Discount-Variety Stores Industry Module 11: Adjusting Accounting Information Kate Johnson

1. Discount-Variety Stores Industry Module 11: Adjusting Accounting Information Kate Johnson

2. Agenda for Presentation • Company Overview and Comparables • Module 11 Notes • Adjustment A: Inventory Method • Adjustment B: Operating Leases • Adjustment C: Special Purpose Entities • Adjustment D: Share-Based Compensation

3. I: Company Information and Comparables

4. “Save Time. Save Money.” • Largest discount retailer in the US by number of stores • Goodlettsville, Tennessee • 11,000 stores • 40 States • Southern, Southwestern, Midwestern, Eastern US • Merchandise is typically $10 or less • Founded in 1939 • Stock publicly traded in 2009

5. Product Types • Two brands: 1)High quality nationalbrands from leading manufacturers 2)Comparable quality privatebrand selections 10,000 SKUS/store 10$ or less

6. How are they profitable? • Convenient Locations • Time Saving Shopping Experience • Everyday Low Prices on Quality Merchandise • Key items in a broad range of general merchandise categories • Most basic shopping needs are met in one trip

7. Discount-Variety Stores **Costco is least comparable

8. But DG is a Dollar Store? • Dollar General is more suited to be compared with Walmart, Target, and Costco, as not everything is $1 (DLTR) and they have produce (unlike FDO) • Characteristics such as industry and size are often chosen for comparable

9. Store Growth • 2011-2012 Growth: 5.72% • 2012-2013 Growth: 5.96% DG is a February 2 year end 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . 10,506 650 24 626 11,132

10. II: Module 11 Notes • In Module 10 we analyzed and included additional sources of information from the footnotes and the MD&A -Allows us to revise and improve our identification of NEA and EPAT • Module 11 allows us to consider the effects of accounting choices -We can then undertake another reformulation

11. Module 11 Continued • Module 11 consists of: • General discussion about the effects of accounting methods • A series of mini-modules covering potential adjustments to address particular accounting methods and valuation relevant issues regarding these methods

12. Module 11 Continued • Over the life of a project or a company, the method of accounting usually does not change total income -Issue is simply one of determining the period in which the revenues/expenses are reported • Accounting method does not affect the computed value for a project • Implication: accounting method choice will not affect value

13. So, why is this module important? • While it may appear that the accounting method choice has no effect whatsoever on the valuation exercise, this is not true • If past accounting data is used as the basis for forecasting, income shifting or differing accounting method choices may cause a reduction of comparability or create an appearance of comparability where it does not actually exist • Module allows us to explore several ways in which accounting method choices may affect realized EPAT and NEA altering comparability and therefore influencing forecasts to the extent that we rely on past realizations or analysis of competitors/comparable in determining inputs to our forecasts

14. Adjustment A: Inventory Method

15. III: Inventory Method • In order to compare companies with different inventory costing methods, we need to adjust the LIFO numbers to their FIFO equivalents or vice versa • Even if all companies that are being compared use LIFO, the LIFO adjustment must still be made • Under US GAAP companies must provide a LIFO adjustment

16. LIFO Reserve and Provisions • After searching through the footnotes for a long period of time, I was having a hard time finding the exact amount of LIFO reserve for Dollar General • This is a problem for another company in my group of comparable; we believe it is due to the retailers using RIM inventory costing systems • I decided to call Investor Relations • Spoke with Emma Joe Kauffman, in charge of Investor Relations at Dollar General, who disclosed the LIFO reserve balance over the phone • (615) 855-5525

17. Dollar General and LIFO • LIFO adjustment of $11 million • LIFO reserve is the difference between reported LIFO and “as if” FIFO • Adjustment should be “net of tax” because, if the company had used FIFO inventory valuation for financial reporting purposes, the IRS would have required that tax reporting also be based on FIFO

18. LIFO Reserve • Can be computed by hand: • Add provision • Subtract LIFO benefit • LIFO Reserve Balance 2013: $90, 905, 608

19. NEA based on Financial Statements

20. LIFO Reserve Adjustment • Adding DG’s LIFO reserve of $90,905,608 to LIFO inventory -$90,905, 608 million increase in 2013 inventory would have: - increased its cumulative pretax profits by $90,905,608 million -increased taxes by $33,635,075 ($90,905,608 million x 37% statutory tax rate) • To adjust the 2012 balance sheet we increase: • inventories by $90, 905, 608 million • tax liabilities by $33, 635, 075 • equity by the difference $57, 270, 533

22. Effect on NEA of adjustment

23. EPAT Adjustment • LIFO reserve decreased by $9.6 million from 2012 to 2013 • - ($11 million-$1.4 million)= $9.6 million • To adjust DG’s 2013 Income Statement from LIFO to “as-if” FIFO, we use this footnoted change in LIFO reserve • - Had DG been using FIFO, its COGS would have been $9.6 million higher • -2013 Gross Profit and Pretax Income would have been $9.6 million lower

25. EPAT Adjustment cont. • DG would have paid $3,552, 000 less in taxes had it used FIFO for inventory valuation (9.6 million x 37% tax rate)

26. EPAT Adjustment for LIFO Reserve Effect Difference in EPAT values is the difference in LIFO reserve from 2013 to 2012

27. Effect of LIFO Inventory Methods Chart

28. Adjustment B: Operating Leases

29. Operating and Capital Leases • The use of operating leases is the most common form of off-balance sheet financing undertaken by companies • Leasing transactions affect both sides of the balance sheet (long-term assets and long-term liabilities) as well as the income statement (leasing expenses are often reported in selling, general, and administrative expenses)

30. Financial Reporting Consequences of Classifying Leases as “Operating” • Lease asset not reported on the DG balance sheet -EATO higher because reported NEA is lower and revenues are unaffected • Lease liability is not reported on the DG balance sheet • Balance sheet measures of financial leverage are improved • Better credit rating • Without adjustment, the return on NEA appears higher, which improves the perceived quality of DG’s return on equity • Net Income higher in the early years • EPAT lower

31. Capitalization Process • Determine the discount rate • Compute the present value of future lease payments • Adjust the balance sheet to include the present value from step 2 as both a lease asset and a lease liability • Adjust the Income Statement to include depreciation and interest in lieu of rent expense

32. 3 Approaches to DetermineAppropriate Discount Rate 1) Company discloses capital leases in addition to the operating leases • We can infer an implicit rate of return on those capital leases 2) Rate that corresponds to the company’s credit rating or the rate from any recent borrowings involving intermediate-term secured obligations 3) Cost of Debt Capital from Module 6

33. Impacts of Operating Leases • 1) Lease asset is not reported on the B/S • EATO higher because reported NEA is lower and revenues are unaffected 2) Lease liability not reported on B/S -Balance sheet measures of financial leverage (like the total liabilities-to-equity ratio) are improved -Reduced financial leverage results in better credit rating and lower interest rates on borrowed funds 3) Without adjustment (capitalization of operating leases), the return on NEA (RNEA) appears higher, which improves the perceived quality of the company’s return on equity

34. Leases: DG usesBoth Capital and Operating • Operating leases record no liability or related asset on the balance sheet. • Off Balance Sheet Financing • Some managers believe that keeping such assets and liabilities off the balance sheet improves the market’s perception of their enterprise’s performance and the company’s financial condition • Module 11 talks about Operating Leases in Adjustment B. Module 11 will take this into account.

35. Operating and Capital Leases

36. Step 1: Appropriate Discount Rate • Future payments by year are disclosed for operating leases, but only the total minimum payments for capital leases are disclosed • Will have to use the cost of debt capital from Module 6

37. Step 2: PV of Future Operating Lease Payments • Cost of debt from Module 6 was 4.05%

38. Step 2 PV of Future Lease Payments Estimate that the omitted asset and liability related to recording the majority of the leases of DG as operating rather than capital is $4,693,444 as of the end of 2013

39. Step 3 Adjust the B/S • Adjust NEA upwards by $4,693,444 to include this additional enterprise asset • Do not adjust enterprise liabilities as the liability arising form the operating leases is not related to the enterprise but instead represents a financing choice • Financing liabilities will be increased by the $4,693,444 • Of this, $523,417 will be current and $4,170,027 will be noncurrent

41. MOD 10 VALUE:

42. Changing the Income Statement • The amount of payments made under operating leases ins a required disclosure for each I/S period

43. Adjustment C: Special-Purpose Entities

44. WSJ March 29, 2002

45. Special Purpose Entities • After speaking with Emma Joe Kauffman about DG’s LIFO reserve, I asked about their use of SPEs, after I read the WSJ article • DG does not use SPEs for leases anymore, however they do use a form of them them for insurance purposes but was unclear of how they worked • Gave me another number to call but I never was able to reach him • I could not find information regarding SPE usage for Insurance purposes

46. Adjustment D:Share Based Compensation

47. Share Based Compensation • On July 6, 2007 DG’s Board of Directors adopted the 2007 Stock Incentive Plan for Key Employees • Plan allows the granting of stock options, stock appreciation rights, and other stock-based awards or dividend equivalent rights to key employees, directors, consultants, or other persons having a service relationship with the Company

48. Share-Based Compensationsubject to MSA • Through May 2011, a significant majority of the Company’s share-based awards were stock options that vest solely upon • 1) Continued employment of the recipient: MSA Time Options • 2) The achievement of predetermined annual or cumulative financial-based targets: MSA Performance Options -vest as of fiscal year end -if targets aren't met for a period, they may still subsequently vest, provided that a cumulative performance target is achieved Both have a contractual term of 10 years and an exercise price equal to the fair value of the underlying common stock on the date of grant

50. Share- Based Awards not subject to MSA • Company also issued share-based awards that are not subject to an MSA • Have generally been in the form of: • stock options: vest ratably and annually over a 4 and 3 year period respectively • restricted stock units vest ratably over a 3-year period • performance share units vest ratably over a 3-year period, providing certain minimum performance criteria are met