GAAP Differences and The Balance Sheet in Detail

1. GAAP Differences andThe Balance Sheet in Detail MIM 517 Fall 2010 Class 2

2. Learning Objectives • Exposure to real balance sheet complexity • Overview of “more complex” line items • Key GAAP differences • Gain familiarity with the footnotes

3. Lets consider what complex financial statements look like

4. Current Assets Cash & Equivalents Investment/Marketable Securities Accounts Receivable net of Allowance for Doubtful Accounts Inventories Deferred income taxes Other current assets Total current assets Long term (equity) investments Building, Machinery, Equip Less: Accumulated Depreciation Land Construction in Progress Goodwill Intangible Assets Total Assets Current Liabilities Accounts payable Accrued expenses Deferred revenue Current portion LTD Total current liabilities Deferred income taxes Long Term Debt Total Liabilities Stockholders’ Equity Common Stock Preferred Stock APIC Retained Earnings Accumulated other comprehensive income Minority interest Total Stockholders’ equity Total Liab’s & SE’s equity U.S. Balance Sheet

5. Accounts Receivable • What does “Net of Allowance for Doubtful Accounts” mean? • Why is AR presented at net realizable value? • NRV involves an estimate • Problem 2.13

6. Inventory • Recorded at cost • US: FIFO, LIFO or weighted average • IFRS: LIFO prohibited • Value at lower of cost or market • Revaluation of inventory • If there is an other than temporary decline in value, inventory must be “written down” • Subsequent recovery of value • U.S. may not write back up • IFRS may reverse write-down

7. Inventory continued • Ex: Have 3 items in inventory, sell one for $20. Cost Item 1: $8 Cost Item 2: $9 Cost Item 3: $10 (1) Under LIFO, what is Net Income? (2) Under FIFO, what is Net Income? (3) Tax consequence? Assume 40% rate. • In times of rising prices, LIFO results in lower NI • Comparability of LIFO vs. FIFO companies. • Difference in COGS, Net Income and Inventory • Use LIFO reserve to adjust

8. Deferred Income Taxes • Only occurs if companies have different rules for tax and book accounting • Reconciles tax liability per IRS to book tax expense on I/S. • See example on pg. 56-57 for mechanics • Is NOT “taxes payable” • U.S. and IFRS similar

9. Deferred Income Taxes • Deferred Tax Asset: • Tax liability per IRS > book tax expense on I/S • Commonly due to operating loses and tax credit carry forwards, or non-cash expenses such as warranty or bad debt write offs. • Deferred Tax Liability: • Tax liability per IRS < book tax expense on I/S • Commonly due to differences in depreciation for fixed assets or for receivables growth.

10. Deferred Income Taxes Consider Starbucks. • How are deferred tax assets and deferred tax liabilities reported at year end? • Where did you find this information? • What transactions drove the deferred taxes?

11. Accounting for Ownership in Other Companies • Why do companies invest in the securities (stock) of other companies? • U.S. & IFRS • Substantially similar treatment, but IFRS does not use strict % guidelines • U.S. generally based upon ownership % • < 20% use Fair Value (Mark-to-Market) Accounting • 20% to 50% use Equity Method • > 50% use Consolidation accounting

12. Accounting for Ownership in Other Companies • What is “control”? • “The son of HP co-founder William Hewlet called Carly Fiorina, HP’s chief executive at 10am to say he and his family would publicly oppose the proposed $20 Billion takeover of Compaq Computer Corp…leaving HP’s executives, lawyers and bankers scrambling to do damage control. The Hewlett family and related trust and foundation hold 5% of HP” (WSJ 11/9/01)

13. Accounting for Ownership in Other Companies: Non-controlling interest • < 20% of debt or equities in other companies • Held-to-maturity: • Record debt securities at cost and don’t revalue • “Fair value” or “Mark to Market” • Trading: • Debt & equities intended to sell. • Show at Fair Value in B/S. Unrealized holding gains and losses are included in income • Available for Sale: • All others. • Show at Fair Value in B/S. Unrealized holding gains and losses are included in equity (and comprehensive income) in US but can be included in income under IFRS • Dividends received from investee are added to NI of investor

14. Accounting for Ownership in Other Companies: Fair Value Method Example: on 1/1/09 Big company bought shares of Little Company for $100,000. The shares were < 20% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little had Net Income of $80,000 and dividends of $1000 were paid to Big. How is this accounted for in the financial statements at 1/1 and 12/31? • If classified as Trading Securities? • If classified as Available for Sale Securities? Does the Net Income of Little Company get recorded in the books of Big Company?

15. Accounting for Ownership in Other Co’s: Fair Value Method Consider Starbucks: • How much did Starbucks have in Available-for sale and trading securities at the end of 2009? Where did you find this? • How much unrealized holding gain or loss did Starbucks report for each in 2009? Where would you find this?

16. Accounting for Ownership in Other Co’s: Fair Value Method Issues with Fair Value Method • How is “fair value” determined? • Level 1: active market • Level 2: observable market data other than quoted market price • Level 3: determined only through “unobservable inputs” and prices based on internal models or estimates • Relevance/Reliability trade-off • Classification of Trading vs. AFS

17. Accounting for Ownership in Other Co’s: Equity Method Equity Method 20% to 50% • Assumed to be “significant influence” unless evidence to contrary • Accounting • Record asset of “Investment in XYZ” • Each year investor’s investment increases by share of investee’s N/I & decrease by dividends received (i.e., share of N/I retained in company) • No adjustment to revalue to market

18. Accounting for Ownership in Other Co’s: Equity Method Example: on 1/1/09 Big company bought shares of Little Company for $100,000. The shares were 40% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little had Net Income of $80,000 and dividends of $1000 were paid to Big. How is this accounted for in the financial statements at 1/1 and 12/31? Is the market value at 12/31 relevant?

19. Accounting for Ownership in Other Co’s: Equity Method Consider Starbucks: • How much did Starbucks have in Equity Investments at the end of 2009? Where did you find this? • What companies were included as equity investees at 9/27/09? Where did you find this? • What are the Cost investment? Why are they accounted for at cost rather than fair value?

20. Accounting for Ownership in Other Companies: Consolidation Method • Consolidation Methods • Generally > 50% Full Consolidation accounting • Idea: “Smoosh together” B/S and I/S • Mechanics • Eliminate intercompany transactions • Eliminate investment account in subsidiary • Parent and Sub: Add together assets and liabilities on B/S and NI • Back out Minority owners’ share: • B/S: record “Minority Interest” of assets in equity section • I/S: subtract “Minority Interest” share of NI on I/S

21. Accounting for Ownership in Other Companies: Equity vs. Consolidation Implications for Analysis • What is “Minority Interest”? • Balance Sheet • Equity Method • Ownership share of investee’s net assets included as one line in called Investment in XYZ • Thus Investment in XYZ excludes the proportion “claimed” by the minority shareholders • Consolidation • Assets and liabilities include portion “claimed” by minority owner • Minority owner’s share included as one line in equity

22. How is a 100% Acquisition or Merger Accounted For? • US and IFRS use Purchase Accounting • Accounting • Assets and liabilities of acquired co. revalued to FMV • Difference between purchase price and FMV net assets = Goodwill • Example: • Purchase company w/ net assets of $40m for $100m. • Fair market value of identifiable assets $75m • What is goodwill? Does this include brand valuation? • Goodwill is subject to annual impairment test • Consider Starbucks Acquisitions

23. Other Goodwill Issues • Value of GW in US at 1600 largest public companies estimated to be $1 trillion (KPMG, 2009) • What does an impairment signal (if anything?)

24. Plant, Property & Equipment (PP&E) • Basis • US: Historical cost • Asset may understate economic value • Capital intensive co w/ old PPE: overstate ROA • IFRS: Revaluation is permitted if can be reliably est • Depreciation: • US: Generally straight line for financial and accelerated for tax • IFRS: Any “acceptable” method reflecting economic life • Impairment • Write-down based on PV of estimated net future cash flows

25. PPE under IFRS in detail • IAS 16 allows a choice in accounting model: • Cost model: The asset is carried at cost less accumulated depreciation and impairment; or • Revaluation model: The asset is carried at fair value • If revaluation model is used, revaluations must be performed regularly to ensure asset’s carrying value equals it’s fair value. • In addition, IAS 16 requires components of an asset with different benefit patterns to be depreciated separately.

26. Scenario: a company purchases an asset for $100k, with a useful life of 10 years and no estimated residual value. At the beginning of year 2, the company estimates the fair value of the asset to be $110k. What is the carrying value of the asset at the end of year 2 under US GAAP and IFRS?

27. Scenario: For the same company in the previous scenario, revenues for year 1 and 2 are $200k and $300k respectively. Assuming all other expenses are the same, what is the difference in net income in each year under US GAAP and IFRS?

28. Intangibles • Definition • Identifiable non-monetary asset lacking physical substance • Common Intangibles • Purchased Goodwill • Patents, Copyrights, Trademarks • Franchises • Brands • Research and Development Expenditures • In-Process R&D (After Dec. 2008) • Purchased as part of a business combination • Capitalize as indefinite life • Write off if project abandoned or amortize over revenue stream

29. Accounting for Intangibles • US: • Internally developed: expensed when incurred • Exception: direct response advertising can be capitalized • Purchased: capitalized • Limited life: amortize over expected useful life • Unlimited: subject to annual impairment test • IFRS: • Differences • Intangibles revalued to fair value if active market • Internal research expenditure: expensed as incurred • Internal development expenditure: capitalized

30. Leases • U.S. and IFRS treatment similar • Capital lease gets treated as a financed purchased of a long-term asset • Lessee – Books lease as asset, and value of future lease payments as liability • Lessor – Records receivable & income and removes equipment from balance sheet. • Operating lease gets treated like a rental • Lessee – Rent expense • Lessor – Rent income

31. Lease Classification • Is a Capital lease if non-cancelable and meets one of the following: • Transfer of ownership • Bargain Purchase Option • Lease term is ≥ 75% of economic life • NPV of future payments ≥ 90% of current FMV • Capital leases tend to be less desirable for lessees, and more desirable for lessors

32. Operating Lease • Why lessees prefer operating leases: • No liability on books for future rental payments • Results in more favorable debt-to-equity relationships or due to debt covenants • Is a form of off-balance-sheet financing • Only footnote disclosure required for all non-cancelable operating leases > 1 year.

33. Operating Leases • Does this treatment seem to fairly reflect the substance of the lease transaction? • Impact of proposed change in accounting for leases? • Consider Starbucks • Where are Starbucks operating lease commitments shown? • How would the change in lease accounting impact Starbucks’ financial statements?

34. Retirement Benefits • US and IFRS: Liability accrued on projected benefits • Japan: Pay as you go • Liability is understated • Example: If the “playing field was leveled” (Morgan Stanley Study cited in WSJ 4/26/99) • Mitsubishi Motors 1996 profit of $100.5 million would have been a $127.3 million loss • Mazda’s 1996 $152.4 million loss would have widened to $371.0 million.