Packard must promote its products whereas Newmont will not likely incur substantial selling expenses. We also ask students why Merck can achieve such a high profit margin (15.4%). As an ethical drug manufacturer with many successful drugs under patent, the firm has the luxury of charging premium prices for its drugs. In addition, Merck does not have to incur large selling and promotion costs once the drugs are developed and proven. We move next to the two service firms, Kelly Services and Omnicom Group. Neither firm will have a high proportion of property, plant and equipment. Thus, Firms (1), (2), and (9) are possibilities. Neither firm should have inventories, so this eliminates Firm (2). The common size percentages for Firm (1) and Firm (9) differ with respect to the amount of receivables and current liabilities relative to revenues and the size of the cost of goods sold and the profit margin percentages. One would expect the value added by employees of Kelly (temporary help services) would be less than that of Omnicom (creative advertising services). Thus, Firm (1) is Kelly and Firm (9) is Omnicom. Another clue that Firm (1) is Kelly is that receivables relative to operating revenues indicate a turnover of 7.9 (= 100.0%/12.7%) times per year and current liabilities relative to operating expenses indicate a turnover of 11.3 (= 98.2%/8.7%) times per year. The corresponding turnovers for Firm (9) are 1.5 (= 100.0%/68.5%)- and 1.0 (= 92.7%/96.4%). One would expect faster turnovers for a temporary help business that pays its employees more regularly for temporary work done. One would expect even higher turnovers for Kelly Services than those above for Firm (1). The turnovers for Omnicom are difficult to interpret because its operating revenues represent the commission and fee earned on advertising work whereas accounts receivable represent the full amount (media time plus commission or fee) billed to clients and accounts payable represent the full amount payable to various media. The higher percentages for receivables and current liabilities for Firm (9) indicate the agency nature of advertising firms. Firm (9) shows a relatively high proportion for other assets, consistent with recognizing goodwill in the acquisition of other marketing services firms by Omnicom in recent years. Neither firm has much long-term debt, consistent with the low collateral value of its assets (primarily employees). Both firms have high cash flow from operations to capital expenditures ratios, consistent with their low capital intensity.
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We move next to the fast-food restaurant, McDonalds. The firm should have inventories but their inventories should turn over rapidly. The remaining firm with the lowest inventory percentage is Firm (8), representing McDonalds. Note that the firm has substantial receivables and a high proportion of its assets in property, plant and equipment. Firm (8) also has a high proportion of its assets in Other Assets, representing the McDonalds leases with its franchisees. These are capital leases, which means that the lease receivables will appear in Other Assets. Some students will not have previously studied operating and capital leases and therefore may not pick up this clue. We are left with four unidentified firms in Exhibit 1.13, (2), (5), (6), and (7) and they are Abercrombie & Fitch, AK Steel, Gillette, and Lands End in some combination. All of these firms have inventories. AK Steel should be the most fixed asset intensive and have the slowest total assets turnover. This suggests that Firm (6) is AK Steel. Its high cost of goods sold to operating revenues is indicative of a commodity product. Its relatively low selling and administrative expense percentage is indicative of a firm that does not market directly to final consumers. However, it does maintain a sales force to market steel to various businesses. Its high proportion for other noncurrent liabilities represents health care and pension benefit liabilities to its unionized workforce. Firm (7) has the highest profit margin of the remaining three firms, typical of a firm like Gillette that sells branded consumer products. Its high percentage for selling and administrative expenses reflects its advertising expenditures. The high proportion for other assets is consistent with Gillettes recent acquisitions of other consumer products companies and the recognition of goodwill. This leaves Firm (2) and Firm (5) as the two retailers, Abercrombie & Fitch and Lands End. Lands End should be less capital intensive than Abercrombie because of the lack of retail space. It should have higher selling expenses because of the cost of catalogs and telecommunication capabilities. Thus, Firm (2) is Lands End and Firm (5) is Abercrombie. Both firms sell through third party credit cards and show low receivables. Abercrombie is also more capital intensive (store buildings). In addition, one might expect a higher profit margin for Abercrombie, given its popularity and with-it appeal as a fashion apparel company. 1.2 Effect of Industry Characteristics and Financial Statement Relationships Global Perspective. There are various approaches to this problem. One approach begins with a particular company and identifies unique financial characteristics (for example, steel companies have a high proportion of property, plant, and equipment among their assets), and then searches the common size financial data to identify the company with that unique characteristic. Another approach begins with the common size data and identifies unusual financial statement relationships (for example, Firm (12) has a high proportion of cash, marketable securities, and receivables among its assets), and then looks over the list of companies to identify the one most likely to have that unusual financial statement relationship. This teaching note employs both approaches.
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The high proportions of cash, marketable securities, and receivables for Firm (12) suggest that it is Fortis, the Dutch insurance and banking company. Insurance companies receive cash from premiums each year and invest the funds in various investment vehicles until needed to pay insurance claims. They recognize premium revenue from the cash received and investment income from investments each year. They must match against this revenue an appropriate portion of the expected cost of insurance claims from policies in force during the year. Fortis includes this amount on the line labeled Operating Expenses in Exhibit 1.14. Operating revenues also include interest revenue on loans made. One might ask: why does Fortis have such a high proportion of financing in the form of current liabilities? This balance sheet category includes the estimated cost of claims not yet paid from insurance in force. It also includes deposits by customers in its banks. One might also ask: What types of quality of earnings issues arise for a company like Fortis? One issue relates to the measurement of insurance claims expense each period. The ultimate cost of claims will not be known with certainty until customers make claims and settlement is made. Prior to that time, Fortis must estimate what that cost will be. The need to make such estimates creates the opportunity to manage earnings and lowers the quality of earnings. Another issue relates to estimated uncollectible loans. Fortis recognizes interest revenue from loans each year and must match against this revenue the cost of any loans that will not be repaid. The need to make such estimates also provides management with an opportunity to manage earnings and therefore lowers the quality of earnings. There are four firms with research and development (R&D) expenses, Firms (2), (3), (5), and (9). These are likely to be Nestle, Roche Holding, Sun Microsystems, and Toyota Motor in some combination. Roche Holding and Sun Microsystems are more technology-oriented and therefore likely to have a higher percentage of R&D to sales. This suggests that they are Firms (2) and (9) in some combination. The inventories of Firm (9) turn over more slowly at 1.4 times per year (= 27.2/20) than those of Firm (2) at 16.1 times per year (= 45.2/2.8). Firm (9) is also more capital intensive than Firm (2). This suggests that Firm (2) is Sun Microsystems and Firm (9) is Roche Holdings. Sun uses only 11.8 cents in fixed assets for each dollar of sales generated. These ratios are consistent with Sun's strategy of outsourcing most of its manufacturing operations. The inventory turnover of Roche is consistent with the making of fewer production runs on each pharmaceutical product to gain production efficiencies. The manufacture of pharmaceuticals is highly automated, consistent with the slower fixed asset turnover of Roche. These two firms have the highest profit margins of the 12 firms studied. Sun is a technology leader in engineering workstations and servers. Roche sells products protected by patents. These advantages permit the firms to achieve high profit margins. Roche has a very high proportion of its assets in cash and marketable securities. It generates interest revenue from these investments, which it includes in other revenues. It is interesting to observe the relatively small cost of goods sold to sales percentage for Roche. The manufacturing cost of pharmaceutical products primarily includes the cost of the chemical raw materials, which machines combine into various drugs. Pharmaceutical firms must price their products significantly above manufacturing costs to recoup their investments in R&D. Note also that Sun has very little long-term debt in its capital structure.
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Computer products have short product life cycles. Lenders are reluctant to lend for a long period because of the concern for technological obsolescence. Computer companies that outsource their production also have few assets that can serve as collateral for long-term borrowing. This leaves Firms (3) and (5) as Nestle and Toyota Motor in some combination. Firm (5) has a larger amount of receivables relative to sales than Firm (3), consistent with Toyota Motor providing financing for its customers' purchases of automobiles. Nestle will have receivables from wholesales and distributors of its food products as well, but not to the extent of the multi-year financing of automobiles. The inventory turnover of Firm (3) is 4.5 times a year (= 44.5%/9.9%), whereas the inventory turnover of Firm (5) is 10.6 times a year (= 68%/6.4%). One might at first expect a food processor to have a much higher inventory turnover than an automobile manufacturer, suggesting that Firm (3) is Toyota Motor and Firm (5) is Nestle. Toyota Motor, however, has implemented just-in-time inventory systems, which speeds its inventory turnover. Nestle tends to manufacture chocolates to meet seasonal demands, and therefore carries inventory somewhat longer than one might expect. Firm (3) has a much higher percentage of selling and administrative expense to sales than Firm (5). Both of these firms advertise their products heavily. It is difficult to know why one would have a substantially different percentage than the other. The profit margin of Firm (3) is substantially higher than that of Firm (5). The auto industry is more competitive than at least the chocolate side of the food industry. However, other food products encounter extensive competition. Firm (5) has a high proportion of intercorporate investments. Japanese companies tend to operate within groups, called kieretsu. The members of the group make investments in the securities of other firms within the group. This would suggest that Firm (5) is Toyota Motor. Another characteristic of Japanese companies is their heavier use of debt in their capital structures. One of the members of these Japanese corporate groups is typically a bank, which lends to group members as needed. With this moreor-less assured source of funds, Japanese firms tend to take on more debt. Although the ratios give somewhat confusing signals, Firm (3) is Nestle and Firm (5) is Toyota Motor. Firms (10) and (11) are unique in that they are both very fixed intensive. Electric utilities and telecommunication firms both utilize fixed assets in the delivery of their services. Firm (11) is the most fixed-asset intensive of the two firms and carries a higher proportion of long-term debt. Electric-generating plants are more fixed asset intensive than the infrastructure needed for distribution of telecommunication services. This would suggest that Firm (10) is Deutsche Telekon and Firm (11) is Tokyo Electric Power. The telecommunication industry is going through deregulation whereas Tokyo Electric Power still has a monopoly position in Japan. Thus, the selling and administrative expense to operating revenues percentage for Deutsche Telekon is substantially higher than for Tokyo Electric Power. The difference in the accounts receivable turnovers is somewhat surprising, given that both firms bill their customers monthly. One would expect an accounts receivable turnover of approximately 12 times a year for each firm. The accounts receivable turnover for Deutsche Telekon is in this ballpark, but not for Tokyo Electric Power. Japan was in a recession during the period studied and this factor may account for its
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slower receivables turnover. Payment policies in Japan may also be more lenient than in other countries. Firms (6) and (8) represent two of the remaining industries that are also capital intensive, but not to the extent of Deutsche Telekon and Tokyo Electric Power. These firms are Accor, a hotel group, and Arbed-Acier, a steel manufacturer. Firms (6) and (8) require the next highest fixed assets per dollar of sales after Firms (10) and (11). Thus, Firms (6) and (8) are Accor and Arbed-Acier in some combination. Firm (8) has virtually no inventories, whereas Firm (6) has substantial inventories. This suggests that Firm (6) is Arbed-Acier, the steel company, and Firm (8) is Accor, the hotel group. Accor has grown in recent year by acquiring established hotel chains. Accor allocates a portion of the purchase price to goodwill in their acquisitions, which accounts for its higher percentage for Other Assets. Steel products are commodities, whereas hotels have some brand recognition appeal. These factors may explain the higher profit margin for Firm (8) than for Firm (6). Firm (7) has an unusually high proportion of its assets in receivables and in current liabilities. Although this pattern would be typical for a commercial bank, we identified Firm (12) earlier as the financial institution. The pattern is also typical for an advertising agency, which creates and sells advertising copy for clients (for which it has an receivable) and purchasing time and space from various media to display it (for which it has a current liability). Additional evidence that Firm (7) is Interpublic Group is the high percentage for Other Assets, representing goodwill from acquisitions. Firm (7) also has a relatively high profit margin percentage, reflective of its ability to differentiate its creative services. Firm (1) is distinguished by its high cost of goods sold to sales and small profit margin percentages. This pattern suggests commodity products with low value added. Of the remaining firms, this characterizes a grocery business. Firm (1) is Carrefour. Its combination of a rapid receivables turnover of 11.8 times per year (=100/8.5) and rapid inventory turnover of 8.9 times per year (=87.8/9.9) are also consistent with a grocery business. Current liabilities comprise more than half of its financing. Current assets make up a similarly high proportion of its current assets. The remaining firm is Firm (4), which is Marks & Spencer, the department store chain. Firm (4) has substantial receivables, consistent with having a credit card.
1.3 Effect of Industry Characteristics on Financial Statement Relationships. There are various strategies for approaching this problem. One approach identifies unique characteristics of a particular firm (for example, Eli Lilly should have a high research and development expense to operating revenues percentage) and then look at the common size percentages in Exhibit 1.15 to identify the firm. Another approach looks for unusual common size percentages in Exhibit 1.15 (for example, Firm (11) has a high proportion of cash and marketable securities among its assets) and then identifies which type of firm would have that characteristic. We follow both approaches here. We begin with the two financial services firms, Citibank and USLife. Financial assets should dominate the assets of these firms, making Firm (11) and Firm (12) the likely choices. A commercial bank lends money to borrowers, whereas an insurance
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company collects premiums regularly and should not have substantial receivables. Thus, Firm (11) is USLife and Firm (12) is Citibank. We begin discussion of USLife by asking why it has such a high proportion of its assets in cash and marketable securities. This question gets students to think about the earnings process for a life insurance company. Such companies collect premiums from policyholders for many years before having to pay life insurance benefits. In the interim, insurance companies invest the premiums to generate a return. Most state insurance regulators require insurance companies to invest in relatively liquid investments to protect policyholders. We then ask why Firm (11) has such a high proportion of its financing among current liabilities, particularly given its high proportion of cash and marketable securities. Some students will be familiar with insurance companies and recognize the current liability as the estimated liability to pay life insurance benefits in the future. We ask students why firms must recognize such a liability if the policyholder is still alive. This question gets at the need to match expenses with revenues in accrual accounting. Insurance companies recognize premium revenue and investment revenue each period and must match a portion of the amount the insurance company expects ultimately to pay as an expense. We then ask how an insurance company would measure this expense. Most students see the need to project mortality rates, interest rates, insurance terminations, and similar factors and then present value the expected payouts. We then ask about the quality of` earnings of a life insurance company. Most students see the estimates required to arrive at the amount of the liability at the end of each year and the change in that liability each year that affects the expense. The other assets of Firm (11) represent unamortized policyholder acquisition costs (costs of investigating the insurance risk of the policyholder, commissions paid to agents for landing the policy). We ask why firms dont expense this cost in the initial year of the policy. The answer is again one of matching expenses with revenues. Because life insurance companies generate revenues each year of the policy, they should amortize front-end costs over these periods of benefit as well. The high cash flow from operations to capital expenditures ratio reflects the low capital intensity of life insurance companies. Citibank lends money to businesses and will therefore have substantial receivables. Its high ratio of receivables to operating revenues reflects the fact that receivables include the full amount of the loans outstanding whereas operating revenues include only the interest earned on the receivables. The seemingly high return of 19.3 percent (= 100.0/518.7) is misleading, because revenues also include fee-based revenues from financial consulting services. We ask why commercial banks maintain such a high proportion of their assets in cash and marketable securities. The answer in part lies in the fact that their major source of financing is deposits by customers. Because depositors can withdraw their deposits with little or no notice, banks must maintain liquid assets. Also, commercial banks borrow shortterm and invest short-term in order to take advantage of small differences in borrowing and investing rates. The high cash flow from operations to capital expenditures ratio reflects the low capital intensity of commercial banks. It is interesting to compare the profit margins of the USLife and Citibank. Life insurance and lending are both commodity products and should generate relatively small profit margins. The financial consulting services of commercial banks are a more differentiated products and account for the higher profit margin for Citibank.
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We move next to the two high technology companies, Firms (6) and (9), with significant research and development expense. The two companies in some combination are Microsoft and Eli Lilly. Each of these firms faces technology risk and therefore has short product life cycles. The life cycles of pharmaceutical companies are longer than those of computer companies because of patent protection and the difficulty of developing new, competing drugs. Also, the manufacturing process of pharmaceutical products is somewhat more capital intensive than that for computer products. Thus, we would expect the balance sheet of Lilly to have a higher proportion of long-term debt and property, plant and equipment. These clues suggest that Firm (6) is Microsoft and Firm (9) is Lilly. Note that the cost of goods sold percentage is extremely small for both of these firms. Once they discover or develop new products, manufacturing costs are relatively inexpensive. Their profit margins are high because they sell differentiated products. Their cash flow from operations to capital expenditures ratios are high both because of their high profit margins and their relatively low capital intensity. The high proportion of total assets represented by cash and marketable securities for Microsoft results from their high level of profitability. The return on these liquid assets is considerably smaller than on computer software. Thus, Microsofts profit margin on software exceeds the 25.3 percent earned overall. We move next to the three capital-intensive businesses, Champion (forest products), Commonwealth Edison (electric utility), and Delta (airline services). Firms (7), (8) and (10) have high proportions of property, plant and equipment relative to operating revenues and are the likely candidates for these three firms. Commonwealth Edison is the most capital intensive of these three firms because it creates its product (electric services) with few employees. Champion is the next most capital intensive because it uses some employees to forest timber and run its paper mills. Delta is the least capital intensive because it combines flight and ground equipment with pilots, mechanics, flight attendants, and others to provide transportation services. These clues suggest that Firm (7) is Delta, Firm (8) is Champion, and Firm (10) is Commonwealth Edison. Another clue is the other noncurrent liabilities percentage. This account primarily includes deferred income taxes related to depreciation timing differences. The three firms rank order on this percentage in the same order as their degree of capital intensity. Another clue is that Firm (7) has a higher selling and administrative expense percentage than Firm (8) and Firm (8) has a higher percentage than Firm (10). Delta must advertise its services, Champion sells to other businesses through a sales force, and Commonwealth Edison does not need to promote its product. Deltas higher proportion of long-term debt relative to Champion reflects the collateral value of its aircraft. Forest lands have less collateral value because of the difficulty of repossessing them. The surprising result is that Commonwealth Edison does not have a higher proportion of long-term debt in its capital structure, given its regulated status. Electric utilities have experienced increasing deregulation in recent years. Commonwealth Edison has reduced its debt levels (reduced financial risk) to compensate for its increased business risk. The profit margins of Delta and Champion are relatively low because of the commodity nature of their products. Both firms have high fixed costs in their cost structures. Net income will therefore fluctuate significantly in response to changes in revenues. In the year from which we drew the data, paper prices
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collapsed and caused the profit margin of Champion to decrease substantially. Load factors on airlines, on the other hand, were higher and resulted in an increased profit margin for Delta. These margin differences manifest themselves in the cost of goods sold percentages. Electric services are also a commodity product. The high profit margin of Commonwealth Edison reflects the regulated status of this industry for the year in which we drew the data. One might expect the profit margin to decline as increased competition sets in. We move next to the two firms that provide services, Marriott and AT&T. These companies should have little or no inventories, which make Firm (1) and Firm (5) the likely candidates. AT&T will have a higher proportion of property, plant and equipment on its balance sheet because of the infrastructure needed to provide telecommunication services. Thus, Firm (1) is Marriott and Firm (5) is AT&T. Managing hotels is a relatively low value-added activity, whereas telecommunication services require in-place technologies. Thus, we would expect a lower profit margin for Marriott than for AT&T. Marriott would also need less selling expenses for its services than AT&T, consistent with the lower selling and administrative expense percentages for Firm (1) relative to Firm (5). The receivables of AT&T turn over 5.8 times per year (= 100.0/17.2), or approximately once ever 63 days. This turnover rate is slower than what one might expect for a firm that bills its customers monthly and probably includes charges to businesses for communication systems and other services that have a longer payment cycle. The other assets of AT&T include goodwill arising from corporate acquisitions in recent years. We are left with three Firms, (2), (3) and (4) and Brown Forman, Kellogg, and NIKE. All three firms have relatively high profit margins, reflecting their brand names. Brown Forman and Kellogg both manufacture their products whereas NIKE outsources its production. We would therefore expect NIKE to be the least capital intensive and to have the highest cost of goods sold percentage. This suggests that Firm (2) is NIKE. Its low long-term debt level is consistent with its low capital intensity. The principal differences between Firm (3) and Firm (4) are in the inventory percentages and property, plant and equipment percentages. The inventories of Firm (3) turn over 6.7 times per year (= 43.0/6.4) and those of Firm (4) turn over 1.5 times per year (= 40.6/28.0). The need for freshness in cereals and the need for aging in liquors suggest that Firm (3) is Kellogg and Firm (4) is Brown Forman. The lower fixed asset intensity of Brown Forman reflects the lesser need for machinery in the aging process. The higher degree of capital intensity of Kellogg is consistent with having a higher proportion of long-term debt in its capital structure.
1.4 Value Chain Analysis and Financial Statement Relationships. Four Firms, (1), (2), (3), and (5) incur research and development (R&D) expenditures and three do not. Wyeth, Amgen, Mylan, and Johnson & Johnson engage in research to develop new products. Thus, they represent these four numbered firms in some combination. One would expect that the firms enjoying patent protection (Wyeth and Amgen) would have the highest profit margins (that is, net income divided by sales). This would suggest that Firms (1) and (2) are Wyeth and Amgen in some order and that Firms (3) and (5) are Mylan and Johnson & Johnson in some order. The perplexing
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aspect of this logic, however, is the common size income statement percentages for Firm (1). Its cost of goods sold percentage is the highest of the four companies and its R&D percentage is the lowest, which are inconsistent with this being either Wyeth OR Amgen. Products with patent protection should have the lowest cost of goods sold percentages (resulting from high markups on cost to arrive at selling prices). Thus, following another line of logic, the need to continually discover new drugs should lead Wyeth and Amgen to have the highest R&D percentages, which would be either Firm (2) or Firm (3) as discussed below. With this being the case, the other two firmsFirm (1) and Firm (5) are Mylan and Johnson & Johnson in some combination. The brand recognition of Johnson & Johnsons products should give it a high profit margin and competition among generic firms, which compete on the basis of low prices, should give Mylan a lower profit margin. This reasoning would suggest that Johnson & Johnson is Firm (1) and Mylan is Firm (5). The contradictory aspect of this conclusion is the low selling and administrative expenses for Firm (1) versus Firm (5). Mylan will not need to advertise its products, although it will use a sales force. Johnson & Johnson, on the other hand, advertises extensively. Thus, Firm (1) is Mylan and Firm (5) is Johnson & Johnson. The high profit margin of Mylan results from offering generic drugs for ethical drugs that have recently come off patent and more aggressive management of drug cost by health care plans (that is, requiring pharmacists to substitute generic drugs for ethical drugs whenever possible). Note that Mylan has a high proportion of cash, relatively small current liabilities, and minimal long-term debt. With the major ethical drug firms now competing aggressively in the generic market, one might expect the profit margin of Mylan to decrease in the future. This leaves Firms (2) and (3) as Wyeth and Amgen in some order. The biotechnology industry is significantly less mature than the ethical drug industry. Few biotechnology drugs have received FDA approval and research to develop new drugs is intensive. Given the few biotechnology drugs available on the markets, Amgens profit margin should be higher and its R&D expense percentage should also be higher than those of Wyeth. Thus, Firm (2) is Amgen and Firm (3) is Wyeth. Amgen has a higher proportion of cash on the balance sheet than Wyeth, reflecting its growth phase and the need to fund R&D. Wyeths higher selling and administrative expense percentage results from it need to maintain a sales force. The biotechnology products of Amgen are fewer in number and are essentially pulled through the distribution process by customer demand at this point. Thus, it has less need for a sales force. We are now left with Quintiles, Cardinal Health, and Walgreen and Firms (4), (6), and (7). Quintiles will have no inventories, whereas both Cardinal Health (wholesaler) and Walgreen (retailer) will have inventories. Thus, Firm (4) is Quintiles. This firm will need property, plant, and equipment to conduct the testing of new drugs. Of the remaining two firms, Cardinal Health and Walgreen, Walgreen will likely have a higher proportion of its assets in property, plant and equipment for retail space. Cardinal Health needs only warehousing facilities for its drug wholesaling activities. Thus, Firm (6) is Walgreen and Firm (7) is Cardinal Health. Advertising expenditures by Walgreen drive up its selling and administrative expense percentage relative to that of Cardinal Health. Walgreen sells for cash or third party
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credit cards and will therefore have less receivables than Cardinal Health, which sells to businesses on credit. It is interesting to note that the highest profit margins in the pharmaceutical industry occur with the upstream activities (discovery of new drugs) instead of the downstream activities (wholesaling and retailing). It is also interesting to note that the profit margin of Quintiles lies between the high profit margins of the creators of new drugs and the low profit margins of those firms involved in distribution. Quintiles must possess some technical expertise in order to offer drug-testing services, thus providing the rationale for a higher profit margin than those achieved by the wholesalers and retailers. The higher profit margin for Walgreen over Cardinal Health is probably attributable to brand name recognition and the large number of retail stores nationwide. The wholesaling function of Cardinal is low value added. The pharmaceutical benefit management services are somewhat differentiable but quickly copied by competitors. It is also interesting to note the extent that these firms use long-term debt financing. The firms involved in upstream activities must invest in research and manufacturing facilities, which can serve as collateral for borrowing. These firms, however, have high profit margins (which should enhance cash flow from operations) and high product risks (introduction of superior products by competitors, legal liability exposure). Thus, these firms tend not to add financial risk to their already high asset-side risk. However, note that all the firms operating in the various sectors of the pharmaceutical industry generally carry relatively low amounts of debt.
1.5 Recasting the Financial Statements of a U.K. Company into U.S. Formats, Terminology, and Accounting Principles. The recast consolidated balance sheet is presented below. The instructor may wish to ask if there are any unusual relationships between the structure of the assets and the structure of the financing of WPP Group. One unusual feature is the excess of current liabilities over current assets. WPP Group serves as an intermediary between its clients desiring media time or space and the providers of that space. Accounts receivable includes the amounts receivable from clients and accounts payable includes amounts payable to media providers. The excess liability suggests a degree of short-term credit risk for WPP Group. A second issue is the amount of long-term debt. WPP Group has few tangible assets to serve as collateral for this borrowing. Most of its long-term assets are in the form of goodwill. This debt, coupled with the excess of current liabilities over current assets, suggest considerable financial risk. However, profitability did improve between Year 10 and Year 11. In addition, the WPP Group is one of the most established advertising groups in the world. The recast consolidated income statement follows the balance sheet. An interesting issue to discuss is the classification of operating expenses. Common practice in the U.K. classifies expenses by their nature. The largest expense for a marketing services firm like WPP Group is compensation. The firm includes this expense in operating expenses rather than cost of goods sold. For WPP Group, the amount for cost of goods sold is only the cost of materials used in preparing advertising copy for clients.
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Students will likely use a variety of single-step and multiple-step income statement formats. The recast consolidated statement of cash flows follows the income statement. The statement of cash flows in the U.K. uses five types of activities instead of the usual three categories in the U.S. Cash inflows from investments and cash outflows for interest and dividends appear as a separate category, as does cash outflows for income taxes. The cash inflows from investments and the cash outflows for income taxes are part of cash flow from operations in the U.S. The cash outflow for dividends is a financing activity in the U.S. The calculation of cash flow from operations appears at the bottom of the consolidated statement of cash flows reported here Note that the WPP Group made significant acquisitions in both Year 11 and Year 10. It appears that the acquisitions in Year 11 were financed by mainly bank loans and to a lesser extent issuance of stock. The large swings in accounts receivable and accounts payable during this two-year period is probably related to these acquisitions made by WPP Group. The firm also increased its investment in property, plant and equipment during the year. Students will often ask why the changes in various accounts on the balance sheet (for example accounts receivable, inventories) do not precisely equal the changes on the statement of cash flows. The usual reason for this difference is that a firm has acquired or sold another firm during the year. The purchase or sale causes individual accounts to change (for example, accounts receivable, inventories). Such changes, however, appear as an investing activity on the statement of cash flows. Thus, part of the change in accounts receivable is an operating activity and part is an investing activity.
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WPP Group Consolidated Balance Sheet (amounts in millions of pounds) (Problem 1.5) Assets Cash..................................................................................... Marketable Securities.......................................................... Accounts Receivable........................................................... Other Receivables............................................................... Inventories........................................................................... Total Current Assets.................................................. Investments in Securities.................................................... Property, Plant and Equipment (net).................................. Corporate Brands (a)........................................................... Goodwill (a)........................................................................ Total Assets................................................................ Liabilities and Shareholders' Equity Accounts Payable................................................................ Bank Loans......................................................................... Taxes Payable..................................................................... Other Current Liabilities..................................................... Total Current Liabilities............................................ Long-term Debt................................................................... Deferred Taxes.................................................................... Pension Liability (b)........................................................... Other Noncurrent Liabilities............................................... Total Liabilities.......................................................... Shareholders' Equity Minority Interest................................................................. Common Stock................................................................... Additional Paid-in Capital (c)............................................. Retained Earnings............................................................... Accumulated Other Comprehensive Income...................... Total Shareholders' Equity......................................... Total Liabilities and Shareholders' Equity................. (a) See Note 1 to the WPP Group financial statements (b) Year 11 = 18 + 135; Year 10 = 11 + 88 (c) Year 11 = 1,044 + 2,363; Year 10 = 1,096 + 2,214 December 31 Year 10 Year 11 1,068 586 -77 2,181 2,392 233 248 241 237 3,723 3,540 552 553 390 432 950 950 3,497 4,439 9,112 9,914 2,575 298 164 1,215 4,252 1,280 30 99 57 5,718 24 111 3,310 (211) 160 3,394 9,112 2,506 319 166 1,331 4,322 1,712 41 153 46 6,274 41 115 3,407 (48) 125 3,640 9,914
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WPP Group Consolidated Income Statement (amounts in millions of pounds) (Problem 1.5) Year 10 13,949 (245) 13,704 (13,325) 379 38 (52) 365 (110) 255 (11) 244 Year 11 20,887 (232) 20,655 (20,149) 506 (24) (71) 411 (126) 285 (14) 271
Sales.................................................................................... Cost of Goods Sold............................................................. Gross Profit......................................................................... Selling, General, and Administrative Expenses................. Operating Income............................................................... Other Income (Expense)..................................................... Interest Expense.................................................................. Income Before Income Taxes and Minority Interest.......... Income Taxes...................................................................... Income Before Minority Interest........................................ Minority Interest in Earnings.............................................. Net Income (Loss)..............................................................
WPP Group Consolidated Statement of Cash Flows (amounts in millions of pounds) (Problem 1.5) Operations Net Income (Loss).............................................................. Depreciation........................................................................ Increase in Provisions......................................................... Other Adjustmentsa............................................................. (Increase) Decrease in Receivables and Prepayments........ (Increase) Decrease in Inventories...................................... Increase (Decrease) in Trade Creditors.............................. Cash Flow from Operationsb..................................... Investing Acquisition of Fixed Assets................................................ Acquisitions........................................................................ Other Investing Activities................................................... Cash Flow from Investing.......................................... Year 10 244 79 74 3 (434) (15) 539 490 (112) (230) (51) (393) Year 11 271 125 27 138 (5) (18) (473) 65 (218) (696) (125) (1,039)
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Financing Increase (Decrease) in Bank Loans..................................... Issue of Capital Stock......................................................... Dividends............................................................................ Cash Flow from Financing........................................ Effect of Exchange Rate Changes on Cash and Cash Equivalents........................................................................ Net Change in Cash and Cash Equivalents......................... Cash and Cash EquivalentsBeginning of Year............... Cash and Cash EquivalentsEnd of Year.........................
aThe amount for "Other Adjustments" is bCash flow from operations includes the
128 78 (26) 180
439 69 (44) 464
35 312 774 1,086
10 (500) 1,086 586
a plug amount. following from WPP Group's cash flow Year 10 624 (53) (81) 490 Year 11 174 (31) (78) 65
statement: Net Cash Flow from Operating Activities.......................... Net Cash Flow from Investments and Servicing of Finance (excluding dividends paid)............................. Taxation.............................................................................. Cash Flow from Operations.......................................
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1.6 Comprehensive Income. a. Changes in the recognition and valuation of assets and liabilities that do not immediately affect net income and retained earnings but will at some point in the future are reported as part of comprehensive income. Stated differently, comprehensive income equals net income for a period plus or minus the change in shareholders equity accounts other than changes from net income and transactions with owners. For WPP Group, comprehensive income for Year 11 is 306 as reported in the statement below. WPP Group Consolidated Statement of Comprehensive Income (amounts in millions of pounds) (Problem 1.6) Year 11 Net income............................................................................. Foreign currency translation adjustment (a).......................... Pension benefit reserve (b).................................................... Comprehensive income.......................................................... 271 53 (18) 306
(a) 133 80 as reported in Note 5 of WPP Groups financial statements (b) 27 45 as reported in Note 5 of WPP Groups financial statements. b Net income as a percent of turnover, or revenues, for Year 11 is 1.3 percent (= 271/20,887). Comprehensive income as a percent of turnover for Year 11 is 1.5 percent (= 306/20,887). Although the ratio is higher using comprehensive income, the difference between the two is not significant. Furthermore, as you will learn in subsequent chapters, analyzing the appropriate level for the ratio involves assessing the trend of the ratio over time, as well as comparing it to ratios of other firms operating in similar industries. The difference between net income and comprehensive income varies across firms, but regardless, to date it appears that analysts have not embraced the concept of comprehensive income. In addition, very few databases report comprehensive income and none of the credit rating agencies (S&P, for example) emphasize comprehensive income in their assessment of a firms profitability and risk.
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1.7 Recasting the Financial Statements of a German Company into U.S. Reporting Formats and Terminology. a. The recast balance sheet appears below. Several items on the balance sheet require elaboration. Leased Vehicles Note 2 indicates that this account captures the vehicles leased to customers by Volkswagen. The leases are for a short duration and thus, the vehicle remains on the balance sheet of the company. An alternative disclosure could be to include the leased vehicles in a separate category under property, plant and equipment. Provisions Note 6 indicates that this account includes pension, warranties, restructuring, taxes and other provisions. With the exception of taxes payable, it is unclear whether these provisions should appear as current or as noncurrent liabilities. Pensions clearly are noncurrent. Warranties and restructuring provisions likely have at least some current portion. Given the limited disclosures made by Volkswagen, we cannot delve any more deeply into this question. We classified all the provisions as noncurrent liabilities except for the taxes payable which we classify as current. Deferred Income Volkswagen likewise does not disclose the term over which it will recognize deferred income. Some of the amounts will almost certainly be current. We classify the entire amount as current. Retained Earnings U.S. firms do not separate earnings available versus unavailable for dividends. Thus, retained earnings at the end of each year is a combination of Accumulated Profits and Revenue Reserves. The instructor may wish to point out certain aspects of the assets and financing of Volkswagen. Accounts receivable and property, plant and equipment dominate the asset side of the balance sheet. The accounts receivable relate to amounts due from both dealers and customers for assets leased. Note also the heavy proportion of debt in the capital structure. A large portion of current liabilities represents bank borrowing. Industrial companies in Germany work closely with their banks and tend to have higher proportions of their financing come from this source. Other noncurrent liabilities also comprise a major portion of total financing. Included here are obligations to employees for pensions, warranty estimates, and other provisions unspecified by Volkswagen (see Note 6).
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Balance Sheet for Volkswagen Group AG (in millions of ) (Problem 1.7) December 31 Year 9 Year 10 Assets Cash............................................................................... Marketable Securities.................................................... Accounts Receivable..................................................... Inventories..................................................................... Prepayments.................................................................. Total Current Assets............................................... Investments in Securities.............................................. Leased Vehicles............................................................ Property, Plant, and Equipment (net)........................... Deferred Tax Assets...................................................... Goodwill and Other Intangibles.................................... Total Assets............................................................. Liabilities and Shareholders Equity Accounts Payable.......................................................... Bank Loans Payable...................................................... Advances from Customers............................................ Other Current Liabilities............................................... Taxes Payable............................................................... Total Current Liabilities......................................... Long-term Debt.............................................................
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2,156 3,886 41,432 9,335 299
4,285 3,610 45,166 9,945 378
57,108 4,216 4,783 19,726 1,377 5,355
63,384 3,999 7,284 21,735 1,426 6,596
92,565 7,435 26,201 204 5,699 1,424
104,424 7,055 30,044 285 6,161 1,418 44,963 12,750
40,963 8,383
Deferred Tax Liabilities................................................ Other Noncurrent Liabilities......................................... Total Liabilities....................................................... Shareholders Equity Minority Interest........................................................... Preferred Stock............................................................. Common Stock............................................................. Additional Paid-in Capital............................................ Retained Earnings......................................................... Total Shareholders Equity..................................... Total Liabilities and Shareholders Equity.............
2,095 19,704 71,145 49 268 803 4,296 16,004 21,420 92,565
2,299 20,364 80,376 53 272 815 4,415 18,493 24,048
104,424
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b. The recast income statement appears below. Different income statement formats are followed by U.S. companies that engage in both the manufacturing and sales financing of passenger and commercial vehicles. The format presented below is similar to that followed by Ford Motor Company. However, Ford breaks out selling and administrative expenses separately for its automotive and financial services division, whereas Volkswagen Group AG does not provide this breakdown. Income Statement for Volkswagen Group AG (in millions of ) (Problem 1.7) December 31 Year 9 Year 10 Automotive Revenues..................................................................... Cost of Goods Sold..................................................... Gross profit automotive....................................... Financial Services Revenues..................................................................... Interest Expense.......................................................... Gross profit financial services............................. Selling and Administrative Expense (a)....................... Other Operating Items (net) (b).................................... Operating Income......................................................... Equity in Earnings of Affiliates.................................... Other Income (expense)................................................ Income before Taxes and Minority Interest.................. Income Tax Expense..................................................... Income before Minority Interest................................... Minority Interest in Earnings........................................ Net Income.................................................................... 83,127 (71,130) 11,997 3,025 (1,812) 1,213 (9,820) (105) 3,285 335 99 3,719 (1,105) 2,614 (7) 2,607 88,540 (75,586) 12,954 3,208 (1,880) 1,328
(10,593) 850 4,539 289 (419) 4,409 (1,483) 2,926 (11) 2,915
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(a) Consists of 7,554 + 2,154 + 885 for Year 10, and 7,080 + 2,001 + 739 for Year 9 (b) Consists of 4,118 3,268 for Year 10, and 3,656 3,761 for Year 9.
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Case 1.1: Nike: Somewhere Between a Swoosh and a Slam Dunk I. Objectives A. Review the purpose, format, terminology and accounting principles underlying the balance sheet, income statement, and statement of cash flows. B. II. Introduce common size and percentage change income statements and balance sheets and the insights such statements provide.
Teaching StrategyWe have taught this case with two approaches. If an opportunity exists to distribute the case prior to the first class session, we give students the solution to the questions involving the income statement, balance sheet, statement of cash flows, and relations between financial statement items. We ask them to review these parts on their own and then prepare the questions under the section labeled interpreting financial statement relationships. We devote the first class session to discussing this last section of the case. If we cannot distribute the case ahead of time, we devote approximately three hours of class to discussing the case. Alternatively, the instructor can choose to emphasize certain questions based on the amount of time available and refer students to the solution for the remaining parts.
Income Statement a. Nike apparently recognizes revenues from the sale of products at the time of sale. It recognizes revenue from license fees as earned, which is probably at the time of delivery of products to licensees. The criteria for revenue recognition are (1) substantial performance of services to be provided, and (2) receipt of cash or a receivable whose cash-equivalent value a firm can measure with reasonable accuracy. The sale of products to retailers constitutes substantial performance unless Nike is required to take back unsold items. There is no indication that returns are substantial, and furthermore, Nike recognizes a reduction for return sales at the time of sales. The futures ordering program likely matches products to specific customer needs. Nike carries substantial accounts receivable from its customers. The allowance for uncollectible accounts had a balance equal to 4.3 percent of gross accounts receivable [$72/($1,621 + $72)] at the end of Year 11 and 4.0 percent [$65/($1,569 + $65)] at the end of Year 10. Thus, Nikes revenue recognition appears appropriate. b. The Notes indicate that Nike uses FIFO for domestic and international inventories. Firms are free to select their inventory cost-flow assumption from the set deemed acceptable by standard-setting bodies. These bodies do not provide a set of criteria that firms must apply to determine which inventory cost-flow assumption is appropriate. The Financial Accounting Standards Board permits firms in the United States to use FIFO, LIFO, weighted average, and several other methods. Nike probably uses FIFO because the physical flow of its inventory is FIFO. Also, Nike saves record keeping costs by using FIFO for both reporting to foreign governments and reporting to its shareholders in the U.S.
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c. Nike does not conduct any of its own manufacturing. Thus, depreciation expense relates to buildings and equipment used in selling and administrative activities. Nikes income statement classifies expenses by their function instead of by their nature. Thus, Nike includes depreciation expense in selling and administrative expenses. d. The Notes indicate that income tax expense of $332 includes $266 payable currently and a decrease in deferred tax assets or an increase in deferred tax liabilities of $66. Firms recognize deferred taxes for temporary differences between taxable income and income for financial reporting. The taxable income of Nike for Year 11 is less than its income before taxes for financial reporting. This probably occurred because Nike recognized revenues for financial reporting in Year 11 that it will recognize in later years for tax reporting and because it recognized expenses during Year 11 for tax reporting that it will not recognize for financial reporting until later years. The basis for measuring the amount of income tax expense is the amount of revenues and expenses recognized during the year for financial reporting. The basis for measuring income tax payable is the amount of revenues and expenses recognized during the year for tax reporting. Because these amounts are usually different, firms are required to recognize deferred tax assets and deferred tax liabilities on their balance sheets. Governmental laws dictate the manner of measuring taxable income. As long as firms apply these laws correctly in measuring their taxable income each year and pay the required taxes, they have no additional obligation to governmental entities at this time. The presence of a deferred tax asset or a deferred tax liability on the balance sheet is not an indication that governmental bodies have permitted firms to delay paying taxes. Rather, it indicates the desire of standard-setters to match income tax expense with income before taxes for financial reporting. Balance Sheet a. The allowance for uncollectible accounts account arises because Nike recognizes revenue earlier than the time when it collects cash. Because Nike is not likely to collect 100 percent of the amount reported as sales revenue, it must recognize an expense for estimated uncollectible accounts and reduce gross accounts receivable to the amount it expects to collect in cash. Nike increases the balance in the allowance account for estimated uncollectible accounts arising from sales each year. It reduces the balance in the allowance account for actual customers accounts deemed uncollectible. Nike reports the balance in the allowance account as a subtraction from gross accounts receivable. b. The Notes indicate that Nike uses the straight line method for buildings and leasehold improvements and the declining balance method for machinery and equipment. As with the inventory cost-flow assumption, standard-setting bodies give firms freedom to select any depreciation method from the set deemed acceptable. These bodies do not provide criteria as to which method is more appropriate for a particular firm. The methods that Nike uses for financial reporting closely coincide with the methods it uses for tax reporting. Thus, Nike
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saves record keeping costs by using similar depreciation methods for financial and tax reporting. c. Generally accepted accounting principles in the United States require firms to expense in the year incurred any expenditures (for example, advertising, promotion, quality control) to develop intangibles (patents, trademarks, goodwill). Thus, expenditures made to develop the Nike name or its trademarks will not appear on the balance sheet as assets. Expenditures made to purchase intangibles from other firms will appear on the balance sheet as assets (in some cases subject to amortization). Most of the identifiable intangible assets and goodwill appearing on Nikes balance sheet arose from the acquisition of Bauer, Inc. five years ago. d. Deferred tax assets arise when a temporary difference provides a future tax benefit for a firm. This occurs either (1) when a firm recognizes revenue earlier for tax reporting than for financial reporting (subsequent recognition of the revenue for financial reporting will not give rise to a tax payment), or (2) when a firm recognizes expenses earlier for financial reporting than for tax reporting (subsequent recognition of the expense for tax reporting will reduce income tax payments). Deferred tax liabilities arise when a temporary difference will require a firm to make a tax payment in the future. This occurs either (1) when a firm recognizes revenue earlier for financial reporting than for tax reporting (subsequent recognition of the revenue for tax reporting will require the firm to pay taxes), or (2) when a firm recognizes an expense earlier for tax reporting than for financial reporting (subsequent recognition of the expense for financial reporting does not give rise to a tax deduction, thereby increasing taxable income and taxes payable). Note that the classification of deferred taxes on the balance sheet depends on (1) whether temporary differences give rise to a deferred tax asset or deferred tax liability, and (2) the timing of the likely reversal of the temporary difference (less than one year or longer than one year). e. The Financial Accounting Standards Board concluded that firms should report changes in assets and liabilities that do not immediately affect net income and retained earningsbut may affect them in the futureas a separate component of shareholders equity. In this case, losses from exchange rate changes are unrealized until the foreign unit makes a currency conversion from its currency into U.S. dollars or vice versa. Statement of Cash Flows a. Firms use the accrual basis of accounting in measuring net income. Firms usually recognize revenue at the time of sale of goods and services, not necessarily when they receive cash from customers. Firms attempt to match expenses with associated revenues, regardless of when they expend cash. The accrual basis gives a better indication of a firms operating performance than the cash basis because of the matching of inputs and outputs. The statement of cash flows reports the amount of cash received from customers net of amounts paid to suppliers of goods and services.
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b. Depreciation expense reduces net income but does not require a cash expenditure in the year of their recognition (the cash effect occurred in the year a firm acquired the property, plant, equipment; the firm classified the cash outflow as an investing activity in the statement of cash flows at that time). The addition adds back to net income the amount subtracted in calculating earnings for the year. c. Question d. in the Income Statement questions indicated that NIKE paid less income taxes during Year 11 than it recognized as income tax expense. Net income on the first line of the statement of cash flows reflects a subtraction for the TOTAL amount of income tax expense, whereas only a portion of it was paid out in cash in Year 9, Year 10 and Year 11. The difference ($66 million in Year 11) is added back to net income in calculating cash from operation to correct for the portion of income tax expense that did not use cash. d. Net income on the first line of the statement of cash flows includes revenues recognized each year. Nike does not necessarily collect cash each year in an amount exactly equal to revenues. It may collect cash during Year 11 from sales made in prior years and it may not collect cash on some sales made in Year 11 until later years. The subtraction for the increase in accounts receivable means that Nike received less cash than it recognized as sales revenue. e. Net income on the first line of the statement of cash flows includes a subtraction for the cost of goods sold during each year. Nike will likely purchase a different amount of inventory than it sells. An increase in inventories means that Nike purchased more than it sold. Thus, the cash outflow for purchases potentially exceeds cost of goods sold and requires a subtraction from net income for the additional cash required. Whether additional cash was in fact required in any year depends on the change in accounts payable, discussed next. f. Accounts payable reflects amounts owed to suppliers for inventory items purchased. Purchases of inventory items increase this liability and cash payments reduce it. The adjustment for inventory in Part e. above converted cost of goods sold to purchases. The adjustment for accounts payable converts purchases to cash payments to suppliers. An increase in accounts payable means that Nike purchased more than its cash expenditure for purchases. Thus, the adjustments for the change in inventories and the change in accounts payable convert cost of goods sold included in net income to cash payments to suppliers for inventory items. The accrued liabilities and income tax payable accounts reflect amounts owed to suppliers of various services. Purchases of these services increase these liabilities and cash payments reduce them. Net income on the first line of the statement of cash flows includes an expense for the cost of these services consumed during the year. An increase in the liability for these items means that the cash expenditure during the year was less than the amount recognized as an expense. The addition to net income indicates that the cash outflow was less than the expense. Cash flow from operations did not decrease by the full amount of the expense.
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g. The Financial Accounting Standard Board requires firms to report the proceeds from selling property, plant and equipment as an investing activity. Their rationale for this classification is two-fold: (1) selling such noncurrent assets is not the primary operating activity of most companies, and (2) cash expenditures to purchase these assets appear as investing activities. If a firm sells such assets at a gain or loss, it must subtract the gain from net income or add back the loss to net income when computing cash flow from operations. This subtraction or addition nets the effect of the gain or loss to zero in the operating section of the statement of cash flows and shows the full cash proceeds as an investing activity. Any gains or losses for Nike were sufficiently small that it did not disclose them separately. h. The Financial Accounting Standards Board requires firms to report changes in short-term bank borrowing as a financing activity. Their rationale for not including such borrowing as an operating activity, which is the classification of changes in other current liabilities, is that a firm does not generate operating cash flows by borrowing from banks. Operating cash flows come from selling goods and services to customers. Changes in other current liabilities on the other hand relate directly to purchases of goods and services used in operations, justifying their inclusion in the operating section of the statement of cash flows.
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Relations between Financial Statement Items (amounts in thousands) a. Sales Revenue................................................................................ Increase in Accounts Receivable*................................................. Cash Collected from Customers.................................................... b. Cost of Goods Sold....................................................................... Increase in Inventories*................................................................. Cost of Inventories Purchased....................................................... Decrease in Accounts Payable**................................................... Cash Paid for Purchases of Inventory...........................................
$ 9,489 (141) $ 9,348 $ 5,785 17 $ 5,768 179 $ 5,981
*Amount taken from the Consolidated Statement of Cash Flows **Amount taken from the Consolidated Statement of Cash Flows. It represents an approximation because Nike combines the change in Accounts Payable with the change in Other Current Liabilities.
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c. Property, Plant and Equipment (at cost): Balance, May 31, Year 10($1,583 + $810)................................... Purchases of Property, Plant and Equipment................................ Book Value of Property, Plant and Equipment Disposed (plug). . Balance, May 31, Year 11 ($1,619+$934).................................... Accumulated Depreciation: Balance, May 31, Year 10............................................................. Depreciation Expense for fiscal Year 11....................................... Accumulated Depreciation of Property, Plant and Equipment Disposed for fiscal Year 11 (plug)............................................. Balance, May 31, Year 11............................................................. Cash Proceeds from Disposal of Property, Plant and Equipment.................................................................................. Book Value of Property, Plant and Equipment Disposed: ($158$73).................................................................................. Loss on Sale of Property, Plant and Equipment...........................
$ 2,393 318 (158) $ 2,553 $ 810 197 (73) 934 13 (85) (72)
$ $ $
Nike likely includes the loss in Other Expenses on the income statement. It added back the loss to net income in calculating cash flow from operations, probably on its line labeled other. d. Net income increased retained earnings by $589 million, dividends reduced retained earnings by $130 million, and the repurchase and retirement of Nike common stock must have resulted in a charge against retained earnings of $152 million. Note that most companies report the cost of treasury stock purchased on a separate line in the shareholders equity section of the balance sheet. Nike chooses to report such repurchases as the retirement of the stock. The charge against retained earnings reflects the increases in the stock price in previous years resulting from the retention of earnings. Interpreting Financial Statement Relationships a. The improved net income/sales percentage between Year 11/Year 10 and Year 9 results primarily from a reduction in the cost of goods sold to sales percentage. The decrease in sales between Year 8 and Year 9 suggests that Nike may have had to reduce selling prices or absorb manufacturing cost increases in order to move its products. The increase in sales between the Year 9 and Year 10 suggests a more attractive pricing environment for Nike, resulting in a reduction in the cost of goods sold to sales percentage. Nike may also have experienced a shift in its sales mix between these two years toward higher margin products. Nike does not provide profit margin information for its various products.
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b. The increase in selling and administrative expense between Year 9 and Year 10 likely results from the need to increase marketing efforts in a period of slower growth in sales. Note that sales grew at 2.5 percent in Year 10, after a year of substantially decline in sales (Year 9 sales declined over Year 8 sales by 8.1 percent). c. The close similarity between the change in sales percentage and the change in cost of goods sold percentage suggests that this cost items is primarily a variable cost. Given that Nike outsources its manufacturing and sells most of its footwear at preestablished selling prices under its Futures program, one would expect a variable cost relationship. Also, Nike does not have any manufacturing facilities of its own that would give rise to fixed manufacturing costs. For Year 10, the reduction in the percentage change in cost of goods sold compared to the increase in the percentage change in sales may have resulted from better cost controls or a more favorable mix of product sales. d. The three companies outsource production of footwear and apparel to plants primarily in Asia. Given that these three companies dominate the footwear industry, they probably have similar bargaining power with suppliers. Thus, each firm probably pays a similar amount for its products. Furthermore, the market for athletic footwear and sports apparel is highly competitive. In terms of their physical characteristics, products are largely commodities. Although each firm attempts to distinguish its products on image characteristics, these three companies face competitive pressures to keep prices in line with each other. Thus, we would expect the three firms to have similar cost of goods sold/sales percentages. e. Nikes profit margin advantage comes from a lower selling and administrative expense/sales percentage. Perhaps the larger sales level of Nike permits it to realize greater scale economies than Reebok and Adidas. These firms likely need a certain minimum level of selling and administrative personnel to compete on an international level. The firm with the larger sales will likely realize greater sales economies. f. These companies outsource their manufacturing and also outsource the retailing of their products. Thus, the principal fixed assets are corporate headquarters, research facilities, warehouses, and transportation equipment. One might think of these companies as serving essentially a wholesaling function along with product development and promotion. g. These firms have few fixed assets to serve as collateral for borrowing. Also, the firms generate more than sufficient cash flow from operations to finance the small amount of investments in fixed assets. Thus, the firms do not need significant long-term debt financing. h. As discussed in Question d., Nike outsources the production of its products to manufacturers located in Asia. The property, plant and equipment needs of Nike are minimal, and probably represent warehouses and distribution facilities. As
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such, one might expect minimal increases in property, plant and equipment each year. i. It appears that Nike has concluded that short-term borrowing rates are low enough to finance some of its inventory needs through short-term notes rather than through accounts payable. Perhaps the terms negotiated with its suppliers are not as good as Nike can obtain in a climate of extremely low short-term rates and, as such, turned to the commercial market for some of its financing needs. j. Adidas appears the most risky from a financial structure perspective. It has the highest proportion of liabilities in its capital structure, with most of its debt in the form of short-term borrowing. Adidas, like most German companies, maintains close relations with its banks and engages in more short-term bank borrowing than is common in the U.S. Adidas has the smallest excess of current asset over current liabilities of the three companies. Although Adidas has gained market share in recent years and experienced a respectable net income/sales percentage, its debt load still places it as more risky than Reebok. k. Nike experienced a substantial increase in inventories that exceeded the increase in sales. Nike apparently stretched its current liabilities to help finance the buildup of inventories, but the buildup exceeded the increase in current operating liabilities. Cash flow from operations therefore declined between the two years. l. Nike experienced only a small increase in net income between Year 10 and Year 11. Although accounts receivable increased substantially, inventory increased by only a small amount relative to the previous year. However, the substantial decrease in other current operating liabilities resulted in big drain in cash flow from operations for Year 11, similar to the drain experienced in the previous year by the build-up of inventory. m. In each year Nike reported a significant addback for depreciation. Although depreciation is not a source of cash, it is deducted as an expense on the income statement to arrive at net income. For firms that have depreciation charges, inevitably cash flows from operations will be greater than net income because net income includes this expense, whereas it is excluded (added back) as a cash flow from operations. n. Cash flow from operations exceeded expenditures on property, plant and equipment each year, so Nike did not need to rely on external financing for its capital expenditures. In fact, it has reduced its long-term debt during the three years. o. The repurchases of common stock substantially exceeded the issue of new stock under stock option plans in Year 10 and Year 11. Thus, repurchasing shares to maintain a level number of shares outstanding to avoid dilution does not appear to be the primary reason for the stock repurchases. It is likely that Nike had excess
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cash and felt that its stock price was undervalued. Such stock repurchases often result in an increase in the market price of the stock. p. In fact, Nike maintained the same dividend payout rate during this three-year period. However, the TOTAL amount of dividends paid out each year decreased slightly because dividends are paid only on stock outstanding. As reported in Exhibit 1.24, Nike repurchased a substantial amount of its stock in Year 9, Year 10 and Year 11, which has the effect of reducing the total amount of stock outstanding each year.
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Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

CHAPTER 1 OVERVIEW OF FINANCIAL REPORTING AND FINANCIAL STATEMENT ANALYSIS

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

128 78 (26) 180

439 69 (44) 464

35 312 774 1,086

10 (500) 1,086 586

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

2,156 3,886 41,432 9,335 299

4,285 3,610 45,166 9,945 378

57,108 4,216 4,783 19,726 1,377 5,355

63,384 3,999 7,284 21,735 1,426 6,596

92,565 7,435 26,201 204 5,699 1,424

104,424 7,055 30,044 285 6,161 1,418 44,963 12,750

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

2,095 19,704 71,145 49 268 803 4,296 16,004 21,420 92,565

2,299 20,364 80,376 53 272 815 4,415 18,493 24,048

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

$ 9,489 (141) $ 9,348 $ 5,785 17 $ 5,768 179 $ 5,981

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

Chapter 1 Overview of Financial Reporting and Financial Statement Analysis

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