(Solution Manual) The analysis and Use of financial statements

White,Sondhi,Fried, 3

Business

Solution Manual

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Solution Manual for The analysis and Use of financial statements, The downloadable file consists of 636 pages, and the total size of the file is 5.74 MB. Purchase now only for highly discounted price.

Author(s): White, Sondhi, Fried

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1-1 Chapter 1 - Solutions Overview: Problem Length Problem #s {S} 1 to 23 [M] 24 1.{S}(i) Short-term lenders are concerned primarily with liquidity. Accounting standards would focus primarily on near-term cash flows and might include cash flow forecasting. Performance reporting would likely emphasize cash -based measures. (ii) Long-term equity investors are primarily concerned with the earning power of the firm. Income measurement would be the focus of standards for such users. (iii)Tax aut horities are concerned with the generation of tax revenue. Accounting standards might limit the ability of firms to shift income from one period to another and place strict controls on the recognition and timing (accrual) of both revenues and deductible expenditures. (iv) Corporate managers seek to control their reported earnings, to cast the best possible light on their stewardship. Accounting standards set by managers would be highly flexible, with little supplementary information and footnote disclosu re. 2.{S}The matching principle states that revenues should be matched with the expenses that generate them. As the revenues and related expenditures may be incurred in different accounting periods, accrual accounting is required to recognize them in the same period. 3.{S}The going concern assumption states that the enterprise will continue operating in a normal fashion. This assumption permits financial statements to record assets and liabilities based on the cash flows that they will generate as the f irm operates. If this assumption were absent, all assets and liabilities would have to be evaluated on a 1-2 liquidation basis. Accrual accounting could not be used, as the assumption that expenditures would produce future revenues could no longer be made. 4.{S}Public companies must provide current investors with detailed financial statements, mandated by the FASB and the SEC. Because of SEC filing requirements, annual and quarterly financial data are publicly available to potential investors as well. Private companies may not prepare audited financial data. When audited financial statements are prepared, they will lack some disclosures (e.g., earnings per share) and certain SEC -mandated data (such as the management discussion and analysis). In addition, these statements may not be made available to potential investors. 5.{S}All public companies in the United States are required to issue financial statements whose form and content are determined by the FASB after much public debate. The SEC oversees this proces s and supplements these standards with additional disclosure requirements. As U. S. GAAP have an investor and user orientation, they require detailed disclosures. Financial statements issued by non -U.S. firms follow local (in some cases, IASB) accounting s tandards, with less disclosure. Local standards reflect legal and political requirements and often do not have the same investor protection objective as in the United States. Foreign firms generally do not provide quarterly reports; semi-annual reporting i s the norm. 6.{S}The FASB sets accounting standards for all audited financial statements prepared under U.S. GAAP. The SEC has jurisdiction over all public companies. Given the overlapping jurisdiction, the SEC generally relies on the FASB to set stand ards but supplements those standards with additional disclosure requirements deemed necessary to inform and protect investors in public companies. 7.{S}The balance sheet includes only those economic events that qualify as assets and liabilities. As accou nting standards define, in effect, assets and liabilities they determine which economic events are accounted for and which are ignored. Events ignored (such as many contracts) are excluded from the process of preparing financial statements. 1-3 The recognition rules also influence managers' decisions regarding the form of contractual agreements used to acquire assets and incur liabilities, thereby affecting the preparation of financial statements. 1-4 8.{S}Liabilities represent the assets of the firm funded by tra de and financial creditors. Equity represents the permanent capital of the firm, and is the residual after all liabilities have been satisfied. Thus the distinction between liabilities and equity is the difference between prior claims and permanent capital . Misclassification will over- or understate the firm's reported debt and the degree of leverage or financial risk. 9.{S}Historical cost is more reliable as it reflects actual past transactions. Market values are less reliable as they may require assumpti ons and estimates. However, general inflation and specific price changes make historical costs less useful (relevant) as time passes. Market values always have relevance as they represent the current value of the firm's resources. The nature of the markets (liquidity, volatility, and transparency) affects the reliability of the values reported. 10.{S} Contra accounts are deductions from asset or liability accounts that accumulate valuation or other adjustments (such as accumulated depreciation) and reduc e the asset or liability account to its "net" amount. Adjunct accounts accumulate certain adjustments outside the historical cost framework (such as fair value adjustments for marketable securities under SFAS 115) and other adjustments (for example, premiu ms and discounts on debt issues). Adjunct accounts are often reported separately. 11.{S}Revenues and expenses result from the firm's operating activities; gains and losses result from valuation and other non -operating events. The latter are peripheral to the normal activities of the firm and, therefore, should be separated for analytic purposes. 12.{S} Comprehensive income includes all changes in equity other than transactions with stockholders. It encompasses operating earnings, "non -recurring" items, v aluation adjustments, and the cumulative effect of accounting changes. As it includes all changes in stockholders' equity (excluding transactions with owners), comprehensive income is more complete than "income from continuing operations" (most useful for earnings forecasting). 1-6 13.{S}Recurring income refers to income from continuing operations, the best measure of the operating profits of the firm for that time period, and therefore the best base for forecasting and valuation. Non -recurring items are unusual and/or infrequent in nature, and usually result from non -operating factors. 14.{S}The classification of cash flows into three categories highlights their differing natures. Cash from operations reports the cash generated or used by the firm's operatin g activities. Cash for investment measures the outflow for investments in capacity, for acquisitions, or for long -term investments. Cash from financing indicates the source (debt or equity) of any financing required by the firm as well as distributions to preferred and common stockholders. These classifications should be viewed over time as indicators of the firm's liquidity and solvency. The relationship among these classifications is especially important. 15.{S}Footnotes are an integral part of the fi nancial statements and are audited. They supply details that augment financial statement data (e.g. employee benefit plan data). Supplementary schedules may be included within the financial statements (e.g. oil and gas disclosures) but may not be audited. 16.{S}The Management Discussion and Analysis is intended to explain changes and trends in reported income statement, balance sheet, and cash flow items and therefore help financial statement users to interpret these financial statements. The MD&A should discuss trends, including those expected to continue in the future. This discussion should aid the prediction of future cash flows and earnings. 1-7 17.{S} Global accounting standards offer the possibility of comparability, as all companies would be required to prepare financial standards using the same accounting methods. There may also be the following disadvantages: (i) Lack of comparability if there is no body empowered to enforce uniform application of global standards. (ii) Loss of the information provided by reconciliations from one set of accounting standards to another, which sometimes highlight important aspects of a firm’s operations. (iii) Different economic and social structures may require differing accounting standards. For example, in an environment where fin ancing comes primarily from banks rather than through issuance of shares, accounting standards would be appropriately geared to the needs of creditors rather than equityholders. 18.{S}(i) The opinion should report any changes in accounting principles used and may refer to the footnote providing additional information on the change. (ii) Changes in accounting estimates are not referred to in the auditor’s opinion. (iii)The auditor's report must describe uncertainties when they are material to the firm's financial position. (iv) While the auditor's opinion provides reasonable assurance that there are no material errors in the financial statements, it is not a guarantee against error or even fraud. Statement on Auditing Standards (SAS)82 (1997), requires auditors to assess the risk of financial statement fraud. 1-8 19.{S}a. Without knowledge of the effects of accounting changes, the analyst may draw incorrect conclusions about trends within the enterprise over time. Comparisons with other companies may also be made incorrectly if differences in accounting methods or the effects of accounting changes are ignored. b. Changes in accounting methods should be highlighted in the auditor’s opinion to inform financial statement users that year -to-year comparabi lity is absent. The accounting changes that Roche adopted in 2000 have significant effects on reported data. 20.{S}The preparer gathers financial data, chooses accounting principles and estimates, and assembles the data into financial statements using tho se methods and estimates. The auditor examines the financial statements for errors, and checks that the accounting methods and assumptions are permissible under GAAP and whether they have been applied consistently over time. 21.{S}Companies generally prep are financial statements using the accounting principles of their home country. When selling securities in a foreign jurisdiction, they may be required to prepare supplementary financial statements using the accounting standards of that country. The cost a nd inconvenience of this extra work may dissuade the firm from selling securities in that country, thus depriving that country's investors of the opportunity to invest. On the other hand, investors must choose between that firm's securities and those of home country firms using local accounting principles. If the foreign firm uses different accounting principles, investors may make poor investment decisions because of their inability to separate real differences between firms from differences caused by alternative accounting principles. 22.{S}a. Because the probability of loss is so low (less than one in ten thousand), Bonnywill will report no loss. If a fire occurs, the firm will then accrue the estimated loss. b. An alternative method would accrue the expected value of the loss, computed by multiplying the number of units sold by the expected loss per unit. The result would be 10,000 x .00009 x $100,000 = $90,000. 1-9 23.{S}a. For firm A the probability of loss is remote (.3%) so that no liability should be recognized. If an accident occurs, the firm would recognize a liability equal to the expected loss. b. Firm B expects to have 10 workers' compensation claims each year (10,000/1,000) with a loss of $10,000 per claim. Thus firm B should accrue $100,00 0 per year. The difference from firm A is that the employee population is large enough to make the loss predictable. 24.{M}a. Note 5 of the Roche 2000 financial statements states that CHF1,282 million of the charge was paid in 1999. The same amount is sho wn within cash flows from operating activities. b. The remaining amount is included in Provisions (see Roche note 26). There is no information as to whether it is in the current or non -current provisions. c. The remaining provision will be included in cash flows from operating activities when cash is paid. d. Assuming that the price fixing that led to the settlement was confined to the vitamin business, the settlement can be viewed as a nonoperating item that should reduce the valuation of Roche shares dollar -for- dollar rather than being deducted from the income used to value the shares. e. However, there are two other arguments. One is that the settlement may have damaged the vitamin business, reducing its value and, therefore, reducing the value of the entire firm. T he second argument is that Roche’s business reputation may have been harmed, resulting in a lower value for the firm. [ Authors’ note : Roche announced an agreement to sell its vitamin division in September 2002.] 2-1 Chapter 2 – Solutions Overview: Problem Length Problem #s {S} 1, 2, 4 - 11, 15, 16, and 18 - 20 {M} 3, 12 - 14, 17, and 21 - 23 1.{S}(i) When the product is a commodity with a known price and liquid market. (ii) When collection is assured because the risk of non - payment can be estimated. (iii)When collection is uncertain because the risk of non - payment cannot be estimated. 2.{S}a. (All data in $ millions) Under the completed contract method, neither revenue nor pre-tax income would be report ed until the project is completed. When the project has been completed, at the end of 2002, LASI Construction would report revenues of $3.0 and pretax income of $0.6 (revenues of $3.0 minus costs of $2.4). Under the percentage -of-completion method, reve nues and pretax income must be reported each year as follows: Year Cumulative % Completion Cumulative Revenue Current Period Revenue Current Period Expense Pretax Income 2000 0.9/2.4 = 37.5% $1.125 $1.125 $0.900 $0.225 2001 1.7/2.4 = 70.8% 2.125 1.000 0.800 0.200 2002 2.4/2.4= 100.0% 3.000 0.875 0.700 0.175 Total $3.000 $2.400 $0.600 b. Computation of construction in progress and advance billings (in $ millions) Percentage -of-Completion Completed Contract Costs incurred $ 0.900 $ 0.900 Profit recognized 0.225 0.000 Construction in progress $ 1.125 $ 0.900 Advance billings (1.000) (1.000) 2-2 Net asset (liability) $ 0.125 $(0.100) 2-3 Balance Sheet on December 31, 2000 (in $ millions) Percentage -of-Completion Completed Contract Assets Cash $ 0.100 $ 0.100 Construction in progress (net) 0.125 0.000 Total assets $ 0.225 $ 0.100 Liabilities and equity Advance billings (net) $ 0.000 $ 0.100 Retained earnings 0.225 0.000 Total liabilities and equ ity $ 0.225 $ 0.100 c. Effect on 2001 revenue and pretax income of a change in estimated costs to complete There is no change in 2001 revenues and pretax income (both are $0.000) under the completed contract method because no revenue or income can be recognized prior to completion. Under the percentage -of-completion method, both revenue and pretax income change and are computed as follows: Year Cumulative % Completion Cumulative Revenue Current Period Revenue Current Period Expense Pretax Income 2001 1.7/2.5= 68.0% $2.040 $0.915 $0.800 $0.115 Note: All changes are in bold. The change in estimated costs to complete raises the total expected costs to complete to $2.500 from the previous estimate of $2.400. Costs incurred at the end of Year 2001 a re $1.700 ($0.900 in 2000 and $0.800 in 2001) because we have assumed that the incremental costs ($0.100) will be incurred in Year 2002. Cumulative revenue of $2.040 must be recognized at the end of 2001; since we recognized $1.125 in revenue in 2000, the difference ($2.040-$1.125) or $0.915 must be recognized in 2001. The effect of the change is recognized in Year 2001 and Year 2000 results are not changed. 2-4 3.{M}a. Because of the highly uncertain life of software products, technological obsolescence, and the possibility of refunds or other concessions, software revenue recognition standards include a presumption that extended payment terms render the sales price (fees) not fixed or determinable. Any extended payment terms beyond the normal payment terms m ay indicate that the fees are not fixed or determinable. In general, a license fee is not considered fixed or determinable if, at the inception of the transaction, a significant portion of the fee is due more than twelve months after delivery or after the expiration of the license. In practice, 10% or more is considered “significant.” When the fee is not fixed or determinable at the outset, revenue must be recognized as payments become due, assuming all other revenue recognition criteria are met. (i) No revenue can be recognized for the fiscal year ending January 31, 2001 because the fee is not fixed or determinable when the product is delivered. (ii) $600,000 would be recognized as revenue for the fiscal year ending January 31, 2002 because that amount is due 30 days after delivery on January 30, 2001. The remaining $400,000 would be reported as revenue for the fiscal year ending January 31, 2003 because it is due 13 months after delivery and falls outside the fiscal year ended January 31, 2002. (iii) No revenue can be recognized in the fiscal year ending January 31, 2001 if the licensing period begins on March 1, 2001. The customer cannot use the product prior to licensing and the seller has not provided any services prior to the onset of the licensing period. b. Since Jasmine, Inc. is not involved (not at risk) in the financing arrangements, revenue can be recognized on receipt of payments, assuming all other revenue recognition criteria are met. c. There is no change in Jasmine’s ability to recognize revenue if it tran sfers, without recourse, the rights to receive payments to an unrelated third party because the presumption that the fee is not fixed and determinable is not overcome. The transfer of payments 2-5 does not change the substance of the transaction between Jasmin e and its customer. (i) If Jasmine’s participation in the financing arrangement increases the probability that the customer or the financing party will receive a refund or a concession, the fee is not fixed and determinable. Where participation indicat es that Jasmine (1) does not have the intent or the ability to enforce the original payment terms absent the financing or (2) exhibits a pattern of amending or tailoring payment terms to the financing plan, the fee is not fixed and determinable. In these circumstances, revenue must be recognized as the customer’s payments become due and payable to the financing party ( and all other revenue recognition criteria are met). (ii) Payments received from the customer or the financing party in advance of revenue recognition must be recorded as a liability, deferred revenue. Although there is no difference in the cash reported on the balance sheet, the deferred revenue increases the liability. Revenue (and consequently, income) may be recognized later on the income statement. The presumption that the fee is not fixed or determinable given Jasmine’s participation in customer financing may be overcome if Jasmine can demonstrate that such arrangements are part of its standard business practice (similar financing arrangements with substantially similar terms) and that it does not grant refunds or concessions to customers or the financing parties. 2-6 4.{S}a. The retailer’s policy results in the recognition of revenue prior to delivery, that is, before it has been earned - a violation of the basic revenue recognition criteria. U.S. GAAP does not permit recognition of revenue prior to delivery. b. Revenue recognition must be delayed until delivery, making reported revenue, cost of goods sold, accrual of tax expense, and income lower than under the previous method (assuming rising sales). Inventory balances will remain on the balance sheet for a longer period and increase the number of days inventory is on hand. In the period the change is first reported, revenue, cost of goods sold, tax expense, income, and retained earnings (and therefore, stockholders’ equity) will be lower and ending inventory will be higher than that previously reported by the company. If we assume that the timing of cash receipts and payments for inpu ts are unchanged, reported cash flow from operations will be unchanged. c. Monthly sales data based on orders written are a useful indicator of market trends and an important input for forecasting and valuation models. However sales data need to be carefu lly evaluated to ensure continuing relevance and correlation with future revenue, income, and cash flow. 5.{S}a. Under the completed contract method, reported earnings are more volatile because all recognition is delayed until completion. As a result, net income is reported only in periods when projects are completed, and depends on the number and profitability of projects completed in each period. b. With many contracts, some averaging occurs so that the volatility of firm results is not as great (al though it is still greater than under the percentage of completion method). c. When a firm has relatively few projects and uses the completed contract method, reported revenues and net income are highly variable. The volatility makes forecasting extremel y difficult. With a greater number of contracts, volatility is reduced, and forecasting is easier. The percentage of completion method, by reporting revenues and net income as earned over the 2-7 life of the project, provides better data regarding the operatio ns of the firm. However, reported cash flows are not affected by the choice of accounting method. 6.{S}(i) Under the completed contract method, no revenues or cost-of-goods-sold are recognized until completion; both are lower during the project but higher in the period when completion takes place. Their trend is highly volatile. Under the percentage of completion method, revenues and COGS are recognized as projects progress; they are higher during the project but lower at completion. The trend will reflect the overall level of activity and will be less volatile. (ii) Earnings recognition follows the same pattern as revenue recognition, as explained in (i), assuming that estimates of project profitability prove to be accurate. Under the percentage of comple tion method, revised estimates of profitability increase the volatility of income as the past over - or underaccrual of income must be offset in the period of revision. (iii)No difference between methods; operating cash flows are not affected by the choic e of accounting method. (iv) Accounts receivable will always be higher under the percentage of completion method, as that method recognizes revenue sooner, creating accounts receivable. Total current assets will also be higher as the higher level of acco unts receivable under the percentage of completion method more than offsets the higher level of inventory under the completed contract method. Long -term assets are not affected by the choice of method. 2-8 7.{S} Account Part a Part b Contracts in process This account reflects the costs actually incurred and the proportionate share of profits on those contracts for which the amount of revenue recognized exceeds payments received from customers The account is similar to accounts receivable that also reflects the excess of revenue recognized over cash payments received. Advance billings This account reflects those contracts for which payments received exceed revenue recognized. The account is similar to advances from customers. c. The company most like ly uses the percentage -of completion method. Under that method, the contracts in process account includes estimated earnings on uncompleted contracts, making it larger than under the completed contract method. As a result, it is more likely that some or a ll contracts will have an excess of contracts in process over advance billings, as illustrated in Exhibit 2 -1B on page 42. 8.{S}a. (i) and (ii) 2001: Revenue = 20% x $6 million = $1.2 million Costs incurred = 20% x $4.5 million = $.9 million. (Income recognized is $.3 million difference.) 2002: Revenue = 60% x $6 million = $3.6 - $1.2 = $2.4 million Costs incurred (cumulative) = 60% x $4.8 million = $2.88 million. As 2001 recognition was $.9 million, 2002 recognition must be $ 1.98 millio n ($2.88 - $0.9). (Income recognized is $.42 million difference, making cumulative recognition $.72 million for two years.) 2-9 b. There should be no effect; expenditures that do not contribute to the completion of the project do not affect revenue or inc ome under the percentage of completion method. 9.{S}(i) Recognition of revenue earlier than justified by GAAP accelerates the timing of recognition of accounts receivable, overstating the amount of both the current and total assets on the balance sheet. (ii) Inventories would be understated because cost of goods sold is recognized early. Both current and total assets would be understated. For profitable transactions, the early recognition of accounts receivable will exceed the effect of lower inventories o n both current and total assets, resulting in overstated net operating assets or working capital. (iii)Earlier recognition increases reported revenues. (iv) Operating profit (assuming profitable sales) would be higher as a result of higher revenues. (v) Stockholders’ equity would be higher because profit is recognized earlier than justified by GAAP. 10.{S}a. Able Baker Charlie David Sales COGS Net income $ 170,0001 85,000 $ 85,000 $ 160,0002 80,000 $ 80,000 $ 100,000 50,000 $ 50,000 $ 50,0003 25,000 $ 25,000 1 Sales = goods shipped + inventory + backorders, all measured at selling price. 2 Sales = goods shipped + inventory 3 Cash collected = sales - accounts receivable b. & c. CFO and cash balances will be identical; revenue and net income differences reflect only the choice of accounting method, not any economic differences among the companies. 2-10 11.{S}a. (i) & (ii) The patterns of income and revenue recognition are identical. Therefore, the answers to a(i) and a(ii) are identical. To maximize the present value of the bonus, you should prefer the method that recognizes revenue (and income) earlier. Thus, you should prefer the percentage of completion method to the completed contract method. The pattern of recog nition is (1/2, 1/4, 1/4) for the percentage of completion method and (1/3, 1/3, 1/3) for the installment method. Since on a cumulative basis, the percentage of completion method (1/2, 3/4, 1) dominates the installment method (1/3, 2/3, 1) it is preferred. (iii)All three methods show identical CFO patterns and you would be indifferent under the third bonus criterion. b. Over the project's life all three methods generate identical total revenue, income, and CFO. Since payment is made at completion, you ar e indifferent. 2-11 12.{M} This problem provides a good opportunity to discuss the subtleties and implications of revenue and expense recognition criteria. a. Revenue recognition is predicated on the following two criteria: (1) Collectibility of cash (2) Provision of service. Criterion (1) is satisfied as the license fee is paid in advance. The focus of the question becomes criterion (2) - provision of service. Some readers will argue that the service is only provided when the games are actually pla yed. Does this argument hold only for the revenues from the season (game)tickets themselves and not to the license fee - as the former is refundable if games aren't played (e.g., players strike) or if the team "folds." The license fee is presumably non - refundable no matter what happens. Thus, the question is whether it is reasonable to recognize the full amount of the license fee as revenue immediately. Consider what would happen if the Raptors did not sell the ticket and license fee separately but ra ther sold lifetime season tickets - i.e. one payment up front entitled the buyer to attend all games forever without additional payment. The first issue that would have to be addressed is similar to the above; i.e. what is refundable if games are cancele d? If we assume that nothing is refundable then should the team recognize the full amount as revenue immediately, even if no games are played? This would lead to the team recognizing revenues without incurring expenditures in performing the service. If one argues that revenues should be recognized pro - rata, what is the correct number of years? Remember that the tickets are sold as a "lifetime" right. Finally, if one made the pro -rata argument for this latter case, one would have to argue as to why it is different than the license portion in the case where there is a separate license and season ticket fee. 2-12 The correct accounting policy depends on the details of the season ticket plan. If the ticket buyer takes all the risk (the team could fail or be mov ed to another city) then the earnings process is complete and the license fee can be recognized immediately. If the team retains some risk (e.g. the fee is refundable if the team is sold or moved to another city) then the accounting policy must reflect tha t risk by deferring some (or all) of the license fee and recognizing it over the estimated life of the agreement. SFAC 7 (see Box 1-1 on page 11 of the text) provides a framework for this policy. b. A corporation that purchased the license would have an intangible asset (see chapter 14) with an indefinite life. For accounting purposes, therefore, it should not recognize any expense for the license fee. However, the firm should evaluate the asset annually to ensure that its “indefinite life” estimate remain s appropriate. The asset should also be evaluated annually for impairment with reference to its fair value. Assuming a market develops for the license, the fair value can be estimated using the current market prices. As suggested in the answer to part a, if the license agreement suggests that the license is likely to expire, then amortization over the estimated life would be more appropriate. c. In analyzing expected earnings, license fees for a given seat sold are a one -time event. Although licenses for other seats may be sold in future years, as capacity is fixed, in the long run revenues from license fees are nonrecurring. The long -run earnings potential depends on season ticket sales. The license fees, however, provide a valuable input in forecasti ng future season ticket sales. It is reasonable to assume that (relative to a season ticket holder without a license) there is a greater probability that a licensee will either buy season - tickets themselves or (if they are not interested) they will try to find someone to sell their license to who would be willing to buy season tickets. 2-13 Thus, the number of licensees acts as a base or threshold level for anticipated season tickets sold each year. The more licenses sold the higher the expected recurring reve nues from season ticket sales. 13.{M}a. The settlement with the Internal Revenue Service (IRS) and the reversal of previous year's writeoffs are not related to the company's 1994 performance. The IRS settlement dates back to a 1985 event and the i nterest earned thereon is related to the 1985 - 1994 period, not 1994 alone. Similarly, the $49 million reversal of pretax income is a correction of an incorrect estimate made in 1992 and 1993 and certainly does not relate to 1994 performance. If we elimin ate these amounts, after tax income would be reduced by $51 million: Elimination of IRS settlement $ 21 million Elimination of restructuring reversal* 30 $ 51 million * From the IRS settlement we estimate tax rate of (1 - $21/$33 =) 38% Therefore, $49 million equals $30 million net of tax) Adjusted Net Income = $622 - $51 = $571 Note: No adjustment is required for equity as these amounts relate to prior years and they should be incorporated in equity in those previous years. Adjusted ROE = $571 = 19.7% $2,902 If these adjustments are made then the "annual incentive award of achieving or exceeding a net income goal" would likely be reduced as net income is reduced by 8% or $51 million. Similarly, the stock options should not be issued as th e adjusted ROE of 19.7% is less than 20%. On the other hand, one might argue that the one time (after-tax) charge of $55 million should also be excluded from 1994 income. Even though the charge was taken in 1994, these charges are for staff reductions and closures to be taken in future years and do not reflect current operations. Excluding these charges: Adjusted net income = $571 + $55 = $ 626 Adjusted 1994 equity = $2,948 + $55 = 3,003 2-14 Adjusted average equity = .5 x ($2,855+$3,003)= 2,929 Adjusted R OE = $626 = 21.4% $2,929 After this adjustment, net income would be higher and ROE would be above the threshold level of 20%, entitling the CEO to the various incentives. b. These non -recurring charges should be excluded when assessing current pe rformance. The charges (often) reflect expenses of past (or future) years. Moreover, as they are subject to management discretion, they can be used to manipulate both reported performance and performance trends. However, ignoring them totally raises anoth er problem. These are real costs and management must be held accountable for them. Otherwise, management can “warehouse” and bury such recurring costs on a year - to-year basis and then clean the slate in a series of lump sum “nonrecurring” charges. This suggests that incentives should perhaps be based on both current performance ignoring noncurrent charges as well as nonrecurring charges using a measure of “average” performance taken over a few years. c. The best estimate of the level of reported “rec urring” profits and ROE would start with this year’s “recurring” level of $571 and 19.7%. Given the restructuring, one might expect future profits to increase as future employee costs will be lowered. However, the reported “recurring” levels may not pai nt an accurate picture of Monsanto’s profitability. One must not ignore the fact that Monsanto may be “warehousing” costs and periodically charging them off as “nonrecurring”. The firm’s profit levels should be adjusted downwards to reflect these periodic non- recurring charges perhaps by averaging the nonrecurring costs over a number of years. These adjusted levels should then be used to forecast future “real” profitability rather than future “reported” profitability. 2-15 14.{M}a.& b. ATT’s adjusted inc ome before nonrecurring charges is computed by adding back the non -recurring charges to reported income. 1991 1992 1993 1994 1995 Revenues $41.8 $43.0 $43.8 $46.0 $48.5 Percent change 2.67% 1.91% 5.07% 5.34% Operating income Reported $ 2.7 $ 6.2 $ 6.6 $ 7.4 $ 5.2 Special charges 3.5 0.0 0.0 0.0 3.0 Adjusted $ 6.2 $ 6.2 $ 6.6 $ 7.4 $ 8.2 1996 1997 1998 1999 2000 Revenues $50.5 $51.3 $53.2 $ 62.6 $66.0 Percent change 4.32% 1.53% 3.71% 17.62% 5.40% Operating income Reported $ 8.8 $ 7.0 $ 7.5 $ 10.9 $ 4.3 Special charges 0.0 0.0 2.5 1.5 7.0 Adjusted $ 8.8 $ 7.0 $ 10.0 $ 12.4 $ 11.3 Comparing the reported and adjusted operating income, we find that with the exception of the year 1997, the adjusted amounts follow a smoother pattern mirroring that of the revenue stream. The reported amounts however are erratic and, although the trend is upwards, the path is volatile and follows no discernible pattern (see graph on page 15). c. If our objective is t o forecast earnings power, the adjusted data appear to be more relevant. They follow a smooth trend that is consistent with that of revenues. However, the repetitive nature (the firm reported such charges in five of the ten years of data shown) of AT&T’s “non-recurring” restructuring charges indicates that the firm is engaging in smoothing/big bath behavior. The firm is storing costs and periodically charging them to earnings in order to make “recurring” operating income look better. Thus, to analyze AT&T ’s actual economic performance or future earnings power the non -recurring items must be considered and the reported operating income adjusted to better reflect future earnings power. Over the 10 - year period, nonrecurring items totaled $17.5 billion. Charging an average of approximately $1.75 billion to 2-16 each year results in the “smoothed A” line on the second graph (page 16). It is closer to the pattern implied by revenues than the adjusted operating income. 2-17 -2468101214161820 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Years -10203040506070 Reported Operating Income Adjusted Operating Income Revenues