American Eagle Apparel Store

1. American EagleApparel Store Module 11: Adjusting Accounting Information By: Nick Cecero

2. Use of Accounting Data • Because our forecasting is based on past accounting data, income shifting or differing accounting method choices may cause a reduction of comparability or create an appearance of comparability that does not exist. • The end result could be an incorrect forecast of enterprise profitability for use in the valuation. • Appropriate assumptions for sales growth, EPM, & EATO may depend on some extent on the observed values of past sales growth, EPM, & EATO.

3. 4 Different Adjustments • Adjustment A: Inventory Method- Whether or not a company chooses to record inventory using the LIFO or FIFO method. • Adjustment B: Operating Leases- “Off Balance Sheet Financing” • Adjustment C: Special Purpose Entities- Allow companies to obtain cheaper cost of capital, and improve liquidity. • Adjustment D: Share-Based Compensation- Employee Stock Options (ESO) A means to compensate employees and to better align the interests of employees and shareholders.

4. Adjustment A: Inventory Method • Some companies may not be comparable due to their choice of accounting methods to account for inventory. Many companies either use the LIFO method or the FIFO method. To compare these companies we would need to adjust the LIFO numbers to their FIFO equivalents. • The adjustment can be calculated since companies who report inventory under the LIFO method are also required to disclose a LIFO adjustment which would enable us to calculate the value of inventory had the company chosen to use the FIFO method.

5. Adjustment A: Inventory Method

6. Adjustment B: Operating Leases • If Operating Leases exist this would not show up on the balance sheet, but could have an impact on both sides of the balance sheet as well as the income statement. • Two approaches for the reporting of leases: 1) Capital Lease Method– Amounts shown on Balance Sheet 2) Operating Lease Method- Amounts not shown on Balance Sheet

7. Adjustment B: Operating Leases • 4 Financial Reporting Consequences by Classifying Leases as “Operating”: • EATO is higher because reported NEA is lower and revenues are unaffected. • Measures of financial leverage are improved, and the end result will be a better credit rating. • The return on NEA (RNEA) appears higher which improves perceived quality of company’s return on equity. • EPAT is lower for an operating lease.

8. Adjustment B: Operating Leases • 4 Step Process for the Capitalization Process: • Determine Discount Rate • Compute Present Value of Future Lease Payments • Adjust Balance Sheet to Include the PV • Adjust Income Statement to include depreciation and interest in lieu of rent expense

9. Step 1: Determine the Discount Rate • 3 Approaches To Determine the Discount Rate: • Look in the footnotes to see if the company discloses capital leases in addition to operating leases and we can then infer an implicit rate of return on those capital leases. • Use a rate that corresponds to the company’s credit rating or rate from any recent borrowings involving intermediate-term secured obligations. • Utilize a cost of debt capital.

10. Discount Rate • Because American Eagle does not disclose capital leases in addition to the operating leases we have look further into the footnotes and see rate they obtained from any recent borrowings. • Rate = 1 Year LIBOR Rate + Margin • Rate = .56% + 1.75% = 2.31%

11. Step 2: AEO’s Estimated Lease Liability • We must now compute the present value of these future operating lease payments using the discount rate of 2.31% that we determined from Step 1. • Assumption: Future years after 2017 will have payments that equal $173,653 until the amount Thereafter is satisfied.

12. AEO’s Estimated Lease Liability

13. Step 3: Adjust The Balance Sheet • Having computed the present value of the future operating lease payments we need to adjust AEO’s NEA upward by $1,511,387 to include this additional enterprise asset which is part of property, plant, and equipment. • Do not need to adjust the enterprise liabilities but instead we need to increase financing liabilities by $1,511,387. • $1,511,387 can be broken down into current and noncurrent. • Current Portion = $257,543 – ($1,511,387*.0231) = $222,630 • Non-Current Portion = $1,288,757

14. Step 4: Adjust The Income Statement • Capitalizing operating leases affects EPAT via the addition of depreciation related to the lease and the removal of the operating lease payments which had been reported as rent expense. • Total Rent Expense 2013 $275,562

15. Adjust The Income Statement • $1,511,387 X .0231 = $34,913.04 • Remove the payment of $275,562 from SG&A and reclassify it as $34,913.04 of interest expense and $240,649 as depreciation expense. • We then have to use American Eagle’s effective tax rate which can also be found in the footnotes and for the fiscal year was 34%. • $275,562 – ($240,649 X (1-.34)) = $116,734 • The $116,734 will increase EPAT by this amount calculated.

16. Overall Effect of Lease Adjustment • NEA Increases By $1,511,387 • EPAT Increases By $116,734 • The two above numbers are substantial since sales were $3,475,802 • This demonstrates that the process may be necessary for some companies or industries as it can have a significant impact when large amount of operating leases is employed.

17. Adjustment C: Special Purpose Entities • Special Purpose Entities (SPEs) are used as financing tools for the securitization of assets and for project and real estate financing. • Two Analysis Implications related to SPEs: • Cost of Debt Capital- Access to lower interest rates. • Liquidity- Package loans for sale, which in turn allows for an increase in liquidity. • SPE’s are however consolidated into the parent company, and our analysis of EPAT and NEA are no affected by their existence. Understanding this though will help us with our ability to forecast future growth of the company. • In this case American Eagle does not have any SPE’s.

18. Adjustment D: Share-Based Compensation • Stock options granted must be expensed by the fair value of the options at the grant date and recognize an equivalent increase in stockholder’s equity. • Stock options represent a transfer of enterprise value to the employees and therefore a reduction of what is available to debt and equity holders. • Stock options have a dilutive effect.

19. 7 Step Process to Adjust for Options Steps: • Compute the value of options exercisable at beginning of year using beginning of year share price. • Compute the value of options exercisable at beginning of year using end of year share price. • Estimate the value of ESOs exercised during the current year using an estimate of the average share price over the year. • Estimate the value of ESOs cancelled during the current year using an estimate of the average share price over the year. • Compute the value of options exercisable at end of year using end of year share price. • Compute an estimate of additional share-based compensation from information computed above. • Adjust NFL, CSE, EPAT, and FEAT using the information computed above. Share Prices Via Yahoo Finance Beginning of the Year Share Price: $20.08 (1/2/2013) End of the Year Share Price: $20.44 (1/28/2013)

20. Footnote 12 AEO Annual Report

21. Adjustment D: Share-Based Compensation

22. 7 Step Process to adjust NFL, CSE, EPAT, and FEAT

23. 7 Step Process Adjustment

24. Restricted Stock • Instead of stock options employees may be compensated instead with restricted stock. • One of the main benefits of restricted stock is that it has tax advantages as compared to stock options.

25. The End Any Questions?