case studies

CASE 1-1Analysis of Contingent Obligation: Bristol-Myers Squibb

INTRODUCTION

In 1992, Bristol-Myers Squibb [BMY], a major U.S. based drug company, reported substantiallitigation against the company by recipients of breast implants manufactured and sold by a sub-sidiary of the company. In 1993, BMY made a provision for losses expected from such litiga-tion.1 In succeeding years, as the litigation proceeded, the company added to that provision forloss. Eight years later, as of December 31, 2000, while many of these claims had been settled,the amount of BMY’s ultimate cash outflows remained uncertain. This case illustrates the diffi-culty in assessing the impact of such litigation on reported income and financial position.

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1As an offset to the loss provisions for the company also provided estimates for amounts recoverable from insurance.

EXHIBIT 1C1-1. BRISTOL-MYERS SQUIBBBreast Implant Litigation Footnotes

Note 17: Contingencies

The company is a defendant in a substantial number of actions filed in various U.S. federal and statecourts and in certain Canadian provincial courts by recipients of two types of breast implants, formerlymanufactured and sold by a subsidiary of the company, alleging damages for personal injuries of vari-ous types. Certain of these cases are class actions, some of which seek to allege claims on behalf of allbreast implant recipients. All federal court actions have been consolidated for pre-trial proceedings infederal District Court in Birmingham, Alabama. In the case of Pamela Jean Johnson v. Medical Engi-neering Corporation, tried in state Court in Harris County, Texas, a jury on December 23, 1992awarded plaintiff compensatory and punitive damages totaling $25 million. Absent settlement, thecompany’s subsidiary will appeal this verdict.

Source: Bristol-Myers Squibb Annual Report, December 31, 1992

Note 17 Litigation

Breast Implant

The Company, together with its subsidiary, Medical Engineering Corporation (MEC), and certain othercompanies, has been named as a defendant in a number of claims and lawsuits alleging damages for per-sonal injuries of various types resulting from polyurethane-covered breast implants and smooth-walledbreast implants formerly manufactured by MEC or a related company. Of the more than 90,000 claimsor potential claims against the Company in direct lawsuits or through registration in the nationwideclass action settlement approved by the Federal District Court in Birmingham, Alabama (the “RevisedSettlement”), most have been dealt with through the Revised Settlement, other settlements, or trial.

In the fourth quarter of 1993, the Company recorded a charge of $500 million before taxes ($310million after taxes) in respect of breast implant cases. The charge consisted of $1.5 billion for potentialliabilities and expenses, offset by $1.0 billion of expected insurance proceeds. In the fourth quarters of1994 and 1995, the Company recorded additional special charges of $750 million before taxes ($488million after taxes) and $950 million before taxes ($590 million after taxes), respectively, related tobreast implant product liability claims. In the fourth quarter of 1998, the Company recorded an addi-tional special charge to earnings in the amount of $800 million before taxes and increased its insurancereceivable in the amount of $100 million, resulting in a net charge to earnings of $433 million aftertaxes in respect to breast implant product liability claims. . . . At December 31, 2000, $186 million wasincluded in current liabilities for breast implant product liability claims.

Source: Bristol-Myers Squibb Annual Report, December 31, 2000

CASE OBJECTIVES:

1. Discuss the value to financial analysts of the initial disclosures in BMY’s 1992 financialstatement footnotes.

2. Examine the impact on BMY’s financial statements and ratios of the 1993 loss provisionand additional loss provisions in following years.

3. Consider the impact on BMY’s financial statements and ratios of alternative financial re-porting (timing and measurement) of the loss.

Exhibit 1C1-1 contains excerpts from the Annual Reports of Bristol-Myers Squibb for the years1992 and 2000. These extracts provide a review of the firm’s disclosures on breast implant liti-gation. Exhibit 1C1-2 contains data, extracted from annual reports for the years 1993 through2000, regarding the income statement and balance sheet consequences of the accounting forthis litigation.

Required:

1. The firm did not record a liability for the breast implant litigation for the year ended De-cember 31, 1992. Discuss the usefulness of the footnote disclosure in 1992.

2. The firm recorded a special charge and related liability in the fourth quarters of 1993,1994, 1995, and 1998. The 1993 charge was offset by $1.0 billion of expected insur-ance proceeds; the 1998 charge was offset by $100 million of expected insurance recov-ery. The firm engaged in litigation with some of its insurers regarding the extent ofinsurance coverage for these losses. Describe the impact of this offset on the incomestatement and the balance sheet.

3. Estimate the actual cash inflows and outflows related to this litigation for the years 1993through 2000, using the income statement and balance sheet information provided.

4. Restate reported earnings for the years 1993 through 2000 assuming that Bristol-Myershad recorded an expense for each year equal to the (net of insurance recovery) cash out-flow for that year. [Use a marginal tax rate of 35% for each year.]

CASE OBJECTIVES W65

EXHIBIT 1C1-2. BRISTOL-MYERS SQUIBBSelected Financial Statement DataYears Ended December 31 ($ in millions)

Income Statement 1992 1993 1994 1995 1996 1997 1998 1999 2000

Breast Implant Litigation

Special charge: gross $1,500 $ 750 $ 950 $ 800(Expected insurance recovery) (1,000) $1,5— $1,5— $1(100)Net charge (pretax) $ 500 $ 750 $ 950 $ 700Net charge (after-tax) 310 488 590 433

Net earnings* $1,378 $1,696 $1,542 $1,517 $2,484 $2,744 $2,750 $3,789 $4,096

*Continuing operations, using restated data from 2000 annual report

Balance Sheet

Non-Current Assets:

Insurance recoverable $1,000 $ 968 $ 959 $ 853 $ 619 $ 523 $ 468 $ 262

Product Liability:

Current portion 100 635 700 800 865 877 287 186Non-current portion $1,370 $1,201 $1,645 $1,031 $1,171 $1,244 $3,167 $1,1—Total $1,470 $1,836 $2,345 $1,831 $1,036 $1,121 $ 354 $ 186

Source: Bristol-Myers Squibb Annual Reports, 1992–2000

W66 CASE 1-1 ANALYSIS OF CONTINGENT OBLIGATION: BRISTOL-MYERS SQUIBB

5. Discuss the effect of the restatement in part 4 on the level and trend of BMY earningsover the 1992 to 2000 time period.

6. Discuss the effect of the restatement in part 4 on Bristol-Myers’ reported return on equity(ROE) for the years 1993 through 2000. [Hint: consider the effect of the restatement onstockholders’ equity as well as income.]

7. Based on information available at December 31, 2000, describe how to compute thecharge that Bristol-Myers should have recorded in December 31, 1992. Describe the im-pact of that charge on BMY earnings and ROE in 1992 and subsequent years.

8. Based on your answers to parts 1 through 7, discuss the advantages and disadvantages tothe company of recording expense equal to(i) The actual cash flows estimated in part 3(ii) The charge described in part 7rather than the special charges actually recorded.

CASE 2-1Revenue and Expense Recognition—Orthodontic Centers of America

CASE OBJECTIVES

The objective of this case is to evaluate the revenue and expense recognition methods used bythe company.

INTRODUCTION

The following information was extracted from the 1999 and 2000 annual reports of OrthodonticCenters of America [OCA].

The company provides practice management services to orthodontic practices in theUnited States. OCA acquires and develops orthodontic centers and manages the business opera-tions and marketing aspects of affiliated orthodontic practices. At December 31, 2000, therewere 592 orthodontic centers, of which the company developed 306 and acquired 361 (75were consolidated into another center).

The affiliated orthodontists control the orthodontic practices, determine which personnel,including orthodontic assistants, to hire or terminate, and set their own standards of practice inorder to promote quality orthodontic care.

A typical patient receives an initial consultation and preliminary procedures (teeth impres-sions, x-rays, and the placing of spacers between the teeth for braces) in advance of the next ap-pointment. The patient signs a contract for treatment in the event the orthodontist recommendsorthodontic treatment. Generally, braces are applied two weeks later and subsequent adjust-ments to the braces are made every four to eight weeks.

The contract specifies the terms and the length of the treatment as well as the total fees. Theaverage contract length is 26 months. No initial down payment is required; the patient makesequal monthly payments followed by a final payment on completion of the treatment.

OCA provides the following services to its affiliates:

1. Staffing2. Supplies and inventory3. Computer and management information services4. Scheduling, billing, and accounting services

An unrelated financial institution finances operating losses and capital improvements for newlydeveloped orthodontic centers; OCA guarantees the related debt.

1999 REVENUE RECOGNITION

The Company earns its revenue from long-term service or consulting agreements with affiliated or-thodontists. Through December 31, 1999 OCA recognized monthly fees equal to approximately:

• 24% of the aggregate amount of all new patient contracts entered into during that partic-ular month, plus

• The balance of contract amounts allocated equally over the remaining term of the contract.

Gross amounts are reduced by the portion of contract amounts expected to be retained bythe orthodontist.

OCA recognizes operating expenses as incurred.

Required:1. OCA believes that at least 24% of its services relate to the first month of the patient

contracts. Given the services provide by OCA and the terms of the service and consult-ing agreements:• Evaluate the revenue recognition method used by OCA.• Propose and justify a more appropriate revenue recognition method.

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W68 CASE 2-1 REVENUE AND EXPENSE RECOGNITION—ORTHODONTIC CENTERS OF AMERICA

2. Estimate OCA’s average contract balance for new patients in 1999, using the operatingdata in Exhibit 2C-1.

3. Estimate the first year revenue that OCA recognizes from a new patient contract, as-suming that OCA’s share of the contract amount is $3,000, the contract length is 26months, and the contract is signed on(i) January 1 of the first year(ii) July 1 of the first year(iii) December 1 of the first year

4. Estimate the second year revenue that OCA recognizes from a new patient contract,under the same assumptions as Question 3, for each of the three signing dates.

5. Explain why, using your answers to Questions 3 and 4, OCA must expand its opera-tions rapidly to maintain revenue growth.

2000 Revenue RecognitionEffective January 1, 2000, OCA changed its revenue recognition method citing SEC Staff Ac-counting Bulletin No. 101 (see page 45 of text). OCA now recognizes net revenue using astraight-line allocation of patient contract revenue over the duration of the patient contract (typi-cally 26 months). The company reported that

The cumulative effect of this accounting change, calculated as of January 1, 2000, was $50.6 mil-lion, net of income tax benefit of $30.6 million. The effect of this accounting change in 2000 was toreduce revenue by $26.3 million. In 2000, the Company recognized revenue of $57.3 million thatwas included in the cumulative effect adjustment.1

The company also reported the pro forma effect of the accounting change on net income, as-suming it had been in effect in prior years. Results for those years were not, however, restated.

Exhibit 2C-1 contains operating and income statement data for OCA for the years 1997through 2000. The exhibit also shows reported balance sheet data for 1998 through 2000,and restated data for 1999 (see Question 15). Use the exhibit to answer the questions thatfollow.

Required:6. Redo Questions 3 and 4, using the revenue recognition method that OCA adopted in

2000.7. Compare the first and second year revenue recognized under the 2000 and 1999 meth-

ods. Note: use an average of the three signing assumptions.8. The accounting change had two effects on year 2000 revenue:

• Revenue recognized from new patients was reduced.• Revenue from patients signed in prior years, included in the cumulative effect adjust-

ment, was recognized in 2000.(i) From the company’s disclosure of the effect of the accounting change, compute

each of these effects.(ii) Use your answer to Question 7 to estimate the second of these effects.

9. Compute OCA’s 2000 revenue and net income assuming that it had not changed itsrevenue recognition policy.

10. Explain why OCA’s revenue recognition policy has a disproportionate effect on netincome.

11. Discuss the effect of the accounting change on your answer to Question 5.12. Compute the annual percent changes in each of the following statistics for 1997 to

2000, and discuss their trend and their implications for future revenue growth:• Number of orthodontic centers• Total case starts• Number of patients under treatment

13. Describe the effect of the accounting change on OCA’s receivables.

1Source: footnote 2 to 2000 financial statements.

14. Compute each of the following statistics for 1997 to 2000. Discuss their trend, their im-pact on reported income, and their implications for future revenue and income growth.Discuss the effect of the accounting change on the 2000 statistics.(i) Revenue, expense, and operating profit per patient under contract(ii) Revenue, expense, and operating profit per center

15. In 2000, OCA restated its 1999 balance sheet to aggregate billed and unbilled patient re-ceivables (as service fee receivables). It also reduced that amount by patient prepayments,

1999 REVENUE RECOGNITION W69

EXHIBIT 2C-1. ORTHODONTIC CENTERS OF AMERICAReported Operating and Financial Data

Years Ended December 31

Operating Data 1997 1998 1999 2000

Number of orthodontic centers 360 469 537 592Total case starts 70,611 95,377 126,307 160,639Number of patients under treatment 130,000 195,000 267,965 343,373New patient contract balances ($ millions) $ 369.1 $ 494.1

Income Statement Years Ended December 31

(Amounts in $ Thousands, Except Per Share Data) 1997 1998 1999 2000

Net revenue $117,326 $171,298 $226,290 $268,836Operating expense $(81,368) (117,012) (149,366) (188,834)Operating profit $ 35,958 $ 54,286 $ 76,924 $80,002Net interest income (expense) $331,143 $444,280 $1 (2,204) $8 (3,731)Pretax income $ 37,101 $ 54,566 $ 74,720 $ 76,271Income tax expense $ (14,469) $ (20,753) $ (28,206) $ (28,549)Net income* $ 22,632 $ 33,813 $ 46,514 $ 47,722

*Before cumulative effect of accounting changes

Diluted earnings per share $ 0.50 $ 0.70 $ 0.96 $ 0.96

Provision for bad debt expense $ 1,851 $ 2,295 $ 2,079 $ 373

Pro Forma for 2000 Accounting Change

Net income $ 12,013 $ 22,276 $ 32,326 n/aDiluted earnings per share $ 0.26 $ 0.46 $ 0.66 n/a

Balance Sheet Data December 31

(Amounts in $ Thousands) 1998 1999 2000Reported Restated

Patient receivables1 $ 20,163 $ 25,976Unbilled patient receivables2 46,314 65,793Service fees receivable3 $ 87,563 $ 35,350Total assets 296,798 367,022 362,816 367,947

Patient prepayments 4,326 4,206 — —Deferred revenue 2,516Total debt 20,055 50,632 50,632 58,575Total liabilities 65,639 88,495 84,289 80,751Stockholders’ equity 231,159 278,527 278,527 287,196

1Net of allowance for uncollectibles of $5,356 in 1998 and $6,403 in 19992Net of allowance for uncollectibles of $2,209 in 1998 and $3,241 in 19993Net of allowance for uncollectibles of $9,644 in 1999 and $2,598 in 2000

W70 CASE 2-1 REVENUE AND EXPENSE RECOGNITION—ORTHODONTIC CENTERS OF AMERICA

previously shown as a current liability. Compute the ratio of the allowance for uncol-lectible amounts to gross receivables for:• Billed and unbilled patient receivables for 1998 and 1999• Service fees receivable for 1999 (restated) and 2000.

(i) Discuss whether the differences between the ratios for billed and unbilled re-ceivables accord with the nature of the receivables.

(ii) Discuss the trend in the allowance ratios over the 1998 to 2000 period.(iii) Explain why the aggregation is a loss of information useful for financial analysis.

16. Compare the trend of earnings per share for 1997 to 2000 using the pro forma datawith the trend as originally reported. Explain which time series better represents the op-erating results over that time period.

17. Discuss two reasons why the time series that is your answer to question 16 may not bea reliable basis for forecasting future results.

CASE 3-1Cash Flow Analysis—Orthodontic Centers of America [OCA]

This case is a continuation of Case 2C-1, which provides information about the business con-ducted by OCA and describes the revenue recognition method used by OCA (both before andafter the January 2000 accounting change). Use the data provided in Case 2C-1 and Exhibit 3C-1to answer the following questions.

Required:1. Calculate the actual cash collections for the years 1998–2000.2. Compare the cash collection amounts computed in question 1 with revenues

(i) Reported for each year(ii) Calculated using the pre-January 1, 2000 revenue recognition method (see Case 2-1,

question 9).(iii) Calculated using the post-January 1, 2000 revenue recognition method. (Hint: To

adjust reported 1998 and 1999 revenue, use the pro forma earnings provided andassume a 35% tax rate.)

3. Discuss how the answers to question 2 provide insight as to the appropriate revenuerecognition method.

4. Analyze the trends in the company’s cash from operations, cash for investing, free cashflows, and cash from financing.

Exhibit 3C-1 also provides information as to how the company acquires new affiliated orthodontists.5. (a) Explain how these acquisition costs affect the company’s cash from operations, cash

for investing, and free cash flows. State where the remaining acquisition costs are re-ported in the cash flow statement.

(b) Explain how the reporting of the cash flows associated with the acquisition of affili-ated practices differs from the reporting of cash flows associated with newly devel-oped practices.

6. Describe the effect of the company’s treatment of the affiliated practice acquisition costson the analysis of the company’s cash flows. Suggest an alternative approach to cashflow analysis and redo question 4 after making the required adjustments to the cash flowstatement for the acquisition costs.

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W72 CASE 3-1 CASH FLOW ANALYSIS—ORTHODONTIC CENTERS OF AMERICA [OCA]

EXHIBIT 3C-1. ORTHODONTIC CENTERS OF AMERICAFinancial Statement Disclosures

Consolidated Statements of Cash Flows

($ in thousands) Years Ended December 31

OPERATING ACTIVITIES 2000 1999 1998

Net income (loss) $ (2,854) $ 45,836 $ 33,813Adjustments

Provision for bad debt expense 373 2,079 2,295Depreciation and amortization 15,175 12,238 9,124Deferred income taxes (7,792) 1,273 (2,767)Cumulative effect of changes in accounting principles 50,576 678 —

Changes in operating assets and liabilities:Service fee receivables (13,549) (27,491) (22,733)Supplies inventory 889 (2,305) (2,663)Prepaid expenses and other (2,309) (1,342) 228Advances to/amounts payable to orthodontic entities (8,233) (2,420) (1,756)Accounts payable and other current liabilities $(17,368 $1(5,199) $(26,568

Cash from operations $ 39,644 $ 23,347 $ 22,109

INVESTING ACTIVITIES

Purchases of property and equipment (20,271) (22,520) (17,638)Proceeds from (sales of ) available-for-sale investments (16) 204 19,674Intangible assets acquired (28,246) (17,178) (42,216)Advances to orthodontic entities — (3,951) (4,906)Payments from orthodontic entities $(48,5— $$(48,370 $(41,927Cash used in investing activities $(48,533) $(43,075) $(43,159)

FINANCING ACTIVITIES

Repayment of notes payable to affiliated orthodontists and long-term debt (6,530) (6,742) (7,864)Proceeds from long-term debt 7,483 30,577 20,055Repayment of loans from key employee program 2,632 — —Issuance of common stock $(14,299 $(23,114 $(43,595Cash provided by financing activities $ 7,884 $ 23,949 $ 12,786

Foreign currency translation adjustment $11,(127) $(48,5— $(48,5—Change in cash and cash equivalents $ (1,132) $ 4,221 $ (8,264)Cash and cash equivalents: beginning of year $(15,822 $(11,601 $(19,865

end of year $ 4,690 $ 5,822 $ 1,601

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES

Notes payable and common stock issued to obtain Service Agreements $ 5,974 $ 4,512 $ 13,609

Transactions with Orthodontic Entities

The following table summarizes the Company’s finalized agreements with orthodontic entities to obtain Service Agreements and to ac-quire other assets for the years ended December 31, 2000, 1999 and 1998:

Total Remainder Share Value CommonAcquisition Notes Payable (Primarily (at average Stock Shares

Costs Issued Cash) cost) Issued

2000 $34,220,000 $1,255,000 $28,246,000 $4,719,000 227,0001999 21,700,000 3,600,000 17,190,000 910,000 80,0001998 56,900,000 8,700,000 43,994,000 4,206,000 253,000

CASH FLOW ANALYSIS—ORTHODONTIC CENTERS OF AMERICA [OCA] W73

EXHIBIT 3C-1 (continued)

At December 31, 2000 and 1999, advances to orthodontic entities totaled $16,701,000 and $20,530,000, respectively. Of these amounts,approximately $1,208,000 and $5,045,000 related to orthodontic entities that generated operating losses during the three months endedDecember 31, 2000 and 1999, respectively. At December 31, 2000 and 1999, advances to orthodontic entities in international locationstotaled $6,196,000 and $1,413,000, respectively.

Intangible Assets

The Company affiliates with a practicing orthodontist by acquiring substantially all of the non-professional assets of the orthodontist’spractice, either directly or indirectly through a stock purchase, and entering into a Service Agreement with the orthodontist. The terms ofthe Service Agreements range from 20 to 40 years, with most ranging from 20 to 25 years. The acquired assets generally consist ofequipment, furniture, fixtures and leasehold interests. The Company records these acquired tangible assets at their fair value as of thedate of acquisition, and depreciates or amortizes the acquired assets using the straight-line method over their useful lives. The remainderof the purchase price is allocated to an intangible asset, which represents the costs of obtaining the Service Agreement, pursuant towhich the Company obtains the exclusive right to provide business operations, financial, marketing and administrative services to the or-thodontist during the term of the Service Agreement. In the event the Service Agreement is terminated, the related orthodontic entity isgenerally required to purchase all of the related assets, including the unamortized portion of intangible assets, at the current book value.

Source: 2000 Annual Report

CASE 4-1Integrated Analysis of Pfizer, Takeda Chemical, and Roche

INTRODUCTION

Ratio analysis should not be simply a mechanical exercise but a means to an end. It can be usedin two different ways. The first method is to compute a number of ratios and then look forchanges over time or differences among companies. Such analysis leads to an understanding ofthe level and trend of profitability as measured by return on equity (ROE). The second method isto start with ROE and then, by analyzing the components that comprise this measure, explainchanges over time or differences among companies.

CASE OBJECTIVES

1. Compute the financial statement ratios for two companies in the same industry, usingthe following categories: activity, liquidity, solvency, and profitability.

2. Discuss the factors that limit the usefulness of such comparisons.3. Show how ratios can be aggregated to explain differences in ROE among companies.4. Show how “top-down” ratio analysis can be used to explain changes in ROE for a com-

pany over time as well as differences between companies.

Takeda operates in the same industry as Pfizer and its 1999 financial statements are contained inthe CD (and web site) accompanying the text. Note that the Takeda statements are prepared inJapanese yen and in accordance with Japanese GAAP.

Required

1. For Takeda, compute ratios for 1999 in the following categories, using the Pfizer exhibitscited as a guide:• Activity (Exhibit 4-4)• Liquidity (Exhibit 4-6)• Solvency (Exhibit 4-8)• Profitability (Exhibit 4-10)

2. Using your answers to Question 1 and the corresponding Pfizer data, compare the ratiosof the two companies in each of these categories. Discuss factors that limit the useful-ness of this comparison and additional data that would be needed to improve it.

3. Prepare an integrated ratio analysis of Takeda, using Exhibits 4-12 and 4-14 as a guide.4. Compare the 1999 ROE of Pfizer and Takeda, and determine the key ratios that explain

the difference in ROE. Discuss other factors that might explain the differences in ROEand any additional data needed to adjust for these factors.

Roche also operates in the same industry as Pfizer and Takeda. Its year 2000 annual report isavailable on the CD (and web site) accompanying the text. Its financial statements are denomi-nated in Swiss francs (CHF) and prepared according to IAS GAAP.

5. Using the top-down approach suggested by the discussion relating to Exhibit 4-13, de-termine the key ratios that explain the(i) changes in Roche’s ROE from 1999 to 2000(ii) difference between the 1999 ROE for Pfizer and Roche

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CASE 6-1Inventory Analysis of Nucor

INTRODUCTION

Nucor [NUE] is one of the largest steel companies in the United States. Exhibit 6C-1 contains fi-nancial data for the five years ended December 31, 1999. Nucor has used the LIFO method forall inventories during the entire time period.

CASE OBJECTIVES

The objectives of this case are to

1. Show the impact of Nucor’s use of the LIFO inventory method on its:• Balance sheet• Income statement• Cash from operations• Financial ratios

2. Discuss the advantages and disadvantages of use of the LIFO method.3. Discuss the relationship between price trends and use of the LIFO method.

The following questions should be answered using the data provided in Exhibit 6C-1. Assume amarginal tax rate of 35% for all years.

1. Calculate gross margin (both level and as a percent of sales) under both the LIFO andFIFO methods for the years 1995–1999.

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EXHIBIT 6C-1. NucorSelected Financial DataYears Ended December 31Data in $millions

1994 1995 1996 1997 1998 1999

Income Statement

Sales $3,462,046 $3,647,030 $4,184,498 $4,151,232 $4,009,346Cost of products sold 2,900,168 3,139,158 3,578,941 3,591,783 3,480,479Pretax 432,335 387,769 460,182 415,309 379,189Net income 274,535 248,169 294,482 263,709 244,589

Earnings per share $ 3.14 $ 2.83 $ 3.35 $ 3.00 $ 2.80Tax rate 35% 35% 35% 35% 35%

Balance Sheet

LIFO inventory $ 243,027 $ 306,773 $ 385,799 $ 397,048 $ 435,885 $ 464,984LIFO reserve 81,662 93,932 73,901 100,576 5,121 28,590

Current assets 830,741 828,381 1,125,508 1,129,467 1,538,509Current liabilities 447,136 465,653 524,454 486,897 531,031

Stockholders’ equity 1,122,610 1,382,112 1,609,290 1,876,426 2,072,522 2,262,248Per share $ 12.85 $ 15.78 $ 18.33 $ 21.32 $ 23.73 $ 25.96

Statement of Cash Flows

Cash from operations $ 447,160 $ 450,611 $ 577,326 $ 641,899 $ 604,834

Source: Nucor Annual Reports, 1994–1999

W76 CASE 6-1 INVENTORY ANALYSIS OF NUCOR

2. Discuss the differences in the level, trend, and variability of gross margins under thetwo methods.

3. Calculate net income assuming Nucor had used the FIFO method of reporting for1995–1999 and discuss differences in the level, growth rate, and variability of net in-come under the two methods.

4. Calculate stockholders’ equity per share assuming Nucor had used the FIFO method ofreporting for 1995–1999. Compare your results to reported equity and discuss the dif-ference in level and growth rate.

5. Calculate Nucor’s cash from operations assuming Nucor had used the FIFO method ofreporting for 1995–1999. Compare your results to reported cash from operations anddiscuss the difference in level and growth rate.

6. Calculate the following ratios for Nucor, using both reported data and assuming it hadused the FIFO method of reporting, for 1995–1999:• Current ratio• Return on (average) equityDiscuss the effect of using LIFO on the level and variability of both ratios.

7. Calculate Nucor’s inventory turnover ratios for 1995–1999, using:(i) LIFO data(ii) FIFO data(iii) Current cost dataDiscuss the differences among these three turnover ratios and select the method thatprovides the best measure of economic turnover. Discuss the trend in Nucor’s inven-tory turnover over the 1995–1999 period. Discuss factors that might account for thevariability of reported turnover.

8. Using the results of Questions 1–7 and the data in Exhibit 6C1-1, discuss the advantagesand disadvantages to Nucor of use of the LIFO method over the 1995–1999 time period.

9. Nucor’s LIFO reserve at December 31, 1999 was less than 6% of gross inventory (FIFObasis) compared with a peak of more than 27% at December 31, 1990. There havebeen no LIFO liquidations during this time period.(a) What information does this decline provide about the price trend in steel scrap

(Nucor’s major raw material input)?(b) Discuss how this decline affects the advantages and disadvantages to Nucor of

using the LIFO method.10. If Nucor were considering switching from LIFO to FIFO, what date would it have cho-

sen to make the change? Why?11. If Nucor did switch from LIFO to FIFO, what information would that convey about the

company’s price expectations? Explain.12. Steel Dynamics [STLD], a Nucor competitor, uses the FIFO inventory method. Selected

data for 1997 through 1999 follow ($ in thousands):

1997 1998 1999

Sales $514,786 $618,821Cost-of-goods-sold 428,978 487,629Net Income 31,684 39,430Ending Inventory $ 60,163 126,706 106,742Ending Equity 337,595 351,065 391,370

(a) Using reported data, compute each of the following ratios for 1998 and 1999 forSteel Dynamics:• Gross profit margin• Return on equity• Inventory turnover ratio

(b) Assume that Steel Dynamics used the LIFO inventory method. Redo (a) using ad-justed ratios for Steel Dynamics. For each ratio, use the method(s) you deem mostappropriate and justify your choice.

(c) Explain why the adjustments improve the apparent performance of Steel Dynamicsfor 1998 but reduce it for 1999.

(d) Explain why the adjusted ratios provide a more useful comparison for the twoyears.

(e) Explain why the adjusted ratios provide a more useful comparison between SteelDynamics and Nucor for the two years.

CASE OBJECTIVES W77

CASE 7-1Analysis of Software Capitalization: International Business Machines

INTRODUCTION

The capitalization of computer software costs affects reported net income and stockholders’ eq-uity in each accounting period. Because capitalized amounts must be amortized, the capitaliza-tion decision affects future accounting periods as well. In addition, while capitalization does notaffect cash flow, it does change the allocation between cash from operations and cash for in-vestment. In this case we explore these issues using International Business Machines [IBM], theworld’s largest computer manufacturer.

CASE OBJECTIVES:

1. Compute the effect of IBM’s capitalization of software expenditures on its reported bal-ance sheet, income, cash flows, and financial ratios.

2. Show how changes in IBM’s capitalization affected the level and trend of measures ofincome and cash flow.

3. Show how capitalization obscures trends in total spending on software and on researchand development.

4. Show how capitalization affects segment profitability measures.5. Discuss the possible effect of changes in corporate profitability on accounting policies.

Exhibit 7C1-1 contains corporate financial data, software segment data, and data regarding thecapitalization of computer software costs by IBM over the period 1992 � 2001. IBM capitalizeda portion of computer software costs as permitted by accounting standards discussed in thechapter.

Use the information provided to answer the following questions.1. Compute the effect on IBM’s net income of software capitalization for the years 1992 �

2001. Assume a 35% tax rate.2. Compute the effect of software capitalization on IBM’s

(i) Cash from operations(ii) Cash for investmentfor the years 1992–2001. Discuss the effect of capitalization on the trend of both cashflow measures.

3. Compute IBM’s total spending on computer software (whether expensed or capitalized)over the period 1992 � 2001. Compute the percentage of spending that was capital-ized each year.

4. Compute the year-to-year percentage change in IBM’s software segment external rev-enues for 1992–2001. Discuss the trend over that time period. Note that IBM redefinedthat segment in 1996 so that 1996 � 2001 revenues are not comparable to 1992–1995amounts.

5. Compute the gross profit and gross profit percentage for IBM’s external software revenuesfor 1992 � 2001. Discuss the trend in segment profitability over that 1992–2001 period.

6. IBM started disclosing total software revenues in 1996. Compute the pretax profit mar-gin for IBM’s total software revenues for 1996–2001. Discuss the trend in segment prof-itability over that time period.

7. Compute the return on assets for IBM’s software segment over the 1996 � 2001 period.Discuss the trend in segment ROA over that period. Explain how the level and trend ofsegment ROA are affected by IBM’s accounting policies on R&D. Hint: consider the ef-fect on ROA of capitalizing either all software-related R & D or none.

8. Discuss how the capitalization of software affects ROA in(i) Years with large capitalized amounts(ii) Years with small capitalized amounts

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9. Compute IBM’s total R&D expenditures (including amounts capitalized) over the pe-riod 1992–2001 and compute total expenditures as a percentage of total corporate rev-enues. Discuss the trend in that percentage, the possible reasons for that trend, and thequestions you would want to ask IBM management about that trend. Note: IBM reclas-sified some R&D expenditures in 2001; our data for prior years is not restated.

10. Compute IBM’s after-tax profit margin and return on average stockholders’ equity overthe period 1992 to 2001. [1991 equity was $36,679 million.]

11. The capitalization of software expenditures reflects accounting standards in effect eachyear, the nature of software expenditures, and changes in corporate policy. Discuss thepossible effects of each of these three factors on the amount of software capitalizationby IBM over the 1992–2001 time period. Your answer should incorporate your an-swers to parts 1 through 10 of this case.

CASE OBJECTIVES W79

EXHIBIT 7C1-1International Business Machines

Amounts in $millions 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Corporate Financial Data

Revenue $64,523 $62,716 $64,052 $71,940 $75,947 $78,508 $81,667 $87,548 $88,396 $85,866Net income* (6,865) (7,987) 3,021 4,178 5,429 6,093 6,328 7,712 8,093 7,723

*Before accounting changes

Cash from operations 6,274 8,327 11,793 10,708 10,275 8,865 9,273 10,111 9,274 14,265Cash for investing (5,878) (4,202) (3,426) (5,052) (5,723) (6,155) (6,131) (1,669) (4,248) (6,106)Stockholders’ equity 27,624 19,738 23,413 22,423 21,628 19,816 19,433 20,511 20,624 23,614

Total R & D Expense* 6,522 5,558 4,363 4,170 4,654 4,877 5,046 5,273 5,151 5,290

*IPRD included in expense 1,840 435 111 111 9Software-related R & D 1,161 1,097 793 1,157 1,726 2,016 2,086 2,036 1,948 1,926Software Segment Not comparable to 1996–2001External revenue $11,103 $10,953 $11,346 $12,657 $11,426 $11,164 $11,863 $12,662 $12,598 $12,939Internal revenue $12,593 $12,671 $12,749 $12,767 $12,828 $12,981Total revenue $12,019 $11,835 $12,612 $13,429 $13,426 $13,920Cost of external revenue 3,924 4,310 4,680 4,428 2,946 2,785 2,260 2,240 2,283 2,265Pretax segment income 2,466 2,034 2,742 3,099 2,793 3,168Segment assets 2,813 2,642 2,57 2,527 2,488 3,356

Statement of Cash FlowsCFO: Addback to Net Income

Amortization of software 1,466 1,951 2,098 1,647 1,336 983 517 426 482 625

CFI

Investment in software 1,752 1,507 1,361 823 295 314 250 464 565 655

Source: Data from International Business Machines Annual and 10-K Reports, 1994–2001

CASE 10-1Analysis of Debt Capitalization: Read-Rite

INTRODUCTION

Read-Rite [RDRT] is one of the largest manufacturers of magnetic recording heads for computerdisk drives, a highly competitive business characterized by rapid technological change. In Au-gust 1997, Read-Rite issued $345 million of convertible subordinated notes. Over the nextthree years, the company’s operating results and financial condition deteriorated, bringing thecompany close to insolvency. Early in 2000, the company offered to exchange new notes forthe old ones. That exchange, accompanied by improved operations, resulted in the retirementof virtually all of the old notes in exchange for common stock, with beneficial effects on thecompany’s financial statements.

CASE OBJECTIVES

The objectives of this case are to:

1. Analyze the financial condition of Read-Rite over time.2. Show the effects of the exchange offer on Read-Rite’s financial condition.3. Discuss the economic significance and the financial statement relevance of the recog-

nized gain from the exchange offer.4. Discuss the significance of the difference between carrying value and market value of debt.5. Analyze, from the note holder perspective, the decision to accept the note exchange.

In August 1997, Read-Rite issued $345 million of 6.5% subordinated notes, due in September2004. The notes were convertible into Read-Rite common shares at $40.24 per share. As shownin Exhibit 10C-1, the company reported substantial losses in 1998 and 1999. As a result, Read-Rite’s auditor opinion at September 30, 1999 had a “going concern” qualification (Exhibit 1-3).

Because of its large losses, Read-Rite violated the financial covenants of its bank debt facil-ity, which it had drawn down in 1998 and 1999 to fund its cash needs and provide adequateliquidity. Threatened with default and the possibility of having to file for bankruptcy, Read-Ritemade an exchange offer for the 6.5% notes. For each $1,000 of old notes, holders were offered$500 of new notes, convertible into Read-Rite common shares at $4.51 per share (15% abovethe current stock price). Interest at 10% could be paid in cash or Read-Rite shares, at the com-pany’s election. The new notes were due September, 2004.

In March 2000, Read-Rite completed the exchange of $325.2 million of old notes for$162.6 million of new notes, and sold an additional $61.2 million of new notes for cash. Read-Rite wrote off $5 million of unamortized issuance costs of the old notes.

The new notes provided for automatic conversion into common shares if the Read-Riteshare price exceeded $9.02 for a specified time period. When that condition was achieved,Read-Rite invoked the automatic conversion provision and the notes were converted to com-mon shares in October 2000. The pro forma balance sheet at September 30, 2000 reflects thatconversion as well as the sale of new common shares for $18.9 million cash and $28.8 millionof bank debt repayments. The auditor’s opinion at September 30, 2000 has no qualification.

Exhibit 10C-1 contains Read-Rite financial data for the four fiscal years ended September30, 2000.

Use the information provided to answer the following questions.1. Compute each of the following ratios at December 31, 1997–2000:

(i) Total debt to equity (both as reported)(ii) Net debt to equity (both as reported)(iii) Total debt to equity (both at market)(iv) Net debt to equity (both at market)where net debt is total debt less cash and marketable securities and equity is defined asshareholders’ equity plus minority interest.

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EXHIBIT 10C-1Read-RiteSelected Financial Data Amounts in $millions

Years Ended September 30

Balance Sheet Data 1997 1998 1999 2000*

Cash and equivalents $ 118.6 $ 62.4 $ 80.5 $ 54.6Short-term investments 179.5 46.0 145.9 —Other current assets $1,285.2 $1,172.9 $1,183.2 $1,127.6

Total current assets $ 583.3 $ 281.3 $ 309.6 $ 182.2Property, plant, equipment 672.8 573.6 457.2 285.1Intangible and other assets $1,145.4 $1,124.9 $1,117.7 $1,119.9

Total assets $1,301.5 $ 879.8 $ 784.5 $ 477.2

*Pro forma for debt conversion and related transactions.

Short-term debt $ 12.6 $ 22.5 $ 158.1 $ 11.1Other current liabilities $1,227.5 $1,161.1 $1,132.8 $1,125.3Total current liabilities $ 240.1 $ 183.6 $ 290.9 $ 136.4Convertible debt1 345.0 345.0 345.0 19.8Other long-term debt 58.9 43.3 16.7 25.4Other long-term liabilities $1,138.7 $1,132.0 $1,115.8 $1,115.1

Total liabilities $ 682.7 $ 603.9 $ 658.4 $ 186.7Minority interest 73.1 42.0 41.9 19.3Stockholders’ equity2 $1,545.7 $1,233.9 $1,184.2 $1,271.2

Total equities $1,301.5 $ 879.8 $ 784.5 $ 477.2

1Fair value 345.0 182.8 146.3 12.72Includes retained earnings 191.1 (129.2) (284.3) (409.1)

Income Statement Data

Net sales $1,162.0 $ 808.6 $ 716.5 $ 555.9Cost of sales (923.2) (941.4) (739.7) (616.9)Operating expenses3 (119.1) (220.1) (159.0) (213.0)Interest expense (15.7) (29.6) (31.9) (33.0)Debt conversion expenses — — — (29.4)Interest income 8.6 7.1 4.1 11.1Income tax expense (29.3) 24.6 25.9 —Minority interest (((((((7.1) $(3131.1 $(1128.4 $(1141.9Net income before extrod.item $ 76.2 $ (319.7) $ (155.7) $ (283.4)Gain on debt conversion $1,158.6Net income $ (124.8)

3Includes PPE write-downs (70.0) (29.7) (106.5)

Cash Flow Data

Operating activities $ 190.1 $ (8.8) $ 76.2 $ (67.7)Investing activities4 (392.8) (54.4) (200.8) 52.2Financing activities 235.7 7.0 142.7 (0.6)Foreign currency effects $111,3.3 $$$,—.1 $$$,—.1 $$$,—.1Net cash flow $ 36.3 $ (56.2) $ 18.1 $ (16.1)

4Includes capital expenditure (272.8) (186.2) (101.0) (93.6)

Stock price—high 33.13 26.81 19.69 11.56—low 15.38 5.50 4.03 1.88—year end 26.81 7.81 4.41 11.25

Year-end shares (millions) 48.133 48.764 49.675 117.014

Source: Read-Rite data from 1998–2000 annual reports.

W82 CASE 10-1 ANALYSIS OF DEBT CAPITALIZATION: READ-RITE

2. Discuss the trend in these four ratios over the period 1997–1999.3. State and justify which of the ratios computed in (1) best represented the company’s fi-

nancial condition.4. Justify the auditor’s decision to give a “going concern” qualification at September 30,

1999. Your response should include the computation and discussion of Read-Rite’s:(i) Gross margin(ii) Interest coverage ratio(iii) Cash flowover the 1997–1999 period.

5. Discuss three benefits that Read-Rite obtained from the exchange offer. State the “cost”to the company of the exchange offer.

6. When the note exchange became effective in 2000, Read-Rite recognized a gain of$158.6 million. Show how that gain was computed.

7. Discuss whether the $158.6 million gain should have been recognized in fiscal 2000rather than fiscal 1998 and 1999. Discuss whether, in economic terms, there was anygain at all.

8. From the note holder perspective, explain one advantage and two disadvantages of thenew notes. Discuss why most note holders accepted the exchange offer. Evaluate thatdecision based on subsequent events.

CASE 11-1Off-Balance-Sheet Financing Techniques for Texaco and Caltex

The objective of this case is to extend the analysis of the off-balance-sheet financing activities ofTexaco begun in Exhibit 11-7 of the text. Specifically the case focuses on Texaco’s affiliates andtheir OBS activities and the adjustments to reported financial statements required to reflect theseactivities.

Caltex is a joint venture between Texaco and Chevron [CHV] (another oil multinational);each partner owns 50%. Exhibit 11C-1 contains the 1999 condensed balance sheet, incomestatement, and selected footnotes of Caltex as well as general information, all extracted fromTexaco’s 1999 10-K report.

Relevant financial information relating to Texaco can be obtained from Texaco’s 1999 An-nual Report (on the website/CD) and from the information provided in Exhibits 11-6 and 11-7 inthe text.

Required:1. Exhibit 11-7 shows Texaco’s reported and adjusted debt-to-equity ratios. To extend the

analysis, compute the following ratios on a reported and adjusted basis for 1999:• Return on assets (Use 1999 year end total assets)• Times interest earned

2. (a) Using the Caltex reported balance sheet and income statement (without any adjust-ments), prepare a capitalization table for Caltex for the year ended December 31,1999.

(b) Compute the following Caltex ratios for 1999:• Debt-to-equity• Return on assets• Times interest earned

3. (a) Using the footnote data from Exhibit 11C-1, compute the appropriate adjustments toCaltex debt for its off-balance-sheet obligations.

(b) Using the result of part (a), recompute the ratios in question 2(b).(c) Discuss the significance of your results.

4. Use the results of Questions 2 and 3 to further adjust Texaco’s debt and equity, and ra-tios calculated in Question 1.

5. Describe the information not contained in the Texaco and Caltex financial data thatwould help you evaluate the impact of their off-balance-sheet obligations on future cashflows. (Your discussion should include both financial and operational factors.)

In addition to Caltex, Texaco’s major affiliates are Equilon Enterprises LLC (44% owned) andMotiva Enterprises LLC (32.5% owned).1 A description of these affiliates follows.

• Equilon was formed and began operations in January 1998 as a joint venture betweenTexaco and Shell. Equilon, which is headquartered in Houston, Texas, combines majorelements of Texaco’s and Shell’s western and midwestern U.S. refining and marketingbusinesses and their nationwide transportation and lubricants businesses. Texaco owns44% and Shell owns 56% of the company. Equilon refines and markets gasoline andother petroleum products under both the Texaco and Shell brand names in all or parts of32 states. Equilon is the seventh largest refining company in the U.S.

(Continued on page W87.)

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1Equilon and Motiva are limited liability companies (LLC) and do not pay income taxes directly. Taxes are the re-sponsibility of the limited partners. As such, their financial statements do not record a provision for taxes.

EXHIBIT 11C-1. CALTEX GROUP OF COMPANIESExcerpts from 1999 Financial Statements ($millions)

Condensed Consolidated Income StatementYear Ended December 31, 1999

Sales and other operating revenue $14,583

Cost of sales 12,775Selling, general and administrative 582Depreciation, depletion, and amortization 459Maintenance and repairs $13,154

Total expenses $13,970

Operating income 613

Income in equity affiliates 252Dividends, interest, and other income 80Foreign exchange, net (11)Interest expense (152)Minority interest $1211(2)

Total other income (deductions) $ 167

Income before income taxes 780Income taxes $13,390Net income $ 390

Condensed Consolidated Balance SheetDecember 31, 1999

Assets

Current assets $ 2,705Investments and advances 2,223Net property 5,170Other $10,211

Total assets $10,309

Liabilities and Equity

Short-term debt $ 1,588Accounts payable 1,545Other $10,262

Current liabilities $ 3,395

Long-term debt 1,054Deferred income taxes 206Other 1,356Minority interest $10,223

Long-term liabilities $ 2,639

Stockholders’ equity $14,275Total liabilities and equity $10,309

General Information

The Caltex Group of Companies (Group) is jointly owned 50% each by Chevron Corporation and Tex-aco Inc. (collectively, the Stockholders) and was created in 1936 by its two owners to produce, trans-port, refine, and market crude oil and petroleum products.

Note 4—Equity in Affiliates

Investments in affiliates at equity include the following:

Equity % 1999 1998

Caltex Australia Limited 50% $ 260 $ 324Koa Oil Company, Limited (sold August, 1999) 50% — 298LG-Caltex Oil Corporation 50% 1,441 1,170Star Petroleum Refining 64% 269 304All other Various $2,157 $2,158

$2,127 $2,254

OFF-BALANCE-SHEET FINANCING TECHNIQUES FOR TEXACO AND CALTEX W85


Shown below is summarized combined financial information for equity affiliates:

100% Equity Share

1999 1998 1999 1998

Current assets $3,005 $3,689 $1,535 $1,855Other assets 6,333 7,689 3,287 4,004Current liabilities (3,351) (3,547) (1,816) (1,795)Other liabilities .(1,883) .(3,505) ..$(937) .(1,866)Net worth $4,104 $4,326 $2,069 $2,198

100% Equity Share

1999 1998 1997 1999 1998 1997

Operating revenues $12,796 $11,811 $14,669 $6,511 $5,968 $7,452Operating income 726 1,101 1,078 358 539 532Net income 539 193 853 252 58 390

Cash dividends received from these affiliates were $71 million, $50 million, and $43 million in 1999,1998, and 1997, respectively.

Retained earnings as of December 31, 1999 and 1998 includes $1.4 billion which represents theGroup’s share of undistributed earnings of affiliates at equity.

Note 7—Operating Leases

The Group has operating leases involving various marketing assets for which net rental expense was$112 million, $103 million, and $105 million in 1999, 1998, and 1997, respectively.

Future net minimum rental commitments under operating leases having non-cancelable terms inexcess of one year are as follows (in Millions of U.S. Dollars): 2000—$66; 2001—$42; 2002—$30;2003—$13; 2004—$10; and 2005 and thereafter—$37.

Note 9—Commitments and Contingencies

. . . .A Caltex subsidiary has a contractual commitment until 2007 to purchase petroleum products inconjunction with the financing of a refinery owned by an affiliate. Total future estimated commitmentsunder this contract, based on current pricing and projected growth rates, are approximately $700 mil-lion per year. Purchases (in billions of U.S. dollars) under this and other similar contracts were $0.7,$0.8, and $1.0 in 1999, 1998, and 1997, respectively.

. . .Caltex is contingently liable for sponsor support funding for a maximum of $278 million in connec-tion with an affiliate’s project finance obligations. The project has been operational since 1996 and hassuccessfully completed all mechanical, technical, and reliability tests associated with the plant physicalcompletion covenant. However, the affiliate has been unable to satisfy a covenant relating to a workingcapital requirement. As a result, a technical event of default exists which has not been waived by thelenders. The lenders have not enforced their rights and remedies under the finance agreements and theyhave not indicated an intention to do so. The affiliate is current on these financial obligations and antic-ipates resolving the issue with its secured creditors during further restructuring discussions. During1999, Caltex and the other sponsor provided temporary short-term extended trade credit related tocrude oil supply with an outstanding balance owing to Caltex at December 31, 1999 of $149 million.

Environmental Matters

The Group’s environmental policies encompass the existing laws in each country in which the Groupoperates, and the Group’s own internal standards. Expenditures that create future benefits or contributeto future revenue generation are capitalized. Future remediation costs are accrued based on estimates ofknown environmental exposure even if uncertainties exist about the ultimate cost of the remediation.Such accruals are based on the best available undiscounted estimates using data primarily developed bythird party experts. Costs of environmental compliance for past and ongoing operations, includingmaintenance and monitoring, are expensed as incurred. Recoveries from third parties are recorded asassets when realizable.

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EXHIBIT 11C-2. TEXACO AFFILIATES: EQUILON AND MOTIVAExcerpts from 1999 Financial Statements ($millions)

Condensed Consolidated Income StatementYear Ended December 31, 1999

Equilon Motiva

Sales and other operating revenue $29,174 $12,196

Cost of sales 26,747 10,917Selling, general, and administrative 1,308 876Depreciation, depletion, and amortization $28,878 $12,378

Total expenses $28,933 $12,171

Operating income 241 25Equity in income of affiliates 154 ,—Dividends, interest and other income 70 ,—Interest expense (115) (94)Minority interest $2891(3) $12 ,—

Total other income (deductions) $ 106 $ (94)

Net income $ 347 $ (69)

Condensed Consolidated Balance SheetDecember 31, 1999

Equilon Motiva

Assets

Current assets $ 4,209 $1,271Investments & advances 529 180Net property 6,312 4,974Other assets 1 1,367 6 ,153

Total assets $11,417 $6,578


Short-term debt 2,157 363Accounts payable 2,481 377Other 1 1,998 1 ,538

Current liabilities $ 5,636 $1,278

Long-term debt 5 1,451Other liabilities 11 ,730 2 ,644

Long-term liabilities $ ,735 $2,095Stockholders’ equity 2 5,046 $3,205

Total liabilities and equity $11,417 $6,578

Equity in Affiliates

Equilon: Summarized financial information for Equilon’s affiliate investments and Equilon’s equityshare thereof for the year ended December 31, 1999 is as follows:

Equity Companies at 100% and at Equilon’s Percentage Ownership ($ millions)

100% Equilon’s Share

Current assets $1,684 $ 750Noncurrent assets 3,601 1,097Current liabilities (1,585) (629)Noncurrent liabilities and deferred credits (2,543) $1(692)

Net assets $1,157 $ 526

Revenues 2,002 615Income before income taxes 664 176Net income 494 154Dividends received — 144

OFF-BALANCE-SHEET FINANCING TECHNIQUES FOR TEXACO AND CALTEX W87

• Motiva was formed and began operations in July 1998 as a joint venture among Shell,Texaco, and Saudi Refining, Inc., a corporate affiliate of Saudi Aramco. Motiva com-bines Texaco’s and Saudi Aramco’s interests and major elements of Shell’s eastern andGulf Coast U.S. refining and marketing businesses. Texaco and Saudi Refining, Inc.,each owns 32.5% and Shell owns 35% of Motiva. Motiva refines and markets gasolineand other petroleum products under the Shell and Texaco brand names in all or part of26 states and the District of Columbia, providing product to almost 14,000 Shell- andTexaco-branded retail outlets.

Exhibit 11C-2 contains the condensed balance sheet, income statement, and selected footnotesof Equilon and Motiva, all extracted from Texaco’s 1999 10-K report.

6. Using the data from Exhibit 11C-2, compute the appropriate adjustments to Texaco’s fi-nancial statements and recompute the ratios calculated in Question 1.


Operating Leases and Throughput Agreements

As of December 31, 1999 Equilon and Motiva had estimated minimum commitments for payment ofrentals under leases that, at inception, had a non-cancelable term of more than one year, as follows:($ millions)

Equilon Motiva

2000 $ 76 $ 512001 63 492002 62 472003 61 392004 59 38After 2004 $1,775 $410Total $1,096 $634Less sublease rental income $1,075 $1—Total lease commitments $1,021 $634

Equilon has assumed crude and refined product throughput commitments previously made by Shell andTexaco to ship through affiliated pipeline companies and an offshore oil port, some of which relate tofinancing arrangements. As of December 31, 1999 and 1998, the maximum exposure was estimated tobe $297 million and $333 million, respectively. No advances have resulted from these obligations.

CASE 13-1Coca-Cola: Consolidation Versus Equity Method

Coca-Cola (Coke) [KO] is the largest soft drink firm in the world. However, Coke does not bottleand distribute its beverages; that activity is carried out by affiliates in which Coke has a large eq-uity interest.

Coca-Cola Enterprises (Enterprises) [CCE] is the world’s largest marketer and distributor ofCoke products. The relationship between the two firms is complex:

1. Enterprises produces virtually all its products under license from Coke and buys softdrink syrup, concentrates, and sweeteners directly from or through Coke.

2. Coke provides national advertising as well as local marketing support for Enterprises’products.

3. Through programs such as ‘Jumpstart’ that are designed to accelerate the placement ofcold drink equipment, Coke provides funding to Enterprises to help set up the infrastruc-ture required to distribute its products.

4. Approximately 90% of Enterprises’ sales volume is generated through the sale of prod-ucts of The Coca-Cola Company; raw materials purchased from Coke account for over50% of Enterprises’ cost of goods sold. To a great extent, Coke controls Enterprises’products and input costs.

5. Three members of Enterprises’ board of directors are current officers of Coke.

It would not be an understatement to suggest that Enterprises (and Coke’s other affiliated bottlingcompanies) are an integral part of Coke’s success, providing an outlet for its products. However,by keeping its ownership below 50%, Coke has been able to use the equity method to report itsinterest in Enterprises and the other bottlers.

Exhibit 13C1-1 contains condensed 2001 financial statements of Coke and Coca-Cola En-terprises. The following information with respect to its ownership interest in its bottlers is ex-cerpted from Coke’s financial statements:

• Coca-Cola Enterprises is the largest soft drink bottler in the world. Coke owns approxi-mately 38 percent of the outstanding common stock of Coca-Cola Enterprises and, ac-cordingly, accounts for its investment by the equity method of accounting.

• At December 31, 2001, the Company owned approximately 35 percent of Coca-ColaAmatil, an Australia-based bottler of Company products that operates in 12 countries.

• As a result of a merger in 2000 between Coca-Cola Beverages and Hellenic BottlingCompany S.A. to form the combined entity Coca-Cola HBC S.A., Coke’s previous 50.5%ownership in Coca-Cola Beverages was reduced to a 24% share of the combined entityCoca-Cola HBC S.A.

• Coke states in its MD&A that

In line with our long-term bottling strategy, we consider alternatives for reducing our ownership in-terest in a bottler. One alternative is to combine our bottling interests with the bottling interests ofothers to form strategic business alliances. Another alternative is to sell our interest in a bottling op-eration to one of our equity investee bottlers. In both of these situations, we continue to participatein the bottler’s results of operations through our share of the equity investee’s earnings or losses.

Additional information that is also relevant to analysis of the bottling affiliates is presented below:

• 2001 Financial Information ($ in millions)

Intercompany sales From Coke to Enterprises $3,900From Enterprises to Coke 395

Net marketing payments From Coke to Enterprises 606

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(Continued on page W90.)

COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD W89

EXHIBIT 13C1-1. THE COCA-COLA COMPANY AND COCA-COLA ENTERPRISESCondensed 2001 Financial Statements (in millions)

Balance Sheets at December 31, 2001 Coke Enterprises

Current Assets

Cash and marketable securities $ 1,934 $ 284Trade accounts receivable 1,882 1,540Inventories 1,055 690Prepaid expenses and other assets $12,300 $23,362

$ 7,171 $ 2,876

InvestmentsEquity method investments

Coca-Cola Enterprises 788 —Coca-Cola Amatil Limited 432 —Coca-Cola HBC S.A 791 —Other, principally bottling companies 3,117 —

Cost method investments, principally bottling companies 294 —Other assets $22,792 $23,1—

$ 8,214 —

Property, Plant, and Equipment (Net) 4,453 6,206Intangible assets* $12,579 $14,637Total assets $22,417 $23,719

Current Liabilities

Accounts payable and accrued liabilities $ 4,530 $ 2,610Accounts payable to The Coca-Cola Company 38Deferred cash payments from The Coca-Cola

Company 70Notes payable and current debt $23,899 $11,804

$ 8,429 $ 4,522

Noncurrent Liabilities

Long-term debt 1,219 10,365Other long-term liabilities 961 1,166Deferred taxes 442 4,336Deferred cash payments from The Coca-Cola

Company $23,1— $16,510$ 2,622 $16,377

Shareholders’ Equity

Preferred stock — 37Common stock 873 453Capital surplus 3,520 2,527Retained earnings 23,443 220Other comprehensive income (2,788) (292)Treasury stock (13,682) $12(125)

$11,366 $ 2,820Total liabilities and equity $22,417 $23,719

*Intangible assets of Coke consist primarily of goodwill and trademarks. Intangible assets for Enterprises consistprimarily of franchise rights to bottle Coca-Cola products.

W90 CASE 13-1 COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD

• Prior to 2001, Enterprises had recorded payments received from Coke for programs suchas ‘Jumpstart’ as offsets to expenses incurred in constructing the infrastructure. Starting in2001, Enterprises changed its accounting and recorded the money received as obliga-tions to Coke to be amortized over the life of the programs. Coke, itself, records these ex-penditures as part of Other Assets and amortizes them over time.

Required:1. Given the relationship between Coke and Enterprises, discuss the appropriateness of

Coke’s use of the equity method to account for its investment in Enterprises.2. Prepare a 2001 balance sheet, income statement, and cash flow statement for Coke,

with Enterprises fully consolidated.3. Compute the following ratios for Coke (as reported), Enterprises, and Coke after full con-

solidation of Enterprises:(a) Current ratio (h) Return on assets(b) Debt-to-equity (i) Return on tangible assets(c) Debt-to-tangible equity (j) Return on equity(d) Debt-to-assets (k) Return on tangible equity(e) Current ratio (l) Times interest earned(f) Debt-to-equity (m) Inventory turnover(g) Debt-to-tangible equity (n) Receivable turnover

EXHIBIT 13C1-1 (continued)

Income Statement, Year Ended December 31, 2001 Coke Enterprises

Net operating revenues $20,092 $15,700Cost of goods sold $,(6,044) $,(9,740)Gross profit $14,048 $ 5,960Selling, administrative, and general expenses $,(8,696) $,(5,359)Operating income $ 5,352 $ 601Interest income 325 —Interest expense (289) (753)Equity income 152 —Other income $11,130 $11,512Income before taxes $ 5,670 $ (150)Income taxes $,(1,691) $11,131Income before cumulative effect of accounting change $ 3,979 $ (19)Cumulative effect of accounting change $111(10) $11(302)Net income $ 3,969 $ (321)Preferred dividends $11,3— $1111(3)Net income (loss) applicable to common shareholders $ 3,969 $ (324)

Cash Flow Statements,Year Ended December 31, 2001 Coke Enterprises

Cash Flow from Operations

Net income $ 3,969 $ (324)Equity income, net of dividends (54)Other adjustments $11,195 $11,438

$ 4,110 $ 1,114Cash Flows from Investing Activities (1,188) (2,010)

Cash Flows from Financing Activities

Debt financing (926) 946Issue and repurchase of stock (113) 12Dividends $ (1,791) $111(72)

$ (2,830) $ 886Effect of exchange rate changes $212(45) $11,3—Change in cash $ 47 $ (10)

Source: Adapted from 2001 annual reports of The Coca-Cola Company and Coca-Cola Enterprises.

COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD W91

EXHIBIT 13C1-2. THE COCA-COLA COMPANY AND SUBSIDIARIESSupplementary Data

Notes to Consolidated Financial Statements

Other Equity Investments

Operating results include our proportionate share of income (loss) from our equity investments. A sum-mary of financial information for our equity investments in the aggregate, other than Coca-Cola Enter-prises, is as follows

(in millions):

December 31, 2001 2000

Current assets $ 6,013 $ 5,985Noncurrent assets $17,879 $19,030

Total assets $23,892 $25,015Current liabilities $ 5,085 $ 5,419Noncurrent liabilities $ 7,806 $ 8,357

Total liabilities $12,891 $13,776Shareowners’ equity $11,001 $11,239Company equity investment $ 4,340 $ 4,539

Year Ended December 31, 2001 2000 1999

Net operating revenues (1) $19,955 $21,423 $19,605Cost of goods sold $11,413 $13,014 $12,085Gross profit (1) $ 8,542 $ 8,409 $ 7,520Operating income (loss) $ 1,770 $ (24) $ 809Cash operating profit (2) $ 3,171 $ 2,796 $ 2,474Net income (loss) $ 735 $ (894) $ (134)

Notes: Equity investments include non-bottling investees.(1) 2000 and 1999 Net operating revenues and Gross profit have been reclassified for EITF Issue No. 00-14

and EITF Issue No. 00-22.(2) Cash operating profit is defined as operating income plus depreciation expense, amortization expense

and other non-cash operating expenses.

Net sales to equity investees other than Coca-Cola Enterprises were $3.7 billion in 2001, $3.5 billion in2000, and $3.2 billion in 1999. Total support payments, primarily marketing, made to equity investeesother than Coca-Cola Enterprises, the majority of which are located outside the United States, were ap-proximately $636 million, $663 million, and $685 million for 2001, 2000, and 1999, respectively.

In February 2001, the Company reached an agreement with Carlsberg A/S (Carlsberg) for the dis-solution of Coca-Cola Nordic Beverages (CCNB), a joint venture bottler in which our Company had a49 percent ownership. In July 2001, our Company and San Miguel Corporation (San Miguel) acquiredCoca-Cola Bottlers Philippines (CCBPI) from Coca-Cola Amatil Limited (Coca-Cola Amatil).

In November 2001, our Company sold nearly all of its ownership interests in various Russian bot-tling operations to Coca-Cola HBC S.A. (CCHBC) for approximately $170 million in cash and notes re-ceivable, of which $146 million in notes receivable remained outstanding as of December 31, 2001.These interests consisted of the Company’s 40 percent ownership interest in a joint venture with CCHBCthat operates bottling territories in Siberia and parts of Western Russia, together with our Company’snearly 100 percent interests in bottling operations with territories covering the remainder of Russia.

In July 2000, a merger of Coca-Cola Beverages plc (Coca-Cola Beverages) and Hellenic BottlingCompany S.A. was completed to create CCHBC. This merger resulted in a decrease in our Company’sequity ownership interest from approximately 50.5 percent of Coca-Cola Beverages to approximately24 percent of the combined entity, CCHBC.

In July 1999, we acquired from Fraser and Neave Limited its ownership interest in F&N Coca-Cola Pte Limited.

If valued at the December 31, 2001, quoted closing prices of shares actively traded on stock mar-kets, the value of our equity investments in publicly traded bottlers other than Coca-Cola Enterprisesexceeded our carrying value by approximately $800 million.

Source: Coca-Cola 2001 Annual Report

W92 CASE 13-1 COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD

4. Discuss the differences in the ratios in part 3 between Coke as reported and after theconsolidation of Enterprises.

5. Repeat parts 2 through 4, but using proportionate consolidation for Enterprises.6. Exhibit 13C1-2 contains summarized data regarding Coke’s other bottling affiliates (ex-

cluding Enterprises) accounted for using the equity method. Discuss the expected effectof:(i) Full consolidation on Coke’s financial statements.(ii) Proportionate consolidation

7. Discuss the expected effect of the FASB exposure draft on consolidation (Box 13-3) onCoke’s accounting treatment of its bottling affiliates.

8. Coke states “In line with our long-term bottling strategy, we consider alternatives for re-ducing our ownership interest in a bottler.” Discuss Coke’s motivation to reduce suchownership interests.

9. As a financial analyst, discuss the advantages and disadvantages of viewing Coke, withits bottling affiliates:(i) On the equity method(ii) Proportionately consolidated(iii) Fully consolidated

CASE 14-1Conversion of Pooling to Purchase MethodPfizer Acquisition of Warner-Lambert

INTRODUCTION

On June 19, 2000 Pfizer [PFE] merged with Warner-Lambert [WLA], issuing approximately2,440 million PFE shares in exchange for all of the equity of WLA. The merger was accountedfor as a pooling of interests as permitted by U.S. GAAP at that time.

CASE OBJECTIVES

1. Determine the effect of the acquisition of Warner-Lambert on Pfizer’s financial statements.2. Compare the financial statement effects of the merger with the effects if Pfizer had ac-

counted for the acquisition as a purchase under(i) U.S. GAAP (SFAS 141 and SFAS 142)(ii) IAS GAAP

Exhibit 14C1-1 shows the condensed balance sheet of Warner-Lambert on December 31, 1999.Exhibit 14C1-2 contains extracts from WLA’s financial statement footnotes on the same date. Ex-hibit 14C1-3 shows the condensed income and cash flow statements for Warner-Lambert for theyear ended December 31, 1999. Use these exhibits and the Pfizer 1999 financial statements onthe CD/website to answer the following questions.

1. Describe the effects of the merger with Warner-Lambert on Pfizer’s 1999(i) Balance sheet(ii) Income statement(iii) Cash flow statement(iv) Financial statement footnotesas reported in Pfizer’s 2000 Annual Report

2. Compute the effect of the merger with Warner-Lambert on each of the following Pfizerratios for 1999:

(i) Current ratio(ii) Total debt to equity(iii) Book value per share(iv) Gross profit margin(v) Operating profit margin(vi) Return on equity(vii) Cash from operations (CFO) to debt

W93

EXHIBIT 14C1-1. WARNER-LAMBERTCondensed Balance Sheet at December 31, 1999Amounts in $ millions

Cash and equivalents $ 1,943 Short-term debt $ 297Inventories 979 Other current liabilities 3,391Other current assets 2,768 Long-term debt 1,250Property (net) 3,342 Deferred income tax 463Investments and other assets 793 Other long-term liabilities 942Intangible assets $11,616 Stockholders’ equity $15,098

Totals $11,441 $11,441

Source: Warner-Lambert 1999 10-K

W94 CASE 14-1 CONVERSION OF POOLING TO PURCHASE METHOD PFIZER ACQUISITION OF WARNER-LAMBERT

3. Assume that Pfizer had been required to account for the acquisition of Warner-Lambertunder SFAS 141 and SFAS 142. Prepare a pro forma balance sheet for December 31,1999 using the Pfizer balance sheet on the CD/website, the data in Exhibits 14C1-1and 14C1-2, and the following assumptions:(i) The price of PFE shares on that date was $32.44(ii) The following fair values of WLA assets ($millions):

• Inventories $1,250• Fixed assets 4,000• In process research and development 1,000

4. Prepare a pro forma 1999 income statement for Pfizer as if the merger had occurredJanuary 1, 1999, using the data and assumptions from Question 3. State any additionalassumptions required to prepare the income statement.

5. Redo Question 2 using the data and assumptions from Questions 3 and 4.6. Describe the effect of the acquisition of Warner-Lambert, using the assumptions from

Question 3, on Pfizer’s(i) Income statement for 2000(ii) Income statement for following years

EXHIBIT 14C1-2. WARNER-LAMBERTExtracts from Footnotes at December 31, 1999Amounts in $ Millions

Fair Values of Financial Instruments

Carrying Amount Fair Value

Investment securities $ 149 $ 149Long-term debt (1,249) (1,222)Foreign exchange contracts — (16)

Pensions and Other Postretirement Benefits Pensions OPEB

Benefit obligation at year-end $2,634 $ 277Plan assets at year-end 2,644 —Amounts recognized on balance sheet:Prepaid benefit cost 219Accrued benefit liability (161) (169)Intangible asset 4Comprehensive income 14

Assets Liabilities

Deferred Income Taxes 1,020 463


EXHIBIT 14C1-3. WARNER-LAMBERTCondensed Income and Cash Flow Statements, Year Ended December 31, 1999Amounts in $ Millions

Condensed Income Statement Condensed Cash Flow Statement

Sales $12,929 Operating activities $2,437Cost of goods sold (3,042) Investing activities (1,234)Selling, general, administrative (5,959) Financing activities (500)Research and development (1,259) Exchange rate effects $1, (15)Other expense, net $1, (228) Increase in cash $ 688Pretax income $ 2,441Income tax expense $1, (798)Net income $ 1,643


(iii) Cash flow statement for 2000(iv) Cash flow statement for following years

7. Using your answers to the prior questions, explain why PFE preferred using the poolingof interest method to account for the acquisition.

8. From the perspective of a financial analyst, state two advantages of each accountingmethod (pooling and purchase).

9. Now assume that Pfizer accounted for the acquisition of Warner-Lambert using IASGAAP. Redo Questions 3 through 6, in each case showing how the effect of IAS GAAPdiffers from SFAS 141 and 142.

10. State and justify whether Pfizer, given a choice, is likely to prefer using IAS standards toaccount for the acquisition of WLA, rather than SFAS 141 and 142.

11. In 2000 Pfizer recorded an income statement charge for “merger-related costs,” brokendown as follows (in $millions):

Payment to American Home Products* $1,838Transaction costs 226Restructuring charges 947Integration costs $3,246Total $3,257

Discuss which (if any) of these components should be included in Pfizer’s net income for valua-tion purposes.

*For termination of merger agreement with Warner-Lambert0

CONVERSION OF POOLING TO PURCHASE METHOD PFIZER ACQUISITION OF WARNER-LAMBERT W95

CASE 14-2Conversion of Purchase to Pooling MethodWestvaco Acquisition of Mead

INTRODUCTION

On January 29, 2002 Westvaco [W] merged with Mead [MEA], issuing approximately 99.2 millionshares and $119 million cash in exchange for all of the equity of MEA. The merger was accountedfor as a purchase as required by SFAS 141. While the companies were quite similar in size, andthe merger was presented as a merger of equals, Westvaco was deemed to be the acquirer. Thenew (combined) company is called MeadWestvaco [MWV]. The purchase price was estimated as:

Value of MWV shares issued (at $30.06 per share) $2,981 millionCash paid to MEA shareholders 119Value of MEA stock options 85Transaction costs $3,235Total $3,220which was allocated as follows:Mead net assets at historical cost 2,317Fair value adjustments 846Elimination of MEA goodwill (257)Acquisition goodwill recognized $3,314Total $3,220

CASE OBJECTIVES

1. Determine the effect of the acquisition of Mead on Westvaco’s financial statements.2. Compare the financial statement effects of the merger with the effects if Westvaco had

accounted for the acquisition as a purchase under IAS GAAP:(i) Using the purchase method(ii) Using the pooling of interests method

3. Compare the financial statement effects of the merger with the effects if it had been ac-counted for as a purchase under US GAAP but with Mead as the acquirer.

Exhibit 14C2-1 shows the pro forma condensed balance sheet of the combined company(MWV) as of October 31, 2001. Exhibit 14C2-2 shows the pro forma condensed income state-ment of MWV for the year ended October 31, 2001. Use these exhibits and the additional infor-mation provided to answer the following questions.

1. Describe the effects of the merger with Mead on Westvaco’s 2001 and 2002(i) Balance sheet(ii) Income statement(iii) Cash flow statement(iv) Financial statement footnotes

2. Compute the effect of the merger with Mead on each of the following Westvaco ratiosfor 2001:

(i) Current ratio(ii) Total debt to equity(iii) Book value per share(iv) Gross profit margin(v) Operating profit margin(vi) Interest coverage ratio(vii) Return on ending equity

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3. Discuss the effect of use of the purchase method on MWV’s(i) Trend of reported revenue for fiscal years 2001–2003(ii) Trend of reported income for fiscal years 2001–2003(iii) Trend of reported CFO for fiscal years 2001–2003(iv) Trend of balance sheet ratios for fiscal years 2001–2003

4. From the perspective of a financial analyst, explain the usefulness of the pro forma fi-nancial statements.

5. Discuss whether the restructuring charges should be included in pro forma net incomefor analysis purposes.

CASE OBJECTIVES W97

EXHIBIT 14C2-1. MEADWESTVACOPro Forma Condensed Balance SheetAmounts in $ millions

October 31, 2001

Adjustments

Assets Westvaco Mead Amount # Combined

Cash and equivalents $ 81 $ 51 $ 132Accounts receivable 415 471 886Inventories 426 540 $ 209 1 1,175Other current assets $1,094 $1,107 $11(65) 2 $13,136

Total current assets $1,016 $1,169 $ 144 $ 2,329Property (net) 4,227 3,129 1,248 3 8,604Prepaid pension asset 780 317 (229) 4 868Goodwill 565 257 57 5 879Other assets $6,199 $6,587 $6,193 6 $13,879

Total assets $6,787 $5,459 $1,313 $13,559


Current debt 173 227 148 7 548Other current liabilities $6,528 $6,698 $6,110 8 $11,336

Total current liabilities $ 701 $ 925 $ 258 $ 1,884Long-term debt 2,660 1,315 (7) 9 3,968Deferred income tax 1,008 591 297 10 1,896Other liabilities $4.477 $3,311 $1,310 11 $13,398

Total liabilities $4,446 $3,142 $ 558 $ 8,146Stockholders’ equity $2,341 $2,317 $1,755 12 $15,413

Liabilities and equity $6,787 $5,459 $1,313 $13,559Millions of shares outstanding 102.4 99.1 198.5

Adjustment #

1. Fair value adjustment2. Deferred income tax3. Fair value adjustment4. Pension plan adjustment to plan status5. Acquisition goodwill less elimination of Mead goodwill6. Fair value adjustment7. Debt incurred for payments to Mead shareholders and other costs8. Transaction and restructuring costs and fair value adjustments9. Fair value adjustment

10. Deferred income tax11. Pension and OPEB adjustments to plan status12. Replace Mead equity with value of MWV shares issued

Source: Adapted from March 8, 2002 corporate release

W98 CASE 14-2 CONVERSION OF PURCHASE TO POOLING METHOD WESTVACO ACQUISITION OF MEAD

6. Assume that Westvaco had been required to account for the acquisition of Mead usingthe purchase method under IAS GAAP. Discuss any differences in the effect of themerger on the combined company’s(i) Pro forma balance sheet at October 31, 2001(ii) Pro forma income statement for the year ended October 31, 2001

7. Assume that the merger had been accounted for as the acquisition of Westvaco byMead using the purchase method under US GAAP. Using the following fair value ad-justment information for Westvaco, prepare a pro forma balance sheet for the com-bined company at October 31, 2001:

Assets Liabilities

Inventories 135 Long-term debt 100Capitalized operating leases 145 Capitalized leases 145Timberland 461 Deferred income tax (1,007)

Note: information from Exhibit 14C2-1 and the introduction is also required to an-swer this question.

8. Discuss any differences (from the actual method used) in the effect of the merger on thecombined company’s(i) Trend of reported revenue for fiscal years 2001–2003(ii) Trend of reported income for fiscal years 2001–2003(iii) Trend of reported CFO for fiscal years 2001–2003(iv) Trend of balance sheet ratios for fiscal years 2001–2003

EXHIBIT 14C2-2. MEADWESTVACOPro Forma Condensed Income StatementAmounts in $ Millions

Year Ended October 31, 2001

Adjustments

Westvaco Mead Amount # Combined

Sales $ 3,935 $ 4,176 $ 8,111Cost of goods sold $ (3,241) $ (3,597) $(43) 1 $(6,881)Gross margin $ 694 $ 579 $(43) $ 1,230Selling and administrative (364) (494) (5) 2 (863)Restructuring charges (52) (45) (97)Other revenues $3,2 (48 $13,119 $1(1) 3 $(6,166EBIT $ 326 $ 59 $(49) $ 336Interest expense $12(208) $41(110) $1(4) 4 $1,(322)Pretax income $ 118 $ (51) $(53) $ 14Income tax expense $3,2 (30) $13,134 $(20 5 $81124Net income $ 88 $ (17) $(33) $ 38

Earnings per share 0.87 0.18 0.19Average shares (millions) 101.5 99.1 197.6

Adjustment #

1. Additional depreciation resulting from fair value adjustment less Mead goodwill amortization andeffect of pension plan adjustments

2. Amortization of higher fair value of Mead intangible assets3. Same as #24. Interest on new debt and amortization of fair value debt adjustment5. Income tax effects of other adjustments

Source: Adapted from March 8, 2002 corporate release

9. Now assume that Westvaco accounted for the acquisition of Mead using the poolingmethod under IAS GAAP. Prepare a pro forma condensed:(i) balance sheet for the combined company as of October 31, 2001, using the format

of Exhibit 14C2-1.(ii) income statement for the combined company for the year ended October 31,

2001, using the format of Exhibit 14C2-2.10. Redo Questions 1 through 3, in each case showing how the effect of IAS GAAP differs

from US GAAP.11. State and justify which method, given a choice, the companies would have preferred to

use to account for the merger.

CASE OBJECTIVES W99

CASE 15-1 AFLACAnalysis of Exchange Rate Effects: Single Currency

INTRODUCTION

AFLAC (American Family Life) is a major specialty insurance company. Although the companyis American, its Japanese subsidiary, AFLAC Japan, accounted for 85% of 1995 revenues and90% of assets. Because AFLAC presents its financial statements in U.S. dollars, changes in theyen-dollar exchange rate have important effects on reported income, net worth, cash flow, andfinancial ratios.

With only a single foreign currency, the complexity that often characterizes the analysis ofexchange effects is eliminated. The yen is one of the world’s major currencies, and exchangerate data are widely available. As a result, the impact of exchange rate changes is easier to cal-culate and understand.

CASE OBJECTIVES

The objectives of this case are to use AFLAC to:

1. Show the effects of exchange rate changes on levels and trends of revenue, income, cashflow, and financial position.

2. Calculate translation gains and losses.3. Show how currency exposure can be managed.

EXCHANGE RATE EFFECTS ON INCOME STATEMENT

As AFLAC Japan dominates corporate results, we start with an examination of that subsidiary.Exhibit 15C1-1 shows the revenues and pretax income of AFLAC Japan over the 1986 to 1995period, in both Japanese yen and U.S. dollars. The average annual yen-dollar exchange rates arealso provided. The Japanese yen rose from 168 to the dollar (1986 average) to 94 to the dollar(1995 average) over this time span, rising in seven of the nine years. The strengthening yen mag-nified the growth rate of AFLAC Japan, as yen results were translated into U.S. dollars at everhigher rates. Revenues rose from 154 billion yen (1986) to 575 billion yen in 1995, an increaseof 274%; the nine-year increase in U.S. dollars was 570%. Due to an average 6% increase inthe value of the yen, average revenue growth of less than 16% (in yen) was reported as morethan 24% in dollars.

The effect of the yen’s rise on reported pretax earnings was equally dramatic. Over the1986 to 1995 period, AFLAC Japan’s pretax earnings increased 175% in yen but 392% aftertranslation to U.S. dollars. It should be noted that the effect of the exchange rate on revenue andpretax income is not affected by the choice of functional currency in this case; all the sub-sidiaries’ revenues and expenses are monetary.1

However, the exchange rate effect was not beneficial every year. As shown in Exhibit15C1-1, the U.S. dollar revenue growth rate was only 2.8% in 1989, as 10.7% revenuegrowth (in yen) was mostly offset by a 7.7% decline in the yen relative to the dollar. A furtheryen decline in 1990 again resulted in a lower growth rate in dollars than in yen. Pretax in-come gains in 1989 to 1990 were also depressed (when reported in dollars) by the fallingyen.

AFLAC Japan’s growth rate has declined (in yen) in recent years. Strong gains by the yen,however, made the revenue growth rate accelerate (in dollars) in the 1990s.

W100

1As an insurance company, AFLAC has immaterial depreciation and no cost of goods sold.

EXCHANGE RATE EFFECTS ON CASH FLOW

As AFLAC Japan’s cash flows are translated into dollars at the average exchange rate, thestrengthening yen also increased reported cash flow, as can be seen from the following data:

Cash Flow from Operations ($ in billions)

1993 1994 1995

Consolidated $1.8 $2.4 $2.9AFLAC Japan 1.7 2.1 2.7% Increase N/A 24% 28%Exchange rate effect N/A 9% 9%

Exchange rates accounted for approximately one-third of the increase in AFLAC Japan’s cashfrom operations over the 1993 to 1995 period; AFLAC Japan accounted for more than 90% ofconsolidated cash from operations.

EXCHANGE RATE EFFECTS ON BALANCE SHEET

Because AFLAC Japan has no inventories and almost no fixed assets, its assets and liabilities arevirtually all translated at current exchange rates.2 Thus, changes in the yen-dollar exchange rate di-rectly affect the consolidated balance sheet as AFLAC Japan accounts for 90% of corporate assets.

EXCHANGE RATE EFFECTS ON BALANCE SHEET W101

EXHIBIT 15C1-1. AFLAC JAPANExchange Rate Effects on Revenues and Pretax Operating Income (Japanese Yen and U.S. $ in Billions)

Revenues Pretax Operating Income

Yen Rate Dollars Yen Rate Dollars

1986 153.9 168.56 0.913 19.2 168.56 0.1141987 194.1 144.67 1.342 21.0 144.67 0.1451988 218.7 128.19 1.706 23.5 128.19 0.1831989 242.1 138.00 1.754 27.8 138.00 0.2011990 286.7 144.83 1.980 31.8 144.83 0.2201991 339.8 134.52 2.526 35.6 134.52 0.2651992 399.6 126.67 3.155 40.3 126.67 0.3181993 456.3 111.21 4.103 44.4 111.21 0.3991994 524.3 102.26 5.127 48.2 102.26 0.4711995 575.5 94.10 6.116 52.8 94.10 0.561

Percent Change (%) Percent Change (%)

Yen Rate Dollars Yen Rate Dollars

1987 26.1 �14.2 46.9 9.4 �14.2 27.41988 12.7 �11.4 27.2 11.9 �11.4 26.31989 10.7 7.7 2.8 18.3 7.7 9.91990 18.4 4.9 12.8 14.4 4.9 9.01991 18.5 �7.1 27.6 11.9 �7.1 20.51992 17.6 �5.8 24.9 13.2 �5.8 20.21993 14.2 �12.2 30.1 10.2 �12.2 25.51994 14.9 �8.0 25.0 8.6 �8.0 18.11995 9.8 �8.0 19.3 9.5 �8.0 19.0

Average 15.9 �6.0 24.1 11.9 �6.0 19.5

Source: AFLAC, 1995 Annual Report.

2This is true regardless of whether the functional currency is the yen or dollar.

W102 CASE 15-1 AFLAC ANALYSIS OF EXCHANGE RATE EFFECTS: SINGLE CURRENCY

The effect on total assets can be seen in Exhibit 15C1-2. Appreciation of the yen against thedollar increased the growth rate of total assets. Although assets grew 476% in yen over the 1986to 1995 period, the growth rate in dollars was 799%. The yen appreciated in six of the nineyears. Note that the exchange rate effects each year differ from the income statement effectsshown in Exhibit 15C1-1. The reason is that balance sheet accounts are translated at the closingrate for the year, whereas income statement (and cash flow) accounts are translated at the aver-age rate. For example, although the yen’s average rate appreciated 8% during 1995, its closingrate at December 31, 1995 declined 3.1% from the rate one year earlier.

Although liabilities also increased as the yen rose, significant net assets in yen had a posi-tive effect on stockholders’ equity in dollars. As the Japanese yen is the functional currency forAFLAC Japan, translation gains and losses are accumulated in the cumulative translation adjust-ment (CTA) mandated by SFAS 52. At December 31, 1995, the CTA was $213 million, or 10%of AFLAC consolidated equity.

With the yen as the functional currency, the CTA is a function of changes in the yen-dollarexchange rate and the net assets (in yen) of AFLAC Japan. Given the substantial size (and networth) of AFLAC Japan, we would expect the CTA to increase when the yen rises and declinewhen it falls. Changes in the CTA over the 1993 to 1995 period were

12/31/93 12/31/94 12/31/95

Opening CTA $ 68,978 $123,294 $174,091

Increase during year $154,316 $150,797 $139,228Closing CTA $123,294 $174,091 $213,319

Given the depreciation in the yen during 1995, it is surprising that the CTA increased in thatyear. That increase can be explained, however, using information provided in AFLAC’s annualreport and an understanding of how exchange rate changes impact the CTA.

EXHIBIT 15C1-2. AFLAC JAPANExchange Rate Effects on Total Assets (Japanese Yen and U.S. $ in billions)

Total Assets

Yen Rate Dollars

1986 408.1 160.60 2.5411987 511.5 123.05 4.1571988 631.0 126.00 5.0081989 760.5 143.55 5.2981990 909.3 134.60 6.7561991 1,093.4 125.25 8.7301992 1,285.8 124.70 10.3111993 1,523.0 112.00 13.5981994 1,822.9 99.85 18.2561995 2,351.0 102.95 22.836

Percent Change (%)

Yen Rate Dollars

1987 25.3 �23.4 63.61988 23.4 2.4 20.51989 20.5 13.9 5.81990 19.6 �6.2 27.51991 20.2 �6.9 29.21992 17.6 �0.4 18.11993 18.4 �10.2 31.91994 19.7 �10.8 34.31995 29.0 3.1 25.1Average 21.5 �4.3 28.4

AFLAC’s yen exposure decreased sharply, from 60 billion yen at December 31, 1994, to 29billion yen one year later. The reduced exposure resulted from two management decisions:

• AFLAC incurred yen debt, designated as a hedge of its investment in AFLAC Japan.• AFLAC Japan increased its U.S. dollar investments by more than $300 million.

But AFLAC’s yen exposure remained positive, suggesting that the CTA should still have declinedin 1995. The timing of these decisions, however, is crucial to an analysis of their impact.

These transactions apparently took place in the summer of 1995 (the borrowing took placein August), when the yen rose to approximately 85 per dollar, before declining to the year-endlevel of 103 per dollar. The change in CTA during the year, therefore, has two components:

1. An increase due to the yen’s rise from 100 to 85 (per dollar) from January through August2. A decline (but with sharply reduced exposure) over the balance of the year

The following calculations approximate the 1995 CTA change:

Dollar exposure at December 31, 1994 $601.9 millionExchange rate 99.85 yen/dollarYen exposure at December 31, 19943 Y 60.1 billion

If we assume the yen borrowing and increase in dollar investments took place August 15, 1995,at an exchange rate of 85 yen per dollar, the CTA change from January 1 to August 15, 1995would be

If the yen exposure was reduced to Y 29 billion on August 15, 1995, the CTA change over thebalance of 1995 (August 15 to December 31) would be

The net increase in the CTA for 1995 would be $105 � $60 � $45 million. This increase ex-ceeds the actual increase in the CTA during 1995; some of the investment changes were proba-bly made at exchange rates closer to 90 yen per dollar, reducing their positive impact on theCTA.

Anticipating the reversal of the yen-dollar exchange rate, AFLAC was able to reduce its ex-posure to the yen sharply and mitigate the effect of the yen’s decline on the CTA and consoli-dated stockholders’ equity. AFLAC describes the critical transactions in its annual reports.However, the surprising change in the CTA would have alerted a perceptive analyst that a signif-icant alteration in AFLAC’s yen exposure must have taken place. This is another example of howfinancial analysis can focus attention on management actions, even when those actions havenot been reported.

QUESTIONS FOR FURTHER DISCUSSION

1. The yen continued to decline, reaching nearly 110 per dollar by June, 1996. Predict theeffect of this decline on AFLAC’s:(a) Revenue growth for the second quarter (ending June 30) of 1996 as compared with

the second quarter of 1995(b) Growth in pretax income for the second quarter (ending June 30) of 1996 as com-

pared with the second quarter of 1995(c) CTA change for the six months ended June 30, 1996(d) Asset growth for the six months ended June 30, 1996

2. AFLAC carries all investments as available-for-sale under SFAS 115 (see Chapter 13).AFLAC Japan’s fixed income investments (including those purchased in 1995) are,

Y 29.3 � 185

� 1102.95� � $60 million Decrease

Y 60.1 � 199.85

� 185� � $105 million Increase

QUESTIONS FOR FURTHER DISCUSSION W103

3$601.9 times 99.85.

W104 CASE 15-1 AFLAC ANALYSIS OF EXCHANGE RATE EFFECTS: SINGLE CURRENCY

therefore, reported at their market value in U.S. dollars. The current yield (interest) onthese $U.S. investments is far higher than that on yen investments of comparablequality.

Discuss the effect of the 1995 shift from yen investments to dollar investments on1996 growth in investment income (and pretax income) of both:• AFLAC Japan (in yen)• The consolidated enterprise (in U.S. dollars)

3. AFLAC accounts for the U.S. dollar investments of its Japanese subsidiary by reportingthem at market value and ignoring any exchange effects. Yet one might argue that, underSFAS 52, the U.S. dollar investments of AFLAC Japan should be remeasured into yen, thefunctional currency for AFLAC Japan, and then translated into dollars.

Discuss how this accounting approach would alter the reported effects of yen-dollarchanges on reported income.

CASE 15-2Exchange Rate Effects on Operations and Financial StatementsAracruz

INTRODUCTION

Aracruz Celulose, S.A. is a leading producer of wood pulp in Brazil. It exports more than 90% ofits production, mainly to the United States and Europe. Its shares are traded in Brazil and on theNew York Stock Exchange [ARA].

Because it is primarily an exporter and international pulp prices are referenced in U.S. dol-lars, Aracruz finances its operations mainly using $U.S. debt. While almost all operations are lo-cated in Brazil, Aracruz prepares financial statements using U.S. GAAP with the U.S. dollar asthe functional currency (see footnote 1(a)).1 The Aracruz 2000 Annual Report (which includes$U.S. financial statements), is located in the CD and website.

CASE OBJECTIVES

1. Examine the effect of changing exchange rates on the local currency financial statementsof a company that exports most of its output.

2. Forecast future results using alternative exchange rate assumptions.3. Discuss the expected result of exchange rate changes on a company’s common stock

price.4. Discuss whether the accounting effects of exchange rate changes on foreign operations

are consistent with their economic effects.

The following exchange rates (reai/dollar) should be used for the case:

Average Year-end

1998 1.16 1.211999 1.81 1.792000 1.83 1.96

Required:1. Exhibit 15C2-1 contains the balance sheet for Aracruz at December 31, 1998. Certain

assets and liabilities are subdivided by currency. Using the 2000 financial statementsand footnotes, complete Exhibit 15C2-1 for 1999 and 2000. Note: as currency data isprovided only for total debt, we have aggregated current and non-current debt into asingle amount. Assume that the debt securities are denominated in $U.S., as stated infootnote 17(a). For simplicity, we have combined all balance sheet amounts denomi-nated in euros with the U.S. dollar amounts.

2. Compute ARA’s net debt, segregated between $U.S. and R, at each balance sheet date.Note: net debt is defined as total debt, less cash and cash equivalents and debt securi-ties available for sale.

3. Using the exchange rates provided in the table above, compute the net debt in reais(R), segregated between $U.S. and R, at each balance sheet date.

4. Compute the amount of net debt reduction (measured in dollars) in 1999 and 2000 thatwas due solely to exchange rate changes.

5. Explain why the currency in which monetary assets and liabilities are denominated isrelevant to the analysis of ARA’s balance sheet.

W105

1Aracruz also reports in Brazilian reais, using local GAAP.

W106 CASE 15-2 EXCHANGE RATE EFFECTS ON OPERATIONS AND FINANCIAL STATEMENTS

6. Exhibit 15C2-2 contains the Aracruz income statement for the year ended December31, 1998, slightly reformatted. Using the 2000 financial statements, complete Exhibit15C2-2 for 1999 and 2000.

7. ARA reported a translation loss for 1998 and 1999 and a translation gain for 2000. Dis-cuss whether these amounts are consistent with the balance sheet data in Exhibit 15C2-1.

EXHIBIT 15C2-1Aracruz Balance Sheet by Currency, December 31, 1998 ($ in thousands)

Assets

Cash and equivalents $US $ 123,464R 29,607

Investment in debt securities $US 696,404Accounts receivable: $US 52,519

R 21,518Inventories $US 82,942Other current assets $US $1,023,864

Current assets $1,030,318Property, plant, equipment $US $1,892,451Other long-term assets R $1,277,720

Total assets $3,200,489


Non-debt current liabilities R 65,515Total debt $US 1,262,876

R 259,879Other long-term liabilities R $1,644,619

Total liabilities $1,632,889Minority interest R $1,632,436Stockholders’ equity $1,567,164Total liabilities and equity $3,200,489

Source: Data from Aracruz 1998 Annual Report.

EXHIBIT 15C2-2Aracruz Income Statement by Currency, Year Ended December 31, 1998 ($ in thousands)

Revenues: Domestic R $ 38,449Export $US $(462,163

Total revenue $ 500,612

Sales taxes R (39,490)Cost of sales R (349,621)Other expenses R $(109,657)

Total operating cost $(498,768)Operating income $ 1,844

Financial income 104,840Financial expense (120,955)Translation gain (loss) (7,780)Other expense (income) $498,1(65)

Pretax income $ (22,116)Income tax expense 25,306Minority interest in loss $(498,257

Net income $ 3,447

Sales volume (000 tonnes): Brazil 68.8Export $(.1,085.0

Total 1,153.8

Source: Data from Aracruz 1998 Annual Report.

8. Assume that Aracruz used the Brazilian reai as its functional currency. Discuss the im-pact on the computation of $U.S.(i) Total assets(ii) Stockholders’ equity(iii) Reported net incomeYour response should explain the principal differences from use of the $U.S. as func-tional currency and, where possible, the direction of change.

9. Compute the average sales price per tonne in U.S. dollars.10. Compute the average sales price per tonne in reais (R) for each year using the same

measure as in Question 9 and the appropriate exchange rate.11. In its press release reporting 2000 results, Aracruz stated that the largest single factor in

its earnings improvement was higher prices of $186 million. Show how that amountwas computed.

12. Compute ARA’s operating cost (cost of sales plus other expenses) per tonne in bothU.S. dollars and Brazilian reais. Discuss which measure is more useful as a base forforecasting future cost levels.

13. Compute ARA’s operating margin (net revenue less operating cost) per tonne in bothU.S. dollars and Brazilian reais. Discuss the impact of exchange rate changes on bothmeasures of operating margin.

14. Forecast 2001 operating income in U.S. dollars for Aracruz using the following assumptions:• No change in sales volume• No change in $U.S. pricesunder each of the following sets of assumptions:Case I: No change in exchange rates

Operating costs (R/tonne) increase 10% from 2000Case II: The reai declines by 20% (average for year) against the $U.S.

Operating costs (R/tonne) increase 15% from 2000For each case, compute operating margin per tonne in both R and $U.S.

15. Discuss the sensitivity of the 2001 forecast to changes in exchange rates and R costs.Discuss whether these changes are independent.

16. Using your answers to Questions 1 through 15, discuss the expected effect of changesin the R/$ exchange rate and the price of Aracruz shares:(i) in R(ii) in $U.S.

17. Explain why the U.S. dollar is a more appropriate functional currency for ARA than theBrazilian reai (R).

18. Now assume that Aracruz is a subsidiary of a U.S. company that uses the U.S. dollar asthe functional currency to account for its investment.(i) Describe the effect of the decline in the Reai on the parent’s investment in Aracruz

(in $U.S.).(ii) State where the resulting gain or loss would be reflected in the parent’s balance

sheet.(iii) Discuss whether the resulting gain or loss is consistent with your answer to Ques-

tion 16.19. Answer Question 18 assuming that the functional currency is the reai.

CASE OBJECTIVES W107

CASE 15-3 IBMAnalysis of Exchange Rate Effects: Multiple Currencies

INTRODUCTION

IBM is one of the world’s largest multinational corporations, and changes in currency rates havepervasive effects on the firm’s financial statements. As IBM provided supplementary data regard-ing its foreign operations for many years, we can use the company to illustrate the analysis ofmultinational corporations.

CASE OBJECTIVES

The objectives of this case are to use IBM to:

1. Show the effects of exchange rate changes in levels and trends of revenue, income, cashflow, and financial position.

2. Show the effect of exchange rate changes on financial ratios.3. Calculate the effect of exchange rate changes on assets and liabilities.4. Calculate translation gains and losses resulting from exchange rate changes.

IBM DISCLOSURES RELATED TO FOREIGN OPERATIONS

Exhibit 15C3-1 contains IBM’s balance sheet at December 31, 1989, and 1990. Within thestockholders’ equity section, we see “translation adjustments” of $1,698 and $3,266 billion (4.4and 7.6% of net assets), respectively. These entries tell us that the company has significant non-U.S. operations and its uses foreign functional currencies. If the company used the U.S. dollar asthe functional currency for all foreign operations, all gains and losses would have been includedin income.

Exhibit 15C3-2 contains IBM’s consolidated statement of cash flows for the three yearsended December 31, 1990. The only reference to translation in the cash flow statement is the“effect of exchange rate changes on cash and cash equivalents” near the bottom.

Exhibit 15C3-3, which provides the primary raw material for our analysis, is supplementarydata on IBM’s non-U.S. operations. Although much of this disclosure is not required (and, unfor-tunately, rarely provided), it enables us to obtain an understanding of the effect of changing ex-change rates on the company’s financial condition and operating performance.

The first part of Exhibit 15C3-3 contains summarized balance sheets and income statementsfor IBM’s non-U.S. operations. These data suggest steady growth in foreign revenue, net earn-ings, and net assets over the period 1988 to 1990. Comparison of these data with IBM’s consoli-dated balance sheet and income statement indicates that foreign operations accounted for 60%of revenue for 1990. We return to the analysis of these data shortly.

ESTIMATION OF COMPOSITE EXCHANGE RATES

Before starting our analysis, we need data on the exchange rates that affect IBM’s financialstatements. For a company operating in a single currency (such as Foreign Subsidiary, in thechapter, or AFLAC in Case 15C1-1), we can obtain year-end and average exchange rates cov-ering the period being analyzed. For a multinational such as IBM, we need data on many cur-rencies and a breakdown of IBM’s operations by functional currency. The latter is unavailable(to an external user), and the analysis of many currencies is very time-consuming.1 We need ashortcut.

W108

1In some cases, annual reports for foreign subsidiaries of multinational companies are available, either because oflocal filing requirements or subsidiary financing. These reports can shed light on significant foreign operations.However, these reports are generally prepared in local currencies according to local accounting standards, not inU.S. dollars under U.S. GAAP. In some cases, reports are available only in the local language, further hamperinguse. Nonetheless, when a company has one or a few highly significant foreign subsidiaries, the subsidiary annual re-port may provide insights not available from the parent’s consolidated financial statements.

ESTIMATION OF COMPOSITE EXCHANGE RATES W109

EXHIBIT 15C3-1.IBM Balance Sheet

At December 31: 1990 1989

(Dollars in millions)AssetsCurrent AssetsCash $ 1,189 $ 741Cash equivalents 2,664 2,959Marketable securities, at cost, which approximates market 698 1,261Notes and accounts receivable—trade, net of allowances 20,988 18,866Other accounts receivable 1,656 1,298Inventories 10,108 9,463Prepaid expenses and other current assets 1,617 1,287

38,920 35,875

Plant, Rental Machines, and Other Property 53,659 48,410Less: Accumulated depreciation 26,418 23,467

27,241 24,943

Investments and Other Assets:Software, less accumulated amortization (1990, $5,873; 1989, $4,824) 4,099 3,293Investments and sundry assets 17,308 13,623

21,407 16,916

$87,568 $77,734

Liabilities and Stockholders’ EquityCurrent Liabilities:Taxes $ 3,159 $ 2,699Short-term debt 7,602 5,892Accounts payable 3,367 3,167Compensation and benefits 3,014 2,797Deferred income 2,506 1,365Other accrued expenses and liabilities 5,628 5,780

25,276 21,700

Long-Term Debt 11,943 10,825

Other Liabilities 3,656 3,420

Deferred Income Taxes 3,861 3,280

Stockholders’ Equity:Capital stock, par value $1.25 per share 6,357 6,341

Shares authorized: 750,000,000Issues: 1990—571,618,795; 1989—574,775,560

Retained earnings 33,234 30,477Translation adjustments 3,266 1,698

42,857 38,516Less: Treasury stock, at cost (Shares: 1990—227,604; 1989—75,723) 25 7

42,832 38,509

$87,568 $77,734

Source: IBM Corporation, 1990 Annual Report.

W110 CASE 15-3 IBM ANALYSIS OF EXCHANGE RATE EFFECTS: MULTIPLE CURRENCIES

Fortunately, there are indices of the value of the U.S. dollar against a basket of foreign cur-rencies, normally computed on a trade-weighted basis. Using such a series for IBM requires usto make the assumption that IBM’s business has the same currency mix (distribution over variouscurrencies) as U.S. trade flows. Although that assumption might be untenable for a smaller com-pany with more limited foreign operations, it appears reasonable for a giant multinational suchas IBM. Exhibit 15C3-4 shows average and year-end exchange rates for the period covered byour analysis.

EXHIBIT 15C3-2.IBM Statement of Cash Flows

For the Year Ended December 31: 1990 1989 1988

(Dollars in millions)Cash Flow from Operating Activities:Net earnings $ 6,020 $ 3,758 $ 5,806Adjustments to reconcile net earnings to cash provided from operating activities:Depreciation 4,217 4,240 3,871Amortization of software 1,086 1,185 893Loss (gain) on disposition of investment assets 32 (74) (133)(Increase) in accounts receivable (2,077) (2,647) (2,322)Decrease (increase) in inventory 17 (29) (1,232)(Increase) in other assets (3,136) (1,674) (1,587)Increase in accounts payable 293 870 265Increase in other liabilities 1,020 1,743 519

Net cash provided from operating activities 7,472 7,372 6,080

Cash Flow from Investing Activities:Payments for plant, rental machines, and other property (6,509) (6,414) (5,390)Proceeds from disposition of plant, rental machines, and other property 804 544 409Investment in software (1,892) (1,679) (1,318)Purchases of marketable securities and other investments (1,234) (1,391) (2,555)Proceeds from marketable securities and other investments 1,687 1,860 4,734

Net cash used in investing activities (7,144) (7,080) (4,120)

Cash Flow from Financing Activities:Proceeds from new debt 4,676 6,471 4,540Payments to settle debt (3,683) (2,768) (3,007)Short-term borrowings less than 90 days—net 1,966 228 1,028Payments to employee stock plans—net (76) (29) (11)Payments to purchase and retire capital stock (415) (1,759) (992)Cash dividends paid (2,774) (2,752) (2,609)

Net cash used in financing activities (306) (609) (1,051)

Effects of Exchange Rate Changes on Cash and Cash Equivalents 131 (158) (201)

Net Change in Cash and Cash Equivalents 153 (475) 708Cash and Cash Equivalents at January 1 3,700 4,175 3,467

Cash and Cash Equivalents at December 31 $ 3,853 $ 3,700 $ 4,175

Supplemental Data:Cash paid during the year for:Income taxes $ 3,315 $ 3,071 $ 3,405Interest $ 2,165 $ 1,605 $ 1,440


BALANCE SHEET EFFECTS

Exhibit 15C3-3 states that IBM had non-U.S. net assets of approximately $19 billion. What func-tional currencies did the company use to account for its foreign operations? The exhibit reports that

non-U.S. subsidiaries which operate in a local currency environment account for approximately90% of the company’s non-U.S. revenue. The remaining 10% . . . is from subsidiaries and brancheswhich operate in U.S. dollars or whose economic environment is highly inflationary.

BALANCE SHEET EFFECTS W111

EXHIBIT 15C3-3.IBM Data on Non-U.S. Operations

Non-U.S. Operations 1990 1989 1988

(Dollars in millions)At end of year:Net assets employed:Current assets $24,337 $20,361 $20,005Current liabilities 15,917 12,124 11,481

Working capital 8,420 8,237 8,524Plant, rental machines, and other property, net 11,628 9,879 9,354Investments and other assets 9,077 6,822 5,251

29,125 24,938 23,129

Long-term debt 5,060 3,358 2,340Other liabilities 2,699 2,607 2,505Deferred income taxes 2,381 1,814 1,580

10,140 7,779 6,425

Net assets employed $18,985 $17,159 $16,704

Number of employees 168,283 167,291 163,904

For the year:Revenue $41,886 $36,965 $34,361

Earnings before income taxes $ 7,844 $ 7,496 $ 7,088Provision for income taxes 3,270 3,388 3,009

Net earnings $ 4,574 $ 4,108 $ 4,079†

Investment in plant, rental machines, and other property $ 3,020 $ 2,514 $ 2,389

†1988 net earnings before cumulative effect of accounting change for income taxes.

Non-U.S. subsidiaries which operate in a local currency environment account for approximately 90%of the company’s non-U.S. revenue. The remaining 10% of the company’s non-U.S. revenue is fromsubsidiaries and branches which operate in U.S. dollars or whose economic environment is highly inflationary.

As the value of the dollar weakens, net assets recorded in local currencies translate into more U.S.dollars than they would have at the previous year’s rates. Conversely, as the dollar becomes stronger,net assets recorded in local currencies translate into fewer U.S. dollars than they would have at the pre-vious year’s rates. The translation adjustments, resulting from the translation of net assets, amounted to$3,266 million at December 31, 1990, $1,698 million at December 31, 1989, and $1,917 million at De-cember 31, 1988. The changes in translation adjustments since the end of 1988 are a reflection of thestrengthening of the dollar in 1989 and the weakening of the dollar in 1990.



In other words, the local currency is the functional currency for 90% of IBM’s foreign opera-tions. The U.S. dollar is the functional currency for the remainder, including subsidiaries operat-ing in hyperinflationary economies.

Assuming that the 90% figure applies equally to the balance sheet, we conclude that IBMhad net assets in nondollar functional currencies of $17.086 billion (90% of total nondollar netassets of $18.985 billion) at December 31, 1990. The corresponding figures for year-end 1989and 1988 were $15.443 billion (0.90 � $17.159 billion) and $15.034 billion (0.90 � $16.704billion), respectively. These amounts represent IBM’s exposure to changes in exchange ratesunder SFAS 52.

Translation gains and losses resulting from exchange rate fluctuation have been accumu-lated as a component of stockholders’ equity, in accordance with SFAS 52. The text of Exhibit15C3-3 gives us the cumulative translation adjustments at each year-end:

December 31 Cumulative Translation Adjustments

1988 $1.917 billion1989 1.6981990 3.266

These calculations enable us to compute the actual increase in IBM’s foreign net assets in func-tional currencies. By taking the reported change and subtracting the effects of translation(change in accumulated adjustment), we get the real change ($ in millions):

Year Reported � Translation � Real

1989 $ 455 $ (219) $6741990 1,826 1,568 258

From the reported change, it appears that IBM’s foreign net assets increased more rapidly in1990 than 1989. The reality is that the large 1990 increase was mostly due to the appreciationof foreign currencies against the dollar; before translation (in real terms), the 1989 increase waslarger.

EXHIBIT 15C3-4Dollar’s Trade-Weighted ExchangeIndex, 1988 to 1990 (1973 � 100)

December 31 Index

1988 92.81989 93.71990 83.7

Average Rates for Year, 1980 to 1990

Year Index

1980 87.41981 103.41982 116.61983 125.31984 138.21985 143.01986 112.21987 96.91988 92.71989 98.61990 89.1

Sources: Economic Report of the President, February 1991 (annual data) and Fed-eral Reserve Bank of St. Louis (December 31 data).

The year-to-year change in the cumulative translation adjustment account is the effect oftranslation for each year. Compare those changes with IBM’s exposure:

These calculations reveal that the IBM-weighted functional currency composite declined by1.46% against the dollar in 1989 and rose by 10.15% against the dollar in 1990.2

Turning to our trade-weighted index in Exhibit 15C3-4, we see that the percentage changesare

These changes approximate the IBM-weighted changes, reassuring us that our index is a goodproxy. But when possible, we use the IBM-weighted index that we have now derived.

First, consider the company’s inventories. Exhibit 15C3-3 does not break out non-U.S. in-ventory, so we must assume that inventories are a constant percentage of current assets.3 At De-cember 31, 1989, consolidated inventories were 26.4% of consolidated current assets (Exhibit15C3-1). We assume that non-U.S. inventories also were 26.4% of non-U.S. current assets of$20.361 billion or $5.375 billion, of which $4.838 billion (90%) were in nondollar functionalcurrencies.

Applying the IBM-weighted exchange rate change of 10.15% results in an estimated in-crease in non-U.S. inventories of $491 million due to changing exchange rates. This accountsfor most of the $645 million ($10.108 billion–$9.463 billion) increase in IBM’s consolidated in-ventories during 1990 (data from Exhibit 15C3-1). These calculations suggest that most of the1990 inventory increase was due to the impact of changing exchange rates rather than to oper-ating changes.

We can confirm this result from the company’s cash flow statement. In Exhibit 15C3-2, wefind that IBM’s inventory change, excluding the effect of translation, was a decrease of $17 mil-lion, suggesting that the true effect of exchange rate changes was $662 million [$645 million ac-tual change less (�$17 million) real change].4

Although our estimated effect of $491 million is not equal to the true effect of $662 millionfor 1990, they are not unreasonably far apart. Clearly, our assumptions did not precisely hold.But even if we did not have the true figure, our estimate would still have told us that IBM’s in-ventory increase in 1990 was mostly due to currency effects rather than operating causes. It isthis conclusion that makes the analysis worthwhile. This technique, although superfluous whenthe cash flow statement excludes the impact of exchange rate changes, is useful when cash flowstatements (such as those for non-U.S. firms) are not adjusted to exclude that impact.

We can perform this same analysis for IBM’s fixed assets. Exhibit 15C3-3 shows that non-U.S. fixed assets were $9.879 billion; we estimate that $8.891 billion (90% of $9.879 billion)was in nondollar functional currencies. The estimated effect of currency changes is $902 million(10.15% of $8.891 billion).

The actual impact of currency changes on fixed assets was disclosed in IBM’s 10-K report inSchedules V and VI. These reconciliations of fixed assets (gross) and accumulated depreciationreveal that translation increased fixed assets by $963 million ($2,143 million for gross fixed as-sets less $1,180 million for accumulated depreciation).

Again, our estimate is approximately correct, despite the assumptions required. Consolidatednet fixed assets rose by $2.298 billion in 1990 (Exhibit 15C3-1), or 9.2%. Nearly half the gain re-sulted from exchange rate changes rather than new investment. Even if the 10-K data had notbeen available (Schedules V and VI are no longer required), we would have the same knowledge.

1990: �11.9% 1989: �1.0%

1990: $3.266 billion � $1.698 billion

$15.443 billion � �10.15%

1989: $1.698 billion � $1.917 billion

$15.034 billion � �1.46%

BALANCE SHEET EFFECTS W113

2Perceptive readers will note that we have omitted the effect of changing exchange rates on the increase in IBM’snet assets in functional currencies. Given the small change in those assets (in functional currency terms) over the pe-riod 1988 to 1990, we have opted for simplification.3IBM uses the FIFO inventory method worldwide. For companies with significant LIFO inventories, this calculationshould be made on a FIFO basis by adding back the LIFO reserve (see Chapter 6).4This computation, and similar computations in this case, are possible only because IBM made no purchase methodacquisition during 1990. Chapter 14 discusses the impact of purchase method acquisitions on the statement of cashflows.


INCOME STATEMENT EFFECTS

Turning to the income data (Exhibit 15C3-3), we note that IBM had revenues of $41.886 billionin currencies other than the dollar, an increase of 13.3% from the 1989 level of $36.965 billion.On the surface, it appears that the 1990 gain in foreign sales was much larger than the 1989 in-crease (up 7.6% from the 1988 level of $34.361 billion). However, analysis reveals that ex-change rate effects distort the data.

In 1990, non-U.S. sales of $37.697 billion (90% of $41.886) were in operations with non-dollar functional currencies (FC) (with the remainder in operations with nondollar local curren-cies but the dollar as functional currency). These revenues (and all expenses) were translatedinto dollars at the average rate for 1990. Using the data in Exhibits 15C3-3 and 15C3-4, we cancompute the effect of rate changes for each year:

($ in millions)

1988 1989 1990

Non-U.S. revenues ($, Exhibit 15C3-3) $34,361 $36,965 $41,886Non-$ FC revenues ($, 90%) 30,925 33,268 37,697

% Increase — +7.6% +13.3%Dollar index (Exhibit 15C3-4) 92.7 98.6 89.1FC revenues FC 28,667 FC 32,802 FC 33,588

% Increase — +14.4% +2.4%

The last entry, FC revenues, is an artificial index, derived by multiplying estimated non-$ FC rev-enues by the dollar index.5 The result is a measure of revenue from which the impact of changesin the value of the dollar has been removed. As a result, we can estimate the “real” change inforeign revenues.

We find that the decline in the value of the dollar accounted for most of the gain in foreignrevenues in 1990; the increase is only 2.4% when that factor is removed. Conversely (since thedollar rose in value in 1989), the real (FC) gain is 14.4% as compared with a gain of 7.6% indollars. The rise in the dollar in 1989 resulted in a smaller percentage sales gain in dollars thanlocal currencies. (These calculations assume that local currency prices were unaffected by ex-change rate changes.)

This exercise, therefore, approximates the impact of changing exchange rates on IBM’snondollar revenues. A similar calculation approximates the effect on net income. IBM’s annualreport to shareholders provides virtually no disclosure of this impact.

Exhibit 15C3-5 contains the result of this analysis for the 11-year period 1980 to 1990.6

Comparison of the reported data with the adjusted data reveals differences that are quitesignificant.

The year-to-year percentage changes in both revenues and pretax income are, in mostyears, quite different after adjustment for changes in the value of the dollar. We have already

5We must use the index because we do not have average “IBM weights,” only year-end to year-end data. As wehave shown that the index tracked the IBM weights well, we can use it to examine the trend of revenues and pretaxincome.6The analysis in Exhibit 15C3-5 uses total non-U.S. sales rather than the proportion for which IBM uses nondollarfunctional currencies. This proportion has declined over the 1980 to 1990 period, but the disclosure on this point isvague. For simplicity and because we believe the analysis would not be significantly affected, we omit that step inour analysis.

In principle, it is preferable to use only sales in nondollar functional currencies, as in the 1988 to 1990 compu-tations above. Although other foreign sales are also affected by exchange rate changes, there is an important differ-ence. Foreign sales for which the dollar is the functional currency are likely to be in hyperinflationary countries orwhere local selling prices are the local currency equivalent of dollar prices. In these cases, changes in exchange ratesmay affect volume but do not affect dollar prices; they do not create income statement distortion as discussed in thissection. In addition, the index derived from changes in the cumulative translation adjustment is not applicable tothese situations.

In practice, however, the proportion of sales for which the dollar is the functional currency is rarely availableand, therefore, the analyst must use total foreign sales for analytic purposes.

discussed the impact on the period 1988 to 1990. For a broader perspective, we have summa-rized the data for the entire period:

Percentage Changes in IBM Foreign Results, 1980 to 1990

Revenues Pretax Income

Period Reported Adjusted Reported Adjusted

1980–85 �56.3% �155.7% �100.1% �227.3%1985–90 �94.4 �21.1 �41.4 �11.91980–90 �203.8 �209.7 �183.0 �188.4

Source: Data in Exhibit 15C3-5.

Over the entire ten years, the reported and adjusted trends are quite similar. As the dollarshowed a very small increase in value over the period, we conclude that local currency revenuegrowth was only slightly greater than revenue growth reported in dollars.

But for the two subperiods, the adjusted data tell a completely different story from the re-ported data. During the period 1980 to 1985, the value of the dollar rose sharply; the data in Ex-hibit 15C3-4 show that the average value of the dollar in 1985 was 63.6% higher in 1985 than1980 (143.0/87.4 � 1.636). Thus, revenues and earnings in foreign currencies were continuouslydevalued when translated into dollars. The growth in revenues during this period was 155.7% inlocal currencies, but only 56.3% after translation into dollars. Pretax income was similarly deval-ued; the local currency growth was 227.3%, whereas the dollar growth was only 100.1%.

The individual year-to-year changes also reflect the impact of the strengthening dollar. In1981, for example, reported pretax income declined by 3.9%; after adjustment, there was a gain

INCOME STATEMENT EFFECTS W115

EXHIBIT 15C3-5Analysis of IBM’s Foreign Operations, 1980 to 1990

Year Revenues % Change Pretax Income % Change

Reported Data ($U.S. in millions)

1980 $U.S. 13,787 $U.S. 2,7721981 13,982 �1.4% 2,664 �3.9%1982 15,336 �9.7 3,226 �21.11983 17,053 �11.2 3,841 �19.11984 18,566 �8.9 4,640 �20.81985 21,545 �16.0 5,546 �19.51986 25,888 �20.2 5,871 �5.91987 29,280 �13.1 5,683 �3.21988 34,361 �17.4 7,088 �24.71989 36,965 �7.6 7,496 �5.81990 41,886 �13.3 7,844 �4.6

Adjusted Data (FC Units in Millions)

1980 FC 12,050 FC 2,4231981 14,457 �20.0% 2,755 �13.7%1982 17,882 �23.7 3,762 �36.61983 21,367 �19.5 4,813 �27.91984 25,658 �20.1 6,412 �33.21985 30,809 �20.1 7,931 �23.71986 29,046 �5.7 6,587 �16.91987 28,372 �2.3 5,507 �16.41988 31,853 �12.3 6,571 �19.31989 36,447 �14.4 7,391 �12.51990 37,320 �2.4 6,989 �5.4


of 13.7%. In every year during the period 1980 to 1985, the performance of IBM’s foreign oper-ations was better in local currencies than U.S. dollars.

During the second half of the decade, 1985 to 1990, the impact of exchange rates reversed.The value of the dollar declined in most years, and by 1990 it had returned to a level very closeto 1980. The declining value of the dollar inflated foreign currency revenues and income whentranslated into dollars.

Over the 1985 to 1990 period, IBM’s foreign revenues (in dollars) increased by 94.4%,higher growth than in the 1980 to 1985 period. The adjusted data suggest that the reverse wastrue; IBM’s local currency revenues grew by only 21.1% over the second half of the decade, amarked slowing from the 155.7% growth during the first half.

Although the decline of the dollar was not consistent, some of the individual year data echothis conclusion. In both 1986 and 1987, foreign revenues (in dollars) rose sharply, suggesting fa-vorable performance trends. The adjusted data show that, for both years, foreign currency rev-enues declined.

The pretax income data also appear significantly different after adjustment for changes inthe value of the dollar. Over the period 1985 to 1990, foreign pretax earnings rose by 41.4% indollars, but declined by 11.9% in local currencies. The years 1986 and 1990 are the clearest ex-amples of this effect in individual years: In both cases, pretax income rose in dollars but de-clined in local currencies.

It is important to caution, however, that this analysis makes a crucial assumption—thatIBM’s foreign operations were unaffected by exchange rate changes. For some firms, sellingprices (and, therefore, revenues and earnings) are affected by variations in exchange rates,which impact the cost of imported components, and the prices of competitive products. Wecannot assume that local currency results are always independent of exchange rates.

Nonetheless, it is apparent that the rising value of the dollar during the 1980 to 1985 perioddisguised the excellent performance of IBM’s foreign operations. It is equally clear that the dol-lar decline during the second half of the decade masked the deterioration of the operating per-formance of the company’s foreign subsidiaries.

These conclusions show that analysis of a multinational enterprise is seriously deficient un-less the impact of changing exchange rates is taken into account. Despite the approximationsand assumptions required, the analyst gains important insights into operating trends and can usethese to question management more perceptively about its real operating performance.

RATIO EFFECTS

The impact of foreign currency changes on IBM’s financial ratios is hard to determine becauseof inadequate data. Since IBM uses functional currencies other than the U.S. dollar for 90% ofits non-U.S. operations, we can conclude that income statement ratios in dollars largely repli-cate the local currency data. This would also be true of ratios using only balance sheet data,such as the current or debt-to-equity ratios.

The increased importance of foreign operations in 1990, resulting from the weakness of thedollar, gave foreign operations more weight in the consolidated total in 1990 than 1989. With-out details of the income statement and balance sheet for foreign operations, we cannot easilytell which ratios are improved (or worsened) by this effect.7

CONCLUDING COMMENTS

As stated at the outset, the analysis of IBM was made possible by the voluntary disclosures (thefirst part of Exhibit 15C3-3) regarding its non-U.S. operations. Few companies provide similardata; IBM stopped providing extensive disclosures after its 1991 Annual Report. Why, then,have we devoted a case to this analysis?

Our major objective is to illustrate how changing currency rates distort financial statementsin the context of a real company. The analysis issues exist for all companies with significant for-eign operations. Our goal is to enable analysts and other readers of this text to apply portions ofthis analysis of IBM to other companies.

7By using cash flow data and the technique previously employed to estimate the effect of exchange rate changes onvarious balance sheet and income accounts, we can approximate ratios for IBM’s foreign operations.

Required:Note: Make the simplifying assumption that IBM uses local currencies as the functional currencyfor all foreign subsidiaries.

1. Using Exhibit 15C3-3, the balance sheet and income statement for IBM’s non-U.S. oper-ations after translation to U.S. dollars:(a) Convert the 1989 and 1990 balance sheets to FC units.(b) Convert the 1990 income statement to FC units.(c) Using only FC net income, try to reconcile the change in FC equity (net assets) dur-

ing 1990. Provide one possible reason for the discrepancy.2. Exhibit 15C3-3 states that IBM invested $3,020 million in plant, rental machine, and

other properties during 1990. Calculate the amount in FC units. Using this result, esti-mate depreciation expense (in FC units) for IBM’s non-U.S. operations.

3. [Cash flow analysis of IBM foreign operations](a) Assume that cash is 5% of the current assets shown in Exhibit 15C3-3. Prepare a

1990 cash flow statement in FC units for IBM’s non-U.S. operations.(b) Convert the FC unit cash flow statement prepared in part (a) to a U.S. dollar cash

flow statement.(c) (i) Compute the percentage of IBM’s 1990 consolidated cash from operations that

came from its non-U.S. operations.(ii) Compute the percentage of IBM’s 1990 consolidated borrowings made by its

non-U.S. operations.(iii) Compute the percentage of IBM’s 1990 investment in fixed assets that took

place in its non-U.S. operations.(iv) Discuss how your answers to parts (i) through (iii) contribute to your under-

standing of the importance of IBM’s non-U.S. operations to the company.(v) Discuss the limitations of your answers to parts (i) through (iii).

(d) Using the cash flow data calculated in part (c) estimate the effect of exchange ratechanges on cash and cash equivalents. Compare your results to the amount shownin IBM’s statement of cash flows (Exhibit 15C3-2).

CONCLUDING COMMENTS W117

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