Financial Accounting for MBAs [6 ed.] 9781618531001

Table of contents :
Cover
Title
Copyright
ABOUT THE AUTHORS
PREFACE
BRIEF CONTENTS
CONTENTS
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Module 11
Module 12
Module Appendices

Citation preview

Sixth Edition

Financial Accounting for MBAs Peter D. Easton John J. Wild Robert F. Halsey Mary Lea McAnally

To my daughters, Joanne and Stacey -PDE

To my students and my loving family -JJW

To my wife Ellie and children, Grace and Christian -RFH

To my husband Brittan and children Loic, Cindy, Maclean, Quinn and Kay -MLM

Cambridge Business Publishers FINANC IAL ACCOUNTING FOR MBAs, Sixth Edition, by Peter D. Easton, John J. Wild, Robe rt F. Halsey, and Mary Lea McAnally. COPY RIGHT© 20 15 by Camb ridge Business Publishers, LLC. Published by Cambridge Business Publishers, LLC. Exclusive rights by Cambridge Business Publis hers, LLC for manufacture and export.

ALL RIGHTS RESERVED. No part of this publication may be reproduced , distributed , or stored in a database or retrieval system in any form or by any means , without prior written consent of Cambridge Business Publishers , LLC , including , but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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Printed in the United States of Amer ica. 10987654321

ABOUT THE AUTHORS

T

he combined sk ills and expertise of Easton , Wi ld, Halsey , an d McAnally create the ideal team to author the fir st new financial accounti ng textbook for MBAs in more than a generation. Their co llec tive expe rience in awar d- w innin g teaching, co nsultin g, and research in the area of financia l accounti ng an d analysis provides a powerfu l foundation for this innovative textbook . Peter D. easton is an expert in accounting and valuation and holds th e Notre Dam e Alumni Chair in Accountancy in the Mendoza College of Business . Professor Easton 's expert ise is widely recognized by the academic research comm unit y an d by the legal comm uni ty. Professor Easton frequently serves as a co nsulta nt on accounting and va luation issues in federal and state co urts. Profe ssor Easton hold s undergraduate degrees from the Universi ty of Adelaide and the Un ivers ity of South Austra lia. He hold s a gra duat e degree from the Univers ity of New Eng land and a PhD in Business Administration (m ajo ring in accounting and finance) from the Uni versity of California, Berkeley. Prof essor Easton's research on corporate valuation has been published in the Journal of Accounting and Economics, Journal of Accounting Research, The Accounting Re view, Contemporary Accounting Research,Review of Accounting Studies, and Journal of Business Finance and Accounting. Professor Easton has serve d as an associate ed itor for 11 leading accounting journals and he is currently an assoc iate editor for the Journal of Accounting Research, Journal of Business Finan ce and Accounting, and Journal of Accounting, Auditing, and Finance . He is an editor of the Re view of AccountingStudies . Prof essor Easton has held appo intm ents at the Unive rsity of Chicago, the University of Ca lifornia at Berkeley, Ohio State University, Macquar ie Un iversity, the Australian Graduate School of Management, the University of Melbourne, Tilburg University, National Univers ity of Singapore, Seou l Nationa l University, an d Nye nrod e University . He is the recipient of numerous awards for exce llence in teaching and in research . Professor Easton regu larly teaches accounting analys is and secur ity va luat ion to MBAs. In addition, Prof essor Easton has taught manager ial accounting at the graduate leve l.

John J. WilD is a di stinguishe d professor of acco untin g and business at the University of Wisconsin at Madison. He previously held appo intm ents at Mi chigan State University and the University of Manchester in Eng land. He receive d his BBA, MS , and PhD from the University of Wisconsin. Professor Wild teaches co urses in acco untin g and analysis at both theundergraduate and graduate leve ls. He has receive d the Mabel W. ChipmanExcellence-in-Teaching Award, the departmental Exce llence- in-Teac hin g Award, and th e MBA Teaching Excellence Award (twice) from the EMBA graduatio n classes at the University of Wisconsin. He also received the Beta Alpha Psi and Sa lmonson Exce llence-in-Teaching Award from Michigan State University . Pro fessor Wild is a past KPMG Peat Marw ick National Fe llow and is a prior rec ipient of fellowships from the American Accounting Association and the Ernst & Young Foundation . Professo r Wild is an active member of the American Accounting Association and its sect ions. He has serve d on several com mitt ees of theseorganizations, including the Outstanding Accounting Educator Award , Wild man Award, National Program Advisory, Publi cation s, and Research Committees. Profe ssor Wild is author of severa l best-sell ing books . His research articles on financ ial acco untin g and ana lys is appear in The Ac counting Review, Journal of Ac counting Research, Journal of Accounting and Economics, Contemporary Accounting Research, Journal of Ac counting, Auditing & Finance, Journal of Acco unting and Public Policy, Jo urnal of Business Finance and Accounting, Auditin g : A Journal of Themy and Practice , and other accounti ng and business journa ls. He is past assoc iate ed itor of Contemporary Accounting Research and has serve d on editori al boards of severa l respected jou rnals, including The Accounting Review and the Journal of Accounting and Public Policy.

iii

iv

About

the Authors

robert F. halsey is Ma!:Y lea Mcanallv is Professo r of Accounting and the Philip Ljundahl Profe ssor of Faculty Director of the Master of Accounting and Associate Dean Science in Accounting program at for Graduate Programs at the Babson College. He receive d hi s Mays Bu siness Schoot She MBA and PhD from the Unive rsity obtained her Ph.D. from Stanford of Wisconsin. Prior to obtaining University and B. Comm. from the his PhD he wo rked as the chief U niversi ty of Alberta. She work ed financial officer (CFO) of a as a Chartered Accountant (in privately held reta iling and Canada) and is a Certified Internal manufacturing compan y and as the Auditor. Prior to arriving at Texas vice preside nt and manager of the commercial lend ing A&M in 2002, Prof essor McAnally held po sition s at di vision of a large bank. University of Texas at Austin, Canadian Na tional Railways, an d Dunwoody and Company. Professor Halsey teac hes courses in financial and manager ial accounting at both the graduate and undergraduate levels, including a popular course in financial stateme nt analysis for second year MBA students. He has also taught numerous exec utive education courses for large multinational compa nies through Babson 's schoo l ofExecutive Education as well as for a numbe r of stock brokerage firms in the Boston area . He is regarded as an innovative teacher and has been recognized for out standing teaching at both the University of Wiscon~in and Babson College. Prot essor Halsey co-au tliors Advanced Accounting published by Cambridge Business Publishers and Financial Statements: Construction, Analysis and Forecasting, an undergrad uate introductory acco unting textbook, to be published in 2014. Profe ssor Halsey's research interests are in the area of financial reporting, including firm valuation, financial statania State University Andy Garcia , Bowlin g Green State Uni,,ersity Maclean Gaulin. Rice U11il'ersity Julia Grant , Case Western Res erve University Kris Gulick, University of Iowa Karl Hackenbrack, Vanderbilt Unl\•ersity Michelle Hanlon , MIT Bob Hartman, U11iversity of Imva David Harvey , Univer.sity of Georgia Carla Hayn, University ofCalifomia-Los Angeles Frank Heflin, Florida Stare University Michele Henney , University of Oregon Elaine Henry , University of Miami Clayton Hock, Miami U11il'ersity Judith Hora , University of San Diego Herbert Hunt, Califomia Stare University-Long Beach

Richard Hurley , University ofConnecticw Ross Jennings, University ofTexas -- Austin Greg Jonas , Case Western Reserve University Sanjay Kallapur, Indian School of Business Greg Kane , University of Delaware Victoria Kaskey, Ashland University Zafar Khan , Eastern Michigan University Saleha Khumawala , University of floust o11 Marinilka Kimbro , U11iversity of Washington -Tacoma Ron King , lVashing ton U11ivel'sity Michael Kirschenhe iter , University of Illinois Chicago Krishna Kumar , George Washington University Lisa Kutcher , University of Orego11 Brian Leventhal. University of 11/inoi.r-C hicago Pierre Liang , Carnegie 1\1ellon University Joshua Livna t, New York University Barbara Lougee , Univenity of San Diego Yvonne Lu, Lehig h University Luann Lynch, University ofVirgi11ia-Darden Michael Ma ier, University of Alberta Arie l Markelevich , Suffolk University Ron Mano , Westminster College Brian McAllister , University of Colorado at Colorado Springs Bmce McClain, Cleveland State University Karen McDougal, St. Jos eph's University James McKinney , University of Mary land Greg Miller, University of Michigan Jose Miranda -Lopez , California State University -Fullert o11 Melan ie Mogg, U11iversity of Mi11nesota Steve Monahan, INSEAD John Morris, Kansas State U11h•ersity Denn is Murray , University of Colorado-De11ver Sandeep Nabar , Oklahoma Stare University Suresh Nallareddy, Columbia University Ramesh Nara simhan , Montclair State Uni,•ersity Siva Nathan, Georgia State University Ooron Nissim, Columbia U11iversity Shai l Pandit , University of Illinoi s-Chicago Susan Parker , Sama Clara University William Pasewark, Texas Tech Stephen Penman, Columbia University Mark Penno, University of 101,, va Gary Peters , University of Arka11sas Kathy Petroni , Michigan State University Christine Petrovits , New York University Kirk Philip ich, University of Mi chigan- Dearbom Morton Pincus , University ofCalifomia-lrvine Kay Poston , University of Indianap olis Grace Pownall, Emor y U11il'el'sity David Randolph , Xa vier University Laura Rickett, Ke/11State University Susan Riffe , Southern Methodist University

Bruce Samuelson, Pepp erdine University Diane Satin , California State Unl\•ersity -- East Bay Shahrokh Saudagaran , University of WashingtonTronto Stock Exchange. The Compan y operates in Western and Atlantic Canada, the United States and the Asia Pacific Region with upstream and downstream business segments. The compan y uses IFRS to prepare its finan cial statements. During 20 12, the compan y reported depreciation expense of $2,583 million. The property and equipment footnote follows.

Property, Plant and Equipment ($ millions)

Oil and Gas Properties

Cost December 31, 2011 . . . . .. . . . . . . . . . . . . . . . Addit ions . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . Aquisitions . . . . . . . . . . . .. . . . . . . . . . . . . . . . Transfers from exp loration and evaluation . . . . Changes in asset retirement ob ligations . . . . . Disposa ls and derecognition ............ .. Exchange adjustments . . . . . .. . . . . . . . . . . . .

$33,640 3,971 16 198 1,097 (76) (20)

$ 930 53

$38,826

$ 981

December 31 , 2012 . . . . .. . . . . . . . . . . . . . . .

Processing, Transportation and Storage

(2)

Upgrading $1,972 47

(13)

. . .. . . . . . . . . . . . . . . ... . . .. . . . . . . . . . . . . . . ...

$ 17,740 20,879

$2,176 146

(7 1)

29 (127) 1

(93)

Total $43 ,634 4 ,566 16 198 1,040 (210) (112)

$2,006

$5,094

$2,225

$49 ,132

$ (848) (102)

$(1,046) (241) 3 24

$(1,154) (103) 124

$(19 ,355) (2,583) 176 29

$(443)

$ (950)

$(1,260)

$(1,133)

$(21,733)

$523 538

$1,124 1,056

$3,870 3,834

$1,022 1,092

$24 ,279 27,399

---

Net book value December 31, 2011 December 31 , 2012

$4,916 349

Retail and Other

(7)

Accumulated depletion , depreciation, amortization and impairment December 31, 2011 . . . . .. . . . . . . . . . . . . . . . $(15,900) $(407) Depletion, deprec iation and amort ization . . . . . (2,101) (36) Disposa ls and derecognition ............ .. 49 Exchange adjustments . . . . . .. . . . . . . . . . . . . 5 Decembe r 31 , 2012 . . . . .. . . . . . . . . . . . . . . . $(17,947)

Refining

Husky Energy (HSE)

---

Required a . Comput e the estimated useful life of Husky Energy 's depreciable assets at year-end 20 12. Ass ume

6-55

Module

6 I Re porting an d Analyzing Oper at ing A ssets

b. Estimate the percent used up of Husky Energy's depreciable assets at year-end 2012. How do we interpret this figure? c. Husky Energy increase d total PPE by $1 ,097 million for asset retirement obligation related to Oil and Gas Propert ies. Explain in layman's terms what this represents . d. Est.imate the effect that the asset ret.irement obligation had on depreciat.ion expen se for Oi l and Gas Properties for 20 I 2. 16-46. Schneider Electric

Computing and Evaluating Receivables, Inventory and PPE Turnovers (L01, 2, 3) Schneider Electric is a multination al eneigy company headquartered in Rueil-Malma ison, France . Selected balance sheet and income statement information for 2010 through 2012 follows .

(€ in millions)

Sales

2010 . . . . . . . . . . .. . €19 ,580 201 1 . . . . . . . . . . .. . 22,345 2012 . . . . . . . . . . .. . 23,946

Cost of Good s Sold

Trade Receivables

Inventories

Plant, property , and equipment, net

€11 ,842 13,958 14,889

€4,44 1 5 ,402 5 ,289

€3 ,139 3 ,349 3 ,090

€2,337 2,573 2,622

Required a . Comput e the rece ivables, inventory, and PPE turnover ratios for both 20 1I and 20 12.

b. What changes are ev ident in the turnover rates of Schneider Electric for these years? c . Discuss ways in which a compan y such as Schneider Electric can improve receivables, inventory, and PPE turno ver ratios. 16-47. Unilever UnileverN.V. UnileverPLC

Analyzing an d Int er pr et ing Re ceivabl es, I nventor ies, and R elat ed R atio s (L01 , 2) Unilever is a dual-listed compan y consisting of Unilever N.V. in Rotterdam, Netherlands and Unilever PLC in London , UK. Both Unilever companies have the same directors and effectively operate as a single business. Following is the current asset section of Unilever 's balance sheet.

2012

2011

Inventories . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . ... . . . . . . . . . Trade and other current receivab les . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . Current tax assets . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . Cash and cash equivalents . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . Other f inancial assets . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . Non-current assets held for sale . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . .

€ 4,436 4,436 217 2,465 401 192

€ 4,601 4,513 219 3,484 1,453 21

Total current assets . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . .. .. . . . . . . . .

€12 ,147

€ 14,291

2012

2011

Curr ent Assets (€ million)

Trade a nd Other Current Rec eivables (€ million) Due within one yea r Trade receivables . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . Prepayments and acc rued income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . Other receivab les . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . .

€2 ,793 549 1,094

€2 ,897 59 1 1,02 5

€ 4,436

€ 4,513

Aging of Trade Receivables (€ million)

2012

Total trade receivab les . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . ... . . . . . . Less impairment provision for trade receivables . . . . . . . . . . . . . . . . . . . . . .

€ 2,916 (123)

€3 ,013 {116)

€ 2,793

€2,897

€2,473 236 80 48 79 (123)

€2,505 300 72 52 84 (116)

€ 2,793

€ 2,897

Of which: Not overdue . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . Past due less than three months . . . . . . . . . . . . . . .. . . . . . . . . ... . . . . . Past due more than three months but less than six months . . . . . . . . . . . Past due more than six months but less than one year . . . . . . . . ... . . . . Past due more than one year . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . Impa irment provision for trade receivables . . . . . . .. . . . . . . .. . . . . . .. . . .

2011

Modul e 6 I Reporting and Analyz ing Operating Assets

6-56

Required a. What are Unilever 's gross trade and other current receivables at the end of 2011 and of 2012?

b. For both 2011 and 2012, compute the ratio of the allowance for unco llectible accounts to gross receivab les . What trend do we observe? c. The company reported net sales of €51,324 in 2012. Compute the receivab les turnover ratio and the average collection period for 2012 based on gross receivables computed in part a. d. The company reported cost of sales of €30 ,703 in 2012. Compute the inventory turnover and the average inventory days outstanding for 2012. 16-48.

Anal yzin g and Int er pr etin g Op eratin g Asset Rati os (L01 , 2, 3) Canadian 1ire Corporation, Limited operates retail stores in Canada that sell genera l merchand ise, clothing, and sporting goods. The company offers everyday products and services to Canadians through more than 1,700 retai l and gasoline outlets from coast-to-coas t. Canadian Tire uses IFR S, and the asset side of the 2012 balance sheet is as follows: In Millions of CDN Dollars

2012

2011

.. .. .. .. .. .. ..

$ 1,015.5 168.9 750 .6 4,265 .7 1,503 .3 39.1 5.5

$ 325 .8 196.4 829 .3 4,081 .7 1,448.6 44 .3 30.5

.

7,748.6

6,956 .6

.. .. .. .. .. ..

681.2 182.7 1,089 .9 95.1 3,343.5 40.4

668.9 128 .2 1,110 .0 72.4 3,365 .9 36.8

Total assets . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . .

$13, 18 1.4

Cash and cash equivalents . . . .. .. . .... . . . Short-term investments . . .. . . . . . . . . . . . . . . Trade and other receivables . . . . . . . . . . .. . . . Loans receivable . . . . . . . . .. . . . . . . . . . . . . . Merchandise inventories . . . . . . . . . . . . . .. . . Prepaid expenses and deposits . . . . . .. . . . . . Assets classified as held for sale . .. . . . . . . ...

........ .. ... . . . ........ . .. . . . . . . . ... . . . ........ . . . . . ..

.. .. .. .. .. .. ..

.. ... .. .. ... .. ..

.. . ... . . . . . . . . .. . . . .. . . . . ... . . . . . . . .. . . .. . . . . . . . .......... .. .. .. .. ..

Total current assets . . . .. . . . . . . . . . . . . . . . . .. . . . . . ... . . . . . .. . ..... Long-term receivables and other assets . . . . . .. ... . . . Long-term investments . . . . . . .. . . . . . . . . . . . . . . . .. . Goodwil l and intang ible assets . . ... .. . . . . . . . . . . . . . Investment property .. . . . . . . . . . . . . . . .. . . . . . . . . . . . Property and equipment. .. . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . ..

.. .. .. .. .. ..

... .. .. .. .. ..

. .. .. .. .. ..

. . . .. . . . ........ ........ . ... . . . . . . .. . . . . ........

Canadian Tire

$12,338.8

Required a. Compute inventory turnove r and average inventory days outstanding for 2012(2012 cost of goods

b. c.

d.

e.

16-49.

sold is $7,929 .3 million). Comment on the level of these two ratios. Is the leve l what we expect given Canadian Tire's industry? Explain. GAA P allows for FIFO, LIFO, and average cost inventory costing methods . How does IFRS differ? In periods of rising prices , how will net income be affected under the diffe rent inventory costing methods? Compute the accounts receivable turnove r for 20 12. The 2012 sales were C$ 1l ,427 .2 million and 2011 sales were C$ l 0,387 . I million . Compute the days ' sales outstanding for both years . Compare the two and determine which year has better accounts receivab le efficiency. (Hint: Use trade and other receivab les in the ratios.) During 20 12, the company recorded depreciation expense of C$335 . 1 million . Footnotes reported accumu lated depreciation on PPE of C$2, 118.6 million, and cost of land and construction in progress of C$744.3 million and C$ 102.3 million respectively. Compute PPE turnover, average useful life, and percent used up for 2012.

Analyzin g and Interpr etin g O peratin g Ratios (L01 , 2, 3) Headquar tered in Bella vista , NSW, Woolworths Limited is the large st retail company in Austra lia anctW00 New Zea land by market capitalization and sales. The company is the laigest food retailer, liquor retailer and the largest hotel and gam ing poker machine operator in Austra lia. The company emp loys over 200,000 people.

1worths Limited

6-57

M o dule

6 I Reporting and Analyzing Operat ing Assets

(AUS$ millions)

2012

2011

. . . .. . . . . . . . . . .. . . . . . . . . . . . . . .... . . . . . . . . . . ... . . . . .. . . . .

$ 833.4 869.9 3,698.3 23.8

$ 1.519.6 856 .1 3,736 .5 120.8

Assets classified as held for sale . . . . . . . . ... . . . . .. . . . . . . . . . . . . . . . . .

5,425.4 376 .7

6,233.0 93.9

Current assets Cash . . . . . . . . . . . . .. . . . . . . Trade and other receivables . . Inventories . . . . . . . .. . . . . . . Other f inancia l assets . . . . .. .

.. .. .. ..

.. ... .. ..

.. . .. ..

.. .. .. ..

. .... . ...... . .. . . . ......

. . . . ... . ........ . ... . . . . .... . . . .

Total current assets . .. . . . . . . . . . . . . . . .. . . . . ... . . . . . ... .. . . . . . . . .

Trade and Other Receivable s (AUS$ millions)

Current Trade receivables . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . Other receivables . . . . . . . .. . ... . . . . . ... . . .. . . . . . . . . . . . . . . . .. . . . . Prepayments . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . ......... ..

---

---

$5,802. 1

$6,326 .9

2012

2011

$218.0 385.3 266.6

$196.6 426.5 233 .0

$869.9

$856.1

Trade receivables are presented net of impairment allowance. Impairment provision balance as at 24 June 2012 was $13 .3 million. 2012

Property , Plant and Equipment (AUS$ millions)

Development propert ies, Non-current At cost . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated depreciation . . . . .. . . ... . . . . . ... . .. . . . . . . . . . . . .

Freehold land, warehouse, retail and other propert ies At cost . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . Less: accumulated depreciation . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . .

2011

$ 1,415 .9 $ 1,576.3 (7.5) (12.9) 1,408.4

1,563.4

2,839.0 (138.8)

1,638 .5 (91.3)

2,700.2

1,547 .2

2,270.3 {917.0)

2,080 .8 (802.9)

1,353.3

1,277.9

. . . . . ... . .

10,702.6 (6,575 .5)

10,321 .2 (6,089.4)

4, 127. 1

4,231.8

book value . . .. . . . . . . . . . . . . . .

$ 9,589 .0

$ 8,620.3

Leasehold improvements At cost . . . . . . . . . .. . . . . . . . . . . . .... . . . . . . .. . . . . . . .. . . . . . . . . . . . . Less: accumulated amortisation . . .. . . . . . . . . . . . . . . . .. . . . . ... . . . . . .

Plant and equipment

At cost . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . ... . . . . . .. . . . . . . . . . . . Less: accumulated depreciation . . . . .. . . . . . . . . . . . . . . ....

Total property, plant and equipment-net

During 2012, the company reported total revenue from sale of goods of $55, 129.8 million and cost of goods sold of $40,792.4 million. Deprec iation expense on property, plant and equipment was $894.8 million . Required a. What amount does Woolworths expect to collect from its trade customers?

b. What are Woolworths's gross accounts from its trade customers? c. Determine the number of days it took Woolworths to collect from its trade customers during 20 12. Does the figure computed make sense? Why or why not? d. Compute inventory turnover for 2012. Given the narure of the company ' s operations, does this ratio make sense? e. What is the gross amount and tota l accumulated depreciation and amortization of property , plant and equipment reported on the balance sheet in 20 12? f Compute PPE turnover for 2012. Explain in layman ' s terms what this rat.io represents. g. Compute percent used up and useful life of the company's PPE .

Module

6 I Reporting and Analyz ing Operating Assets

MANAGEMENT MA6-50.

6-58

APPLICATIONS

Managing Operating Asset Reduction (L01, 2, 3) Return on net operating assets (RNOA = NOPAT/Average NOA, see Module 4) is commonly used to evaluate financial performance. If managers cannot increase NOPAT, they can still increase this return by reducing the amount of net operating assets (NOA) . List specific ways that managers cou ld reduce the following assets:

a. Receivables b. Inventories c. Plant, property and equipment

MA6-51. Eth ics and Governance: Managing the Allowance for Uncollectib le Accounts (L01) Assume that you are the CEO of a publicly traded company . Your chief financial officer (CFO) informs you that your company will not be able to meet earnings per share trugets for the current quarter. In that event, your stock price will likely decline. The CFO proposes reducing the quarterly provision for uncollectible accounts (bad debts expense) to increase your EPS to the level analysts expect. Th is will result in an allowance account that is less than it should be. The CFO exp lains that outsiders cannot easily detect a reduction in this allowance and that the allowance can be increased next quarter. The benefit is that your shareho lders will not experience a decline in stock price. a. Identify the parties that are likely to be affec ted by this proposed action . h. Ho w will reducing the provision for uncollectible accounts affect the income statement and the

balance sheet? c. How will reducing the provision for uncollectible accounts in the current period affect the income

statement and the balance sheet in a furure period? d. What argument might the CFO use to convince the company's externa l auditors that this action is justified? e. Ho w might an analyst detect this earnings management activity? f How might this action affect the moral compass of your company? What repercussions might this action have?

ONGOING

PROJECT

(This ongoing pmject began in Module 1 and continues thmugh most of the hook; even if p1evious segments were not completed, the requirements are still applicable to any business analysis.) 1. Accounts Receivable Th e followi ng provides some guidance for analyzing a company's accounts receivable. Are sales primarily on credit or is a typical sale transacted in cash? Consider the industry and the companies' business model. What is the relative size of accounts receivable? How has this changed over the recent three-year period? How large is the allowa nce for doubtfu l accounts? Determine the balance relative to gross accounts receivable. What did the company record for bad debt expe nse? Compute the commo n size amount. Compute accounts receivable rurnover and days sales outstanding for all three years reported on the income statement. One will need to obtain addit.ional balance sheet information to be able to compute average balances for the denominato r. Consider the curre nt economic environment and the companies' competitive landscape. Would one expect collection to have s lowed down or sped up during the year? Does the company have any large customers that increase the company's credit risk? For each point of analysis, compare across companies and over time. The goal is to determine whethe r each company's accounts receivable (levels and changes) seems appropriate and to gauge the quality of the receivab les . 2. Inventory The following provides some guidance for analysis of a company's inventory. What is inventory for the company? Does the compa ny manufacture inventory? What proportion of total inventory is raw materials? Work in process? Finished goods? Compa re the two compan ies' inventory costing methods. Adjust LIFO inventory and cost of goods sold if necessary. Is the LIFO reserve significant? Estimate the tax savings associated with LIFO costing method. (Use the adjusted COGS and inventory figures for a ll calcu lations and ratios.)

6-5 9

Module

6 I Reporting and Analyzing Operat ing Assets

What is the relative size of inventory? How has this changed over the recent three-year period? Compute inventory turnover and average inventory days for all three years reported on the income statement. Compute gross margin in percentage terms. Conside r the current economic environment and the companies' competitive landscape. Can we explain any changes in gross profit levels? Have costs for raw materia ls and labor increased during the year? Have sales volumes softened? What has happened to unit prices? Read the MD&A to determine senior management's take. Does the company face any inventory related risk? What has been done to mitigate this risk? Read theM D&A. For each point of analysis, compare across companies and over time. 3. Plant Assels The following provides some guidance to the companies' long-term (fixed) assets. Are fixed assets significant for the companies? What proportion of total assets is held as fixed assets (PPE)? What exactly are the companies' fixed assets? That is, what is their nature? Compare the two companies' depreciation policies. Do they differ markedly? What is the relative size of fixed assets? How has this changed over the three-year period? Did the company increase fixed assets during the year? Was the increase for outright asset purchases or did the company acquire assets via a merger or acquisition? Compute PPE turnover for all three years reported on the income stateme nt. Compute the average age of assets and percentage used up. Are any assets impaired? Is the impairment charge significant? Is the impairment specific to the company or is the industry experiencing a downturn? For each point of analysis, compare across companies and over time .

Mid-Module

Review

1

Solution 1. AsofDecember31,2012:

Current . . . . . . . . . . . . . . . . . . . . . . . . . $468,000

x x

1%

$ 4,680

1-60 days past due . . . . . . . . . . . . . . .

244,000

61-180 days past due . . . . . . . . . . . . .

38,000

X

15%

5,700

Over 180 days past due . . . . . . . . . . . .

20,000

X 40%

8,000

Amount required . . . . . . . . . .. .. ....

.

Unused allowance balance . . . . . . . . . Provision . . . . .. . . . . . . . . . . . . . . . .. .

5%

12,200

---

30,580 7,000 $23,580

2012 bad debts expense

2. Curre nt assets section of balance sheet: Accounts receivable, net of $30,580 in allowances . . .

$739,420

3. The infotmation here revea ls that the HP subsidiary has marked ly increased the percentage of the allowance for uncollectib le accounts to gross accounts receivable; from the historical 2% to the current 4% ($30,580/$770,000). There are at least two poss ible interpretations: a. The qua lity of the HP subsidiary!; receivables has declined. Possible causes include the following: ( I) Sales have stagnated and the company is selling to lower-quality accounts to maintain sales volume; (2) It may have introduced new products for which average credit losses are higher; and (3) Its administration of accounts receivable has become lax. b. The company has intentionally increased its allowance account above the level needed for expected future losses so as to reduce current-pe riod income and "bank" that income for future periods (income shifting).

Modul e 6 I Reporting and Analyzing Operat ing Assets

Mid-Module

Review

6-60

2

Solution

Preliminary computation: Units in ending inventory = 4,800 availab le - 2,800 sold = 2,000 1. First-in, first-out (FIFO) Cost of goods sold computation:

Units

Cost

1,000

@

$18.00

1,800

@

$18.25

32,850

~---

2,800 Cost of goods available for sale . . . . . . . . . . . . .. . Less: Cost of goods sold . . . . . . . . . .. . . . . . . . . . Ending inventory ($22,800

+ $14,800) . . . . . . . . . .

Total

$18,000

$88,450 ,.____ 50,850 ...

-; $50 ,850

__,

$37,600

2. Last-in, first-out (LIFO) Cost of goods sold computation:

Units @

$19.00

$22,800

800

@ @

$18 .50 $18 .25

14,800

800

14,600

2,800

.-----

Cost of goods available for sale. . . . . . . . . . . . . . . Less: Cost of goods sold. . . . . . . . . . . . . . . . . . . . Ending inventory ($18,000

Total

Cost

1,200

+ [1,000

x $18.25]). . .

$88,450 52,200 ... ,._ ___

$52,200

__.

$36,250

3. Average cost (AC) Average unit cost Cost of goods sold Ending inventory

= $88,450/4,800 units = $18.427 1 = 2,800 x $18.427j = $51,596 = 2,000 x $18.427 = $36,854

4. a.FIFO is no1mally the method that most close ly reflects physical flow. For examp le, FIFO would apply to the physica l flow of pe1ishab le units and to situations where the earlier units acquired are moved out first because of risk of deteriora tion or obso lescence . b. LIFO results in the highest cost of goods sold during periods of rising costs (as in the HP subs idiary case); and, accordingly, LIFO yields the lowest net income and the lowes t income taxes . 5. Last- in, first-out with LIFO liquidation Units 800 1,800 200

Cost of goods sold computation:

2,800 Cost of goods available for sale (Beginning inventory + Purchase #1 + Purchase #2) . . . . .. . ... . . Less: Cost of goods sold . . . . . . . . .. . . . . . . . . ... . . . . . . Ending inventory (800 X $18) . . . . . . . . . . . . . . . . . .....

..

@

Cost $18.50 $ 18.25 $18.00

s

@

@

Total $14,800 32,850 3,600

$51,250

$65,650 5 1,250 $14,400

The company's LIFO gross profit has increased by $950 ($52 ,200 - $5 1,250) because of the LIFO liquidation. The reduction of invento ry quant ities matched older (lower) cost layers against curren t sell ing prices . The company has, in effect, dipped into lower-cost layers to boost current-period profit- all from a simple delay of inventory purchases.

6-61

M o dule

6 I Reporting and Analyzing Operat ing Assets

Module-End

Review

Solution

b.

I. a . Straight-line depreciation expense = ($95,000 - $ I 0,000)/5 years = $17,000 per year Double-decli ning-ba lance (note: twice straight-line rate = 2 X [100%/5 years] = 40 %) Net Book Value x Rate

Year 1 . . .. . . . .

2 . . .. 3 . . .. 4 . . .. 5 . . ..

.... .... .... ....

($95,000 ($95,000 ($95,000 ($95,000

-

$95,000 $38,000) $60,800) $74,480) $82,688)

X

X X X X

0.40 0.40 0.40 0.40 0.40

= = = = =

Depre ciation Expense

Accumulated Depreciation

$38,000 22,800 13,680 8,208 2,312*

$38,000 60,800 74,480 82,688 85,000

'The formula value of $4,925 is not reported for Year 5 because doing so would depreciate the asset below the estimated salvage value; only the $2,312 needed to reach salvage value is deprec iated.

2.

The HP subsidiary reports the equ ipment on its balance sheet at its net book value of $44 ,000. Equipment, cost . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . .... . Less accumulated depreciation ($17,000 x 3) . . . . . . . ... .

$95,000 51,000

Equipment, net (end of Year 3) . . . . . .. . . . . . . . . ... . ....

$44,000

.

3. The estimated usefu l life is computed as: Deprec iable asset cost/Depreciation expense = $95,000/ $ 17,000 = 5.6 years. Because companies do not usua lly disc lose salvage values (not requ ired disc losure), the usefullife estimate is a bit high for this asset. Th is estimate is still informative because compan ies typically only provide a range of useful lives for depreciab le assets in the footnotes . The percent used up is computed as: Accumu lated deprec iat ion/ Depreciab le asset cost = $51,000/ $95,000 = 53.7% . The equipment is more than one-ha lf used up at the end of the th ird year. Again , the lack of know ledge of salvage value yields an underestimate of the percent used up. Still, this estimate is usefu l in that we know that the company ' s asset is over one-half used up and is likely to require rep lacement in about two years (estimated as less than one-half of its estimated usefu l life of 5.6 years). Th is replacement will require a cash outflow or fina ncing and should be cons idered in our projec tions of future cash flows . 4. The equipment is impaired since the und iscounted expected cas h flows ($40,000) are less than the net book value of the equipment ($44,000) . The HP subsidiary must write down the equ ipment to its fair value of $36,000. The effect of this write-down is to reduce the net book value of the equ ipment by $8,000 ($44,000 - $36,000) and recognize a loss in the income statement . 5. The HP subsidiary must report a gain on this sale of $6,000, computed as proceeds of $50,000 less the net book va lue of the equipment of $44,000 (see part 2) .

Module

Reporting and Analyzing Nonowner Financing Learning

Objectives

L01

Describe the account ing for current operating liabilities, including accounts payable and acc rued liabilities. (p. 7- 4)

L02

Describe the account ing for current and long- term nonoperating liabilities. (p. 7- 10)

L03

Explain how credit ratings are deter mined and identify thei r effect on the cost of debt. (p. 7-21)

Verizon Communications, Inc, began doing business in 2000, when Bell Atlantic Corporation merged with GTE Corporation . Verizon is one of the worlds leading provid-

In the early 2000s, the Internet frenzy had cooled and Verizon's stock price had plunged, fa lling from an all-time high of $70 in late 1999 to $27 in mid-2002. Since then, the stock has risen to over $50 per share (see chart below). Verizon survived the Internet and telecom downturn. Now it faces a formidable new challenger: cable. Cable companies spent billions upgrading their infrastructure to

ers of communications services. It is the largest provider of wireline and wireless communications in the U.S. , and is the largest of the "Baby Bells" as of 2012 with over $115 billion in revenues and $225 billion in assets.

$55

I

Verizon Stock Price

~

- j

k'v ~

11 '

'

2009

V""

'

f\

6,

, '

"'" '

-

'

2010

l

~ '

j#

-, ,. ... ..... ... ' ....

I~

'

"~

....,,.

$45 $40 $35

r '

$50

$30

' '

'

2011

'

'

'

'

2012

'

'

'

'

2013

'

'

$25 $20

offer customers discounted bundled packages of local voice , high-speed Internet connections, and video . MaF ket analysts estimate that cable companies could capture a quarter of the local voice market over the next decade as they deploy new voice over Internet protocol (VOiP) technology. While \erizon and the other traditional phone companies see their market positions erode, they also struggle to retain their image as innovators. They face ceative pre& sures fiom reseaichers and from companies who continue to develop new wireless technologies . Competitors are rushing to build networks to deliver TV service and high-speed broadband access and \erizon is spending billions to roll out its FiOS phone , data , and video network to give its customers faster Internet service and an alternative to cable. Indeed, over the past three years, Verizon has spent nearly $50 billion on capital expenditures. The demand for new capital spending is com ing at an inopportune time. Verizon is currently saddled with a debt load of over $51 billion as of 2012 (one-third of which matuies

over the next five years) and emp loyee benefit ob ligations of over $34 billion. It is also paying over $5 bill ion in dividends annually. This module focuses on liab ilities ; that is, short-term and long-term obligations. Liabilit ies are one of two financing sources for a company. The other is shareholder financing. Bonds and notes are a major part of most companies' liabilities . In this module , we show how to pr ice liab ilities and how the issuance and subsequent payment of the principal and interest affect financial statements . We also discuss the required disclosures that enab le us to effective ly analyze a company's abil ity to pay its debts as they come due. Verizon is now working harder than ever to transform itself in an era of fiber optics and wireless communication. The dilemma now facing lkrizon 's management is how to allocate available cash flow between strateg ic investment and debt payments.

Source: Veriz on 2012 10-K and 2012 Annual Report to Shareholders.

7-3Modu

le 7 I Report ing and Analyzing Nonowner

MODULE ORGANIZATION

Financ ing

Reporting and Analyzing Nonowner Financing

Long- Term Liabilities

Current Liabilities

Credit Ratings

•

Accounts Payable

•

Pricing and Issuance

•

Levels of Credit Ratings

•

Accrued Liabilities

•

Interest Expense

•

Criteria Used in Setting Ratings

•

Nonoperating Current Liabilities

•

Gains and Losses on Retirement

The accounting equation (Assets = Liab ilities + Equity) is a useful tool in helping us think about how the balance sheet and income statement are constructed, the linkages among the financial statements, and the effects of transactions on financial statements. The account ing equation is also useful in helping us think about the statements from another perspective, namely, how the business is financed. Consider the following represen tation of the accounting equation:

Assets

L..r Uses of funds

=

Liabi lities + Equit y

=

Sources of fund s

Assets represent inve stmen ts (uses of fund s) that mana ge ment has mad e. It includ es current opera ting assets such as cas h, accounts rece ivab le, and inventori es . It also includ es long-term operating assets suc h as manufa cturing and admini strative faciliti es. Mo st compan ies also inves t funds in nonoperating assets (mark etable securiti es) that pro vide the liquidit y a compan y needs to con duct tran saction s and to react to mark et opportunities and changes . Ju st as asset di sclosures pro vide us with information on where a co mp any in ves ts its funds, its liability and equ ity di sclos ures inform us as to how tho se assets are finan ced. The se are the sources of fund s. To be successfu l, a co mpan y mu st not on ly inves t fund s wisely, but must also be astut e in the manne r in which it rai ses fund s. Comp anies strive to finan ce their assets at the lowest possible cost. Current liabiliti es (such as acco unts paya ble and accrued liabiliti es) are ge nerall y non-interest-bearing. As a result , compan ies try to maximi ze the financin g of their assets with these sour ces of funds. Cu rrent liabiliti es , as the name impli es, are short -term in natur e, generall y requ iring paym ent within the comin g year. As a result, they are not a suitab le source of fund ing for long-term assets th at ge nerat e cas h flow s over severa l yea rs. Instead , companies often financ e long-te rm assets with long-term liabilit ies th at requir e payment s over severa l yea rs. Genera lly, compani es try to link the pattern of th e cas h outflows of the finan cing sourc e with the cas h inflo ws of the rel ated asset. As such, long-term finan cing is usually in the form of bond s, notes, and stoc k issuances . When a company acqui res assets , and finances them with liabilit ies , its financial levera ge increases . Also, th e requir ed liability payment s increase proportionally with the leve l of liabi lities, and tho se large r paym ents imply a higher prob ability of default shou ld a downturn in business occ ur Gr eater leve ls of liabiliti es, then, m ake the comp any riskier to inves tors who, conseque ntly, demand a higher return. Assess ing the appropriate leve l of liabilit ies is part of liquidit y and solve ncy analys is. Thi s modul e desc rib es and ana lyzes on-ba lance-sheet financing , n amely current and noncurrent liabiliti es that are report ed on finan cial stat em ents. If comp anies can find a way to purch ase assets and have neither the asset , nor its related financing , appear on the balanc e sheet, they can repo rt higher leve ls of asset turnover and appear less risky. This creates off-ba lance-s heet financing, which is the focu s of Modul e 10.

Module 7 I Reporting and Analyzing NonownerFinancing

CURRENT

7-4

LIABILITIES

Current liabilities consist of both operating and nonop erat ing liabilities . Most current operating liabilities LO 1 Describe such as those related to inventory (account s payable) or to utilities, wages, insurance, rent , and taxes (ac-the accounting for crued liabiliti es), impact operating expenses such as cost of goods sold or selling, genera l and adminis tra-curren t operating tive expenses . Current nonoperating liabilities compr ise short-term bank notes or the current portion ofliabilit ies, including long-term debt. Verizon's balance sheet from its 20 12 10-K reports the following current liabiliti es: accounts payable and accrued liabilities. At December 31 ($ millions)

______

Debt maturingwithinone year . . . . . . . . . . . . . . . . . . . . Accounts payable and accrued liabilities............ Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Totalcurrent liabilities.. . . . . . . . . . . . . . . . . . . . . . . . . .

2012

$ 4,369 16,182 6,405 $26,956

2011 $ 4,849 14,689 11,223 $30,761

Verizon report s thr ee categor ies of curr ent liabilities: (I) long -term debt obligations th at are scheduled for paym ent in the upcomin g year, (2) accounts payabl e and accrued liabiliti es, and (3) other current liabiliti es, which consist mainly of custom er depo sits , di vidend s paya ble, and misce llaneou s obligations. Analysi s and interpretation of the return on net operating assets (RNOA) requires that we separate current liabiliti es into opera ting and nonopera ting components. In general, these two components consist of the followin g: 1. Current operating liabilities

• Accounts payable Obligations to others for amounts owed on purcha ses of goods and services; these are usuall y non-int erest-bearing. • Accrued liabilities Obligations for which there is no related external transaction in the current period. These include, for exam ple, accruals for employee wages earned but yet unpaid, accruals for taxes (usually quart erly) on payroll and current period profits, and accrua ls for other liabi lities such as rent, utilities, and insurance. Compani es make accruals to properl y reflect the liabiliti es owed as of the finan cial statement date and the expenses incurred for the period. On e diff erence between accounts paya ble and accrued liabilitie s is that an invo ice has not been received, nor is often expected, for the latter. • Unearned revenue Obligations to provide goods or services in the com ing year; these arise from customers' deposits, subscription s, or prepayments. 2. Current nonoperating liabilities • Short-term interest-bearing debt Short-term bank borrowin gs and not es expec ted to mature in whole or in part during the upcoming year; this item can includ e any accrued interest payable. • Current maturities of long-term debt Lon g-term borrowings that are scheduled to m ature in whole or in part durin g the upcoming year; this current portion of long-term debt includes maturin g principal payment s only. The rem ainder of this section describes, analyzes and interprets current operating liabiliti es followed by a discussion of current nonopera ting liabilities .

Accounts

Payable

Accounts payab le arise from the purchase of goods and services from others . Accounts payable are normally non -interest-bearing and are, thus, an inexpensive financing source. Verizon does not break out account s payable on its balance sheet but, instead , reports them with other accruals . It reports $ 16,182 million in accounts payable and accrued liabiliti es in 20 12, and $14,689 million in 2011. The footnot es revea l th at accounts paya ble represent $4 ,740 million in 2012, and $4,194 million in 20 11, or about ?Q01,.,"f

thP tnt~I

P~r h

\lP~r

7-5

Module

7 I Reporting and Analyz ing Nonowner

Financ ing

The following financial stateme nt effects template shows the accounting for a typical purchase of goods on credit and the ultimate sale of those goods . A series of four connecte d transact ions illustrate the revenue and cost cycle . Balance Sheet Transaction INV

100

AP

100 INV

100

I AP

I AR Sales

100

140 140

AR 140

I

Sales

I

140

100

COGS

INV

100 COGS

100

I INV

I

100

140

Cash

AR

140 Cash

140

I AR

I AP

140

100 100

Cash

AP 100

I

Cash

I

100

Cash Asset

+

Liabilities

Noncash Assets

+

Income Statem ent Contrib. + Capital

Earned Capital

"

Revenues

1. Purchase $100 inventory on credit

Inventory

2a. Sell inventory on credit for $140

+ 140

+ 140

+ 140

Accounts Receivable

Retained Earnings

Sales

2b. Record $100 cost of inventory sold in 2a

Inventory

3. Collect $140 on accounts receivab le 4. Pay $100 cash for accounts payab le

+ 100

=

+ 100

- 140

Cash

Accounts Receivable

- 100

+1 00 Cost of Goods Sold

- 100

= - 100

:

+ 140

Retained Earnings

:

- 100 Cash

"'- Net Income

=

Accounts Payable

- 100

+ 140

Expenses

=

Accounts Payable

The financial statement effects template reveals several impacts related to the purchase of goods on credit and their ultimate sale. 1.

Purcha se of inventory is reflected on the balance sheet as an increase in inventory and an increase in accounts payable. 2a. Sale of inventory involves two components -r evenue and expense. The revenue part reflects the increase in sales and the increase in accounts receivable (revenue is recognized when earned, even though cash is not yet received). 2b. The expense part of the sales transaction reflects the decrease in inventory and the increase in cost of goods sold (COGS). COGS is reported in the same income statement as the related sale (this expense is recognized because the inventory asset is sold, even though inventory-related payables may not yet be paid). 3.

4.

Collection of the receivab le reduces accounts receivab le and increases cash. It is solely a balance sheet transaction and does not impact the income statement. Cash payment of accounts payable is solely a balance sheet transaction and does not impact income state ment acco unts (expense relating to inventories is recog nized when the inventory is sold or used up, not when the liability is paid).

Accounts

Payable

Turnover

(APT)

Inventories are financed , in large part , by accounts payable (also called trade credit or trade payables). Such paya bles usually represent interest-free financing and are, therefore, less expens ive than using available cash or borrowed money to finance purchases or inventory prod uction. Accordingly, com panies use trade credit whenever possible. This is called leaning on the trade . The accounts payable turnover reflects management 's success in using trade credit to finance purchases of goods and services. It is computed as: Accounts Payable Turnover (APT) = Cost of Goods Sold/Average Accounts Payable

Module

7 I Reporting and Analyz ing No nowner Financing

7-6

Payables reflect the cost of inventory, not its retail value. Thus, to be consistent with the denom inator, the ratio uses cost of goods sold (and not sales) in the numerator. Management desires to use trade cred it to the greatest extent possib le for financing . This means that a lower accounts payable turnover is preferable. Verizon 's accounts payable turnover rate for 20 12 is 10.4 times per year, computed as ($46,275 million/[ ($4,740 million + $4,194 million)/2]); this compares with 11.3 times the prior year. This decrease in accounts paya ble turnover indicates that Verizon is paying its obligations more slowly than it did the year before . A metric analogous to accounts payable turnover is the accounts payable days outstanding which is de fined as follows: Accounts Payable Days Outstanding (APDO)

=Acco unts Payable/ Average Daily Cos t of Goods Sold

Because accounts paya ble are a source of low-cost financing, management desires to extend the accounts payable days outstanding as long as possible, pmvided that this action does not harm supply channel relations. Verizon 's acco unts payable rema in unpaid for 37.4 days in 20 12, com puted as ($4,740/ [$46,275/365 days]), up from 33.4 days the prior year. This ratio con firms that Verizon is paying its suppliers more slowly than it did in 20 111 Accounts payable reflect a source of interest-free financing . Increased payables reduce the amount of net operating working capital as payables (along with other current operating liabilities) are deducted from current operating assets in the computat ion of net operating working capital. Also, increased payables mean increased cash flow (as increased liabilities increase net cash from operating activit ies) and increased profitability (as the leve l of interest-bearing debt that is required to finance operat ing assets declines). RNOA increases when companies make use of this low-cost financing source.2Yet, companies must be careful to avoid excessive " leaning on the trade " as short-term income gains can yield long-term costs such as damaged suppl y channels.

MID-MODULE

REVIEW

1

Verizon 's accounts payable turnover (Cost of goods sold/Average accounts payable) decreased from 11.3 in 2011 to 10.4 in 2012. a. Does this change indicate that accounts payable have increased or decreased relative to cost of goods sold?

Explain. b. What effect does this change have on net cash flows from operat ing activ ities? c. What management concerns, if any, might this change in accounts payable turnover pose?

The solution is on page 7-53.

Accrued

Liabilities

Accrued liabi lities reflect ex penses that have been incurred durin g the per iod but not yet paid in cash . Accrued liab ilities can also reflect unearned reve nue as exp lained in Module 5. Verizon reports deta ils of its accrued li abilities (alo ng with accounts payab le) in the following footnote to its 20 12 10-K report.

1 Exces sive delays in payment of payables can result in supp liers charging a higher price for their goods or, ultimately , refusing to sell to certain buyers . Although a hidden "financing " cost is not interest , it is s1ill a real cost. 2

Accounts payable often carry credi t terms such as 2/10, net 30. These terms give the buyer 2% off the invoice price of goods purchased if paid within 10 days . Otherwise the entire invoi ce is payable within 30 days. By failing to take a discount , the buyer is effectively paying a 2% interest charge to keep its funds for an additiona l 20 days. Because there are approximately 18 such 20-day periods in a year (365/20), this equates to an annual rate of interest of about 36%. Thu s, borrow ing funds at less than 36% to pay this liability within the discount period would be cost effective.

7-7

M o dul e

7 I Reporting and Analyz ing Nonown er Financ ing

At December 31 ($ in millions)

______

2012

Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued Liabilit ies

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 4 ,740 4,608

Accrued vacation , salaries and wages . . . . . . .. . . . . . . Interest payab le . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . Taxes payab le . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . .

5 ,006 632 1,196

Total accounts payable and accrued liabil it ies. . . . . . . .

$16 ,182

2011

$ 4 ,194 3,786 4 ,857 774 1,078 $ 14,689

Verizon reports one nonoperating accrual: interest payable. Its other accrued liabilities are operatin g ac cruals that include miscellaneous accrued expenses, accrued vacation pay, accrued salaries and wages, and accrued taxes. Verizon 's accrual s are typical. To record accrual s, comp anies recognize a liability on the balance sheet and a corr esponding expense on the income statement. This means that liabilities increase, current income decreases, and equity decreases. When an accrued liability is ultimat ely paid, both cash and the liability decrease (but no expense is recorded because it was recognized prev iously).

Accounting

for Accrued

Liabilities

Accounting for a typical accrued liability such as accrued wages, for two con secutive period s, follows: Income Statement

Balance Sheet Transaction WE WP

75 75

WE 75

WP 75

WP

75

Cash

75

WP 75 Cash 75

Cash Asset

Period 1: Accrued $75 for employee wages earned at period -end Period 2: Paid $75 for wages earned in prior period

+

Noncash Assets

=

:

- 75 Cash

Liabilities

+

Contrib. Capital

+

Earned -" Capital

Revenues

Expenses

+ 75

- 75

+ 75

Wages Payable

Retained

Wages Expense

Earnings

- 75 :

Wages Payable

"- Net Income

:

- 75

=

The following financial statement effects result from this accrual of employee wages : •

Emplo yees have worked during a period and have not yet been paid . The effect of this accrual is to increase wages payable on the balance sheet and to recognize wages expense on the income statement. Failure to recognize this liability and associat ed expense would understate liab ilities on the balance sheet and overstate income in the current period and understate income in the subsequent period .

•

When the compan y pays employees in the following period , cash and wages payable both decrease. Thi s payment does not result in expense because the expense was recognized in the prior period when incurred.

The accrued wages illustration relates to events that are fairly certain. We know, for example, when wages are incurred but not paid . Other examples of accruals that are fairly certain are rental costs, insurance premium s, and taxes owed.

Contingent Accrued Liabilities Som e accrued liabilities are less certain than others. Consider a company facing a lawsuit. Should it record the possible liability and related expense? The answer depends on the likelihood of occurrence and the ability to estimate the obligation . Specifically, if the obligat ion is p robable and the amount estimabl e with reasonabl e certainty, then a comp any will recognize this obligation, called a contingent liabilit y. If an obligation is only reasonably pos sible (or cannot be reliably estimated), the contingent liability is not reported on the balance sheet and is merely disclosed in the footnot es. All other contingent liabilities that are less than reasonabl y possible are not disclosed. Management of Accrued Liabilities Managers have some latitude in determining the amount and timing of accruals. This latitude can lead to misreporting of income and liabilities (unintentional or

Modu le 7 I Report ing and Analyz ing N onowner Financing

7-8

otherwise). Here's how: If accruals are underestimated, then expenses are underestimated, income is overestimated, and retained earnings are overestimated. In subsequent periods when an understated accrued liability is settled (for more than the "under" estimate), reported income is lower than it should be; this is because prior-period income was higher than it should have been. (The reverse holds for overestim ated accruals.) The misreport ing of accruals, therefore, shifts income from one period into anoth er. We mu st be keenly aware of this potential for income shifting as we analyze the financial condition of a comp any. Experience tells us that acc rued liabilities related to restructuring programs (includin g severa nce accruals and accruals for asset write-downs), or to lega l and environmental liabilities, or business acquisitions are somewhat problematic. These accruals too often represent early recognition of expenses. Sometimes companies aggressively overestimate one-time accruals and record an even larger expense. This is called taking a big bath. The effect of a big bath is to depress current-period income, which relieves future periods of these expenses (thus, shifting income for ward in time). Accordingly, we must monitor any change or unusual activity with accrued liabilities and view large one-time charges with skepticism. IFRS INSIGHT

IFRS requires that a "provision" be recogn ized as a liability if a present obligation exists, if it is probab le that an outflow of resources is required, and if the obligation can be reasonab ly es timated . These provisions are basically the same as accrua ls under GAAP such as that for wages. However, unlike GAAP,contingent liabilities are not recorded for IFRS such as an accrual for litigation. Contingenc ies do not meet the IFRS provisions definition because a present obligation does not exist as it may or may not be confirmed by uncertain future events . IFRS requires footnote disc losure of such contingent liabilities unless the eventual payment is remote in which case , no disclosure is required .

Estimating

Accruals

Some accrued liabilities require more estim ation than others. Warrant y liabilities are an example of an accrual that requir es managerial assumptions and estimates. Warranties are commitm ents that m anufacturers make to their customers to repair or replace defective produ cts within a specified period of time. The expected cost of thi s commitm ent can be reasonably estimated at the time of sale based on past experience. As a result, GAAP requires manufa cturers to record the expected cost of warranties as a liability, and to record the related expected warranty expense in the income statement in the same period that the sales reve nue is reported. To illustrate, assume that a company estimates that its defective unit s amount to 2% of sales and that each unit costs $5 to replace. If sales during the period are $ 10,000, the estimated warranty expense is $ 1,000 ($ 10,000 X 2% X $5). The entries to accrue this liability and its ultimate payment follow. Balance Sheet Transaction

Cash Noncash Asset + Assets

Period 1: Accrued $1,000 of expected warranty cost s on units sold during t he period Period 2: Delivered $1 ,000 in replace ment produc ts to cover warranty c laims

=

:

Liabilities

Income Statement Contrib.

Earned JI.

+ Capital + Capital

Revenues

Expenses

+ 1,000

- 1,000

+ 1,000

Warranty Payab le

Retained Earnings

Warranty Expense

"'- Net Income WRE 1,000 WRP 1,000 WRE

=

- 1,000

I

1,000 WRP

I

WRP INV

- 1,000

- 1,000

Inventory

Warranty Payab le

Accruing warranty liabilities has the same effect on financial statements as accruing wages expense in the prev ious section. That is, a liability is recorded on the balance sheet and an expense is reported in th e income statement. When the defective product is later replaced (or repaired), the liability is reduced

1,000

1,000 1,000

WRP

1,000

I INV

I

1,000

7-9

Module

7 I Re porting and Analyz ing Nonowne r Financ ing

together with the cost of the inventor y and/or the cash paid for other costs th at were necessa ry to sati sfy the claim. (Only a portion of the produ cts estimat ed to fail do es so in the current period ; we exp ect other produ ct failure s in futur e period s. Mana gement monitor s this estim ate and adju sts it if failur e is higher or low er than expected.) As in the accrual of wages, the ex pense and the liabilit y are report ed when incurred and not when paid. To illustrate, Harley-Davidson report s $60,263 thou sand of warrant y liability on its 2012 balance shee t. Its footnot es reve al the follo w ing additional inform ation:

Estimated warranty costs are reserved for motorcycles, motorcycle parts and motorcycle accessories at the time of sale. The warranty reserve is based upon historical Company claim data used in combination with other known factors that may affect future warranty claims. The Company updates its warranty estimates quarterly to ensure that the warranty reserves are based on the most current information available. The Company believes that past claim experience is indicative of future claims; however, the factors affecting actual claims can be volatile. As a result , actual claims experience may differ from estimated which could lead to material changes in the Company's warranty provision and related reserves .... The Company currently provides a standard two-year limited warranty on all new motorcycles sold worldwide, except for Japan, where the Company provides a standard three-year limited warranty on all new motorcycles sold. In addition, the Company started offering a one-year warranty for Parts & Accessories (P&A)in 2012. The warranty coverage for the retail customer generally begins when the product is sold to a retail customer. The Company maintains reserves for future warranty claims which are based primarily on historical Company claim information. Additionally, the Company has from time to time initiated certain voluntary safety recall campaigns. The Company reserves for all estimated costs associated with safety recalls in the period that the safety recalls are announced. Changes in the Company 's warranty and safety recall liabilitywere as follows (in thousands): Product Warranty

Warranty and Safety Recall Liability (in thousands)

Balance, beginning of period .......................... Warranties issued during the period .................... Settlements made during the period .................... Recalls and changes to pre-existing warranty liabilities ..... Balance , end of period ..........................

2012

2011

2010

$54,994 54,394 (67,247) 18,122

$54,134 44,092 (55,386) 12,154

$68,044 36,785 (58,067) 7,372

$54,994

$54,134

---

. . . . . $60,263

---

The liabilityfor safety recall campaigns was $4.6 million, $10.7 millionand $3.2 millionat December 31, 2012 , 2011 and 2010, respectively.

At the beg innin g of 2012, Harl ey reported a rese rve of $54,994 thou sand for estimat ed produ ct war ranty and safet y recall costs. Durin g 2012 , the compan y add ed $72,516 thou sand ($54,394 thou sand + $18,122 thou sand) to the rese rve . Th e comp any rec ogni zed an exp ense in 2012 of the same amount. Also durin g 2012 , the comp any paid out $67,247 thou sand to settle warrant y cl aims. Th e settlements are cash paid to customers for refund s, wages paid to emplo yees who repair the motor cycles, and the cost of part s used in repair s. It is import ant to und erstand that onl y the increase in the liability res ulting from addition al accrual s ($72,516 thousand ) impa cts the income statement, reducin g incom e throu gh addition al warranty ex pense. Pay ments mad e to settle warranty claim s do not affect current-period incom e; they merely redu ce the pree xisting liabilit y. GAAP requir es that the warranty liability reflects the estim ated amount of cost that the compan y expects to incur as a result of warranty cl aims. Thi s is often a diffi cult estim ate to make and is pron e to error . Th ere is also the po ssibility that a comp any might und erestim ate its wa rranty liability to report higher current incom e, or overestimat e it so as to de pre ss curr ent incom e and create an additional liability on the balan ce sheet (cookie ja r reserve) that can be used to ab sorb future warran ty costs and , thu s, to redu ce futur e expenses . Th e overestimation would shift incom e from the current-period to on e or mor e futur e period s. Warranty liabiliti es mu st, therefore, be examin ed closely and comp ared with sales leve ls. Any dev iation s from the histori ca l re lation of the warrant y liabilit y to sales, or from level s report ed by comp etitor s, should be scrutini ze d.

Modu le 7 I Reporting and Analyz ing Nonowner Financing

MID-MODULE

REVIEW

7-10

2

Assume that Verizon's employees worked during the curren t month and earned $10,000 in wages that Verizon will not pay until the first of next month. Must Verizon recognize any wages liabili ty and expense for the current month ? Explain. Use the financial statement effects temp late to show the effect of this accrual.

The solution is on page 7-53.

Current

Nonoperating

Liabilities

Current nonoperating liabilitie s include short -term bank loans, accrued interest on those loans, and the current maturiti es of long-term debt. Compani es generally try to structur e their financin g so that debt service requirem ents (payments) coincide with the cash inflows from the assets financed. Thi s means that current assets are usually financed with current liabilities, and that long-term assets are financed with long-term liabilities (and equity). To illustrate, assume that a seasonal compan y's investment in current assets tends to fluctuat e during the year as depicted in the graphic below:

..j .. .. f_ r r: .. Current Assets

$2,000

/

$1,500

/

$1,000

./

$500

/

$0

..

L4

~

r J

- -- --

~

/

Jan.

....

Feb. Mar. Apr.

- - ~~

May June July

}

Seasonal current assets

}

Permanent current assets

-

Aug. Sep. Oct.

Nov. Dec.

This compan y does most of its selling in the summer month s. More inventory is purcha sed and m anufactured in the early sprin g than at any other time of the year. High summer sales give rise to accounts receivable that are higher than normal during the fall. The company's working capital peaks at the height of the selling season and is lowest as the business slows in the off-season. There is a perman ent level of working capital required for this business (about $750), and a seasonal compon ent (maximum of about $1,000). Different businesses exhibit different patterns in their working capita l requirements, but many have both perman ent and seasonal component s. The existence of permanent and seasonal current operating assets often requires that financing sources also have permanent and seasonal components. Consider again the company depicted in the graphic above. A portion of the comp any 's assets is in inventories that are financed, in part, with account s payabl e and accruals . Thu s, we expect that current operating liabilities also exhibit a seaso nal compon ent that fluctuates with the level of operation s. These payabl es are generally non-interestbear ing and, thus, provide low-cost financ ing that should be used to the greatest extent possible. Addition al financing needs are covered by short-term interest- bearing debt. Thi s section focu ses on current nonoperatin g liabilit ies, which include short-term debt, current maturiti es of long-term liabilities, and accrued interest expenses.

Short-Term

Interest-Bearing

Debt

Seasonal swings in working capital are often financed with a bank line of credit (short -term debt) . In this case the bank commit s to lend up to a maximum amount with the understand ing that the amounts borrowed will be repaid in full sometime during the year. An interest-bearing note evidences any such borrowin g.

L02

Describe

the accoun ting for curren t and long term nonoperating liabilities .

7-11

Module

7 I Reporting and Analyzing Nonow ner Financing

When the company borrows these short-term funds, it reports the cash received on the balance sheet together with an increase in liabilities (notes payable). The note is report ed as a current liability because the company expects to repay it within a year. This borrowing has no effect on income or equity The borrower incurs (and the lender earns) interest on the note as time passes. GAAP requ ires the borrower to accrue the interest liability and the related interest expense each time financial statemen ts are issued. To illustrate, assume that Verizon borrows $1,000 cash on January L The note bears interest at a 12% annual rate, and the interest (3% per quarter) is payable on the first of each subsequent quarter (April 1, July 1, October I , January 1). Assuming that Verizon issues calendar-quart er financial statements, this borrowing results in the following financial statement effects for January 1 through April 1. Balance Sheet Transaction Cash NP

1,000 1,000 Cash

I

1,000

NP

I IE

1,000

30 30

IP IE

30 IP

30

Jan 1: Borrow $1,000 cash and issue note payable

Cash Asset

+

Income Statement

N:~=~h ~:~i~:· ~:~:!

+ 1,000

=

~:::-

+

+

JJ

Revenues

Expen- = " Net ses Income

+ 1,000 Note

Cash

Payable

Mar 31: Accrue quarterly interest on 12%, $1,000 note payable

+ 30

- 30

+ 30

Interes t

Retained

Interest

Payable

Earnings

Expense

- 30

··············································-··························-····················-·······-················-·························· IP

30 Cash

30 IP

30

Apr 1: Pay $30 cash for interest due

- 30

- 30

Cash

Interest Payab le

Cash

30

The January 1 borrowing increases both cash and notes payable. On March 31, Verizon issues its quarterly financial statements. Although interest is not paid until April I, the com pany has incurred three months ' interest obligation as of March 3 1. Failure to recognize this liability and the expense incurred would not fairly present the financial condition of the compa ny Accordingly, the quart erly accrued interest payable is computed as follows: Interest Expense $30

= Principal = $1,000

x Annual Rate x Portion of Year Outstanding X

12%

X

3/12

The subsequent interest payment on April 1 reduces both cash and the interes t payable that Verizon accrued on March 3 1. There is no expense reported on April I, as it was recorded the previou s day (March 31) when Verizon prepared its financial statements . (For fixed-maturity borrowings spec ified in days, such as a 90-day note, we assume a 365-day year for interest accrual computations , see Mid-Module Review 3.)

Current

Maturities

of Long-Term

Debt

Principal payments that must be made during the upcoming 12 months on long-term debt (such as for a mortgage), or on bonds and notes that mature within the next year, are reported as current liabilities called current maturities of long-term debt . All companie s must provid e a schedule of the maturiti es of their long-term debt in the footnotes to the financial statements (see the discussion later in this mod ule). To illustrat e, Verizon reports $4,369 million in long-term debt due within one year in the current liability section of the balance sheet shown earlier in the module. MID-MODULE

REVIEW

3

Assume that on January I 5, Verizon borrowed $10,000 on a 90-day, 6% note payable. The bank accrues interest daily based on a 365-day year. Use the financial statement effects templ ate to show the January 31 interest accrual.

The solution is on page 7-54.

Modu le 7 I Report ing and Analyz ing N onowner Financing

LONG-TERM

7- 12

NONOPERATING

LIABILITIES

Compani es often include long-term nonoperating liabilities in their capital structure to fund long-term assets. Smaller amount s of long-term debt can be readily obtained from banks, private placements with insurance comp ani es, and other credit sources. However, when a large amount of finan cing is required, the issuance of bonds (and notes) in capital markets is a cost-efficient way to raise fund s. The following discussion uses bonds for illustration , but the concepts also apply to long-term notes. Bonds are structured like any other borrowing. The borrower receives cash and agrees to pay it back with interest. Generally, the entire face amount (principal) of the bond is repaid at m aturity (at the end of the bond 's life) and interest payments are made in the interim (usually semiannually). Comp anies th at ra ise fund s in the bond market norm ally work with an und erwrit er (lik e Merrill Lynch) to set th e terms of the bond issue. Th e und erwrit er th en sell s indi vidual bonds (usuall y in $ 1,000 denomin ation s) from this general bond issue to its retail cl ient s and profess ional portfo li o managers (like The Vanguard Group ) , and rece ives a fee for und erwritin g the bon d iss ue. These bond s are in ves tment s for indi vidu al in ves tors, other comp anies, retir em ent plan s and insuran ce comp anies. Aft er they are issued, the bonds can trade in th e secondar y market ju st like stoc ks. M arket prices of bond s flu ctuate d aily despite th e fac t that the co mpany's obli gati on for payment of principal and interest normally remain s fixed thro ughout th e life of the bond. Then, why do bond prices change? Th e answer is that th e bond 's fixed rate of interest can be higher or lowe r th an the interes t rates offered on other secu riti es o f simil ar risk . Beca use bonds comp ete with oth er poss ible inves tment s, bond pri ces are set relative to the prices of oth er inves tm ent s. In a comp etitive inves tm ent m ark et, a parti cul ar bond will beco m e more or less des irabl e dependin g on the genera l leve l of int erest ra tes off ered by comp eting sec uriti es. Just as for any item, comp et itiv e pressures will cause bond pri ces to rise and fall. Thi s section analyzes and interprets the reporting for bond s. We also examine the mechanics of bond pricing and describe the acco unting for, and reportin g of, bond s.

Pricing

of Debt

The following two different interest rates are crucial for pricing de bt.

•

•

Coupon (contract or stated) rate The coupon rate of interest is stated in the bond contract; it is used to comput e the dollar amount of interest payments th at are paid to bondhold ers dur ing the life of the bond issue. Market (yield or effective) rate Thi s is the interest rate that investors expect to earn on the investment in this debt security; this rate is used to price the bond .

The coupon (contract) rate is used to compute interest payments and the market (yield) rate is used to pr ice the bond . Th e coupon rate and the market rate are nea rly always different . Th is is beca use the coupon rate is fi xed prior to issuance of the bond and norm ally remains fi xed throu ghout its life . Market rates of interest, on the oth er hand , fluctuate continu ally with the suppl y and demand for bond s in th e marketplace , ge nera l m acroeco nomi c co ndit ions, and the borro wer 's financial condition. The bond price, both its initial sales price and the price it trad es at in the secondary market subsequent to issuance, equals the present value of the expected cash flows to the bondholder. Specifically, bondholders normally expect to rece ive two different types of cash flows : 1. Periodic interest payments (usually semiannual ) during the bond 's life; these payments are called an annuity because they are equal in amount and made at regular intervals.

2. Single payment of the face (principal) amount of the bond at maturity; this is called a lump-sum because it occurs only once. The bond price equals the present value of the periodic interest payments plus the present value of the single payment. If the present value of the two cash flows is equal to the bond 's face value, the bond is sold at par. If the present value is less than or greater than the bond 's face value, the bond sells at a discount or premium, respective ly. We next illustrate the issuance of bonds at three different prices : at .............

.. .... ,-1· " ............. .... ..

........ ,-1 ...... ..........

,... ...... ·, .......

7-13

Module

7 I Reporting and Ana lyzing Nonowne r Financing

Bonds

Issued

at Par

To illustrate a bond issued (also said to be sold) at par, assume that a bond with a face amount of $10 million, has a 6% annual coupon rate payab le sem iannually (3% semiann ual rate), and a matur ity of 10 years. Semiannual interest payments are typical for bonds . This means that the issuer pays bondholders two interest payments per year. Each semiannual interest paymen t is equa l to the bond's face value times the annual rate divided by two . Investors purchasing these bonds receive the fo llow ing cash flows . Number of Payments Semiannual interest payments. . . . .

Total Cash Flows

Dollars per Payment

1O years x 2 = 20

$10,000,000

X

3% = $300,000

Principa l payment at maturity . . . . . .

$6,000,000

$10,000,000

----

10,000,000

$16,000,000

Speci fically, the bond agree ment dictates that the borrower must make 20 semiannua l paymen ts of $300,000 each, compute d as $10,000,000 X (6%/2) . At maturit)( the borrower must repay the $10,000,000 face amou nt. To price bonds, investors identify the number of interes t payments and use that number when computing the prese nt value of both the interest payments and the principal (face) payment at matur ity. The bond price is the present value of the periodic interest payme nts (the annuity) plus the present value of the principal payme nt (the lump sum). In our example, assuming that investors desire a 3% semiannual market rate (yield), the bond sells for $10,000,000, which is compute d as follows: Present value factors are from Append ix A

Payment Interest . . . . . . ... . . . . . . ..

$300,000 Principal . .. . . . . . . . . . . . . . $10,000,000

Calculator N = 20 I/Yr= 3 PMT = - 300 ,000 FV = - 10,000,000

IPV = 10,000,000

p resent Value Factor • 14.87747b 0.553685,536,800

Present Value

$ 4,463,200

d

$1 0,000,000 • Mechanics of using tab les to compute present values are expl ained in Appendix 7A; present value factors come from Append ix A near the end of the book.

I

b

Present value of an ordinary annuity for 20 periods discount ed at 3% per period.

' Present value of a single payment in 20 periods discounted at 3% per period. Excel = PV(rate, nper. pmt,[fv],[typeD

= PV(3%, 20. - 300000. - 10000000 . 0) = 10,000,000

d

Rounded.

Because the bond contract pays investors a 3% semia nnu al rate when investors demand a 3% sem iannual market rate, given the borrower 's credit ratmg and the time to maturity, the investors purchase those bonds at the par (face) value of $10 million .

Discount Calculato r N = 20 I/Yr= 4 PMT = - 300 ,000 FV = - 10 ,000,000

Bonds

As a secon d illustratio n, assume investo rs demand a 4% semiannual return for the 3% semiannual coupo n bond, while all other deta ils remai n the same . The bond now sells for $8,640,999, com puted as follows: Payment Interest . . . . . . . . . . . . . . . . . $ 300,000 Principa l . . . . . . . . . . . . . . . . $10,000,000

IPv = a ,640 ,967.3r l

Present Value Factor

Present Value

13.59033 $4,077 ,099 0.45639 4,563,900 8

$8,640 ,999

*rounding difference Excel = PV(rate, nper. pmt,[fv],ftypeD

• Present value of an ordinary annuity for 20 periods discounted at 4% per period.

= PV(4%, 20. - 300000 . - 10000000. 0)

b

Present value of a single payment in 20 periods discounted at 4% per period.

= 8 ,640,967.37

Because the bond carries a cou pon rate lower than what investors demand, the bond is less desirab le and sells at a discount . More generally , bonds sell at a discount wheneve r the coupon rate is less than the market rate.

Module 7 I Reporting and Analyzing Nonowner Financing

Premium

7-14

Bonds

As a third illustration, assume that investors demand a 2% semiannua l return for the 3% semiannua l coupo n bonds, while all other details remain the same. The bond now sells for $ 11,635,129, computed as follows:

Payment Interest . . . . . . . . . . . . . . . . .

Present Value Factor

$ 300,000

16.35143 3

Calculator N = 20 I/Yr= 2 PMT = - 300,000 FV = - 10,000,000

Present Value $4,905,429

0 .6729lf6,729,700

Principal . . . . . . . . . . . . . . . . $10,000,000

$11,635,129

IPv = 11,635,143.33* 1

• Present value of an ordinary annuity for 20 periods discounted at 2% per period. • Present value of a single payment in 20 periods discounted at 2% per period.

Because the bond carries a coupon rate higher than what investors demand, the bond is more desirable and sells at a premium . More genera lly, bonds sell at a premium whenever the coupon rate is greater than the market rate.3 Exhibit 7.1 summar izes this relation for bond pricing.

EXHIBIT

7.1

Coupon

Rate , Market

Coupon rate > market rate Coupon rate = market rate Coupon rate < market rate

7 7 7

Rate , and Bond Pricing

Bond sells at a premium (above face amount) Bond sells at par (at face amount) Bond sells at a discount (below face amount)

Exhibit 7 .2 shows an announcement (called a tombstone) of a Union Pacific Corp $500 mill ion debt issuance. It has a 4 % coupon rate paying 2% semiannual interest, maturing in 202 1, with an issue price of 99.525 (sold at a discount) . Union Paci fic Corp 's underwriters took 0 .65% in fees ($3 .25 million) for underwriting and selling this debt issue .4

Effective

Cost

of Debt

When a bond sells for par, the cost to the issuing comp any is the cash interest paid . In our first illustration above, the effective cost of the bond is the 6% interest paid by the issuer. When a bond sells at a di scount, the issuer must repay more (the face value when the bond matures) th an the cash received at issuance (the discounted bond proceeds ). This means that the effective cost of a discount bond is greater than if the bond had sold at par. A discount is a cost and, like any other cost, must eventua lly be transferred from the balance sheet to the income statement as an expense. When a bond sells at a premium , the borrower received more cash at issuance than it must repay. The difference, the premium, is a benefit that must eventually find its way into the income statement as a reduction of interest expense. As a result of the premium , the effective cost of a premium bond is less than if the bond had sold at par. Bonds are priced to yield the return (market rate) demanded by investors. Consequently, the effective rate of a bond always equals the yield (market) rate demanded by investors, regardless of the coupo n rate of the bond . This means that companies cannot influence the effective cos t of debt by rais ing or lowering the coupon rate. Doing so will only result in a bond premium or discount. We discuss th e factors affecting the yield demanded by investors later in the module . The effective cost of debt is reflected in the amount of interest expense reporte d in the issuer 's income statement. Because of bond discounts and premiums, interest expense is usually different from 3 Bond prices are often stated in percent form. For example , a bond sold at par is said to be sold at I00 (that is, 100% of par). The bond sold al $8,640,999 is said to be sold al 86.41 (86.41 % of par, computed as $8,640 ,999/$10,000 ,000) . The bond sold for a premium is said to be sold at 116.35 (116.35 % of the bond's face value).

4

The tombstone makes clear that if we purchase any of these notes (in denominat ions of $ 1,000) after the semiannual interest date, we must pay accrned interest in addition to the purchase price. This interest is returned to us in the regular interest payment. (This procedure makes the bookkeeping easier for the issuer/underwriter because all interest payments are equa l regardless of when the company actually sold the bond.)

*rounding difference Excel

= F'V(rate,nper,

pmt ,(fvJ,(type])

- PV(2%, 20, - 300000, - 10000000,0)

=11,635,143.33

7- 15

Modu le

7 I Reporting and Ana lyzing Nonowner

EXHIBIT

7.2

Financing

Announcement

(Tombstone)

of Debt Offering

to Public

$500 ,000 ,000

fil

Union Pacific lULWcorporation 4.00 % Notes due 2021 We will pay interest on the notes each February 1 and August 1, commencing February 1, 2011 . The notes will mature on February 1, 2021 . We may redeem some or all of the notes at any t ime and from time to time at the redemption price described in this prospectus supp lement. There is no sinking fund for the notes. See "Description of the Notes " for a description of the terms of the notes .

Price to Public (1)

Underwriting Discount

Proceeds to t he Compa ny

99.525 % $497 ,625 ,000

0.650 % $3,250,000

98.875 % $494,375 ,000

Per Note Tot al (1) Plus acc rued int eres t, if any, from A ugus t 2, 20 10.

Neither the Securities and Exchange Commission nor any state securities commiss ion has approved or disapproved of these securities or determined if this prospectus supp lement or the accompanying prospectus is truthful or complete . Any representation to the contrary is a crim inal offense. Delivery of the notes, in book-entry form only through The Depository Trust Company, will be made on or about August 2, 2010 . The date of this prospectus supplement is July 28, 2010 .

Joint Book-Running Manage rs

BofA Merrill Lynch

J.P. Morgan

Morgan Stanley

Senior Co-Managers

Citi

BNP PARIBAS Co-Manage rs Mitsubishi UFJ Secu rities

Sun Trust Robinson Humphrey

US Bancorp

RBS

Wells Fargo Secur ities

the cash interest paid. The next section discusses how management reports, and how we interpret, bonds on the balance sheet and interest expense on the income statement.

REPORTING

OF DEBT

FINANCING

Thi s section identifies and describes the financial statement effects of bond transaction s.

Financial Bonds

Statement

Issued

Effects

of Debt

Issuance

at Par

When a bond sells at par, the issuing company receives the cash proceeds and accepts an obligation to make payments per the bond contr act. Specifically, cash is increased and a long-term liability (bond s paya ble) is increase d by the same amount. There is no revenue or expense at bond issuance. Using the facts from our $ 10 million bond illustration above, the issuance of bonds at par has the following financial statement effects:

M odul e 7 I Report ing and Analyzing Nonowner Financing

7-16

Balance Sheet Transaction

Ca sh Asset

Noncash

+ Assets

Liabilities

Income Statement Contrib.

Earned .It

+ Capital + Capital

Revenues

Expen- = "'- Net ses Income Cash

Issue bonds + 10,000 ,000 at par for Cash cash

10.000.000

LTD

+ 10,000,000

10,000,000

Cash

Long-Term Debt

, 0.000.000

I

LTD

I ,0 .000 .000

Discount

Bonds

When a bond is sold at a discount, the cash proceeds and net bond liability are recorded at the amount of the proceeds received (not the face amount of the bond). Again, using the facts above from our bond discount illustration , the financial statement effects follow: Balance Sheet Transaction

Cash Asset

Noncash

+ Assets

Issue bonds at discount + $3 ,54 o,999 for cash

Cash

Liabilities

Income Statement Contrib.

Earned .It

+ Capital + Capital

Revenues

Expenses

= "'- Net Income Cash

+ $8 ,640,999

LTD

Long-Term

8,640,999 8,640,999 Cash

a.s,o,999

Debt

I

LTD

I a.s40.999

The net bond liability (long-term debt) reported on the balance sheet consists of two components as follows: Bonds payable, face. . . . . . . . . Less bond discount . . . . . . . . .

$ 10,000,000 (1,359 ,001)

Bonds payable, net . . . . . . . . .

$ 8,640,999

Bonds are reported on the balance sheet net of any discount. When the bond matures, however, the compan y is obligated to repay the face amoun t ($10 million). Accordingly, at maturity, the bonds payable account needs to read $10 million, the amount that is owed . Thi s mean s that between the bond BUSINESS INSIGHT Zero-coupon bonds and notes , called zeros, do not carry a coupon rate. Pricing of these bonds and notes is done in the same manner as those with coupon rates-the exception is the absence of an interest annuity. This means that the price is the present value of the principal payment at matu rity ; hence the bond is sold at a deep discount . A press release reported the outcome of a zero-coupon bond sale by the German government as follows: An offer ing of a new line of Germany's zero coupon two-year bonds drew strong demand on Wednes day and the country paid record low yield as investors looked for a safe haven amid rising speculation of Greece's exit from the euro area. The country raised EUR 4.555 billion from the sale of its new June 2014 Federal Treasury Notes or Schatz, the Bundesbank said . The auct ion target was EUR 5 billion . . .. The yield on the zero interest debt was 0.07 percent , which was reported ly the lowest on record for similar secur ities . Source: http://www.rtt news.com/1892575/germany-zero-coupon-bond-sale -attracts-strong-demand-record- low-yield.aspx

When Germany 's central bank, the Bundesbank, issued its zero-coupon convertible notes in May 2012, they had a maturity value of €4 .561 billion and were slated to mature in 2014 . No interest is paid in the interim . The notes sold for €4.555 billion . The difference between the sales proceeds and the maturity value represents Germany's interest costs, which is the return to the investor . The effective cost of the debt is the interest rate that equates the issue price and maturity value, or approxima tely 0.07% , a very low rate of interest.

7-17

Module

7 I Reporting and Ana lyzing Nonowne r Financing

issuance and its maturity , the discoun t must decli ne to zero . This reduction of the discount over the life of the bond is called amortization . The next section shows how discount amort ization results in additional interest expense in the income statement. This amortization causes the effective interes t expense to be greater than the periodic cash interest payments .

Premium

Bonds

When a bond is sold at a premium, the cash proceeds and net bond liability are recorded at the amo unt of the proceeds received (not the face amount of the bond) . Again , using the facts above from our premium bond illustrat ion, the financial statement effects follow: Balance Sheet Transaction Cash 11,635,129 LTD 11 ,635,129 Cash

11.635.129 1 LTD

Assets

Issue bonds at prem ium + $11,635, 129 for cash

Liabilities

+ Noncash =

Cash Asset

Income Statement Contrib.

Earned ¥

+ Capital + Capital

Revenues

Expen- = " Net ses Income

+ $11,635, 129 :

Cash

=

Long-Term Debt

h1 ,635,129

The bond liability reported on the balanc e sheet, again, consists of two parts: Bonds payable, face . . . . . . . . . Add bond premium

$10,000,000

Bonds payab le, net . . . . . .. . .

$11,635,129

1,635 ,129

The $ JO mill ion must be repaid at maturity, and the prem ium amortized to zero over the life of the bond. The prem ium represents a benefit, which reduces interest expense on the income statement.

Effects

of Discount

and Premium

Amortization

For bonds issued at par, interest expense reported on the income statement equa ls the cash interest payment. How ever, for bonds issued at a discount or premium, interest expense reported on the income statement also include s any amort ization of the bond di scount or premium as follows: Bonds issued at a discount

+

Cash interest paid Amortization of discount Interest expense

Calculator N=6 I/Yr = 2 PMT = - 9,000 FV = - 600,000

IPV =

583,195.71

Excel

= PV(rate.nper, pm t.(fv],[type]) = PV(2%, 6.-9000 ,-600000.0) = 583,195 .71

Bonds issued at a premium or

Cash interest paid - Amortization of premium Interest expense

Speci fically, periodic amortization of a discount is added to the cash interest paid to get interest expense. Amortization of the discount reflects the additional cost the issuer incurs from issuing the bonds at a discount. Over the bond's life, the discount is transferred from the balance sheet to the income statement via amortizat ion, as an increase to interest expe nse. For a prem ium bond, the prem ium is a benefit the issuer receives at issua nce. Amorti zation of the prem ium reduces interest expe nse over the bond 's life. In both cases, interest expe nse on the income statement represents the effective cost of debt (the nominal cos t of debt is the cash interest paid) . Companies amortize discounts and premium s using the effective interest method. To illustrate, assume that Verizon issues bonds with a face amount of $600,000, a 3% annua l coup on rate payable semiannually (1.5% semiannual rate), a maturity of three years (six semiannual payment period s), and a market (yield) rate of 4% annual (2% semiannual) . These facts yield a bond issue price of $583 ,195.7 1, which we round to $583, 196 for the bond discount amortization tab le of Exh ibit 7.3. The interest period is denoted in the left-most column. Period O is the point at which the bond is issued, and period I and following are success ive six-month periods (reca ll, interest is paid semiannu ally) . Column [A] is interest expense, which is report ed in the income statement. Interest expense is

Module 7 I Reporting and Analyz ing N ono w n er Fin ancing

7-18

comput ed as the bond 's net balanc e sheet value (the carrying amount of the bond ) at the beginnin g of the period (column [E]) multipli ed by the 2% semiannual rate used to comput e the bond issue price. Column [BJis cash interest paid, which is a con stant $9,000 per the bond contract (fac e amount X coupon rat e). Column [CJ is discount amortization, which is the diff erence betwe en interest expense and cash inter est paid . Column [DJ is the discount balan ce, which is the previous balan ce of the discount less the di scount amortizat ion in column [CJ. Column [El is the net bond payab le, which is the $600,000 face amount les s the unamortiz ed discount from column [DJ. EXHIBIT

7.3

Period

[AJ ({E] x marlcet%) Interest Expense

[BJ (Face x coupon%) Cash Interest Paid

[CJ ({AJ - [BJ) Discount Amortization

$11,664

$ 9,000

$2,664

Bond

Discount

Amortization

Table

[DJ (Prior bal - [CJ) Discount Balance

[EJ (Face - [DJ) Bond Payable, Net

$16 ,804

0

11,717

2

9,000

2,717

9 ,000

11,423

2 ,772

588,577

4

11,772 11,827

9,000

2,827

8,651 5 ,824

5

11,884

9,000

2,884

2 ,940

6

11,940

9,000

2,940

0

3

$70,804

$54,000

591 ,349 594,176

During the bond life, ca rrying value is adj usted to par and the d iscount to zero

597,060

..

$16,804

lt·'- --------'-"------.:.,,,... lt

$583, 196 585 ,860

14,140

600 ,000 lt

lt ________________

Cash paid

plus d iscount

Th e table shows amount s for the six interest paym ent period s. The amort ization process continu es amortizat ion until period 6, at which time the discount balan ce is O and the net bond payabl e is $600 ,000 (the matu - equa ls interest rity value) . Each semiannual period, interes t expense is record ed at 2%, the market rate of interest at the ._e_ x_p_e_n_se___ _. bond's issuanc e . This rate does not change over the life of the bond , even if the prevailin g market intere st rates chang e. An amorti zation table reveals the financial statement effec ts of the bond for its duration. Specificall y, we see the income statement effects in column [A] , the ca sh eff ects in column [BJ, and the-~------~ balance sheet effects in column s [DJ and [EJ. Calculator To illustrate amorti zation of a premium bond, we assum e that Verizon issues bond s with a $600 ,000 N = 6 I/Yr = 1 face value, a 3% annual coupon rate payabl e semiannually (1 .5% semiannual rate), a maturity of thr ee PMT = _ 9 ,000 ye ars (six semiannua l interest payments), and a 2% annual (I % semiannual ) mark et interest rate . The se FV = _ 600 ,000 facts yield a bond issue price of $617 ,386.4 3, which we round to $6 17,386 . Exhibit 7.4 show s the pre- PV = 617 ,386 .43 mium amorti zation table for thi s bond . -

I

EXHIBIT

7.4

Bond

Premium

[AJ ({E]

x market %) Interest Expense

Period

Amortization

[BJ (Face x coupon%) Cash Interest Paid

Table

[CJ ([BJ - {AJ) Premium Amortization

[DJ (Prior bal - [CJ) Premium Balance

0

[E] (Face+ [DJ) Bond Payable, Net

$17,386 $ 6,174

2

6,146 3

6,117

$ 9 ,000 9,000

$ 2,826

9 ,000

2,883

2 ,854

14,560 11,706 8,823

$617 ,386 614,560 611 ,706 608 ,823

4

6,088

9,000

2 ,912

5,91 1

605 ,911

5

6,059

9,000

2 ,941

2,970

602 ,970

2 ,970

0

600 ,000

6

6 ,030 $36 ,614

9 ,000 $54 ,000

Excel ==PV(rate, nper. pmt,[fv],[typeD = PV(1%,6,-9000 ,-st n ~vm t>nt ~nrl rlisrn nnt ~mnrtintin

n nn T11nt>,O ?.0 14 ~nrl

n)

st>mi~nni rnl int nt>st n~vme, nt

~

7-41

Module

7 I Reporting and Analyzing Nonowne r Financing

E 7-36.

Anal yzing and Repor tin g Financial Stat ement E ffects of Bond Tran sa ction s (L02) On January 1, 2014, Verrecchia Company issued $450,000 of 5-year, 13% bonds for $502, 12 1, yielding a market (yie ld) rate of I 0%. Interest is payable semiannua lly on June 30 and December 3 1.

a. Confirm the bond issue price. b. Indicate the financial statement effects using the template for (I) bond issuance, (2) semiannua l interest payment and premium amortization on June 30, 20 14, and (3) semiannual interest payment and premium amortization on December 3 1, 20 14.

PROBLEMS P7-37. PepsiCo , Inc. (PEP)

Interpretin g Term Structure s of Coupon Rate s and Yield Rat es (L02 , 3) PepsiCo, Inc. reports $26,445 million of long-term debt outstanding as of December 2012 in the follow ing schedu le to its 10-K report. Debt Obligations and Commitments 2012

2011

$ 2,901 1,101 813

$ 2,549 2,973 683

$ 4,815

$ 6,205

$ 2,891 3,237 3,300 1,878 1,250 13,781 108

$ 2,353 2,84 1 3,335 1,632 1,876 258 10,548 274

Less: current maturities of long-term debt obligations . . . . . . . . .

26,445 (2,901)

23,117 (2,549)

Total . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . ... . . .

$23 ,544

Short-term debt obligations Current maturit ies of long-ter m debt . . . . . . . . . . . . . . . . . . . . . . . Commercial paper (0.1 % and 0.1 %) . . . . . . . . . . . . .. . . . . . . . . . Other borrowings (7.4% and 7.6%) . . .. . . . . . . . . . . . . . . . .. . . .

Long-term debt obligations Notes due 2012 (3.0%) . . . . . . . . ... . . . . . . . . . . . . . . . Notes due 2013 (2.3%) . . . . . . . . . . . . . . . . . . . . . . . . . . Notes due 2014 (4.4% and 4.6%) . . . . . . . . . . . . .... . . Notes due 2015 (1.5% and 2.3%) . . . . . . . . . . . . .... . . Notes due 2016 (3.9%) . . . . . . . . . . .. . . . . . . . . . . . . . . Notes due 2017 (2.0% and 5.0%) . . . . . . . .. . . . . . . . . . Notes due 2018-2042 (4.4% and 4.8%) . . . . .. . . . . . ... Other, due 2013-2020 (9.3% and 9.9%) . . . ... . . .. . . .

. . ... . . . . ... . . . . . . .. . . . . . .. . . .. . .. . . . ... . . ...... .. .. .. .

$20,568

Long-Term Contractual Commitments

Payments Due by Period ($ millions)

Total

2013

20142015

20162017

2018 and beyond

Long-ter m debt obligat ions . . . . . . . .

$26,445

$2,90 1

$6,450

$3,105

$13,989

Our bo"owing costs and access to capital and credit markets may be adversely affected by a downgrade or potential downgrade of our credit ratings. Our object ive is to maintain cred it ratings that provide us with ready access to globa l capital and cred it markets . Any downgrade of our credit ratings by a credit rating agenc)( especially any downgrade to below investment grade, cou ld increase our future borrowing costs and impair our ability to access capital and cred it markets on terms commercially acceptable to us, or at all. In addition, any downgrade of our current short-term credit ratings could impair our ability to access the co mmercial paper market with the same flexibility that we have experienced historically, and theefore requie us to rely moe heavily on more expensive types of debt financing . Our borrow ing costs and access to the co mmeicial paper market could also be adversely affected if a credit rating agency announces that our ratings are under review for a potential downgrade.

Modul e 7 I Reporting and Analyzing Nonowner Financing

7-42

Moody's Investor Service (www.moodys.com) reported the following regarding PepsiCo: Rating Action: Moody 's downgr ade s Pepsi to A1; affirm s P-1 short-term rating ; outlook is stable. New York, June 25, 2013-Moody's today lowered the long-term ratings of PepsiCo ("Pepsi") and its rated subsidiaries to A 1 from Aa3 . Pepsi's short-term rating was affirmed at P-1 and the outlook for the company is stable. oday 's act ion concludes Moodys review of Pepsi for downgrade which was initiated on May 30th . Source: Mood)S Investor Service (wwwnoodys.com)

As of December 2013, the price of its $ 1 billion 5.0% senior notes maturing in 2018 follows (from

Yahoo! Finance , reports.finance.yahoo.com ): Type

Issuer

Price

Coupon(%)

Maturity

YTM(%)

Fitch Ratings

Callable

Corp

PEPSICO INC

113.79

5 .0

01-Jun-20 18

1. 75

A

No

Required a. PepsiCo reports current maturities of lon g-term debt of $2,90 1 million as part of short-term debt. Why is th is amount reported that way? PepsiCo reports $6 ,450 million of long-term debt due in 2014-2 015. What does this mean? I s this amount important to our analysis of PepsiCo? Explain. b. T he $1 billion 5.0% notes maturing in 20 18 are priced at 113.79 (1 13.79% of face value, or $1.1379 billion) as of D ecember 2013, resulting in a yie ld to maturity of 1.75% . A ssuming that the credi t ratin g of PepsiCo has not changed, what does the pricing of this bond imply about interest rate changes sin ce Pepsi Co issued the bond ? c. What does the schedule of long-term contractua l commitments reveal that might be useful in analyz ing PepsiCo 's liquidit y? d. Moody 's Investor s Service lowered the lon g-term ratings of PepsiCo in 2013. Wh y might a reduction in credit ratings result in higher inte rest costs and restrict PepsiCo 's access to credit markets ? e. What type of action s can PepsiCo take to impro ve it s credit ratings?

P7-38.

Interpreting Debt Footnotes on Interest Rates and Interest Expense (L02) CVS Caremark Corporation di scloses the followin g as part of its lon g-term debt footnote in its 2012 BORROWING AND CREDIT AGREEMENTS The following table is a summary of the Company's borrowings as of December 3 1:

In millions Commercial paper . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . 4.875% senior notes due 2014 . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . 3.25% senior notes due 20 15 ......... . . . . . . . . . . .. . . . . . . . . . . 6.125% senior notes due 2016 . . .. . . . . . . . . . . . . . . .. . . . . . ... . . 5.75% senior notes due 2017 . . . .. . . . . . . . . . . . . . . .. . . . . . ... . . 6.6% senior notes due 2019 ...... . . . . . . . . . . . . . . .. . . . . . . . . . . 4.75% senior notes due 2020 . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . 4.125% senior notes due 2021 . . .. . . . . . ... . . . . . . .. . . . . . . . . . . 6.25% senior notes due 2027 . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . Trust Preferred Securities . . . . . . . . . . . . ... . . . . ... . . . . .. . . .. . . . 6.125% senior notes due 2039 . . .. . . . . . . . . . ...... ........... 5.75% senior notes due 2041 . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . Enhanced Capital Advantage Preferred Securities due 2062 . . . . . . . 2.75% senior notes due 2022 ......... . . . . . . . . . . .. . . . . . . . . . . Mortgage notes payable . . . . . . . ... . .. . . . . . . . . . . ... . .. . . . . . . Capital lease obligations . . . . .. . . . . ... . . . . . ... .. . . . . . . . . . . . .

2012

9,828 Less: Short-term debt (commercial paper) . . . . . . . . . . . . .. . . . . . . . . . . Current portion of long-term debt . . . . .. ... . . . . . ... . . . .. ... .

2011

$ 750 $690 550 550 550 550 421 700 1,310 1,750 394 1,000 450 450 550 550 1,000 1,000 50 1,500 1,500 950 950 41 42 1,250 1 4 171 168

(690) (5) $9 ,133

10,014 (750) (56) $9,208

10-ttVS Caremark Corporation (CVS)

7-43

7 I Report ing and Analyzing Nonowner Financing

M o dule

CVS also discloses the following informatio n. Interest expense , net- Interest expense, net of capital ized interest, was $561 million, $588 million and $539 million, and interest income was $4 million, $4 million and $3 million in 2012, 2011 and 2010, respectively . Capitalized interest totaled $29 million, $37 million and $47 million in 2012, 2011 and 2010, respectively . Interest paid totaled $581 million, $647 million and $583 million in 20 12, 2011 and 2010 respectively. Maturities of long-term debt-The aggregate maturities of long-term debt for each of the five years subsequent to December 31, 2012 are $5 million in 2013, $555 million in 2014, $556 million in 20 15, $427 million in 2016, and $1.3 billion in 2017.

The price of the $ 1,500 million 6.125% senior note due 2039 as of May 2013 follows (from Yahoo! finance). Maturity Date 2039

Issuer

Security Type

CVS Caremark Corporate (NYSE: CVS) Debentures

Coupon

Current Price

Current Yield

Fitch Rating

Callable

6.125

117.49

5.213

BBB

No

Required

a. What is the average coupon rate (interest paid) and the average effect.ive rate (interest expense) on the long-term debt? (Him: Use the disc losure for interest expense.) b. Does your computat ion of the coupon rate in part a seem reasonable given the footnote disclosure relating to specific bond issues? Explain. c. Explain how the amount of interest paid can differ from the amount of interest expense recorded in the income statement . cl. On its 2012 balance sheet, CVS reports current maturities of long-term debt of $5 million as part of short-term debt. Why is this amount reported that way? Is this amount important to our analysis of CVS? Explain. e. The $1,500 million 6. 125% seniornote due in 2039 is priced at 117.49 (117.49% of face value, or $ 1,762.35 million) as of 2013, resulting in a yield to maturity of 5.213%. Assum ing that the credit rating of CVS has not changed, what does the pricing of this 6.125% coupon bond imply about interest rate changes since CVS issued the bond?

~ Dell Inc. (DELL)

P7-39.

Analyzing Debt Terms, Yields, Prices, and Credit Ratings (L02 , 3) Reproduced below is the debt footnote from the 20 13 I 0-K report of Dell Inc.

Long-Term Debt (in millions) Senior Notes $400 million issued on June 10, 2009 , at 3 .375% due June 2012 ("2012 Notes") . . . . . . . ... . $600 million issued on April 17, 2008 , at 4 .70% due April 2013 ("2013A Notes") . . . . . . . . ... . $500 million issued on September 7, 2010 , at 1.40% due September 2013 . . . . . . . . . . .. . . . . $500 million issued on April 1, 2009, at 5.625% due April 2014 (bl. . .. . . . . . . . . . . . . . . . .. . . . $300 million issued on March 28, 2011, with a f loating rate due Apri l 2014 ("2014B Notes") . . . $400 million issued on March 28, 2011, at 2.10% due April 2014 . . . . . . . .. . . . . . . . . . . . . . . . $700 million issued on September 7, 2010, at 2 .30% due September 2015 (bl . . . . . • . . . . . . .• $400 million issued on March 28, 2011, at 3.10% due April 2016 (bl. . . . . . . . .. . . . . . . . . ... . $500 million issued on April 17, 2008 , at 5 .65% due April 2018 (bl. . .. . . . . ... . . . . . ... . .. . . • . . . . . . . •.•. $600 million issued on June 10, 2009, at 5 .875% due June 2019 lhl. .. ....... $400 million issued on March 28, 20 11, at 4.625% due April 2021 ..... . .. . . . . . . . . . . . . . . . $400 million issued on April 17, 2008, at 6 .50% due April 2038 . . . . . . .. . . . . . . . . . . . . . . . . . $300 million issued on September 7, 2010, at 5.40% due September 2040 . . . . . . . . . . .. . . . . Senior Debentures $300 million issued on April 3, 1998, at 7.10% due April 2028 ("Senior Debentures") (•l . . . .. . . Other Long-term structured f inancing debt . . . . . . .. . . . . . . . . . . . . . . . .. . ... . . . . . ... . . ...... . Less: current port ion of long-term debt .. . . . . . . . . . . . . . . . .. . . . . . ... . . . . . .. . . ....... . Total long-term debt . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . ... . . . . . . . . . . . . . .

February 1, 2013 $-

February 3, 2012 $ 400

601 500 500 300 400 702 402 502 604 398 400 300

605 499 500 300 400 701 401 501 602 398 400 300

379

384

872 (1,618) 5 ,242*

920 (924) 6,387 rnntin,

1Qr/

M o dul e 7 I Reporting and Analyz ing No n ow n er Financ ing

7-44

February 1, 2013

February 3, 2012

Short-Term Debt Commerc ial paper . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. ... . . . • . ... . . Short-term structured financing debt . . . . . . . . . . . . . . . . .. . . . . . ... . . . . . .... . . . . . . . . . . . Current portion of long-term debt . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . ... . . . Other . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . ... . . . . .

1,807 416 1,618 2

1,500 440 924 3

Total short-term debt. . . . . . . . . • . . . . . . . • . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,843

Long-Term Debt (in millions)

_____________________

Total debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$9,085

2,867 $9,254

'Reflects carrying value {net book value)of debt. Aggregate future maturities of long-term debt at face value were as follows at February 1, 2013 :

Maturities by Fiscal Year (in millions) Aggregate future matur ities of long-term debt outstanding . . ..

2014

2015

2016

2017

2018

Thereafter

Total

$1,6 17

$1,465

$790

$400

$-

$2,500

$6,772 ..

*' Reflects face value of debt.

Reproduced below is a summary of the market values as of November 2013 of the Dell bonds maturing from 2021 to 2040 (from Morningstar , quicktake.morningstar.com ).

Name Dell 5.4% . . . . . . . . .. . . . . . . . . . . . . . Dell 6.5% . . . . . . . . .. . . . . . . . . . . . . . Dell 4.625% . . . . . . .. . . . . . . . . . . . . .

Maturity Date

Amount$

Price

9/10/2040 4/15/2038 4/1/2021

300 400 400

69 .50 77 .30 91.50

Coupon % 5.4 6 .5 4.625

Yield to Maturity % 8.24 8.77 6.07

Required a. What is the amount of long-term debt reported on Dell's Februar y 1, 2013, balance sheet? What

b.

c.

d.

e.

P7-40.

are the schedu led maturities for this indebtedness? Why is inforniation relating to a company 's scheduled maturities of debt usefu l in an ana lysis of its financial condition? Dell reported $270 million in interest expense in the notes to its 2013 income statement. In the note to its stateme nt of cash flows, Dell indicates that the cash portion of this expense is $279 million. What could account for the difference between interest expense and interest paid? Explain . Dell's long-term debt is rated Baal by Moody 's, BBB + by S&P, and BBB+ by Fitch. What factors would be important to consider in attempting to quantify the relative riskiness of Dell compared with other borrowe rs? Explain . Dell's $300 million 5.4% notes traded at 69.5 or 69 .5% of par, as of November 2013. What is the market value of these notes on that date? How is the difference between this market value and the $300 million face value reflected in Dell 's financial statements? What effect would the repurchase of this entire note issue have on Dell's financial statements? What does the 69 .5 price tell you about the general trend in interest rates since Dell sold this bond issue? Explain . Examine the yields to maturit y of the three bonds in the table above. What relation do we obse rve between these yields and the maturities of the bonds? A lso, explain why this relation app lies in general.

Analyzin g Notes, Yield s, Financia l Ra tios, and C r edit Ratin gs (L02, 3) Comcast Corporation reports long-term senior notes totaling over $40 billion in its 2012 10-K. Following are selected rat.ios from Exhibit 7.6 computed for Comcast Corp. utilizing its 20 I2 data.

Comcast Corp. (CMCSA)

7-45

Module

7

I Reporting and Analyzing Nonowner Financing

EBITA/Averageassets . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EBITA/lnterest expense . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . EBITAmargin . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . Operat ing margin . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . (Funds from operations + Interest expense) / lnterest expense . . . ... . .. . . . . . Funds from operations/Debt . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . Debt/EBITDA. . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . Debt/Book capitalization .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . .

8.57% 5.48 22.10% 13.14% 6.89 36 .71% 2.03 29.45 %

Required

Th is debt is rated "A 3" by Moody's, which is an upper medium grade. Examine the rat.ios provided above. (Hint : Compare Comcast's ratio s to the ratio values reported in Exhibit 7.6.) What factors do you believe contribute to Comca st 's credit rating being less than stellar?

IFRS 17-41. BP

p.l.c. (BP)

APPLICATIONS Interpreting a Co ntin gent Liabilit y Foot no te (L01) BP operates off -shore dri lling rigs including rigs in the Gulf of Mexico. On April 20, 2010 , explosions and fire on the Deepwater Horizon rig led to the death of II crew members and a 200-million-gallon oil spill in the Gulf of Mex ico. BP 's 2010 annual report (prepared under IFRS) included the following concerning estimates of contingent liabilities (provisions): In est imating the amount of the provision, BP has determined a range of poss ible outcomes for Individual and Business Claims , and State and Local Claims .. .. BP has concluded that a reasonable range of poss ible outcomes for the amount of the provision as at 31 December 2010 is $6 billionto $13 billion. BP believes that the provision recorded at 31 December 2010 of $9.2 billion represents a reliable best est imate from within this range of possible outcomes. How did BP record the $9.2 billion est.imate in its 2010 financial statement s? How would the account ing for this provision differ if BP had prepared its financial statements in accordance with U.S. GAAP?

17-42. Fonciere des Regions

Interpreting Bond Foot note Disclosures (L02) In October 2012 , French real estate compan y Fonciere des Regions issued bonds with a total face value of €500 million. The bond proceeds were €504.087 million. The 2012 annual report has the following note: Fonciere des Regions launched a bond issue as described below: Issue date . . . . . . . . . . . .. . . ... . . . . . ... . .. . . . . . . . . . . . . . . . .. . . . . . . . 19/ 10/2012 Issue amount (€ M) . .. . . . . . . . . . . . . . . . .. . . .. . . . . . . .. . . . . ... . . .. . . . . 500 3.875 % Nominal rate . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . 16/ 01/ 2018

a. Determin e the annual interest payments. (H int: Nominal rate of 3.875% is the coupon or face rate

of interest.) b. Assume the bonds are due in 5.25 years (October 20 12 till Janu ar y 201 8). Determine the effective interest rate. c. What amount of interest expense does the compan y report relate d to these bonds for the first full year after they are issued? 17-43. Deutsche TelekomAG

(L01, 3) Assessing Liabilit y Foo tnot es in Financial Statements Deutsche Telekom AG , headquartered in Bonn , Germany, is the largest telecommun ications compan y in Europ e. The compan y uses IFRS to prepare its financial statements. The compan y's 20 12 financial statements report the following:

Modul e 7 I Reporting and Analyzing Nonow ner Financing

7-46

Changesin netdebt(millionsof€) 40,121

(6,239) -- ,

-

- - - -Netdebtat Free Jan. 1, 2012 cash flow

-•

3400 750 470 ~-----~-, -- - -- ----- -----

(1,906)

- - - - - ~)

_--- -

36,860

Payment Sale of Dividend Payments Effects Spectrum Exchange Netdebtat receivedas Telekom payments to external from acquisition rateand Dec.31, 2012 Srt:Jija(includingto pension theAT&T othereffects partof the non-controlling funds transaction celltower transaction with interests) CrownCastle

T he debt footnote s report detail s about D eutsche Telekom's financing activities as fo ll ows:

At the reporting date, the foreign-currency liabilities for which currency risks were hedged mainly consisted of bonds and medium-term notes in Australian dollars, pound sterling, Japanese yen, Norwegian kroner, Swiss francs, Czech koruna, and U.S. dollars . On account of these hedging activities, Deutsche Telekom was not exposed to any significant currency risks in the area of financing at the reporting date.

Required a. T he graphic shows changes in net debt , which is debt less cash and marketab le securiti es. For each of the changes shown in the graphic, determine if the cash flow was operating , inves tin g, or financing. b. Explain why the company i ssues debt in so many currenc ies.

17-44.

Anal yzing Debt Terms, Yields, Pri ces, and Credit Ratin gs (L02, 3) Statoil ASA, headquartered in Stavanger No rway is a fully int egrated petrol eum company Th e company uses IFRS to prepare it s financial statements. Reproduc ed bel ow i s the lon g-term debt note from its 20 12 annual report .

Carrying amount in NOK billion At 31 December

________

Fair value in NOKbillion

2012

2011

2012

2011

Total financ ial liabilities . . . . . ... . . . . .. . . . . . . . . . Less current port ion . . . . . . . . . . . . . . . . . . . . . . . . .

106.7 5.7

118.8 7.2

126.1 5.9

135.5 7.2

Financial liabilities, non-current portion . . . . . . . . . .

101.0

111.6

120.2

128.3

Weighted average interest rates in% Financial liabilities Unsecured bonds US dollar (USD) ..... . .. . . . . Euro (EUR) . . . . . . . . . ....... Japanese yen (JPY) . . . . . . . . . Great Britain Pound (GBP) . . . . Total . . . . . .. . . . . . . . . . . . . . .

Carrying amount in NOK billion at 31 December

Fair value in NOK billion at 31 December

2012

2011

2012

2011

2012

2011

4.52 4 .99

4.92 4.99 1.66 6 .71

69.9 18.4

80.2 22.8

9.2

65.5 19.5 0.4 9.5

13.8

74.8 23.1 0.4 13.2

97_5

94.9

116.8

111.5

6.71

continued

Statoil ASA (STO)

7-47

Module

7 I Reporting and Ana lyzing Nonow ner Financing

continued from prior page

At 31 December

Maturity profile bonds, bank loans and finance lease liabilities (in NOK billion) Year 2 and 3 . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . ....... . .. . . . Year 4 and 5 . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .......•.. ... After 5 years . . . . . . . . . . .. . . . . . . . . . . . . . . . . .. . . . • . ......•.. ... Total repayment . . . . . . . . . . .. . . . . . ... . . . . . ....

. . . ......

. .. . . .

2012

2011

19.1 10.8 71 .1

21.3 21.8 68 .5

101.0

111 .6

9 4.74

Weighted average maturity (year) . . . . . . . . . . . . . . . .. . . . . ... . . . . . . . Weighted average annual interest rate(%) . . . . . .. . . . . . . ... . . . . . . .

9 4.84

Reproduced below is a summary of the market valu es, at July 2013, of the Sta toi l ASA bonds maturing from 2014 to 2040.

Maturity date

Amount Outstanding

Current price

Statoil Asa USO . . . . . .. . . .

08/17/2017

1,250 .0

105 .8

Statoil Asa USO . . . . . .. . . .

08/ 17/2040 04/30/20 14

750 .0 500 .0

106 .6 102 .6

Currency

Statoil Asa USO . . . . . .. . . .

Coupon

Yield

3.125 5.100 3.875

4.67 0.50

1.67

Required a. What is the amount of total financial liabi lities (debt) reported on Statoil 's 2012 balance sheet? Of

the total financial liabilities, what proportion is due wi thin one year?

b. In what currencies has Statoil issued financial liabiliti es? Why do companies borrow mone y in foreign curre nci es?

c. What are the scheduled maturities for Statoil 's indebtedness ? Why is informat.ion relating to a company's sched uled maturities of debt useful in analyzing financial condition ? d. Statoil's lon g-term debt is rated AA - by Standard and Poor 's and sim ilarl y by other credit agencies. What factors wou ld be important to cons ider in quantify ing the relat ive riskiness of Statoi l compared to othe r borrowers ? Expla in. e. Statoil 's $ 1,250 million , 3.12 5% not es traded at 105.8 or 105 .8% of par , as of Jul y 2013. What is th e market valu e of th ese note s on that date? How is the differ ence between this market value and the $1,250 million face va lue reflected on Statoi l 's financial statements? What does the I 05.8 price tell you about the genera l trend in int erest rates since Statoil sold th is bond issue? Explain . f Examine the yie ld s to maturity of the bonds in the previous table. What relation do we observe between these yields and the maturities of the bonds ? Explain why this relation app lies in general.

17-45. Bombardier, Inc. (BDRBF)

Analyzing Contingent Liabilities: Warranty Reserves (L01) Headquartered in Montr eal, Quebec , Canada, Bombardier, Inc,. is a mul tin at iona l aerospac e and tran sportation company , founded in 1941. The company manufactures reg ional aircraft, busin ess je ts, mass transportation equ ipm ent, and recreat.ional equipment and is also a financial services provider. Bombardier is a Fortune Global 500 company and operates two segme nts : BA (Aerospac e) and BT (Tran sportation) . Bomb ardi er's 20 12 annual report includ es the following details about the company's warranty rese rve : Balance as at December 31, 2011 . . . . . . . . .... . . . . . . . . . . . . .. . . . ... . . Additions . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . • . . . . . . . • . Utilization ... . . ... . . .. . . . . . . . . . . . . . . . . . • . ..... . • . . . . .. . .. . .. . Reversa ls . . . .. . . . . . . . . • . ..... .. ... . . . . . ... . . . .. . . . . . . . . . . . . . Accretion expense . . . . . . . . . . . . . . .. ... . . . . . ... . . . .. . . . . . . . . . . . . Effect of changes in discount rates . . . . . . . . . . .. . . . . . . . . . . ... . .... . Effect of foreign currently exchange . . . .. . . . . . . . . . . . . . . . .. . . . . . ... .

$1,073 308 (365) (66) 1

Balance as at December 31, 2012 . . . . . . . . . . . . . . . ....

$ 966

. .......

. ....

Of which current . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . ... . . . . . ... . Of which non-current . . . . . . . ... . . .. ... . . . . . ... . . . .... . ... . ... . .

.

15

$ 818 148 $ 966

M odul e 7 I Report ing and Analyz ing Nonowner

Financing

7-4 8

Required

a. In common language, explain what is a warranty reserve. When do companies create such reserves?

b. What amount is included on the 2012 balance sheet for warranty reserve? c. What amount is included on the 2012 income statement related to warranties? d. What is meant by "Utilization" in the table? What sort of costs does this entai l? 17-46.

Analyzin g Cont ingent Lia biliti es: Rest ru cturin g Reserves (L01) Headquar tered in Brampton Ontario, Canada, Loblaw Companies is a supermarket chain with numerous stores across Ontario and Quebec. In western Canada, Loblaw operates as Real Canadian Superstore. The company 's 2012 annual report included the following:

Loblaw Companies (L.TO)

Provisions consist primarily of amounts iecorded in iespect of restructru ing, self-insurance, commod ity taxes, environmenta l and decommissioning liabilities and on!D\Js lease arrangements . The following are cont inuities relating to the Company's provisions : (millions of Canadian dollars)

2012

2011

$ 85 80 (20) (8)

$105 56 (50) (26)

Provisions, end of year . . . .. . . . . . . . . . . . . . . .. . . . ... . . . . . ... . .. .

$137

$ 85

(millions of Canadian dollars)

2012

2011

Recorded on the consol idated balance sheets as follows: Current portion of prov isions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-current portion of prov isions. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 78 59

$ 35 50

Total provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$137

$ 85

Provisions, beginning of year . .. Additions . . . . . . .. . . . . . . . . . . Payments . . . . . . . . . . . . . . . . . . Reversals . . . . . . . .. . . . . . . . . .

.. .. .. ..

.. .. .. ..

.. .. . .. . .... . .. .

.. .. .. ...

.. .. .. .

.. .. .. ..

. .. . .... .. ... . . ...

.. .. . .

.. .. .. ..

.. .. .. ..

.... .... ... . ....

... ... ... ...

Required

a. In common language , explain what is a restructuring provision. Whe n do compan ies create such

provisions? b. What amo unt is included on the 2012 balance sheet for tota l provisions? c. What amount is included on the 2012 income statement related to tota l provisions? d. What is meant by "Payme nts" in the table? What sort of costs does this entail? e. What is a reversa l and how do they occur? 17-47.

An alyzin g Debt Footn otes (L02) Headq uartered in Montrea l, Canada, Valeant Pharmaceuticals International, Inc. is a mult inationa l specialty pharmaceutical company that develops and markets prescription and non-prescription pharmaceuticals, principa lly in the areas of dern1atology and neurology. The company is the laigest pharmaceutical company in Canada with a portfolio of more than 500 products and 400 emp loyees involved in R&D activities. The company is listed on both the NYSE and the Toronto Stock Exchange . Its 2012 income statement repor ted the following line item:

($000s)

______

2012

Loss of extingu ishment on debt. . . . . . . . . . . . . . . . . . . . . . $(20,080)

2011

2010

$(36,844)

$(32,413)

Required

a. What is a loss on extinguishment of debt? Why does such a loss ari se?

b. How does the company calculate the loss on extinguishment of debt? c. Would we categorize this income statement item as operating or nonoperating?

Valeant (VRX)

7-49

Module

7 I Report ing and Ana lyzing Nonowne r Financ ing

17-48. Potash Corporation of Saskatchewan (POT)

Analyzing Debt Footnotes (L02, 3) Potash Corporation of Saskatchewan - the wor ld's largest potash producer - is a Canadian corporation based in Saskatoon, Saskatchewan. The company produces nitrogen and phosphate used to produce fertilizer. At the end of 201 I, the company controlled 20% of the world ' s potash production capacity, 2% of nitrogen production capacity and 5% of phosphate supply. Its 20 12 financial stateme nts disclose the follow ing as part of its long-term debt footnote.

Short-term debt at December 3 1 was comprised of:

2012 Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $369

2011 $829

Long-term debt at December 3 1 was comprised of:

2012

2011

notes 1

Senior 4.875% 5.250% 3. 750% 3.250% 6.500% 4.875% 5.875% 5.625% Other . .

notes due March 1, 2013 . . ... . . .. . . . . . . . . . . . . . . .. notes due May 15, 2014 . . . . . . . . . . . . . .. . . . . . . . . . . . notes due September 30, 2015 . . . . . . .. . . . . . . . . . . . . notes due December 1, 2017 . . . . . . . .. . . . . . . . . . . . . . notes due May 15, 2019 . . . . . . . . . . . . .. . . . . . . . . . . . . notes due March 30, 2020 . . . . . . .. . . . . . . . . . . . . . . .. notes due December 1, 2036 . . . . . . . .. . . . . . . . . . . . . . notes due December 1, 2040 . . . . . . . . .. . . . . . ... . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. ... . . . .

. . . $250 $ 250 ... 500 500 ... 500 500 ... 500 500 ... 500 500 ... 500 500 ... 500 500 ... 500 500 ... 6 7

Less net unamortized debt costs . . . . . . . . .. . . . . . . . . . . . . ... .. . .

Less current maturities . . . .. . . . . . . . . . . . . . . . .. . . . . . ... . . . . . . . Add current portion of amortization . . . . . . . . . . . .. . . . . . . . ... . . . .

3,756 (44)

3,757 (49)

3,712

3,708

(250) 4 $3,466

(7) 4 $3,705

' Each series of senior notes is unsecured and has no sinking fund requirements prior to maturity. Each series is redeemable, in who le or in part, at the company's option, at any l ime prior to maturity for a price not less than the principa l amount of the notes to be redeemed, plus accrued and unpaid interest. Under certain condit ions related to a change in control, the company is required to make an offer to purchase all, or any part, of the senior notes other than those maturing in 2013 at 101 percent of the principal amount of the notes repurchased, plus accrued and unpaid interest.

Long-term debt obligations at December 31, 2012 will mature as follows:

20 13. . . . . . .... . ....... 20 14. . . . . . .... . ....... 2015. ...... ......... 2016 . . . . . .. . . . . . . . . . 2017. . . . . .. . . . . . . . . . Subsequent years . . . . .

.. .. .. ..

. .... . .... .... .... .... ....

. . .. .. .. ..

.. .. .. .. .. ..

.. .. .. .. .. ..

.. .. .. .. .. ..

.. .. .. .. .. ..

. . . . . . . .. . . . . . . . .. . . . . . . . .. . . . . . . . .. . . . . . . . .. .........

... ... .. ... ... ..

. . . . . ... . . . .. . . . . . . . ... . . . .. . . ............. ... . . . . . ... . . . .. . . . . . . . ... . . . .. . . .... ............

$ 250 500 500 506 2,000 $3,756

continued

Modul e 7 I Reporting and Analyz ing No nowner Financing

7-50

FINANCE COSTS

2012 Interest expense on Short-term debt .. . . . . . . . . . . . . . . .. . . . . . . . . . . . ... Long-term debt . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . Unwind ing of discount on asset retirement obligat ions . . . . Borrowing costs capita lized to property, plant and equipment . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . ... Interest income . . . . . ... . . . . . .. . . . . . . . . . . . . . ...... .

$ 5 203 12 (102) (4) $114

2011

2010

$ 8 $ 8 227 217 16 11 (84) (8)

(107) (8)

$159

$12 1

Borrowing costs capita lized to property, plant and equ ipment during 2012 were calculated by app lying an average capitalization rate of 4 .6 percent (2011: 4.4 percent, 2010: 5.0 percent) to expenditures on qua lifying assets .

2012 Supp lemental cash flow d isclosure: Interest paid . . . . . . . . . . . . . . . .. . . . . .

2011

$209

2010 $212

$233

Reproduced below is a summary of the May 20 I 3 market values of the Potash bonds maruring from 2015 to 2040 (from Morningstar , quicktake.momingstar. com) .

Coupon

Name

Potash Corp Potash Corp Potash Corp Potash Corp Potash Corp Potash Corp

Sask Sask Sask Sask Sask Sask

3.75% .... 3.25% .... 6.5% ... 4.875%. 5.875%. 5.625% ..

Maturity Date

Amount $(M Ii)

Credit Quality

Price

%

Type (Fixed/ Floati ng!

Ca lla ble

Ru le 144A

09/30/2015 12/01/2017 05/15/2019 03/30/2020 12/01/2036 12/01/2040

500.0 500.0 500.0 500.0 500.0 500.0

High High High High High High

106.1 104.7 120.5 110.4 111.3 112.5

3.750 3.250 6.500 4.875 5.875 5.625

Fixed Fixed Fixed Fixed Fixed Fixed

No No No No No No

No No No No No No

Coupon

Yield to Matu rity

%

0.96 2.11 2.69 3.14 5.05 4.80

a. What is the average coupon rate (interest paid) and the average effective rate (interest expense) on long-term debt? (Hint: Use the disclosure for interest expense.) b. Does the coupon rate computed in part a seem reasonable given the footnote disclosure relating to specific bond issues? Explain. c. Explain how the amount of interest paid in cash can differ from the amount of interest expense recorded in the income statement. d. On its 2012 balance sheet, Pota sh repor ts current maturities of long-term debt of $246 million as part of short-term debt. Why is this amount reported that way? Is this amount important to our analy sis of Potash? Explain . e. The table above show s that the $500 million 5.625% note due in 2040 is priced at 112.5(112.50% of face value, or $562.5 million) as of 2012, resulting in a yield to maturity of 4.80 %. Assuming that the credit rating of Potash has not changed, what does the pricing of this 5.625% coupon bond imply about interest rate changes since Potash issued the bond? f Examine the yield to maturity of the bonds in the table above. What relation do we observe between these yields and the maturi t.ies of the bonds? Also, explain why this relation applies in general.

7-51

M o dul e

7 I Reporting and Ana lyz ing Nonow n er Financing

17-49. Rio Tinto Group

Analyzing Debt Footnotes (L02, 3) Rio Tinto Group , a British -Australian multinational corporation, is among the world leaders in the production of many commodities, including aluminum , iron ore, copper, uranium, coal, and diamonds. Reproduced below is the debt footnote from its 2012 financial statements .

Borrowings at 31 December USO Commercial Paper . . . . . . . . . . . . . .. . . . . . . . . . . . . . . Alcan Inc. Globa l Notes 4.875% due 2012 . . . . . . . ... .. . . Alcan Inc. Globa l Notes 4.50% due 2013 . . . . . . . . . . . .. . . Rio Tinto Finance (USA) Limited Bonds 5.875% 2013 . . . . . Rio Tinto Finance (USA) Limited Bonds 7.125% 2013 . . . . . Alcan Inc. Globa l Notes 5.20% due 20 14 . . . . . . . . . . . .. . . Rio Tinto Finance (USA) Limited Bonds 8.95% 2014 . . ... . Rio Tinto Finance (USA) p ie Bonds 1.125% 2015 .. . . . ... . Alcan Inc. Global Notes 5.00% due 20 15 . . . . . . . . . . . .. . . Rio Tinto Finance (USA) Limited Bonds 1.875% 2015 Rio Tinto Finance (USA) Limited Bonds 2.500% 2016 . . . . . Rio Tinto Finance (USA) Limited Bonds 2.250% 2016 . . . . . Rio Tinto Finance (USA) p ie Bonds 2.0% 2017 . . .. . . . . . . . Rio Tinto Finance (USA) p ie Bonds 1.625% 2017 .. . . . . . . . Rio Tinto Finance (USA) Limited Bonds 6.5% 2018 . . . . . . . Rio Tinto Finance (USA) Limited Bonds 9.0% 2019 . . . . . . . Rio Tinto Finance Pie Euro Bonds 2.0% due 2020(c) . . . . . . Rio Tinto Finance (USA) Limited Bonds 3.5% 2020 . . . . . . . Rio Tinto Finance (USA) Limited Bonds 4.125% 202 1 . . . . . Rio Tinto Finance (USA) Limited Bonds 3.750% 202 1 . . . . . Rio Tinto Finance (USA) p ie Bonds 3.5% 2022 . . .. . . . . . . . Rio Tinto Finance (USA) p ie Bonds 2.875% 2022 .. . . . . . . . Rio Tinto Finance Pie Euro Bonds 2.875% due 2024 . . . . . . Rio Tinto Finance (USA) Limited Bonds 7.125% 2028 . . . . . Alcan Inc. Debentures 7.25% due 2028 . . . . . .. . . . . . . . . . . Rio Tinto Finance Pie Sterling Bonds 4 .0% due 2029 . . . . . . Alcan Inc. Debentures 7.25% due 2031 . . . . . .. . . . . . . . . . . Alcan Inc. Globa l Notes 6.125% due 2033 . . . . . . . . . . .. . . Alcan Inc. Globa l Notes 5.75% due 2035 . . . . . . . . . . . .. . . Rio Tinto Finance (USA) Limited Bonds 5.20% 2040 . . . . . . Rio Tinto Finance (USA) p ie Bonds 4.75% 2042 . .. . . . . . . . Rio Tinto Finance (USA) p ie Bonds 4.125% 2042 .. . . . . . . . Loans from equity accounting units . . . . . . . . . . . . . .. . . . . . Other secured loans . . . . . . . . .. . . . . ... ... . . . . . .. . . . . . Other unsecured loans . . . . . . . ... . . . . . ... . . . . . .. . ... . Finance leases . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . Bank overdrafts . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . Total borrowings including overdrafts . . . ... . . . . .. . . . . . . Derivative financial instruments . . . . . . .. ... . . . . . ... . . . . Other financial liabilities . . . . . . . . . . . .. . ... . . . . . ... . . . . Total other financial liabilities . . . . . . . . . . . . . . .. . . ... . . . . Total borrowings and other financial liabilities . . . . . .. . ... .

Non-current

Current

2012

2012

2012

US$m

US$m

US$m

$-

$ 200

$ 200 498 595 100

498 1,935 498 501 500 696 497 499 1,24 1 2,059 1,456 971 994 997 1,143 992 984 636 1,053 107 804 432 738 283 1,146 489 725 111 918 519 41 24,463 70 58

---

128

$24,591

72 78 556 12 94 2,205 23

--

Total

23

$2,228

498 595 100 498 1,935 498 50 1 500 696 497 499 1,241 2,059 1,456 97 1 994 997 1,143 992 984 636 1,053 107 804 432 738 283 1,146 489 725 183 996 1,075 53 94 26,668 93 58

---

15 1

$26,819

The table below analyses the Groups financia l liabilities by relevant maturity groupings based on the remaining period from the statement of financial position date to the contractual maturity date. As the amounts disclosed in the tab le are the contractua l undiscounted cash flows , these balances will not necessarily agree with the amounts disclosed in the state ment of financ ial position.

continued

Module

7 I Reporting and Analyz ing No nowner Financing

At 31 December 20 12 (Outflowsj/lnflows

7-52

WHhln1 year oron demand

Between 1 and 2 years

Between 2and 3years

Between 3and 4years

Between 4and 5 years

After5 years

Total

USSm

USSm

USSm

USSm

USSm

USSm

USSm

Non-derivative financial liabilities Trade and other payables.

Borrowings before swaps. .. ........... Expected future interest payments

.. .

Other financial liabilities Derivativefinancial liabilities.

(7,612)

(147)

(2,199)

(2,627)

(1,798)

(1,342)

(2,054)

(16,328)

(26,348)

(7,759)

(1,072)

(970)

(878)

(847)

(821)

(6,891)

(11,479)

(49)

(90)

(31)

(5)

(5)

(180)

Derivatives related to net debt - net settled. . Derivatives related to net debt - gross settled:

- grossinflows. - grossoutflows . ... Total

80

80

80

80

80

1,359

1,759

(71)

(71)

(71)

(71)

(71)

(1,297)

(1,652)

(10,923)

(3,825)

(2,698)

(2,185)

(2,871)

(23, 157)

(45,659)

a. What is the amount of debt reported on Rio Tinto 's, 2012, balance sheet?

b. What are the scheduled maturities for this indebtedness? Why is information relating to a company's schedu led maturities of debt useful in an analysis of its financial condition? c. Rio Tinto reported $1,005 million in interest expense in the notes to its 2012 financial statements. In its statement of cash flows, Rio Tinto indicates that the cash portion of this expense was $837 million. What could account for the difference between interest expense and interest paid? Explain. d. Rio Tinto's long-term debt is rated A3 by Moody's and A- by S&P. What factors would be important to conside r in attempting to quantify the relative riskine ss of Rio Tint o compared with other borrowers? Explain. e. Assume that the 4. 125% Rio Tinto Financ e bonds with a face value of $725 million maturing in 2042 were trading at 96.2, or 96.2% of par, as of December 2012. What is the market value of these notes on that date? How is the difference between this market value and the $725 million face value reflected in Rio Tinto's financia l statements? If the company had repurchased this entire note issue on December 31, 2012, what wou ld have been the effec t on Rio Tinto's financia l statements? What does the 96.2 price tell us about the general trend in interest rates since Rio Tinto sold this bond issue? Exp lain.

MANAGEMENT

APPLICATIONS

MA7-SO. Coupon Rate versus Effective Rate (L02) Assume that you are the CFO of a company that intend s to issue bonds to finance a new manufactur ing facility. A subordinat e sugges ts lowering the coupon rate on the bond to lower interest expe nse and to increase the profitab ility of your company . Is the rationa le for this suggestion a good one? Explain. MA7-Sl.

Ethics and Governance: Bond Covenants (L02) Becau se lenders do not have voting rights like shareho lders do, they often reduce their risk by invoking various bond covenants that restrict the compa ny's operating, financing and investing activit ies. For examp le, debt covenants often restrict the amount of debt that the company can issue (in relation to its equity) and impose operat ing restrictions (such as the ability to acquire other companies or to pay dividends). Failure to abide by these restrictions can have serious conseque nces, including forcing the company into bankruptcy and potential liquidation. Assume that you are on the board of directors of a company that issues bonds with suc h restrictions. What safegua rds can you identify to ensure compliance with those restrictions ?

ONGOING

PROJECT

(This ongoing pmject began in Modul e 1 and continues thmugh most of the book; even if p1evious segments were not completed, the requirements are still applicable to any business analysis.) Review liabi lities that ar ise from operating and financing transactions, including the type and quantity of both

7-53

Module

7 I Report ing and Ana lyzing Nonowne r Financ ing

categories. The goal is to consider how the compan ies are financed and whether they can repay their obligations as they come due in the short and longer term. I. Operating Liabilities. Operating liabi lities arise from ordinar y operations and provide a less expensive source of financing. Th e following questions help direct our analysis. Are operating liabilities large for the companies? Compare common -s ized amounts. What proportion of total liabilit ies are operating? What are the companies' main operating liabilit.ies? Compute accounts payab le turnover and compare it over time and between the two companies . Are there substantia l contingencies? What gives rise to these? Read the footnote and determine whether the company has recorded a liability on its balance sheet for these contingencies. 2. Nonoperatin g Liabilities. Examine the debt footnote and cons ider the following questions . What proportion of total liabilities are nonoperating? What is the common-sized debt and how does that compare to published industry averages? What types of debt does the company have? Is it publicly traded? Are there bank loans? Other types of debt? When does the debt mature? Determ ine if there is a large proport.ion due in the next year or two. If so, can the company refinance given its current level of debt ? What is the average interest rate on debt? Compare it to the coupon rates reported. Read the footnote and the MD&A to see if there are any debt covenant s and whether the company is in compliance . If the company has publicly traded debt, determine its current price. Sharp drops in bond prices cou ld indicate a deterioration in the compan y' s cred it quality. 3. Credit Rating s. Find the companies ' cred it ratings at two or three ratings agencies ' Websites. What are the credit rat.ings and how do they compa re across the agenc ies? Are the two compan ies similarly rated? Have the ratings changed during the year? If so , why? Are the companies on a credit watch or a downgrade list? If possible, find a credit report online and read it to gain a better unde rstanding of the companies' creditworthiness . Calculate the ratios in Exhibit 7.6 for you r firms. Compare the ratios to those for firms with sim ilar credit ratings. Do the cred it ratings for the firms seem reasonable?

Mid-Module

Review

1

Solution a. We know that accounts payable turnover is computed as cost of goods sold divided by average accounts pay-

able. Thus, a decrease in accoun ts payable turnover indicates that accoun ts payable have increased relative to cost of goods sold (all else being equal).

b. An increase in accounts payable resul ts in an increase in net cash flows from operating activ ities because Verizon is using cash to pay bills more slowly. c. Increased accounts payable decreases net operating work ing capital (all else being equal), with a consequent increase in cas h flow. While favorab le to cash flow, the less timely payment of accounts payable can strain supp lier relations. Ana lysts must be aware of the costs and benefits of leaning on the trade to a greate r or lesse r exten t.

Mid-Module

Review

2

Solution Yes. Verizon must recog nize liabilities and expenses when incurred , regardless of when payment is made. Accruing expenses as incurred will match the expenses to the revenues they helped generate . Failure to recognize the wages owed to employees for the period would unders tate liabilit.ies and overstate income . Verizon must reflect the wages earned and the rela ted expense in its financial statements as follows:

Module 7 I Reporting and Analyzing Nonown er Financing

7-54

Balance Sheet Cash Asset

Transaction

Noncash Assets

+

Accrue $10,000 in wages expense

Liabilities

=

+

Income Statement Contrib. Capital +

Earned JI Capital

Revenues

'-.. Net Income

Expenses

+ 10,000

- 10,000

+ 10,000

Wages

Retained

Payable

Earn ings

Wages Expense

=

WE WP

10,000 10 ,000

WE 10,000 WP

- 10,000

I I

Mid-Module

Review

10,000

3

Solution Balance Sheet Cash Asset

Transaction

Liabilities

Noncash Assets

+

Jan 3 1: Accrue $26 interest expense* 'Accrued interest = $10,000x

Module-End

+

Income Statement Contrib. + Capital

Earned Capital

JI

Revenues

Expenses

+ 26

- 26

+ 26

Interest

Retained

Interes t

Payable

Earnings

Expense

"- Net Income IE IP

26 26

IE

- 26 26

I I

IP 26

0.06 x 16/365 = $26.

Calculator N = 30 INr= 4 PMT = - 15,000 FV = - 300,000

Review

Solution

I. Issue price for $300 ,000, 15-year bonds that pay 10% interest semiannually, discounted at 8%: Present value of principa l payment ($300,000 x 0.30832) . . . . . . . . . . . . . . . . . . . . . . . . . .

IPv = 351,876.10

$ 92,496

Present value of sem iannual interest payments ($15,000 x 17.29203). . . . . . . . . . . . . . . . .

259,380

Issue price of bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$35 1,876

Excel

= PV(rate,npe r, pmt ,jfv],[typeD ::::PV(4% , 30 . - 15000,

- 300000, 0)

= 351,876. 10

2. Balance Sheet Transaction January 1: Issue 10% bonds

Cash Asset

+

Liabilities

Noncash Assets

+ 351,876 Cash

+

Income Statement Contrib. Capital

+

Earned JI Capital

Revenues

Expenses

+ 351,876 :

"- Net Income

=

Long-Term Debt

351,s16

I LTD

I 3s1 ,s1s IE

June 30: Pay interest and amortize bond prem ium'

351,876 351,876 Cash

Cash LTD

14,075

925 15,000

LTD Cash

- 15,000 Cash

December 31: Pay interest and amortize - 15,000 Cash bond premium2

:

- 925

- 14,075

Long-Term

Retained

Int erest

Debt

Earn ings

Expense

+ 14,075

IE 1,,015

= - 14,075

I

LTD

925

I

Cash

I

:

- 962

- 14,038

+ 14,038

Long-Term

Retained Earnings

Expense

Debt

Int erest

14,038 LTD 962 Cash 15,000

= - 14,038

IE ,,,03s

I LTD

I

962 Cash

I $300 ,000 x 0.10 x 6/12 = $15,000 cash payment; 0.04 x $351 ,876 = $14,075 interest expense; the difference of $925 , is the bond premium amortizat ion, which reduces the net bond carrying amount. 2 0.04 x ($351,876 - $925) = $14,038 interest expense. The difference between this amount and the $15,000 cash payment ($962) is the premium amortizat ion, which reduces the net bond carrying amount. 1

15,000

IE

15,000

Module

• •

Reporting and Analyzing Owner Financing

L ea rnin g Ob jec ti ves

LO 1 Describe and illustrate accoun ting for contr ibuted capita l, including stock sales and repurchases, and equity-based compensation . (p. 8-4)

L02

Explain and illustrate accounting for earned cap ital, including cash dividends, stock dividends , and comprehensive income. (p. 8- 15)

L03

Describe accounting for equity carve -outs and convertib le debt. (p. 8-24)

IBM creates value for clients and solves business problems through integrated solutions that leverage information technology and deep knowledge of business processes . IBM solutions typically create value by reducing a clients operational costs or by enabling new capabilities that generate revenue. These solutions draw from an industry leading portfolio of consulting, delivery and implementation services , enterprise software , systems and financing . In its transformation from a hardware company to a consulting company, IBM shifted its business mix , exited certain segments and increased its presence in higher-profit lines of business such as services and software. As part of this shift, the company acquired moe than 140 companies since 2000, complementing and scaling its portfolio of products and offerings . To capture the opportunities arising from global market trends , IBM is focused on four key growth initiatives: Smarter Planet, Growth Markets, Business Analytics , and Optimization and Cloud Computing. Each initiative represents a significant growth opportunity with attractive profit margins for IBM . The company:; business model is built to support two principal goals : (1) helping clients to become more innovative , efficient and competitive though the applica-

tion of business insight and IT solutions; and (2) provi di ng long-term value to stockholders . The company:; global capabilities include services, software, systems, fundamental reseac h and related financing. The companys major operations consist of five business segments: Global Technology Services and Global Business SeNices , which the company collectively calls Global Services , and the three remaining being Software , Systems and echnology , and Global Financing . IBM 's R&D operations different iate the company fom its competitors . IBM annually invests over $6 billion for R&D, focusing on high-growth , high-value opportunities . IBM Research works with clients and the companys business units through 12 global labs that focus on neaFterm and mid-term innovations. It contributes many new tec hnolog ies to IBM 's portfolio every year and helps clients address their most difficult challenges . In 2012, IBM was awarded more U.S. patents than any other company for the 20th consecutive year IBM s 6,478 patents in 20 12 inclu ded inventions that will enable fundamental advancements in ana lyt ics, big data , cyber securit)( cloud , mobile , soc ial networking and software defined environments , as we ll as industry solutions for retail, banking , healthcare and transportation .

The value IBM creates for its stockholders lies not in plant assets , such as land and buildings , but in the knowledge capital of its employees. This module considers how stockholders' investment is accounted for on a company!:; financial statements. We consider common stock features, stock options, share issuances , shae repuchases , and dividend payments . IBM has one class of stock (and its price behavior over the recent five years is shown below) . Of the 4.7 billion shares that have been authorized for issuance , 2.2 billion have been issued to date. It also has restricted stock units. This stock is awarded to employees as incentive compensation. This module explains and assesses equity-based compensation.

IBM has repurchased over 1.1 billion shares of its stock at a purchase price of over $123 billion. Many companies routinely iepurchase their common stock as it is the best use of excess cash when there exist no better outs ide investment opportunities . Sane companies reµrchase their stock to offset the di lutive effect of stock-based compensation programs. This module explains and analyzes stock repuchases. The module also discusses a variety of equity transactions under the genera l heading of equity carve-outs and convertib les. These transactions inc lude several methods by which companies seek to unlock hidden value for the benefit of their stockho lders.

.... ,.. , .

~

•

"

_Jr

,~-111 --- ---l- -+ - +..i..

~

-+':,e_+.c:. ... - .>f' -=-'""1--+ -+--

l-.W

~

..

-' l .J , IA

..

l--+ - +- - l--+ - +---ll--+

+- ---l--+-+----l--+-.J.----l--+--.J.--l

y 2009

2010

'

$220

~'

$200

'

$180

'

$160

'

$

,

140 $120

~,..

&IJIP--" ...

l- ----+- ,--4... '..Jllll -+---ll--+-+----l--+-

., ,. , , ... .. " "" •

IBM Stock Price I

2011

Source: IBM Corpo ration, Form 2012 10- K and 2012 Annual Report to Stockholders.

20 12

2013

- +---l

,

$100

'

~

'

$60

8-3Module

8 I Reporting and Analyz ing Owner Financ ing

MODULE ORGANIZATION

Reporting and Analyzing Owner Financing

Contributed Capital of Stock • Classes Stock Transactions • Stock-based Compensation •

Equity Carve-Outs and Convertibles

Earned Capital

• • • • •

Cash Dividends Stock Dividends and Splits Comprehensive Income Foreign Currency Effects Noncontroll ing Interest

• • • •

Sell-Offs Spin-Offs Split-Offs Convertible Securities

A company finances its assets through operating cash flow s or it taps one or both of the follow ing sources: either it borrows fund s or it sells stock to stockhol ders. On average, companies obtain about half of their externa l financing from borrowed sources and the other half from stockholders . Th is module describes the issues relating to stockholders' equity, including the accounting for stock transactions (sales and repurchases of stock, dividends, stock-based compensation, and convertible securities). We also discuss equity carve-o uts, a process by which compan ies can unlock substan tial shareholder value via spin-offs and split-offs of business unit s into separate companies. Finally, we discuss the accumulated other comprehensive income and noncontrolling interest components of stockho lders ' equit y. When a company issues stock to the public, it recor ds the receipt of cash (or other assets) and an increase in stockholders' equity, representing the stockholders' investment in the company . The increase in cash and equity is equal to the market price of the stock on the issue date multipli ed by the number of shares sold. Like bonds, stockholders' equity is accounted for at historical cost. Consequently, the company 's financial statements do not reflect fluctuatio ns in the market price of the stock subsequent to its issuance . The company's stock price results from market transactions that involve outside parties and not the company. However, if the company repurchases and/or resells shares of its own stock, the balance sheet will be affected because those transactions involve the compa ny. There is an important difference between accounting for stockholders ' equity and accounting for transactions involving assets and liabilities: there is never any gain or loss reported on the purchase and sale of a company's own stock or the payment of dividends to its stockholders . Instead, these "ga ins and losses" are reflected as increases and decreases in stockholders' equity and do not affect net income (nor earned capital, see below). The typical balance sheet has two broad categories of stockho lders' equity: 1. Contributed capital These acco unt s repo rt the proceeds received by the issuing company from original stock issua nces . It often includ es common stoc k , preferred stock, and add itional paidin ca pital. Netted against these contribut ed cap ital accounts is treasury stoc k, the amounts pa id to repurc h ase shares of the issuer's stock from its inves tor s, less the proceeds from the resale of such shares. Co llective ly, these accou nts are referred to as cont ribut ed cap ital (or paid-in

capital) . 2. Earned capital This sectio n cons ists of (a) retained earnings, which represent the cumulative income and losses of the company, less any dividends to stockho lders, and (b) accumulated other comprehensive income (AOCI), which includes changes to equity that have not yet impacted income and are, therefore, not reflected in retained earnings. In addition, many companies report an equity account called noncontrolling interest, which reflects the equity of minority shareholde rs. Exhibit 8.1 illustrates the stockho lders' equity section of IBM 's balance sheet. IBM 's balance sheet reports three equity accounts that make up contributed capital: commo n stock, additiona l paid-in capital, and treasury (repurc hased) stock. IBM's balance sheet also reports two earned capital accounts: reta ined earnin gs and accumulated other comprehens ive income (loss) . The final component of IBM 's stockholders' equity is the noncontrolling interest account.

Modul e 8 I Reporting and Analyzing Owner Financing

EXHIBIT

8.1

Stockholders

' Equity

from

8-4

IBM 's Balance

Sheet

Stockholders ' Equity ($ in millions except per share amounts) Cont ributed Cap ita l Earned Cap ital Noncontroll ing Interest

December 31, 2012

December 31, 2011

Common stock-par value $.20 per share, and additional paid-in capital Authorized : 4,687,500,000 shares(issued:2012- 2, 197,561,159; 2011-2, 182,469 ,838) . . . $ 50,110

$ 48,129

Treasury stock at cost (shares:2012 - 1,080, 193,483; 2011 - 1,019,287,274) . . . . . . . . . . . . (123,13 1) Retained earnings . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . 117,64 1 Accumu lated other comprehens ive loss . . . . . . .. . . . . . . . . . . . . . . . ....

...•....

Total IBM stockholders' equity . . . . . .. . . . . . . . . ... . . . . .. . . . . . . . . . . . . . . . .. . . Noncontrolling interests . . . .. . . . . . . . ... . . . . . .. . . . . . . . . . . . . . . .. . . ... . . . . .

(110,963) 104,857

(25,759)

(21,885)

18,860 124

20,138 97

Total equity . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . . $ 18,984

$ 20,236

===

'We list contributed and earnedcapital accountstogetherfor learning purposes;in the IBM balancesheet, these accountsare reported in anotherorder.

We discuss contributed capital, earned capital, and noncontrolling interest in order. For each section, we prov ide a graph ic that displays the part of stockholders' equity in the balance sheet impacted by the discussion of that section .

CONTRIBUTED

CAPITAL

Contributed capital represents the cumulat ive cash inflow that the company has received from the sale of various classes of stock, less the net cash that it has paid out to repurchase its stock from the market. The contributed capital of IBM is highlighted in the following graphic. December 31,2012

December 3 1,2011

Common stock-par value $.20 per share, and additional paid-in capital Authorized: 4,687,500 ,000 shares (iss ue d: 2012-2 ,197,561 ,159; 2011-2 ,182 ,469 ,838) . . . $ 50,110 Treasury stock at cost (s hares: 2012-1 ,080 ,193,483 ; 2011-1 ,019,287 ,274) . . . . . . . . . . . . (123,131) Retained earnings . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . 117,641 Accumulated other comprehensive loss . . . ... . . . . . ... .. . . . . . . . . . . . . . . . . .. . . . (25,759)

$ 48,129 (110,963) 104,857 (21,885)

Stoc kholders' Equity ($ in millions except per share a mounts) Cont ributed Cap ital Earned Cap ital Nonco ntroll ing Interest

Total IBM stockholders' equity . . .. . . . . . . . . . . . . . . . ................... . . . .. . . Noncontrolling interests . . . . . . . . . . . . . .... . . . . . .. . . . . . . .. . . . . . . . . . . . . . . . .. .

18,860 124

Total equity .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. ... . . . . . ... . . . . . .. . . . . . . .

$ 18,984

20,138 97 $ 20,236

In 2012, IBMs contributed capital consists of par value and additiona l paid-in capital for the 2, 197,561,159 shares of its common stock that IBM has issued. Its contributed capita l is reduced by the cost of treasury stock for the 1,080,193 ,483 shares that IBM has repurchased .

Classes

of Stock

There are two general classes of stock: preferred and common . The difference between the two lies in the legal rights conferred upon each class .

L01

Describe

and illustrate accoun ti ng for

Preferred

Stock

Preferred stock generally has preference, or priori ty, with respect to common stock . Two usua l preferences are: 1. Dividend preference Preferr ed stockholders receive dividends on their shares before common stockholders do. If dividends are not paid in a given year, those dividends are norma lly forgone.

However, some preferred stock contracts include a cumulative p10vision stipulating that any forgone dividends (dividends in arrears) must first be paid to preferred stockholders, together with the current year's dividends , before any dividends are paid to common stockholders. 2. Liquid ation preference If a company fails, its assets are sold (liquidated) and the proceeds are paid to the creditors and stockholders, in that order . Stockholders, therefore, have a greater risk of loss than cred itors . Among stockholders, the preferred stockho lders receive payment in full before

contribu t ed cap ital, includ ing stock sales and repurchases, and equi t y-based compensation .

8-5

Modu le

8 I Report ing and Ana lyz ing Owner Financ ing

common stockhold ers. Thi s liquidation preference makes preferred shares less risky than common shares. Any liquidation payment to preferred shares is normally at par value, although sometimes the liquidation is specified in excess of par; called a liquidating value. To illustrate the typical provisions contain ed in preferred stock agreements, consider the followin g stockholders' equity and related footnot e disclosure from Dow Chemical Company (2012 10-K) .

At Dece mber 31 (In millions, except share amounts) Stockholders' eq uity Preferred stock, series A ($1.00 par, $1,000 liquidation preference, 4,000,000 shares) . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . Common stock (authorized 1,500,000,000 shares of $2.50 par value each; issued 2012: 1,203,292,822 shares; 2011: 1,184,562,287 shares) . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . .. . . . . . . Retained earnings . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . Accumulated other comprehensive loss . . . . . . . .. . . . . . . . . . . . . . . .. . . . Unearned ESOP shares .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock at cost (2012: zero shares; 2011: zero shares) . . . . . . . . . . .

The Dow Chemical Company's stockholders' equity . . . . . . . . . . . . . . . . .. . Noncontrolling interests . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . Total equity . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . .

20 12

2011

$ 4,000

$ 4,000

3,008 3,281 18,495 (7,516) (391)

2,961 2,663 19,087 (5,996) (434)

20,877

22,281

---

990

1,010

21,867

23,291

Cumulative Conv ertibl e Perpetual Preferred Sto ck, Series A Equity securities in the form of Cumulative Convertible Perpetual Preferred Stock, Series A (" preferred series A") were issued on April 1, 2009 to Berkshire Hathaway Inc. in the amount of $3 billion (3 million shares ) and the Kuwait Investment Authority in the amount of $1 billion (1 million shares). The Company will pay cumu lative dividends on preferred series A at a rate of 8.5 percent per annum in either cash, shares of common stock , or any combination thereof, at the option of the Company. Dividends may be deferred indefinitely, at the Company 's option . If deferred, common stock dividends must also be deferred. Any past due and unpaid dividends will accrue additional dividends at a rate of 1O percent per annum , compounded quarterly. If dividends are deferred for any six quarters, the preferred series A shareholders may elect two directors to the Company's Board of Directors until all past due dividends are paid . Ongoing dividends related to preferred series A are $85 million per quarter; no dividends had been deferred at December 31, 2012. Shareholders of preferred series A may convert all or any portion of their shares , at their option , at any time, into shares of the Company's common stock at an initial conversion rate of 24 .201 O shares of common stock for each share of preferred series A. Under certa in circums tances, the Company will be requiied to adjust the conversion rate. On or after the fifth anniversary of the issuance date , if the common stock price exceeds $53.72 per share for any 20 trad ing days in a consecutive 30 -day window , the Company may, at its option , at any time , in whole or in part, con vert preferred series A into common stock at the then applicable conversion rate. Upon conversion , accrued and unpaid dividends will be payable, at the option of the Company , in either cash, shares of common stock , or any combination thereof .

Followin g are several important feature s of Dow Chemical Com pany's convertible preferred stock: •

Preferred stock is typically reported before common stock to indicate that these stockhold ers will rece ive payments (dividends or payments if the company is liquidated) before common stockholders.

•

Hold ers of convertible preferred stock are entitled to dividends equal to 8.5% of the $ 1 par value per share; during 2012 , the comp any paid $340 million dividends ($85 million per quarter) on preferred shares. Hold ers of convertible preferred stock have a liquidation preference of $ 1,000. Thi s means that if Dow Chemical ceases operation s and liquidat es, preferred stockholders receive $ 1,000 per share before common stockholders rece ive a payment .

•

Modu le 8 I Reporting and Analyz ing Owne r Financ ing

8-6

•

Each share of convertible preferred stock is convertible into 24.201 shares of common stock at the discretion of the stockholder. Upon conversion, the preferred stockho lder receives 24 .201 common shares for each preferred share. Subsequent to conversion, the stockholder no longer receives preferred dividends of $0.085 per share and loses the liquidation preference of $ 1,000. Instead, the stockholder is able to parti cipate in the wealth creation of the comp any with unlimited upside potential both for dividends and share price appreciation.

•

On or after the fifth anniversary of the issuance date, if the common stock price exceeds $53.72 per share for any 20 tradin g days in a consecutive 30-day window, Dow Chemical has the option to convert the preferred series A into common stock. Th is conversion would give preferred stockholders a ga in of $300 per share. At a stock price of $53 .72, preferred stockholders rece ive 24.20 I shares, which is $ 1,300 (24.201 X $53.72), a gain of $300 per share over the $ 1,000 per share purchase price for the preferred stock.

In addit ion to the sorts of conversion features out lined above, preferred shares sometimes carry a part icipati on featu re that allows preferred stockholders to share ratably with common stockholders in dividends. The dividend preference over common shares can be a benefit when dividend payments are meager, but a fixed dividend yield limits upside potential if the comp any performs exce ptionally well. A participation feature can overcome this limitation . IFRS NS G T

Preferred StocKO nder FRS

Under IFRS, preferred stock (called preference shares) is classified according to its under lying characterist ics . Preference shares are classified as equity if they are not redeemab le, or redeemable at the option of the issuer. Preference shares are class ified as liabi lities if the company must redeem the shares (mandatorily redeemable ) or if they are redeemable at the opt ion of the shareho lder. Under IFRS, the critical feature that distinguishes a liability is if the company must (or can be required to) deliver cash or some other financial instrument to the liability holder. Accounting for payments to preference shareholders follows from the balance sheet classification : cash paid out is recorded as interest expense or dividends, when the shares are classified as liabilities or equity , respectively . Under US GAAP, preferred stock is c lassified as equity and cash paid out to preferred shareholders is classified as a dividend.

Common

Stock

IBM has one class of common stock, Class A, which has the following important characteristics :

•

•

•

•

•

IBM 's Class A common stock has a par va lue of $0.20 per share. Par value is an arbitrary amount set by company organizers at the time of comp any formation and has no relation to, or impact on, the stock 's market value. Generally, par value has no substance from a financial report ing perspective (there are some legal implications, which are usually minor). Its main impact is in specifying the allocation of proceeds from stock issuances between the two contribut ed capital account s on the balance sheet : common stock and additional paid -in capital, as we descr ibe below. IBM has 4,687 ,500,000 shares of stock that have been authorized for issuance. The company cannot issue (sell) more shares than have been authori zed. So, if more shares are needed, say for an acquisition or for one of its variou s stock purchase program s, it must fir st get additional autho rization by its stockholders. To date, IBM 's management has issued (sold) 2, 197,56 1, 159 shares of stock. The number of issued shares is a cumulative amount. As of 201 1, IBM had issued 2,182,469,838 shares of stock and it issued an additional 15,09 1,321 (2,197,56 1,159 - 2,182,469,838) shares in 2012. IBM has repurchased 1,080,193,483 shares from its stockholders at a cumulative cost of $123, 13 1 million . These shares are currently held in the company 's treasury, hence the name treasury stock. These shares neither have voting rights nor do they receive dividends. The number of outstanding shares is equal to the issued shares less treasury shares. There were 1,117,367,676 (2, 197,561,159 - 1,080,193,483) shares outstanding at th e end of 20 12.

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8 I Report ing and Ana lyzing Owner Financing

Accounting

for Stock

Transactions

We analyze the accounting for stock transactions in this section, including the account ing for stock issuances and repurc hases.

Stock

Issuance

Companies issue stock to obtain cash and other assets for use in their business. Stock issuances increase assets (cash) by the issue proceeds: the number of shares sold multipli ed by the price of the stock on the issue date . Equity increases by the same amount, which is reflected in contr ibuted capital accounts. If the stock has a par value, the common stock account increases by the number of shares sold multiplied by its par value. The additional paid-in capital account increases for the rema inder. Stock can also be issued as "no-par " or as "no -par with a stated value." For no-par stock, the common stock account is increased by the entire proceeds of the sale and no amount is assigned to additional paid-in cap ital. For no-par stock with a stated va lue, the stated va lue is treate d ju st like par va lue, that is, common stock is increased by the number of shares multipli ed by the stated value, and the remaind er is assigned to the additional paid-in capital account. To illu stra te, assume that IBM issue s 100,000 shares of its $0 .20 par va lue common stock at a mark et pric e of $43 cas h per share. Thi s stock issuanc e ha s the follo wing financ ial statement effec ts: Income Statement

Balance Sheet

Transaction Cash

4,300,000

cs

20,000

APIC

4,280,000

Cash

4,300,00 0

I

cs I

20.000

APIC

Cash Asset

Issue 100,000 + 4,300,000 co mmon shares with $0 .20 par value for $43 cash per share

=

Liabilities

~

+ Contrib. + Earned Capital

Capital

Revenues

Expen- = "- Net Income ses

+ 20,000 Common Stock

=

=

+ 4,280,000 Add itional Paid- In

Cap ita l

I •.2so,ooo

Specifically, the stock issuance affects the financial statements as follows: 1. Cash increases by $4,300,000 (I 00,000 shares x $43 per share) 2. Common stock increa ses by the par value of shares sold (I 00,000 share s X $0.20 par value = $20,000) 3. Addition al paid-in capital increases by the $4,280, 000 difference betwee n the issue proceeds and par value ($4,300,000 - $20,000)

IFRS Alert Stock terminology can differ between IFRS and GAAP. Under IFRS, common stock is called share capital and additional paid-in capital (APIC) is called share premium . Despite different terminology, the accounting for these items is identical under both systems.

Once shares are issued, they are traded in the open mark et among invest ors. The proceeds of those sales and their associate d gains and losses, as well as fluctuation s in the company's stock price subsequent to issuance, do not affect the issuing compan y and are not recorded in its accounting records. Refer again to the followin g report of common stock on IBM 's balance sheet: (In millions except for share amounts) Common stock, par value $0.20 per share, and add itional paid-in capital . . . . . . 50, 110

2012

2011

48, 129

Shares authorized : 4,687,500,000 Shares issued (2012-2, 197,561, 159; 20 11-2,182,469,838)

IBM common stock and additional paid-in capital of $50,llO million , equals the number of shares issued multipli ed by the market price of the stock at the time of issue. The $50,110 has two components; com mon stock at par value (the number of shares issued multipli ed by the par value of $0.20 per share) and additiona l paid-in capital account (the remainder). In this case the credit to common stock at par value is $440 million (2, 198 million shares issued X $0.20 par va lue). The remainder of $49,670 million ($50, 110 million - $440 million) is credited to the additional paid-in capital account. Total proc eeds of $50, 110 million imply that common shares were sold, on average, for $22.80 per share ($50,110 million/2 , 198 million shares) . On December 31, 20 12, IBM 's stock closed at a price of

8-8

Modu le 8 I Reporting and Analyz ing Owner Financing

$ 191.55 per share, markedly higher than the average selling price per share of $22.80. Stockho lders' equity is carried on the balance sheet at historical cost; price appreciation is not captured by GAAP With l , ll 7,367,676 shares outstanding at the end of 2012 , IBM 's market capitalization (or market cap) was $214,0 32 million (1,117 million shares X $ 191.55) . Thi s represents the market value of IBM 's equity, which is the value of the company to its stockholder s. RESEARCH INSIGHT . Stoelelow > cap,.eor-os

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