Financial Statement Analysis and Security Valuation Stephen H. Penman

1. Financial Statement Analysisand Security ValuationStephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

2. The Analysis of the Statement of Shareholders’ Equity Chapter 8

3. Chapter 7 Page 218 Figure 7.3 Product and Input Markets OR Customers F Net Operating Assets (NOA) Net Financial Assets (NFA) C I OE Suppliers d OI - DNOA = C - I C - I = D NFA - NFI + d Operating Activities Financing Activities Business Activities:All the Stocks & Flows Capital Markets The Firm Debt Holders or Issuers Share Holders OR - OE = OI

4. Standard GAAP Statementof Shareholders’ Equity Opening book value of equity + Net share transactions with common stockholders + Capital contributions (paid in capital from share issues) - Share repurchases (into treasury stock) + Net share transactions with preferred shareholders + Capital contributions (share issues) - Share redemptions + Change in retained earnings + Net income • preferred dividends • Common dividends  Dirty surplus items  Other dirty surplus items Closing book value of equity Comprehensive Income

5. Chapter 8 Page 234 Reformulated Statement of Shareholders’ Equity • Beginning book value of common equity (CSEt-1) • + Net effect of transactions with common shareholders • + Capital contributions (share issues) • - Share repurchases • - Dividends • = Net cash contribution (negative means net dividends) • + Effect of operations and non-equity financing • + Net income (from income statement) • + Other comprehensive income • - Preferred dividends • = Comprehensive income (available to common) • Closing book value (CSEt) The reformulated statement gives us the clean-surplus rate of return on common equity, ROCE and on a total dollar basis

6. SharesAmount • Special common stock • Beginning balance - - • Issuance of stock upon exercise of options and warrants 298 6 • Conversion of common stock to special stock 42,349 847 • Ending balance 42,647 853 • Redeemable common stock • Beginning balance 50,106 1,002 • Issuance of stock upon exercise of options and warrants 679 14 • Issuance of stock under employee stock plan 322 6 • Conversion of redeemable common stock to common stock (51,107) (1,022) • Ending balance - - • Common stock • Beginning balance 67,133 1,343 • Issuance of stock upon exercise of options and warrants 512 10 • Issuance of stock under employee stock plan 218 4 • Conversion of redeemable common stock to common stock 51,107 1,022 • Conversion of common stock to special common stock (42,349) (847) • Ending balance 76,621 1,532 • Additional paid-in capital • Beginning balance 1,207,720 • Issuance of stock upon exercise of options and warrants 37,087 • Issuance of stock under employee stock plan 17,819 • Income tax benefits realized from employee stock option exercises 7,204 • Tax benefits arising prior to quasi-reorganization 11,810 • Ending balance 1,281,640 • Retained earnings • Beginning balance 129,127 • Net income 146,432 • Tax benefits arising prior to quasi-reorganization (11,810) • Ending balance 263,749 • Other comprehensive income • Beginning balance 9,592 • Net unrealized gain on securities available-for-sale 44,681 • Ending balance 54,273 • Total shareholders' equity 1,602,047 • ========= Before Restatement:Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1

7. After Restatement:Genentech, Inc. Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases - Common dividends - 62,150 Comprehensive Income Net income 146,432 Other comprehensive income 44,681 Preferred dividends - 191,113 Balance - December 31, 1995: $1,602,047 Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1

8. SharesAmount • Special common stock • Beginning balance - - • Issuance of stock upon exercise of options and warrants 298 6 • Conversion of common stock to special stock 42,349 847 • Ending balance 42,647 853 • Redeemable common stock • Beginning balance 50,106 1,002 • Issuance of stock upon exercise of options and warrants 679 14 • Issuance of stock under employee stock plan 322 6 • Conversion of redeemable common stock to common stock (51,107) (1,022) • Ending balance - - • Common stock • Beginning balance 67,133 1,343 • Issuance of stock upon exercise of options and warrants 512 10 • Issuance of stock under employee stock plan 218 4 • Conversion of redeemable common stock to common stock 51,107 1,022 • Conversion of common stock to special common stock (42,349) (847) • Ending balance 76,621 1,532 • Additional paid-in capital • Beginning balance 1,207,720 • Issuance of stock upon exercise of options and warrants 37,087 • Issuance of stock under employee stock plan 17,819 • Income tax benefits realized from employee stock option exercises 7,204 • Tax benefits arising prior to quasi-reorganization 11,810 • Ending balance 1,281,640 • Retained earnings • Beginning balance 129,127 • Net income 146,432 • Tax benefits arising prior to quasi-reorganization (11,810) • Ending balance 263,749 • Other comprehensive income • Beginning balance 9,592 • Net unrealized gain on securities available-for-sale 44,681 • Ending balance 54,273 • Total shareholders' equity 1,602,047 • ========= Before Restatement:Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1

9. After Restatement:Genentech, Inc. Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases - Common dividends - 62,150 Comprehensive Income Net income 146,432 Other comprehensive income 44,681 Preferred dividends - 191,113 Balance - December 31, 1995: $1,602,047 Logo used with permission of Genetech, Inc. • ROCE1995 = 191,113 / [(1,348,784 + 1,602,047) / 2] = 12.95% • or on a per share basis ROCE1995 = [191,113 / 121,220] / 11.50 = 13.71% Chapter 8 Page 235 Exhibit 8.1

10. Chapter 8 Page 236 Ratio Analysis:Payout and Retention Ratios

11. Chapter 8 Page 237 Ratio Analysis:Shareholder Profitability

12. Chapter 8 Page 238 Ratio Analysis:Growth Ratios

13. Chapter 8 Page 239 Table 8-1 Dirty Surplus Accounting in the US • Operating Income Items: • Some income-increasing accounting changes (APB No. 20) • a. Change from LIFO valuation of inventory • b. Change in long-term contract accounting • c. Change to or from full cost accounting in extractive industries • d. Change triggered by a red line in an accounting standard • (e.g. change from cost to equity method for long-term equities) • e. Change made for the first time in conjunction with a IPO or • business combination • Changes in accounting for contingencies (FASB No. 11) • Additional minimum pension liability (FASB No. 87) • Tax benefits of loss carry forwards acquired (FASB No. 109) • Tax benefits of preferred dividends paid to ESOPs (FASB No. 109) • Financing Income (or Expense) Items: • Preferred dividends • Unrealized gains and losses on securities available for sale (FASB No. 115) • Losses on redemption of preferred stock • Operating or Financing Income Items: • Foreign currency translation gains and losses (FASB No. 52) • Unrealized gains and losses on derivative instruments (FASB No. 133) • Balance Sheet Items to be Reclassified: • Deferred compensation relating to grant of employer stock options (APB No. 25 & • and stock FASB No. 123) • Dividends payable • ESOP loan or loan guarantee (SOP 76-3 & 93-6)

14. Chapter 8 Page 238 Dirty Surplus Item Unrealized Gains and Losses on Marketable Securities Old Method - Unrealized Losses on Long-Term Marketable Securities (prior to 1994) (FASB No. 12) • Idea was to record short-term marketable securities at market with gains or losses running through income statement • Long-term marketable securities were accounted for more conservatively by requiring lower of cost or market valuation. Any losses recognized in adjusting below cost went to equity and could be reversed if price rose back up to market. New Method - Unrealized Gains and Losses on Securities Available for Sale (FASB No. 115) • Instead of short-term and long-term categories, we now have held-to-maturity, available-for-sale, and trading securities • Available-for-sale and trading securities are marked to market. The gains or losses on trading securities go to the income statement and available-for-sale gains and losses go the balance sheet.

15. Chapter 8 Page 239 Dirty Surplus Item Foreign Currency Translation Gains and Losses (FASB No. 52) • Terminology and Concepts: • Entity: can be any form of operation, including a subsidiary, division, branch, or joint venture. • Functional Currency: the currency of the primary economic environment in which the entity operates. • First determine the entity, then determine what its functional currency is. FASB distinguishes two types of situations: • Type A: Translation Gains and Losses • The economic effects of an exchange rate change on an operation that is relatively self-contained and integrated within a foreign country relate to the net investment in that operation. Translation gains and losses that arise from consolidating that foreign operation do not impact cash flows and are not included in net income. • Translation gains and losses are an inherent result of the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars. Translation gains and losses are not included in determining net income for the period but are disclosed and accumulated in a separate component of consolidated equity until a sale in whole or in part or a complete or substantially complete liquidation of the net investment in the foreign entity takes place.

16. Chapter 8 Page 239 Foreign Currency Translation Gains and Losses (FASB No. 52) • Type B: Transaction Gains and Losses • The economic effects of an exchange rate change on an operation that is an extension of the parent’s domestic operations relate to individual assets and liabilities and impact the parent’s cash flows directly. Accordingly, the exchange gains and losses in such an operation are included in net income. • Transaction gains and losses are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency (for example, a U.S. enterprise may borrow Swiss francs or a French subsidiary may have a receivable denominated in kroner from a Danish customer). Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany transactions of a long-term investment nature are considered part of a parent’s net investment and hence do not give rise to gains or losses. Note: Contracts, transactions, or balances that are, in fact, effective hedges of foreign exchange risk will be accounted for as hedges without regard to their form.

17. Change Triggered by a Red Line in an Accounting Standard • e.g., change from cost to equity method for long-term equities • when Company P can exercise “significant influence” over the operating and financing activities of Company S, APB 18 requires that P’s investment in S be reported using the equity method • GAAP presumes that P can influence S when P owns 20% or more of the shares of S, absent evidence to the contrary • that is, there is a red line at 20% ownership • when the 20% redline is reached, the record of investment in the balance sheet changes from lower of cost or market (for the shares of the firm) to the amount that would have been recorded if the equity method had been used since the time of P’s first investment in S -- this change by-passes the income statement

18. One-Time Adjustments Caused By the Adoption of a New Accounting Standard • Adjustments you may see in the financial statements that you use in your projects • SFAS No. 106: Employers' Accounting for Postretirement Benefits Other Than Pensions (1993) • SFAS No. 109: Accounting for Income Taxes (1993) • SFAS No. 115: Accounting for Certain Investments in Debt and Equity Securities (1994)

19. Chapter 8 Page 244-245 Deferred Compensation Relating to Grant of Employer Stock Options and Restricted Stock (APB No. 25) If stock is issued in a plan before some or all of the services are performed, part of the consideration recorded for the stock issued is unearned compensation and shall be shown as a separate reduction of shareholders’ equity. The unearned compensation shall be accounted for as expense of the period or periods in which the employee performs service.

20. Chapter 8 Pages 244-248 A Hidden Dirty Surplus Item • Shareholders lose when shares are issued at less than the market price (e.g.. exercise of options) • This loss, however, is not recorded as expense: clean surplus adjustment must be done • What is the nature of this loss? If options are part of compensation package, this loss is an employee compensation expense • What is the amount of the loss? Market price - exercise price, but it is hard to get information on this. • Special case: options granted in the money are recorded as deferred compensation

21. Chapter 8 Page 240 Exhibit 8.2 Before Restatement: VF Corporation’s 1998 GAAP Statement ofShareholders’ Equity Additional Accumulated Other Common Paid-In Comprehensive Retained StockCapitalIncomeEarnings Balance - January 3, 1998 121,225 744,108 (36,110) 1,037,546 Net income 388,306 Cash dividends: Common stock (97,943) Series B preferred stock (3,717) Tax benefit from preferred stock dividends 568 Redemption of preferred stock (2,763) Restricted common stock 19 208 (37) Purchase of treasury shares (3,223) (144,175) Common stock held in trust for deferred compensation plans (233) (6,728) Exercise of stock options, net of shares surrendered 1,678 57,195 (87) Foreign currency translation, net of $5,638 deferred income taxes 10,471. Balance - January 2, 1999 119,466801,511(25,639) 1,170,970

22. Chapter 8 Page 240 Exhibit 8.2 After Restatement:VF Corporation Balance - January 3, 1998 $1,866,769 Transactions with shareholders Stock issues 59,013 Stock repurchases (154,359) Common dividends (97,943) (193,289) Comprehensive income Net income 388,306 Tax benefit of preferred dividends 568 Loss on redemption of preferred stock (2,763) Foreign currency translation adjustment 10,471 Preferred dividends (3,717) 392,865 Net addition to deferred compensation (37) Balance - January 2, 1999$2,066,308

23. FASB Comprehensive Income Reporting Proposal

24. What is this? Comprehensive IncomeReporting Reality HASBRO, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Earnings Quarters EndedSix Months Ended Jun. 27, Jun. 28, Jun. 27, Jun. 28, 1999 199819991998 Net earnings $ 32,289 5,453 46,084 13,246 Other comprehensive loss (4,774) (7,891) (16,384) (16,173) Total comprehensive earnings (loss) $ 27,515 (2,438) 29,700 (2,927) ======== ======== ======== ========

25. Comprehensive IncomeReporting Reality HASBRO, INC. AND SUBSIDIARIES Condensed Notes to Consolidated Financial Statements (3) The Company's other comprehensive earnings (loss) primarily results from foreign currency translation adjustments.