ACCOUNTING 608 SUMMER 2009
Course ACCT 608- Waiver Preparation for the Financial Accounting Core Instructor Stanley Baiman Office Rm. 1321 Office Phone 898-6782 e-mail [email protected]
INTRODUCTION
The purpose of this course is to prepare the student to take and pass the waiver examination in Financial Accounting, thereby exempting out of the Financial Accounting Core Curriculum. The Accounting Waiver Exam is scheduled for Monday, August 17 from 7pm - 9pm. The Accounting Placement Exam is scheduled for Thursday, August 25 from 7pm - 9pm. Thus, those who do not pass the Waiver Exam and have not placed into Accounting 621 by credential have the opportunity to take the Placement Exam.
This is a review course. I will assume that the student has had at least one full quarter or semester course in financial accounting, and remembers a good deal of it. In particular, I will assume that the student is facile with: accounting terminology and concepts, debits and credits, present value, and accounting for transactions covered in a first course in financial accounting. The lecture notes included in your course packet as well as the book assigned for this course review these transactions. I will discuss only some of these transactions and their mechanics; the emphasis of this course will be, like that in Accounting 620/621, on disclosure and financial statement analysis.
The pace of the course will be extremely fast. Classes will be run on the assumption that all students have read the assigned material and have worked the assigned cases prior to class. Class time will be divided between lectures and discussion of the assigned cases, with the vast majority of class time devoted to the latter. I have included more problems each session than we can cover. I will cover the cases labeled as DISCLOSURE examples at the end of each section of the notes and will try to cover the cases which are indicated in boldface in the assignment sheet. Those cases not covered in class can be used to study for the exam. The cases which we will go over in class are examination questions from past Accounting 620 classes. The waiver examination will be very similar to the cases discussed in class.
Page 1 ACCOUNTING 608 SUMMER 2009
ORGANIZATIONAL DETAILS 1. Course Materials:
Text (Suggested): Dyckman , Financial Accounting, 2nd Edition, Cambridge Business Publishers, 2008.
Course Packets (Required): Please bring all of the material referenced in the assignment for each class session to that class session. You have two course packets for this course. The course syllabus and class lecture notes are included in this file. A separate file contains the homework problems. The files are accessible from the course website on WebCafé, https://webcafe.wharton.upenn.edu/eRoom/acct/608-fa09-1.
Homework The homework will not be handed in. Solutions to each session’s homework will be accessible after class at the course website on WebCafé https://webcafe.wharton.upenn.edu/eRoom/acct/608-fa09-1. .
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ASSIGNMENTS
Session 1, Thurs. August 6 Revenue Recognition Accounts Receivables Cash Flow Statement
Reading Assignment: Chapter 3 Chapter 4 Chapter 5 Packet: Lecture 1 notes
Case Assignment: Packet: Quiz 2 2006 Q1 (1-4) Quiz 2 2007 Q1 Quiz 2 2008 Q1 (1-2)
Session 2 Fri. Aug. 7 Inventory Accounting Accounting for Long-Lived Assets
Reading Assignment: Chapter 6 Appendix 6A Chapter 7 Packet: Lecture 3 notes
Case Assignment: Packet: Quiz 2 2006 Q2 Quiz 2 2006 Q4 Quiz 2 2007 Q2 Quiz 2 2008 Q1 (3-7) and Q3
Session 3, Sat. Aug. 8 Long-Term Debt Leases
Page 3 ACCOUNTING 608 SUMMER 2009
Reading Assignment: Chapter 8 Chapter 9: pp.354 - 366 Appendix 8A Packet: Lecture 4 notes
Case and Cash Flow Problem Assignment: Packet: Quiz 2 2006 Q3 Final Exam 2006 Q4 Quiz 2 2007 Q3 Final Exam 2007 Q4 Quiz 2 2008 Q2 Final Exam 2008 Q2
Session 4, Tues. August 11 Leases, contd. Shareowners' Equity Taxes Reading Assignment: Chapter 9: pp. 354 – 366, 376 - 380 Chapter 10 Packet: Lecture 5 notes
Case Assignment: Packet: Final Exam 2006 Q1 Exam 10 (at end of Homework file) Final Exam 2006 Q3 Final Exam 2007 Q1 and Q3 Final Exam 2008 Q1 and Q3
Session 5, Thurs. August 13 Intercorporate Investments - Minority Reading Assignment: Packet: Lecture 2 notes Chapter 11: pp. 450 - 465
Case Assignment: Packet: Final Exam 2006 Q2 Final Exam 2007 Q2 Final Exam 2008 Q4
Page 4 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
REVENUE RECOGNITION, ACCOUNTS RECEIVABLES, AND CASH FLOW
REVENUE RECOGNITION
The criteria for revenue recognition is the first point at which all of the following are satisfied: a) the principal revenue producing activity has been performed; b) any necessary costs have either been incurred or can be accurately predicted; c) the amount ultimately collectible can be accurately predicted; d) there is evidence of a market transaction.
In general, revenue and the related expense are recognized at the time of delivery. Major exceptions include long-term construction contracts and installment sales. Another exception occurs with mark-to-market accounting which we will study in session 5. Note that much of the accounting scandal associated with Enron grew from its use of mark-to- market accounting for energy contracts. Even under the delivery basis, there is still room for discretion. See the Microsoft articles at the end of this note.
If a firm makes a decision this period to take some action in the future which will make its assets less valuable or obligate it to make some future payment, then the loss resulting from this decision must be recognized in the period of the decision, not in the future when the decision is actually implemented. For example, in 2001 Cisco Systems wrote down the value of its inventory in the amount of $2.5 billion. However, there was little if any cash effect in 2001 from this decision.
PAGE 5 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
CASH FLOW
The objective of the cash flow statement is to explain which transactions gave rise to the change in the cash account, as already reported on the comparative balance sheets.
Given that we are trying to explain the cash flow during the year, a shortcut would be to use the accounting equation Cash= L - NCA + OE.
Where: L = liabilities NCA = non-cash assets OE = owners’ equity
Therefore, for non-cash asset, liability and equity accounts:
Sources of Cash Uses of Cash increase in LIABILITY decrease in LIABILITY increase in OE decrease in OE decrease in ASSETS increase in ASSETS
But this provides no information not already contained in two successive balance sheets. In order for the cash flow statement to provide additional information we need to base it on more detailed information, e.g., the journal entries, themselves.
PAGE 6 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
The cash flow statement has three major parts: 1. cash provided by operations 2. cash flows from investing activities.
Examples of Cash Inflows and Outflows Included in the Investing Section
Cash Inflows Cash Outflows 1. Cash received from the 1. Cash payments for loans made collections of loans made by by the enterprise. the enterprise. 2. Cash received from the sale of 2. Cash payments made to acquire other entities' debt or equity other entities' debt or equity classified as either held to maturity, classified as either held to maturity, available for sale, or affiliates. available for sale, or affiliates. 3. Cash received from the sale of 3. Cash payments made at the time of property, plant and equipment purchase, or shortly after for property, plant and equipment 4. Cash received from the sale of tangible assets other than 4. Cash payments made at the property, plant and equipment. time of purchase, or shortly after purchase for tangible assets, other than property, plant and equipment.
PAGE 7 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
3. cash flows from financing activities
Examples of Cash Inflows and Outflows Included in the Financing Section
Cash Inflows Cash Outflows 1. Cash received from issuing 1. Cash payments for dividends equity securities and other payments to owners. 2. Cash received from issuing 2. Cash payments to reacquire bonds, notes and mortgages. equity securities. 3. Cash received from issuing 3. Cash payments for amounts other short and long-term borrowed. borrowings, other than those noted in 2, above. 4. Cash principal payments to creditors for long-term borrowings.
The analysis of the financing and investing parts of the cash flow statement is straight forward. You just consider all of the investing and financing activities that affected cash and list their effects. That is, just look at each journal entry for a financing or investing activity. If the journal entry involved a debit or credit to cash, list that activity as a financing or investing source or use of cash. If it did not, it is considered a non-cash financing and investing activity and it does not appear on the Statement of Cash Flows.
The problem in constructing a cash flow statement arises in constructing cash from operations. Therefore, the rest of this note deals primarily with constructing cash from operations under the indirect method.
With the indirect method, the cash flow from operations section begins with net income and you need to make a series of adjustments to get from net income to cash from operations. To construct the cash from operations section, you analyze each journal entry associated with an operating activity. If the entry had the same effect on income as cash, there is no need for an adjustment. If the effects on cash and net income were different, you need to adjust net income to get to cash from operations. The adjustments are basically: 1. add back expenses that did not consume cash; 2. subtract revenues that did not generate cash;
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3. adjust for operating cash flows that did not affect income (e.g., the payment of accounts payable or the receipt in cash of accounts receivables); 4. adjust for non-operating items included in net income (e.g., gains and losses on the sale of property, plant and equipment).
Clearly, in order to keep the cash flow statement to a manageable size, many of these adjustments will have to be aggregated. All three sections of the SCF will contain aggregations. For example, in the Cash From Investing Activities you will see a line item typically labeled “Purchases of Property, Plant and Equipment”. This aggregates all the cash paid to buy new property, plant and equipment and all of the cash received from the sale of property, plant and equipment. Recall, though, that any property, plant and equipment financed with other than cash will not show up here. Hence the “Purchases of Property, Plant and Equipment” number reported in the Cash Flow From Investing Activities will not necessarily equal the actual change in Property, Plant and Equipment reported on the Balance Sheet.
Similarly, the Cash From Operations section will contain adjustments such as “Changes in Inventory” or “Changes in Accounts Payable”. These are the sum of the operational adjustments involving inventory (or accounts payable) transactions. The “Changes in Inventory” or “Changes in Accounts Payable” (or other accounts) shown on the cash flow statement will often not equal the actual changes in those accounts as computed from the two successive balance sheet. The difference between the “Changes in Inventory” or “Changes in Accounts Payable” (or other accounts) shown on the cash flow statement and the actual changes in those accounts as reported on the balance sheet is due to non- operational transactions. The following are the major examples of these non-operational transactions:
(i) Acquisition or Sale of a Business
Assume that Company B consists of inventory with a market value of $9 and accounts payable with a market value of $3. Further, assume that Company A buys Company B with $6 of cash. Assume that this was the only transaction which either Company A or B engaged in this year. Company A's statement of cash flows therefore only consists of one investing transaction.
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Company A Statement of Cash Flows
Cash from Operating Activities: 0 Cash from Investing Activities: Purchase of Company B (6) Cash from Financing Activities 0 Net Change in Cash Account (6)
The acquisition changed Company A's inventory and accounts payable accounts; however, the cash payment made for those assets and liabilities acquired do not show up in the operations section of the cash flow statement. Rather they show up in the Investing Activities section as part of business acquisitions.
(ii) Foreign Currency Translation Adjustments
Companies often have subsidiaries that operate in a foreign country, where the subsidiary holds assets and liabilities denominated in foreign currency and does business in the foreign currency.
When the parent produces its financial statements, it must translate the foreign currency denominated assets and liabilities of the subsidiary into US$.
The value of foreign currency fluctuates relative to the US$ and hence the US$ denominated value of the subsidiary's assets and liabilities will change over time.
These changes in the value of the assets and liabilities must be reflected on the parent's US$ denominated financial statements. However, these changes in the US$ denominated value of the subsidiary's assets and liabilities do not have an income statement effect. They do, however, affect an Owners’ Equity account referred to as, Other Comprehensive Income.
For example, say that at the end of year 1, your French subsidiary, which keeps its own books in Euros, bought inventory for 10 Euros when the exchange rate was $1 to 1 Euro. At the end of year 1, the inventory would appear on the French
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subsidiary’s balance sheet at 10 Euros and on your U.S.$-denominated balance sheet at $10. Assume that during year 2, nothing happened, except that at the end of year 2, the exchange rate was 5 Euros to $1. The value of the inventory on the French subsidiary’s balance sheet is still 10 Euros, however, the dollar value of the inventory is now $2, although the inventory appears on your U.S.$-denominated balance sheet at $10. Therefore, you must reduce the inventory balance by $8 on your financial statements. The offsetting entry is to Other Comprehensive Income - Foreign Currency Translation Adj., an Stockholders’ Equity account. The journal entry to the parent’s dollar-denominated books is:
Other Comprehensive Income -Foreign Currency Translation Adj
8 BS
Inventory 8 BS
Thus, your firm would have to write down the dollar value of its foreign currency denominated inventory, but would not recognize this write down in its income statement.
In that case, this transaction has neither an income nor a cash effect and would not show up in the cash flow statement as an adjustment.
Thus, the inventory adjustment that did show up in the cash flow statement would not include the $8 write down and hence would not equal the actual change in the inventory as reported on your balance sheet.
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ACCOUNTS RECEIVABLES
Assume that you sell enough items for credit so that you can come up with a good estimate of the amount ultimately to be collected and hence a good estimate of credit losses associated with sales. In this case, you must use the delivery method to recognize revenue, i.e. recognize revenue when you deliver the goods. But the issue still remains as to when you should recognize the anticipated credit losses. There are two approaches: the direct write-off method and the allowance method. Both of these methods are discussed in Dyckman, et al. With respect to the Allowance Method, there are two additional transactions which are not discussed in the text:
AT THE TIME OF A SURPRISE COLLECTION
Assume that in a prior year, you wrote off an accounts receivable with a balance of $2 and that the $2 is paid to you now.
Cash 2 BS Allowance for uncollectible 2 BS
REESTIMATE OF DEFAULT RATE Recall that the estimated provision for bad debt is based on an estimated default rate. What happens when it turns out to be incorrect on average?
if it was too high in the past, the adjusting entry is:
Allowance for uncollectible BS Gain IS
if it was too low in the past, the adjusting is:
Loss IS Allowance for uncollectible BS where the adjustment is the cumulative previous underestimate or overestimate.
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All of the above is summarized in the following T-accounts:
ACCOUNTS REC ALLOWANCE BB BB GROSS CREDIT SALES DEFAULTS DEFAULTS EST PROV FOR BAD DEBTS
OTHER* AR COLLECTED** GAINS ON REVAL LOSSES ON REVAL
OTHER* RECOVERIES
EB EB
**Does not include recoveries
OTHER* can be a debit or credit and includes Accounts Receivables and the associated Allowances sold or purchased as part of a business divestiture or acquisition, as well as the effects of foreign currency translation adjustments. These are collectively referred to as non-operational effects, transactions or activities.
ACQUISITION OF ANOTHER FIRM INCLUDING ITS ACCOUNTS RECEIVABLES Accounts Receivables BS Other Assets BS Allowance for Uncollectibles BS Cash BS
PAGE 13 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
The indirect cash statement is as follows:
Cash from Operating Activities: NI + estimated provision for bad debt -credit sales +recoveries +cash collections (other than recoveries) -gains on reestimate +losses on reestimate CFO
Note that the above adjustments to NI sum to Net Accounts Receivable from operational activities – i.e., excluding the effect of non-operational activities. The non-operational activities which affected both AR and cash would show up under Investing and/or Financing Activities.
SALES DISCOUNTS In addition to having to allow for bad debts, a seller also may allow for sales discounts. Consider the following example:
In Period 1, A sells inventory to B for $100. The terms are 2/10 net/30. The seller can use either the net, the gross or the allowance method. The net and the allowance are the preferred methods.
At time of If paid w/i If paid at Sale 10 days 30 days Gross: AR 100 Cash 98 Cash 100 Sales rev 100 Sales Disc 2 AR 100 AR 100
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The sales discount account is similar to an interest expense or contra sales revenue account.
Net: AR 98 Cash 98 Cash 100 Sales Rev 98 AR 98 AR 98 Int Rev 2
Allowance: AR 100 Allow 2 Cash 100 Sales 100 Cash 98 AR 100 AR 100 Est Prov 2 Allow 2
Under the allowance method, at the time of a credit sale you estimate how much in discounts will be taken by the current credit customers (in the example above, that is $2 for every $100 of sales). That estimate is recognized by increasing a contra-revenue account (Estimated Provision for Sales Discounts) and a contra-accounts receivable account (Allowance). At the time that a discount is taken, you just reduce the allowance account. Accounting for sales discounts is analogous to accounting for bad debts.
Using the allowance method for bad debt and sales discounts gives us:
ACCOUNTS RECEIVABLES ALLOWANCE BB BB GROSS CREDIT SALES DEFAULTS DEFAULTS EST PROV FOR BAD DEBTS, & SALES DISC
SALES DISC GROSS AMOUNT OF TAKEN AR COLLECTED** RECOVERIES
OTHER† GAINS ON REVAL LOSSES ON REVAL OTHER†
EB EB
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† Indicates Non-operational transactions referred to earlier.
**Does not include recoveries and is gross of any sales discounts taken.
Gains and losses on revaluations include those for bad debts and discount estimates. Estimated provision for bad debts & sales discounts would now include estimated provision for sales discounts to be taken in the future.
DISCLOSRE – DEXTER CORP.
As an example of the disclosure associated with accounts receivables, refer to the information on pages 22 - 22 of this note, taken from Dexter’s 1999 Annual Report and 10- K.
Try to answer the following questions:
Additional Information 1. For 1999, Dexter did not record any revaluation gains or losses with respect to its accounts receivables. 2. There were no surprise collections (i.e. recoveries) in 1999 3. Dexter reports its Estimated Provision for Bad Debt (i.e., Bad Debt Expense) as a contra revenue. 4. FCTAs on Accounts Receivable affected the gross Accounts Receivable account but not the Allowance for Doubtful Accounts.
Questions: What was the amount of the Estimated Provision for Bad Debt (i.e., Bad Debt Expense) which Dexter Corp. recognized in 1999?
What was the amount of defaults which Dexter Corp. recognized (wrote-off) in 1999?
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How much greater or less would Dexter Corp.’s net income before taxes for 1999 have been if it had used the Direct Write-off Method rather than the Allowance Method to account for Doubtful Accounts?
What was the amount of net accounts receivables which Dexter Corp. sold with the assets of the businesses it divested in 1999?
What was the amount of gross accounts receivables which Dexter Corp. sold with the assets of the businesses it divested in 1999?
Refer to Dexter Corp.’s Schedule II. Briefly explain the cause of the $123 entry that was made to the Allowance for Doubtful Accounts in 1997?
Assume that all of Dexter Corp.’s Accounts Receivables which are not denominated in US$ (U. S. dollars) are denominated in Euros. Did the US$ weaken or strengthen relative to the Euro during 1999?
Refer to the supplemental schedule in the footnotes entitled “Increase (Decrease) in Operating Working Capital and Total Working Capital in 1999”. Note that “Additional Information” has been added for your benefit.
Explain what the “Cash Changes” entry of $26,382 for Accounts Receivable, net represents. In particular, list as many of the types of transactions which would be included in that number as you can.
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Business/Financial Desk; Section C Microsoft's Accounting Under Scrutiny By JOHN MARKOFF
07/01/1999 The New York Times Page 1, Column 5 c. 1999 New York Times Company
The Microsoft Corporation announced yesterday that the Securities and Exchange Commission was investigating the company's accounting practices involving the stating of financial reserves.
Industry experts said the S.E.C. investigation could be part of its effort to restrain ''cookie jar'' accounting, which can smooth over differences between strong and weak quarters. Microsoft has consistently denied any such intent and insists that it has adhered to ''conservative'' accounting practices.
In a conference call yesterday with financial analysts and reporters after the market closed, Greg Maffei, Microsoft's senior vice president and chief financial officer, said the company had learned of the S.E.C. inquiry over the last two months and knew few details, including how long it would continue.
''We are obviously a company that is known for conservatism, and I would be surprised if someone was to examine our books and suggest otherwise,'' he said.
As is its custom in such matters, the S.E.C. declined to comment yesterday on whether an investigation was under way.
But Mr. Maffei said Microsoft thought that the S.E.C. had begun its investigation in January in a response to a wrongful discharge suit filed by Charles Pancerzewski, a former internal auditor at Microsoft.
The lawsuit, brought in 1996 and settled last November on terms that were not disclosed, contended that the software giant, based in Redmond, Wash., had manipulated hundreds of millions of dollars in revenue reserves to make its profits appear more stable.
The plaintiff said that after reporting his discovery to his superiors, he was given an unscheduled performance review and asked to resign. He accused Microsoft of wrongful termination, age discrimination and breach of contract.
In January, The Wall Street Journal said Mr. Pancerzewski's lawyer had cited a 1995 E-mail message from a former chief financial officer, Mike Brown, to Microsoft's chairman, William H. Gates Gates, which said, ''I believe we should do all we can to smooth our earnings and keep a steady state earnings model.''
Mr. Pancerzewski, who has recently served as a city councilman in Mukilteo, Wash., was traveling yesterday and could not be reached. His lawyer, Pete Vial, said Mr. Pancerzewski had been in Washington, D.C., but said he could not confirm whether his client had spoken with the
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S.E.C. because of a confidentiality agreement in the settlement of his suit.
The S.E.C. and its chairman, Arthur Levitt, have begun cracking down on what they consider earnings manipulation by companies. The issue ''certainly has Mr. Levitt's attention,'' said Peter H. Knutson, an associate professor emeritus of accounting at the Wharton School at the University of Pennsylvania.
The S.E.C. has been very vocal in its criticism of various accounting practices that may allow companies to smooth out their results. It has brought several high-profile cases against specific companies and called for clearer rules for companies to follow. Just yesterday, the S.E.C. reached a settlement with W. R. Grace & Company involving allegations that the company used excess reserves from a subsidiary to smooth out its results. The company neither admitted nor denied the allegations.
The S.E.C. has also recently brought attention to accounting practices in the banking industry, where banks may be taking excessive reserves against future loan losses in order to put aside something for future periods.
''They are looking at many companies,'' said Joseph Grundfest, a law professor at Stanford University and former member of the S.E.C.
While there are accounting rules that govern how and when companies should record revenue, there is also a lot of flexibility given to management and their accountants to determine just how to apply those rules. The purpose of reserves is to reflect a company's true revenue -- how much it will actually end up collecting in a given period if customers return merchandise or fail to pay their bills. But these accounting practices do ''open up the door to earnings management, if not done right,'' said Jack T. Ciesielski, who writes the Analyst's Accounting Observer, a Baltimore newsletter on accounting.
In Microsoft's case, the company may have reserved too much, which would mean that it may have understated its profit.
Microsoft has set aside about $4 billion in what it calls ''unearned revenues'' as a result of the way it sells both its Windows operating system products and its Office suite of software applications. The company often sets revenue aside to account for upgrades and components that may be delivered later during the product life. It also sells some products on a license or subscription basis, and sets revenue aside there as well.
But Microsoft also sets aside non-public reserves for bad debts, returned products and other related business contingencies, and it is possible that the S.E.C. investigation is related to those practices.
In a separate announcement yesterday that the company said was unrelated to the S.E.C. investigation, Mr. Maffei said Microsoft was making a series of changes in its accounting practices that would have only a small effect on its financial results.
He said the company would reclassify earnings and costs for several of
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its smaller businesses including product support, consulting, certification and consumer Internet service provision from 1997 to the present. The changes will have only a small effect on the company's financial results, which will be reported July 19, he said.
The changes will add about $761 million to the company's revenue for the first three quarters of 1999 but will also have an effect on its expenses, so the net impact will be an addition to its earnings of about 1 cent a share, Mr. Maffei said.
''The important aspect of the call was that the current tone of business was favorable and the quarter remains strong,'' said Christopher Galvin, a financial analyst at Hambrecht & Quist in San Francisco.
The company has still not made enough information public to provide analysts with detailed information on the profitability of its MSN Internet business, Mr. Galvin said, adding, ''There's still room for them to obfuscate.''
Copyright © 1999 Dow Jones & Company, Inc. All Rights Reserved.
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Lifting Spirits On Wall Street, Microsoft Profit Beats Forecasts By STEVE LOHR
10/20/1999 The New York Times Page 1, Column 6 c. 1999 New York Times Company
The Microsoft Corporation reported quarterly earnings yesterday that convincingly surpassed Wall Street's expectations and reflected strong demand for personal computers and their software.
. .
Microsoft's earnings per share, after excluding the gain from the sale of one business, rose 36 percent, to 38 cents a share. The consensus estimate of Wall Street analysts had been for profit of 34 cents a share for the quarter, which ended on Sept. 30. The result was ahead, as well, of the so-called whisper number of 35 cents a share, the estimate analysts mention to favored clients, which may differ from their published earnings projections.
Microsoft's revenue increased 28 percent, to $5.38 billion, up from $4.19 billion in the quarter a year earlier. Including a $156 million gain from the sale of the entertainment city-guide portion of its MSN Sidewalk on-line service, Microsoft's net income rose more than 30 percent, to $2.19 billion, up from $1.68 billion a year earlier. The 1998 results had included a $160 million gain from the sale of a software subsidiary, Softimage.
Company executives were sharply questioned about one balance-sheet item: a decline of $110 million from the June quarter in deferred revenue, to just under $4.13 billion. The reason analysts focus on this item is that they regard it as a financial cushion: the time when Microsoft recognizes revenue on its software licenses to corporations can sharply affect the quarterly earnings. Recognizing more revenue in a particular quarter can give a one-time lift to that quarter's earnings. Mr. Maffei said the drop from the June quarter reflected seasonality in the business.
Microsoft's quarterly statements, and the follow-up conference call with securities analysts and reporters, are scrutinized as much for nuance as for numbers. The performance this time was intended to emphasize that the company is successfully making the transition to becoming an Internet software company.
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DEXTER CORPORATION STATEMENT OF FINANCIAL POSITION
DECEMBER 31 IN THOUSANDS OF DOLLARS 1999 1998 1997
ASSETS CURRENT ASSETS: CASH $ 9,043 $ 8,566 $ 11,273 SHORT-TERM SECURITIES 77,807 102,483 57,033 ACCOUNTS RECEIVABLE, NET 181,726 203,872 185,257
INVENTORIES: MATERIALS AND SUPPLIES 56,451 65,180 61,233 IN PROCESS AND FINISHED GOODS 122,551 129,175 117,467 LIFO RESERVE (15,507) (17,388) (18,799) 163,495 176,967 159,901
CURRENT DEFERRED TAX ASSETS 23,176 14,874 17,107 PREPAID AND DEFERRED EXPENSES 9,307 10,768 9,881 464,554 517,530 440,452 PROPERTY, PLANT AND EQUIPMENT: LAND 27,594 30,879 28,501 BUILDINGS AND IMPROVEMENTS 175,551 193,594 184,388 MACHINERY AND EQUIPMENT 457,314 509,406 474,079 CONSTRUCTION IN PROGRESS 25,260 22,302 25,157 685,719 756,181 712,125 LESS ACCUMULATED DEPRECIATION (357,573) (395,725) (363,953) 328,146 360,456 348,172 INVESTMENTS OF WHOLLY OWNED CAPTIVE INSURANCE COMPANIES 5,972 8,248 9,056 INVESTMENT IN UNCONSOLIDATED AFFILIATES 286 9,861 8,704 PATENTS, TECHNOLOGY, TRADEMARKS AND COVENANTS 113,800 118,152 29,489 EXCESS OF COST OVER NET ASSETS OF BUSINESSES ACQUIRED 112,191 156,989 97,507 OTHER ASSETS 49,179 37,132 28,396 $ 1,074,128 $ 1,208,368 $ 961,776
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PAGE 22 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
DEXTER CORPORATION STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31 IN THOUSANDS OF DOLLARS 1999 1998 1997 OPERATIONS NET INCOME $ 107,499 $ 31,704 $ 56,427 NONCASH ITEMS: DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT 36,212 38,696 37,453 AMORTIZATION 19,243 11,661 7,988 GAIN ON DIVESTITURE OF PRODUCT LINES (95,011) CHARGE FOR RESTRUCTURING BUSINESSES 2,430 ACQUIRED IN-PROCESS RESEARCH & DEVELOPMENT COSTS 24,508 INCOME TAXES (PAID) NOT DUE (7,575) 4,926 (5,660) MINORITY INTERESTS 12,074 14,696 14,667 EQUITY IN NET INCOME OF AFFILIATES (405) (3,319) (4,461) OTHER (5,332) 3,299 (978) OPERATING WORKING CAPITAL (INCREASE) DECREASE (34,252) (26,781) (19,778) 34,883 97,979 84,621
INVESTMENTS
PROPERTY, PLANT AND EQUIPMENT (56,844) (54,198) (62,989) ACQUISITIONS (18,767) (217,963) (68,517) DIVESTITURES 257,935 41,539
!
!
!
PAGE 23 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
FOOTNOTES (All amounts are in thousands, unless otherwise indicated)
WORKING CAPITAL
Total working capital, including cash and short-term securities, decreased $2.5 million from 1998. Operating working capital decreased $15.4 million to $225 million at year-end 1999. The sum of cash, short-term securities, and accounts receivable exceeded total current liabilities at December 31, 1999. The following is a summary of the changes in operating and total working capital during 1999:
INCREASE (DECREASE) IN OPERATING WORKING CAPITAL AND TOTAL WORKING CAPITAL IN 1999†
BUSINESS CHANGE IN ACQUISITIONS AND CURRENCY CONSOLIDATED CASH ACCOUNTING DIVESTED TRANSLATION ACCOUNT IN THOUSANDS OF DOLLARS CHANGES ACCRUALS BUSINESSES EFFECTS BALANCES*
ACCOUNTS RECEIVABLE, NET $26,382 $ 7,975 $(51,558) $(4,945) $(22,146) INVENTORIES AT FIFO 11,393 542 (24,470) (2,818) (15,353) LIFO RESERVE (188) 2,069 1,881 PREPAID AND DEFERRED EXPENSES 802 196 (2,339) (120) (1,461) ACCOUNTS PAYABLE (6,205) 1,472 26,017 1,940 23,224 ACCRUED LIABILITIES AND EXPENSES 2,068 1,002 (3,103) 370 337 OPERATING WORKING CAPITAL 34,252 11,187 (55,453) (5,573) (15,399) CASH 7,340 72 (6,885) (50) 477 SHORT-TERM SECURITIES (22,330) (2,346) (24,676) CURRENT DEFERRED TAX ASSETS 8,302 8,302 SHORT-TERM DEBT 31,436 (156) 65 (113) 31,232 OTHER CURRENT LIABILITIES AND TAXES (5,390) (487) 1,773 (182) (4,286) WORKING CAPITAL $45,308 $18,918 $(58,431) $(8,264) $ (2,469)
Note (Additional Information)
† All amounts reported in parentheses ( ) represent credit entries to the relevant accounts. All other amounts represent debit entries.
* These amounts represent the changes in the indicated Balance Sheet accounts.
PAGE 24 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
INVENTORIES
Inventories are valued at the lower of cost or market. Inventories located in the United States represented 55% of total inventories. The LIFO (last-in, first-out) method was used for determining the cost of 59% of U.S. inventories in 1999 and 1998 and 58% in 1997. The FIFO (first-in, first-out) method was used for determining the cost of the remaining 41% of inventories in the United States and the 45% of total inventories which were located outside the United States. The reduction in levels of LIFO valued inventories (LIFO liquidation) was not significant in 1999, 1998 or 1997. Inventories at December 31 were as follows:
IN THOUSANDS OF DOLLARS 1999 1998 1997
MATERIALS AND SUPPLIES $ 56,451 $ 65,180 $ 61,233 WORK-IN-PROCESS 20,821 19,101 17,664 FINISHED GOODS 101,730 110,074 99,803 TOTAL FIFO COST 179,002 194,355 178,700 LIFO RESERVE (15,507) (17,388) (18,799) $163,495 $176,967 $159,901
ACQUISITIONS AND DIVESTITURES
During 1999 Dexter acquired a number of companies for a total of $222.1 million including transaction costs. The value of the Property, Plant and Equipment acquired in those acquisitions was $4,303.
During 1999 Dexter divested its Packaging Coatings business, including Dexter SAS, and its printed wiring board product line that was part of the Electronic Materials business. The net book value of the Property, Plant and Equipment divested was $47,582.
PAGE 25 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
PROPERTY, PLANT AND EQUIPMENT
Maintenance and repairs are charged to operations as incurred and amounted to $17 million in 1999, $18.9 million in 1998 and $18.3 million in 1997. Betterments and major renewals are capitalized. The cost of assets sold or retired and the related amounts of accumulated depreciation are eliminated from the accounts and the resulting gains or losses are included in net income.
The cost and accumulated depreciation of property, plant and equipment at December 31, were as follows:
IN THOUSANDS OF DOLLARS 1999 1998 1997
LAND $ 27,594 $ 30,879 $ 28,501 BUILDINGS AND IMPROVEMENTS 175,551 193,594 184,388 MACHINERY AND EQUIPMENT 457,314 509,406 474,079 CONSTRUCTION IN PROGRESS 25,260 22,302 25,157 TOTAL COST 685,719 756,181 712,125 LESS ACCUMULATED DEPRECIATION (357,573) (395,725) (363,953) PROPERTY, PLANT AND EQUIPMENT, NET $ 328,146 $ 360,456 $ 348,172
During 1999, Dexter acquired Property, Plant and Equipment – exclusive of business acquisitions – in the amount of $58,962. During 1999 Dexter wrote-down the original cost of its Property, Plant and Equipment in the amount of $1,189.
PAGE 26 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 1 REVENUE RECOGNITION, ACC'T REC., & CASH FLOW
ACCOUNTS RECEIVABLE
Net accounts receivable decreased in 1999 primarily due to the divestiture of product lines.
SCHEDULE II
DEXTER CORPORATION
VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (IN THOUSANDS)
COLUMN C COLUMN A COLUMN B ADDITIONS COLUMN D COLUMN E
BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER END OF DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD
1999 Environmental Reserve...... $15,316 $2,321 $12,995 Restructuring Reserve...... 471 $2,430 1,670 1,231 Allowance for Doubtful Accounts...... 7,112 1,526 3,646(a) 4,992 $22,899 $3,956 $7,637 $19,218 1998 Environmental Reserve...... $15,825 $ 509 $15,316 Restructuring Reserve...... 34 (437)(b) 471 Allowance for Doubtful Accounts...... 7,663 $ 910 1,461 7,112 $23,522 $ 910 $1,533 $22,899 1997 Environmental Reserve...... $16,336 $ 511 $15,825 Restructuring Reserve...... 74 40 34 Allowance for Doubtful Accounts...... 6,620 $2,240 $123(c) 1,320 7,663 $23,030 $2,240 $123 $1,871 $23,522
(a) Includes $2,814 resulting from business divestitures.
(b) Due to recovery of insurance claim.
(c) Due to business acquisitions.
PAGE 27 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 2 INVENTORY AND LONG-LIVED ASSETS
INVENTORY
You should already be familiar with the mechanics of inventory accounting. They are discussed in Dyckman, et al.
With steadily increasing inventory costs over time and no inventory liquidations, LIFO cost of goods sold will always exceed FIFO cost of goods sold. The reason is that the newest, most expensive costs are going into cost of goods sold under LIFO, while the oldest, least expensive costs are going into cost of goods sold under FIFO.
But recall that a firm's lifetime income is cash in - cash out. Nothing we do in financial accounting can affect cash flow, and hence nothing we do in financial accounting can affect lifetime income. So how can we reconcile that total lifetime income must be the same under both methods with NIBTF> NIBTL in every year, if we have inflation? To reconcile these assertions, consider the following example:
Example year 1 firm buys 2 units for $1 each and sell 1 unit for $10 year 2 firm buys 1 unit for $2 and sells 1 unit for $10 year 3 firm buys 1 unit for $3 and sells 1 unit for $10 year 4 firm buys 1 unit for $4 and sells 1 unit for $10 year 5 firm buys -0- units and sells 1 unit for 10 – replacement cost of unit sold = $5
PAGE 28 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 2 INVENTORY AND LONG-LIVED ASSETS
FIFO 1 2 3 4 5 sales 10 10 10 10 10 -cgs -1 -1 -2 -3 -4 NIF 9 9 8 7 6 =39 EIF 1 2 3 4 0 Realized Holding Gain 0 1 1 1 1 Unrealized Holding Gain 0 0 0 0 0
LIFO 1 2 3 4 5 sales 10 10 10 10 10 -cgs -1 -2 -3 -4 -1 NIL 9 8 7 6 9 =39 EIL 1 1 1 1 0 Realized Holding Gain 0 0 0 0 4 Unrealized Holding Gain 0 1 2 3 0
ELR 0 1 2 3 0
The Realized Inventory Holding Gain (or Loss) in a given year is the difference between the cost to replace the inventory which you sold that year and the cost of goods sold recognized on the income statement for the inventory which you sold that year, given the cost flow assumption.
The Unrealized Inventory Holding Gain (or Loss) in a given year is the difference between the cost to replace the goods in Ending Inventory and their historical cost, given the cost flow assumption.
While LIFO and FIFO net incomes differ on a year-by-year basis, lifetime income is the same under both. In the above example, all the profit that LIFO avoided recognizing in years 1-4 is recognized in year 5 when the inventory is liquidated.
PAGE 29 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 2 INVENTORY AND LONG-LIVED ASSETS
If two firms are identical in all respects except that one uses FIFO and the other uses LIFO, they can have vastly different accounting income numbers and financial ratios. Before comparing the two firms you would like to adjust for any differences in accounting methods.
In order to see how to convert a LIFO financial statement to a FIFO financial statement, define LIFO Reserve to be, for the inventory accounted using LIFO, the amount by which a company's inventory account balance under FIFO would exceed its inventory account balance under LIFO. That is:
Ending LIFO Reserve = EIF - EIL
The Ending LIFO Reserve represents how many fewer dollars LIFO has capitalized in inventory and hence how many more dollars LIFO has expensed in Cost of Goods sold as compared to FIFO since the firm has been using LIFO. The Ending LIFO Reserve thus represents the cumulative effect of using LIFO versus FIFO.
Under either LIFO or FIFO the following equality always holds:
EI = BI + Purchases – CGS + Cost of Units Added from Business Acquisitions (BA) – Cost of Units Disposed from Business Divestitures (BD)
Set up this equation for both LIFO and FIFO.
FIFO: EIF = BIF + Purchases - CGSF + BA - BDF
LIFO: EIL = BIL + Purchases - CGSL + BA - BDL
Subtract the second equation from the first:
(EIF - EIL ) - (BIF - BIL ) = CGSL - CGSF + BDL - BDF (B)
LIFO Reserve = Difference in this year's CGS between LIFO and FIFO + Difference between LIFO and FIFO Cost of the Inventory Units Disposed as part of a Business Divestiture (B').
PAGE 30 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 2 INVENTORY AND LONG-LIVED ASSETS
Adding and subtracting (Revenue - other expenses) to the right side of (B') we see that:
Change in LIFO Reserve = Before Tax NIF - Before Tax NIL (B") . regardless of how much inventory is accounted for under LIFO
The left-hand side of equation (B") is this year's Balance Sheet effect of using LIFO rather than FIFO, the right-hand side is this year's before tax income statement effect.
Equation (B") indicates how one can convert from a LIFO income statement to a FIFO income statement using information contained either in the LIFO balance sheet or in the footnotes to LIFO financial statements. In particular, the SEC requires that all registered companies using LIFO for any part of their inventory report their LIFO reserves for the start and end of the year. Therefore one can always convert a LIFO firm to FIFO but one cannot usually go in the opposite direction.
An alternative approach to computing this conversion is to use the following t-account analysis 1. set up inventory and cost of goods sold t-accounts for LIFO 2. derive the inventory purchases number using the inventory t-account 3. set up FIFO inventory account using LIFO reserve numbers, put in the number for purchases and solve for FIFO cost of goods sold.
In an earlier example, we saw what happens when a LIFO inventory layer is liquidated. Some of the profits which you have avoided recognizing by being on LIFO get recognized in the year of the liquidation. Inventory is typically aggregated into several pools, with similar product lines in each pool. Firms disclose the aggregate effect of any inventory liquidations, across all of their pools, in their inventory footnote. Also, note that a firm can simultaneously disclose liquidating profits related to a specific pool, and still report an increase in total inventory.
DISCLOSURE DEXTER CORP. As an example of inventory disclosure refer to the excerpts from the Dexter Corp. 1999 Annual Report in the Lecture 1 Notes.
PAGE 31 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 2 INVENTORY AND LONG-LIVED ASSETS
Try to answer the following questions:
Questions: Did Dexter Corp. liquidate any of its LIFO inventories during 1999?
By what amount would Dexter Corp.’s Cost of Goods Sold for 1999 have changed (from the amount reported) if it had always used the FIFO method, exclusively, to account for all of its inventory rather than the LIFO method to account for some of them?
What is the cumulative amount of additional NIBT which Dexter Corp. would have recognized, as of the end of 1999, if it had always accounted for all of its inventory using the FIFO method?
What was the net book value of the inventory which Dexter Corp. sold with the assets of the businesses it divested in 1999?
If its income tax rate is 35%, what was the total amount of income taxes saved (paid) by Dexter as of the end of 1999 as a result of using the LIFO method rather than the FIFO method to account for some of its inventories?
PAGE 32 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 INVENTORY & LONG-LIVED ASSETS
LONG-LIVED ASSETS
The topic of accounting for long-lived assets is fairly straightforward and covered in Dyckman, et al.
We will summarize the property, plant, and equipment transactions using the T-accounts below:
Historical Cost of Property, Plant, and Equipment Beginning balance Disposals 1
Purchases related to normal business activity or as part of business acquisitions: including capitalized value of newly leased property, plant, and equipment and expenditures for improvements and betterments Write downs 2- permanent impairments Capitalized interest FCTA & Other (could be debits) Ending balance
Accumulated Depreciation of Property, Plant and Equipment Beginning balance
Disposals3 Depreciation costs for the current period (includes both expensed and capitalized depreciation costs)
FCTA & other (could be debits) Ending balance
1Disposals are measured at the historical cost of the property, plant and equipment disposed. 2Write downs could be a credit to accumulated depreciation instead. 3Disposals in the accumulated depreciation account are measured at the accumulated depreciation of the property, plant and equipment disposed.
PAGE 33 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 INVENTORY & LONG-LIVED ASSETS
Book Value of Property, Plant, and Equipment Beginning balance
Purchases related to normal business activity and business acquisitions Write downs - permanent impairments Net Book Value of PP&E disposals
Depreciation costs for the current period (includes both expensed and capitalized depreciation costs)
Capitalized interest FCTA & Other (could be debits) Ending balance
The income statement from the typical property, plant, and equipment transactions would look like
revenue - cgs -depreciation expense - loss on write downs +/- gain/loss on disposal of ppe Net Income
The indirect cash funds statement would look like
Cash from Operating Activities: NI + depreciation expense +/- Loss/Gain on sale or disposal of PPE + Loss on writedown of PPE
Cash from Investing Activities: - Cash used for the purchase of PPE + Cash Proceeds from sale of PPE
PAGE 34 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 INVENTORY & LONG-LIVED ASSETS
Note that the depreciation expense add-back is only for the depreciation expensed, not capitalized. Alternatively one could add back all of the depreciation recognized and subtract out the amount of depreciation capitalized through the adjustment for the change in inventory.
DISCLOSURE DEXTER CORP.
Refer to the excerpts from Dexter Corp.’s 1999 Annual Report and 10-K in the Lecture 1 Notes. Try to answer the following questions about Dexter.
Additional Information Dexter records all of the depreciation on its Property, Plant and Equipment as an expense – that is, none is capitalized.
Dexter did not record capitalized interest for 1999.
For 1999, Dexter recorded a reduction of $3,505 to the Accumulated Depreciation account as a result of FCTAs.
Questions: What was the amount of the accumulated depreciation for the Property, Plant and Equipment which was disposed of (i.e. divested) in 1999?
What was the net book value of the Property, Plant and Equipment which was disposed of (i.e. divested) in 1999?
What was the amount of the Property, Plant and Equipment acquired by Dexter in 1999 – by means other than by business acquisition?
What was the amount of the Property, Plant and Equipment acquired – by other than business acquisition – in 1999 and that was paid for using assets (or liabilities) other than cash?
PAGE 35 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 INVENTORY & LONG-LIVED ASSETS
What was the amount of the foreign currency translation adjustment to the Property, Plant and Equipment, net account in 1999? Was the entry a debit or credit to the account?
PAGE 36 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
LONG TERM DEBT & LEASING
LONG TERM DEBT
Bonds
In these notes, I will assume that you understand the concept of present value and how to compute it, as well as the mechanics of accounting for bonds. Bonds are valued using the effective interest method. These transactions are covered in Dyckman, et al.
Bonds can be retired in a number of ways. We record the journal entries for several of the ways below.
1. retire debt at maturity In the year prior to maturity we must reclassify the debt as current
bonds payable current maturities of long-term debt
In the year of retirement the journal entry is
current maturities of long-term debt Cash
2. retire debt prior to maturity a) If you retire the bonds with cash the journal entry is
Bonds Payable Unamortized Discount Cash Gain (or loss)
PAGE 37 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
b) If you retire the bonds with equity (a debt-equity swap) the journal entry is
Bonds Payable Unamortized discount C.S. - Par C.S. - Excess Gain (or loss)
Until April of 2002, any gain or loss on the retirement of debt was shown as an extraordinary item, net of taxes, on the income statement. For periods after April 2002, these gains and losses are no longer considered extraordinary and no longer shown net of taxes.
We summarize the effects of the usual long-term debt transactions on the associated T- accounts below
Face Value of Long-Term Debt Transfer to the current portion of long- Beginning balance -- Long-term debt that has term debt -- long-term debt scheduled not yet been transferred to the current portion of during the next year long-term debt. New Issues -- face value Face value retired prior to maturity -- early Additions related to business acquisitions -- debt that extinguishments was on the acquired firm's books prior to an acquisition, not debt used to finance the acquisition FCTAs and other (The latter is included in new issues) (could be credits ) Transfers from short-term debt -- in special cases short-term debt can be reclassified as non-current Ending balance
Unamortized Debt Discount Beginning balance -- unamortized discount for the debt in the beginning Period's amortization balance of the face value of long-term debt FCTAs and other (could be debits)
New issues - original discount Early retirements
Transfers to a contra account associated with the Additions related to business acquisitions current portion of long-term debt Ending balance
PAGE 38 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
Because the book value of debt is its face value less its unamortized discount, these accounts can be combined as follows:
Book Value of Long-Term Debt Beginning balance Transfers to the current portion of long- term debt New issues - face value less the original discount
Book value retired prior to maturity Period's amortization
FCTAs & other Book value of additions related to business (could be credits) acquisitions
Transfers from short-term debt Ending balance
You will also need to know the transactions that affect the current portion of long-term debt:
Current Portion of Long-Term Debt Beginning balance -- Long-term debt scheduled Payment of scheduled retirements -- to mature during the current year that was trans- Usually we will assume that this matches ferred at the close of the prior year. the beginning balance. Alternatively stated, all of the debt that is scheduled Business acquisitions for retirement is retired. Transfer from long-term debt -- this debt is scheduled for retirement next period. Usually we will assume that this amount matches the ending balance. Business disposals FCTAs & other (could be debits) Ending balance
The following would be the income statement effect for various long-term debt transactions Sales Revenue - CGS - Interest expense +/- Gain/loss on early retirement of bonds NI
PAGE 39 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
The following would be the indirect cash statement effect of these transactions
Cash from Operating Activities: NI + Interest payable account +/- amortization of discount/premium +/- loss/gain from early retirement
Cash from Financing Activities: - cash payments to retire prior to and at maturity + cash proceeds form new issue
Mortgages
Another type of long-term debt, in addition to bonds, is mortgages. Like bonds, in accounting for mortgages we use the effective interest method. Unlike bonds, mortgages represent an annuity or constant series of payments. With mortgages, each payment represents not only interest, but a partial return of capital. To illustrate the accounting for mortgages, consider a mortgage with a constant payment of 5, for four years, compounded at 5% annually. The journal entries are:
a. when borrow the money - the amount of mortgage principal which is due this year is classified as a current liability (CMLTD, i.e., current maturities of long term debt)
cash 17.72915 mort/p 13.6162375 cmltd 4.1135125
b. first interest accrual and payment at end of first year and the reclassification of the principal due within one year.
PAGE 40 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
int exp .8864875 cmltd 4.1135125 cash 5.
mort/p 4.319188 cmltd 4.319188
DISCLOSURE GENERAL MILLS
Refer to the following excerpts from the General Mills Annual Report. Try to answer the following questions.
What were the fiscal 1996 beginning and ending net book values of General Mills total long-term debt?
How much of the above was due within one year?
What was the net book value of the long-term debt issued for cash in fiscal 1996?
Try to estimate the amount of the debt discount or premium amortized during fiscal 1996.
Were there any retirements of long-term debt during fiscal 1996? If so, how much cash was paid to retire them?
Was there any long-term debt scheduled to be retired during fiscal 1996? How much?
Explain how General Mills treats the notes payable reclassified as long-term debt on the Balance Sheet and on the Statement of Cash Flows.
PAGE 41 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
GENERAL MILLS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
Fiscal Year Ended ------MAY 26, May 28, May 29, In Millions 1996 1995 1994 ------Cash Flows - Operating Activities: Earnings from continuing operations $476.4 $259.7 $336.5 Adjustments to reconcile earnings to cash flow: Depreciation and amortization 186.7 191.4 173.8 Deferred income taxes 42.4 59.0 (34.0) Change in current assets and liabilities, net of effects from business acquired (25.9) (227.8) (79.1) Unusual expenses - 183.2 146.9 Other, net (3.2) (8.1) 17.2 ------Cash provided by continuing operations 676.4 457.4 561.3 Cash provided (used) by discontinued operations (16.6) 210.1 259.3 ------Net Cash Provided by Operating Activities 659.8 667.5 820.6 ------Cash Flows - Investment Activities: Purchases of land, buildings and equipment (128.8) (156.5) (212.5) Investments in businesses, intangibles and affiliates, net of dividends (40.0) (48.8) (140.7) Purchases of marketable securities (21.6) (21.7) (83.8) Proceeds from sale of marketable securities 22.5 49.1 33.7 Proceeds from disposal of land, buildings and equipment 6.2 1.2 3.3 Proceeds from disposition of businesses - 188.3 - Other, net (11.3) (27.5) (45.9) Discontinued operations investment activities, net - (357.5) (336.3) ------Net Cash Used by Investment Activities (173.0) (373.4) (782.2) ------Cash Flows - Financing Activities: Increase (decrease) in notes payable (42.4) (330.4) 93.2 Issuance of long-term debt 42.3 135.0 273.6 Payment of long-term debt (164.7) (117.2) (79.1) Common stock issued 38.0 24.3 13.3 Purchases of common stock for treasury (35.6) (57.7) (145.7) Dividends paid (303.6) (297.2) (299.4) Other, net (13.2) (13.6) (4.2) Discontinued operations financing activities - 347.9 ------Net Cash Used by Financing Activities (479.2) (308.9) (148.3) ------Increase (Decrease) in Cash and Cash Equivalents 7.6 (14.8) (109.9) Cash and Cash Equivalents - Beginning of Year 13.0 27.8 137.7 ------
PAGE 42 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
Cash and Cash Equivalents - End of Year $20.6 $13.0 $27.8 ------
Cash Flow from Changes in Current Assets and Liabilities: Receivables $(59.5) $(11.9) $(11.5) Inventories (23.7) (52.7) (76.1) Prepaid expenses and other current assets (6.3) (11.9) (22.2) Accounts payable 93.2 (18.1) (5.7) Other current liabilities (29.6) (133.2) 36.4 ------Change in Current Assets and Liabilities $(25.9) $(227.8) $(79.1) ------
PAGE 43 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
MANAGEMENT'S DISCUSSION OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS IN 1996 VS. 1995
FINANCIAL CONDITION The accompanying table, when reviewed in conjunction with the capital structure table, shows the composition of our debt structure including the impact of derivatives.
DEBT STRUCTURE Dollars in Millions MAY 26, 1996 May 28, 1995 ------
Floating-rate debt $ 280.3 18% $ 347.9 20% Fixed-rate debt 985.8 62 1,090.4 61 Leases - debt equivalent 159.4 10 165.0 9 Deferred income taxes - tax leases 157.5 10 169.1 10 ------Total debt $1,583.0 100% $1,772.4 100% ------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------
NOTE SEVEN: FINANCIAL INSTRUMENTS AND RISK MANAGEMENT
Most of our financial instruments are recorded on the balance sheet. A few (known as "derivatives") are off-balance-sheet items. Derivatives are financial instruments whose value is derived from one or more underlying financial instruments. Examples of such underlying instruments are currencies, equities, commodities and interest rates. The carrying amount and fair value of our financial instruments at the balance-sheet dates are as follows:
PAGE 44 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
MAY 26, 1996 May 28, 1995 ------CARRYING FAIR Carrying Fair In Millions AMOUNT VALUE Amount Value ------
ASSETS AND LIABILITIES ------Assets: Cash and cash equivalents $ 20.6 $ 20.6 $ 13.0 $ 13.0 Receivables 337.8 337.8 277.3 277.3 Marketable securities 215.1 215.1 216.3 216.3 Liabilities: Accounts payable 590.7 590.7 494.0 494.0 Debt 1,437.9 1,515.7 1,607.5 1,689.6 DERIVATIVES RELATING TO: ------Marketable securities (2.8) (2.8) (1.6) (1.6) Debt - 3.1 - 1.3
The fair values were estimated using current market quotes and interest rates. Gains or losses from derivatives offset and neutralize the corresponding losses or gains from the asset or liability being hedged. We ensure that these derivative instruments correlate with the asset or liability being hedged, and we do not issue or hold derivatives for trading or speculative purposes. We use derivative instruments to reduce financial risk in three areas: interest rates, foreign currency and commodities. The notional amounts of derivatives do not represent actual amounts exchanged by the parties and, thus, are not a measure of the exposure of the Company through its use of derivatives. Interest rate swap and foreign exchange agreements are made with a diversified group of highly rated financial institutions, whereas commodities agreements are entered into through various regulated exchanges. We have credit exposure associated with these agreements to the extent that the instruments have a positive fair value, but we do not anticipate any losses. The Company does not have a significant concentration of risk with any single party or group of parties in any of its financial instruments.
PAGE 45 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
NOTE EIGHT: NOTES PAYABLE
The components of notes payable and their respective weighted average interest rates at the end of the period are as follows:
MAY 26, 1996 May 28, 1995 ------Weighted Weighted Average Average Notes Interest Notes Interest $ in Millions Payable Rate Payable Rate ------U.S. commercial paper $ 15.0 5.2% $ 78.3 6.1% Canadian commercial paper 19.9 4.8 22.8 7.7 Financial institutions 281.7 5.4 261.8 6.4 Amounts reclassified to long-term debt (175.0) - (250.0) ------Total notes payable $141.6 $112.9 ------
We have a revolving credit agreement expiring in December 2000 that provides for the fee-paid credit lines. This agreement provides us with the ability to refinance short-term borrowings on a long-term basis, and therefore we have reclassified a portion of our notes payable to long-term debt.
PAGE 46 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
NOTE NINE: LONG-TERM DEBT
MAY 26, May 28, In Millions 1996 1995 ------Medium-term notes, 5.2% to 9.1%, due 1996 to 2033 $978.1 $1,094.4 Zero coupon notes, yield 11.1%, $284.0 due August 15, 2013 44.5 43.1 8.2% ESOP loan guaranty, due through June 30, 2007 70.4 74.5 Zero coupon notes, yield 11.7%, $64.4 due August 15, 2004 25.3 22.6 Notes payable, reclassified 175.0 250.0 Other 3.0 10.0 ------1,296.3 1,494.6 Less amounts due within one year (75.4) (93.7) ------Total long-term debt $1,220.9 $1,400.9 ------
In 1996, we issued $35.0 million of debt under our medium-term note program with maturities from five to 12 years and interest rates from 5.2% to 7.2%. In 1995, $125.0 million of debt was issued under this program with maturities from two to 12 years and interest rates from 6.4% to 8.0%.
The sinking fund and principal payments due on long-term debt are (in millions) $75.4, $150.6, $84.7, $90.0 and $62.3 in fiscal years ending 1997, 1998, 1999, 2000 and 2001, respectively. The notes payable that are reclassified under our revolving credit agreement are not included in these principal payments.
PAGE 47 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
LEASING
In a lease, the owner (lessor or landlord) of property permits someone else (lessee or tenant) to use the property for a specified period of time in exchange for periodic cash payments. The major question in accounting for leases is: "When does the right to use leased property and the obligation to make payments on that lease represent an asset and a liability to the lessee?" That is, when is a leasing agreement in substance a purchase and a form of debt financing, and hence should be accounted for simultaneously as a loan and purchase of asset?
If the lease is judged to be in substance a purchase (called a capital lease), then the lessee must recognize the asset and liability on his/her balance sheet. The asset is accounted for as any other piece of Property, Plant and Equipment. The liability is accounted for as any other mortgage liability. If the lease is judged not to be in substance a purchase (called an operating lease) no asset or liability is recognized.
For a capital lease, at the inception of the lease, the asset and liability are recorded at the present value of the minimum lease payment (which includes the minimum rental payments and any bargain purchase option) discounted at some appropriate interest rate, or the fair market value of the leased asset, whichever is less. Note that, as with bonds and mortgages, any principal repayment to be made within a year must be reclassified as a current maturity (CMLT Lease). As with mortgages, this principal repayment is the difference between the year-end scheduled cash repayment and the interest expense for this year. Accounting for lease liabilities is done using the effective interest method.
For a lessee, a lease is considered to be a Capital lease if it is noncancelable and meets one or more of following for lessee:
lease transfers ownership to lessee at end of lease term
lease contains a bargain purchase option
lease term equals 75% or more of the asset’s remaining economic life
present value of minimum lease payments > 90% of leased asset's fair market value. Otherwise it is an operating lease.
PAGE 48 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
Consider the following lease accounting example
lease is 5 years $20,000 per year in arrears
interest rate = 10%
present value = 3.79079 x 20,000 = 75,815.8
fair market value of asset = $76,000 if the lease doesn’t satisfy any of the criteria = operating lease
every year the lessee makes the following entry
Rent Expense 20,000
Cash 20,000
if the lease does satisfy one or more of criteria = capitalized lease
at inception
Asset 75,815.8
Lease Liability 75,815.8
next, you must reclassify that part of the principal which is due within the next year as a current liability (current maturity of long term lease liability, or cmltl)
Lease Liability 12,418.42
CMLTL 12,418.42
at end of first accounting period
Amort expense 15,163
Accum. Amort 15,163
PAGE 49 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
CMLTL 12,418.42
Interest Expense 7581.58
Cash 20,000
Lease Liability 13,660.27
CMLTL 13,660.27
at end of second accounting period
Amort expense 15,163
Accum Amort 15,163
CMLTL 13,660.27
Interest Expense 6339.73
Cash 20,000
Lease Liability 15,026.29
CMLTL 15,026.29
PAGE 50 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
The process continues through year 5. Total expense over life of lease is same under both methods only timing is different.
Depr. Exp. Int. Exp. TOTAL 15,163 7581.58 15,163 6339.73 15,163 4973.71 15,163 3471.08 15,163 1818.19 75,815 24,184.29 99,999.29 = same as expense under operating lease. = 5 *20,000 = 100,000
DISCLOSURE – HILLS STORES COMPANY
For a detailed example of lease disclosure refer to the following parts of Hills Stores Company fiscal 1997 Annual Report on the following pages.
For the purposes of this case, please make the following assumptions: i. “Fiscal 1998” refers to the 52 weeks ending January 31, 1999. ii. “Fiscal 1997” refers to the 52 weeks ending January 31, 1998. iii. “Fiscal 1996” refers to the 52 weeks ending February 1, 1997. iv. During fiscal 1998 there will be no capitalized lease retired prior to maturity. v. During fiscal 1997 there were capitalized leases retired at and prior to maturity. vi. The fiscal 1996 ending balance of Hill’s current portion of capital leases liability was paid off in full, and in cash, as scheduled during fiscal 1997.
PAGE 51 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
vii. The fiscal 1997 ending balance of Hill’s current portion of capital leases liability was paid off in full, and in cash, as scheduled during fiscal 1998. viii. All new leases start at the end of the fiscal year. ix. There were no FCTAs, write-downs, business acquisitions, business divestitures, or capitalized interest associated with Hills’ capital lease assets or capital lease liabilities during fiscal 1997. x. During fiscal 1997, $2,200 (in thousands) of capital leases were entered into by Hills. xi. During fiscal 1997, in total, capital leased assets with a net book value of 1,200 (in thousands) were retired at and prior to maturity.
Try to answer the following questions:
At the end of fiscal 1997, what is the historical cost of property under capital leases?
What is the amount of expense relating to operating leases that Hills expects to recognize in fiscal 1998?
What is Hills’ fiscal 1998 journal entry to recognize the payment of interest and principal relating to capital leases?
During fiscal 1997, what was the historical cost of capital leases that were retired both at and prior to maturity?
What was the amount of amortization expense related to capital leases that Hills recognized during fiscal 1997?
What was the net book value of the obligations under capital leases that were discharged during fiscal 1997 when Hills retired capital leases prior to maturity?
PAGE 52 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
HILLS STORES COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
January 31, February 1, (dollars in thousands) 1998 1997
ASSETS Current assets: Cash and cash equivalents $ 37,523 $ 66,163 Accounts receivable, less allowance for doubtful accounts of approximately $5,500 and $4,500 21,869 24,346 Inventories 340,719 341,477 Deferred tax asset, net (Note 16) 26,933 32,991 Other current assets 5,542 5,115 ------Total current assets 432,586 470,092
Property and equipment, net (Note 2) 183,112 173,701 Property under capital leases, net (Note 7) 102,350 112,201 Deferred tax asset, net (Note 16) 28,592 21,585 Reorganization value in excess of amounts allocable to identifiable assets, net (Notes 1 and 3) 89,112 97,508 Other assets, net (Note 1) 40,748 18,418 ------$882,581 $900,353
LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of capital leases and financial obligations (Note 7) $ 10,541 $ 7,255 Current portion of long term debt (Note 6) 500 - Accounts payable, trade 110,329 111,064 Other accounts payable and accrued expenses (Note 4) 77,803 81,752 ------Total current liabilities 199,173 200,071
Long term debt (Note 6) 204,500 195,000 Obligations under capital leases (Note 7) 113,919 120,539 . . . .
PAGE 53 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
HILLS STORES COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Fiscal Year Fiscal Year Fiscal Year Ended Ended Ended January 31, February 1, February 3, 1998 1997 1996 (in thousands) (52 Weeks) (52 Weeks) (53 Weeks)
CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ($ 9,015) ($ 35,058) ($ 16,666) Adjustments to reconcile net loss to net cash provided by (used for) operating activities: Depreciation and amortization 36,845 35,130 31,784 Amortization of deferred financing costs 2,538 5,942 4,847 Deferred income taxes ( 949) ( 12,332) ( 11,260) . . . Other, net 96 ( 330) ( 1,962) ------Net cash provided by (used for) operating activities 28,663 47,519 ( 20,587)
CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures ( 34,267) ( 32,858) ( 56,714) Deferred software expenditures ( 24,828) ------Net cash used for investing activities ( 59,095) ( 32,858) ( 56,714)
CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from secured term loan 10,000 - - Proceeds from issuance of 12 1/2% Senior Notes - 195,000 - Fees incurred with the issuance of 12 1/2% Senior Notes - ( 8,100) - Redemption of 10.25% Senior Notes - ( 160,000) - Principal payments under capital lease obligations ( 7,099) ( 6,467) ( 6,121) . . . .
PAGE 54 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
HILLS STORES COMPANY AND SUBSIDIARIES NOTES TO THE FINANCIAL STATEMENTS
7. LEASE COMMITMENTS ------The Company's operations are conducted predominantly in leased properties which consist principally of retail outlets. Leases are generally for periods between twenty to thirty years plus renewal options and generally include fixed rentals and rentals based on sales in excess of predetermined levels.
The composition of property under capital leases, net of accumulated amortization, is shown below (in thousands): January 31, February 1, 1998 1997 ------Retail outlets $138,094 $138,094 Other 982 982 ------139,076 139,076 Accumulated amortization ( 36,726) ( 26,875) ------Property under capital leases, net $102,350 $112,201 ======
PAGE 55 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 3 LONG TERM DEBT & LEASING
Minimum future lease commitments under noncancelable leases in effect at January 31, 1998 are listed below (in thousands):
Capital Financing Operating Fiscal years: Leases Obligations Leases Total ------1998 $ 19,488 $ 8,369 $ 35,290 $ 63,147 1999 19,159 7,699 30,817 57,675 2000 17,396 7,789 27,742 52,927 2001 16,931 6,257 24,906 48,094 2002 16,546 8,393 21,926 46,865 Thereafter 151,754 17,389 122,674 291,817 ------Minimum rental commitments 241,274 $55,896 $263,355 $560,525 ======Less amount representing interest 120,579 21,796 ------Present value of net minimum lease payments 120,695 34,100 Current portion ( 6,776) ( 3,765) ------$113,919 $30,335 ======
PAGE 56 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
SHAREHOLDERS' EQUITY
Comprehensive Income
The Financial Accounting Standards Board has, through the years, enlarged the number of assets and liabilities which they require to be reported at market value on the balance sheet. That means that at the end of every period, these asset and liability accounts have to be revalued, i.e., written up or down. The issue remains whether the asset or liability revaluations on the balance sheet should result in gains or losses on the income statement. In those cases in which a gain or loss is recognized on the income statement, Retained Earnings is increased or decreased, thereby balancing the balance sheet.
In several cases, the FASB has ruled that these required asset or liability revaluations should not result in gains or losses on the income statement. But if you are going to, for example, write up an asset (i.e., debit it), and you don’t want to credit a gain (i.e., income statement) account, how is the balance sheet to balance? For those asset and liability revaluations which are required but for which recognizing gains or losses are not allowed, the offsetting entry goes to a Shareholders’ Equity account called, Accumulated Other Comprehensive Income.
Other Comprehensive Income includes changes in: 1. the market value of certain equity securities 2. the market value of certain derivative/hedging securities 3. the book value of foreign currency denominated assets and liabilities due to foreign currency translations 4. certain pension liabilities.
We have studied examples of the third type of changes earlier in the course. We will study examples of the first type next session.
The Harley – Davidson Statement of Income, Balance Sheet and Statement of Shareholders’ Equity below illustrates Income and Accumulated Other Comprehensive Income disclosures.
PAGE 57 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
HARLEY-DAVIDSON, INC. CONSOLIDATED STATEMENTS OF OPERATIONS Years ended December 31, 1998, 1997 and 1996 (In thousands, except per share amounts) 1998 1997 1996 ------Net sales $2,063,956 $1,762,569 $1,531,227 Cost of goods sold 1,373,286 1,176,352 1,041,133 ------Gross profit 690,670 586,217 490,094 Operating income from financial services 20,211 12,355 7,801 Selling, administrative and engineering (377,265) (328,569) (269,449) ------Income from operations 333,616 270,003 228,446 Interest income, net 3,828 7,871 3,309 Other, net (1,215) (1,572) (4,133) ------Income from continuing operations before provision for income taxes 336,229 276,302 227,622 Provision for income taxes 122,729 102,232 84,213 ------Income from continuing operations 213,500 174,070 143,409 Discontinued operations: Gain on disposition of discontinued operations, net of applicable income taxes - - 22,619 ------
Net income $ 213,500 $ 174,070 $ 166,028 ------
PAGE 58 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
HARLEY-DAVIDSON, INC. CONSOLIDATED BALANCE SHEETS December 31, 1998 and 1997 (In thousands, except share amounts) ASSETS 1998 1997 ------Current assets: Cash and cash equivalents $ 165,170 $ 147,462 Accounts receivable, net 113,417 102,797 Finance receivables, net 360,341 293,329 Inventories 155,616 117,475 Deferred income taxes 29,076 24,941 Prepaid expenses 21,343 18,017 ------Total current assets 844,963 704,021 Finance receivables, net 319,427 249,346 Property, plant, and equipment, net 627,759 528,869 Deferred income taxes - 3,001 Goodwill 51,197 38,707 Other assets 76,863 74,957 ------$1,920,209 $1,598,901 ------
PAGE 59 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 122,722 $ 106,112 Accrued and other liabilities 199,051 164,938 Current portion of finance debt 146,742 90,638 ------
Total current liabilities 468,515 361,688 Finance debt 280,000 280,000 Long-term liabilities 67,376 62,131 Postretirement health care benefits 72,083 68,414 Deferred income taxes 2,324 - Commitments and contingencies (Note 7) Shareholders' equity: Series A Junior Participating preferred stock, none issued - -
Common stock, 158,405,584 and 157,241,441 shares issued in 1998 and 1997, respectively 1,584 1,572 Additional paid-in capital 211,960 187,180 Retained earnings 873,171 683,824 Accumulated other comprehensive income (loss) 1,128 (2,835) ------1,087,843 869,741
Less: Treasury stock (5,473,969 and 4,916,488 shares in 1998 and 1997, respectively), at cost (57,133) (41,959) Unearned compensation (799) (1,114) ------Total shareholders' equity 1,029,911 826,668 ------$1,920,209 $1,598,901 ------
PAGE 60 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
HARLEY-DAVIDSON, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years ended December 31, 1998, 1997 and 1996 (In thousands, except share amounts)
------
Accumulated Common Stock other comp------Additional rehensive Issued paid-in Retained income Shares Balance Capital Earnings (Loss) ------
Balance December 31, 1997 157,241,441 1,572 187,180 683,824 (2,835)
Comprehensive income: Net income ------213,500 -- Other comprehensive income - Foreign currency translation adjustment, net of taxes of ($2,278) ------3,963 Comprehensive income Dividends ------(24,153) -- Repurchase of common stock ------Acquisition of Buell Motorcycle Company -- -- 996 -- -- Amortization of unearned compensation ------Exercise of stock options 1,164,143 12 11,121 -- -- Tax benefit of stock options -- -- 12,663 -- --
Balance December 31, 1998 158,405,584 $ 1,584 $ 211,960 $ 873,171 $ 1,128 ------
Unearned Treasury comp- Stock ensation Total ------
Unearned Treasury comp- Stock ensation Total ------
Balance December 31, 1997 (41,959) (1,114) 826,668
Comprehensive income:
PAGE 61 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Net income -- -- 213,500 Other comprehensive income - Foreign currency translation adjustment, net of taxes of ($2,278) -- -- 3,963 ------Comprehensive income 217,463 Dividends -- -- (24,153) Repurchase of common stock (15,175) -- (15,175) Acquisition of Buell Motorcycle Company 1 -- 997 Amortization of unearned compensation -- 315 315 Exercise of stock options -- -- 11,133 Tax benefit of stock options -- -- 12,663 ------Balance December 31, 1998 $ (57,133) $ (799) $ 1,029,911 ------
PAGE 62 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Stock Transactions The three basic types of stock in the owners' equity section of the balance sheet are common stock, preferred stock, and treasury stock. The usual transactions involving each are discussed in Dyckman et al.
Stock Grants A firm can grant an employee stock in the company, subject to certain restrictions on its use, as a form of compensation. These stock grants are therefore referred to as restricted stock grants.
Assume that a company grants 1 share when the stock is trading at $5 per share. Assume that the share's par value is $1. If the stock is for past services, then the company records:
at the granting of the stock
compensation expense 5 IS capital stock-par 1 BS additional paid in capital 4 BS
If the stock is for future services, then the company records:
at the granting of the stock
deferred compensation expense 5 BS capital stock-par 1 BS additional paid in capital 4 BS
The deferred compensation expense account, also referred to as the Unearned Compensation Expense account, is a contra – Stockholders’ Equity account.
The firm would then amortize the balance in this contra – Stockholders’ Equity account over the vesting period of the stock grant. For example, assume that the stock
PAGE 63 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES grant vests over the next five years. Then each year for the next five years, the company would make the record the following entry:
compensation expense 1 IS deferred compensation expense 1 BS
Stock Options Another form of non-cash compensation which the firm can grant an employee is stock options. Stock options entitle employees to purchase shares of stock at an established price (referred to as the strike or exercise price).
SFAS123 R requires accounting for stock option using the Fair Value Method. Under the Fair Value Method the company estimates the fair value of the stock options granted to its employees each year. The company then amortizes to expense this fair value over the options’ vesting period. Companies will often use either the Black- Scholes method or the Binomial Method to estimate the fair value of the options.
Below are some additional details regarding SFAS 123 R: 1. the journal entry recognizing the expense each year over the vesting period is compensation expense IS Shareholders’ Equity (usually APIC) BS 2. on the Statement of Cash Flows, the stock option expense should be added back to net income to arrive at Cash Flow from Operations. 3. to account for the value of unvested options granted prior to the adoption of SFAS 123 R, SFAS 123 R allows companies to use either of two methods: a. modified prospective method – the expense recognized each period includes the amortization of the fair value of new options granted plus the amortization of the grant-date value of all unvested options granted in prior periods b. modified retrospective method – the fair value method of expensing options is applied to all years presented as if FAS 123(R) had been adopted for option grants after Dec. 15, 1994.
PAGE 64 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
DISCLOSURE – PEPSICO 2006
See the excerpts from Pepsico’s 2006 Form 10-K report on pages 66 - 80. Try to answer the following questions.
1. At what price does Pepsico set its strike price on its stock option grants? 2. What is the typical vesting period for its stock option grants? 3. What is the typical life of its stock option grants before it is exercised? 4. How does Pepsico account for its options granted prior to the adoption of SFAS 123 R? 5. Explain the line item, “Excess tax benefits from share-based payment arrangements” in the Operations and Financing sections of the Statement of Cash Flows. 6. What was the journal entry for stock-based compensation expense in 2006? 7. How much cash was received by Pepsico for options exercised in 2006? 8. What was the journal entry for the common shares repurchased in 2006? 9. What was the weighted fair value of options in 2006? 10. What are the main parameters of the Black-Scholes option pricing model and how do they affect the value of options?
Stock Dividends, Stock Splits and Treasury Stock These topics are discussed in the Dyckman et al. book.
PAGE 65 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
FORM 10-K For the fiscal year ended December 30, 2006
PepsiCo, Inc.
OUR CRITICAL ACCOUNTING POLICIES
Stock-Based Compensation Expense
We believe that we will achieve our best results if our employees act and are rewarded as business owners. Therefore, we believe stock ownership and stock-based incentive awards are the best way to align the interests of employees with those of our shareholders. A majority of our employees participate in our stock-based compensation programs. Stock option grants are made at the current stock price, meaning each employee's exercise price is equivalent to our stock price on the date of grant. Employees must generally provide three additional years of service to earn the grant, referred to as the vesting period. Our options generally have a 10-year term, which means our employees would have up to seven years after the vesting period to elect to pay the exercise price to purchase one share of our stock for each option exercised. Employees benefit from stock options to the extent our stock price appreciates above the exercise price after vesting and during the term of the grant. There have been no reductions to the exercise price of previously issued awards, and any repricing of awards would require approval of our shareholders.
Executives who are awarded long-term incentives based on their performance are offered the choice of stock options or restricted stock units (RSUs). Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior officers do not have a choice and are granted 50% stock options and 50% RSUs. RSU expense is based on the fair value of PepsiCo stock on the date of grant and is amortized over the vesting period, generally three years. Each RSU is settled in a share of our stock after the vesting period. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets.
Method of Accounting
PAGE 66 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock option expense at the date of grant. All stock grants have an exercise price equal to the fair market value of our common stock on the date of grant. The fair value of stock option grants is amortized to expense over the vesting period.
On January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, under the modified prospective method. Since we had previously accounted for our stock-based compensation plans under the fair value provisions of SFAS 123, our adoption did not significantly impact our financial position or our results of operations. Under SFAS 123R, actual tax benefits recognized in excess of tax benefits previously established upon grant are reported as a financing cash inflow. Prior to adoption, such excess tax benefits were reported as an operating cash inflow.
Our Assumptions
Our Black-Scholes model estimates the expected value our employees will receive from the options based on a number of assumptions, such as interest rates, employee exercises, our stock price and dividend yield. Our weighted-average fair value assumptions include:
Estimated 2006 2005 2004
2007
Expected life 6 yrs. 6 6 6
yrs. yrs. yrs.
Risk free interest rate 5.7% 4.5% 3.8% 3.3%
Expected volatility 18% 18% 23% 26%
Expected dividend yield 1.9% 1.9% 1.8% 1.8%
The expected life is a significant assumption as it determines the period for which the risk free interest rate, volatility and dividend yield must be applied. The expected life is the period over which our employee groups are expected to hold their options. It is based on our historical experience with similar grants. The risk free interest rate is based on the expected U.S. Treasury rate over the expected life. Volatility reflects movements in our stock price over the most recent historical period equivalent to the expected life. Dividend yield is estimated over the expected life based on our stated dividend policy and forecasts of net income, share repurchases and stock price.
PAGE 67 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
2007 Estimated Expense and Sensitivity of Assumptions
Our stock-based compensation expense, including RSUs, is as follows:
Estimated 2006 2005
2007
Stock-based compensation expense $271 $270 $311
If we assumed a 100-basis-point change in the following assumptions, our estimated 2007 stock-based compensation expense would increase/(decrease) as follows:
100-Basis-Point 100-Basis-Point
Increase Decrease
Risk free interest rate $6 $(6)
Expected volatility $1 $(1)
Expected dividend yield $(9) $10
If the expected life were assumed to be one year longer, our estimated 2007 stock-based compensation expense would increase by $7 million. If the expected life were assumed to be one year shorter, our estimated 2007 stock-based compensation expense would decrease by $8 million. As noted, changing the assumed expected life impacts all of the Black-Scholes valuation assumptions as the risk free interest rate, expected volatility and expected dividend yield are estimated over the expected life.
PAGE 68 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Consolidated Statement of Income PepsiCo, Inc. and Subsidiaries Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
(in millions except per share amounts) 2006 2005 2004
Net Revenue $ 35,137 $ 32,562 $ 29,261
Cost of sales 15,762 14,176 12,674
Selling, general and administrative 12,774 12,314 11,031 expenses
Amortization of intangible assets 162 150 147
Restructuring and impairment charges sts - - 150
Operating Profit 6,439 5,922 5,259
Bottling equity income 616 557 380
Interest expense (239 ) (256 ) (167 )
Interest income 173 159 74
Income from Continuing Operations before 6,989 6,382 5,546
Income Taxes
Provision for Income Taxes 1,347 2,304 1,372
Income from Continuing Operations 5,642 4,078 4,174
Tax Benefit from Discontinued Operations - - 38
Net Income $ 5,642 $ 4,078 $ 4,212
PAGE 69 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Consolidated Statement of Cash Flows PepsiCo, Inc. and Subsidiaries Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
(in millions) 2006 2005 2004
Operating Activities
Net income $ 5,642 $ 4,078 $ 4,212
Depreciation and amortization 1,406 1,308 1,264
Stock-based compensation expense 270 311 368
Excess tax benefits from share-based (134 ) - - payment arrangements
Restructuring and impairment charges - - 150
Cash payments for merger-related costs - (22 ) (92 ) and restructuring charges
Tax benefit from discontinued - - (38 ) operations
Pension and retiree medical plan (131 ) (877 ) (534 ) contributions
Pension and retiree medical plan 544 464 395 expenses
Bottling equity income, net of (479 ) (411 ) (297 ) dividends
Deferred income taxes and other tax (510 ) 440 (203 ) charges and credits
Other non-cash charges and credits, net 32 145 166
Change in accounts and notes receivable (330 ) (272 ) (130 )
Change in inventories (186 ) (132 ) (100 )
Change in prepaid expenses and other (37 ) (56 ) (31 ) current assets
Change in accounts payable and other 223 188 216 current liabilities
Change in income taxes payable (295 ) 609 (268 )
Other, net 69 79 (24 )
Net Cash Provided by Operating 6,084 5,852 5,054
Activities
PAGE 70 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Investing Activities
Snack Ventures Europe (SVE) minority - (750 ) - interest acquisition
Capital spending (2,068 ) (1,736 ) (1,387 )
Sales of property, plant and equipment 49 88 38
Investment in finance assets (25 ) - -
Other acquisitions and investments in (522 ) (345 ) (64 ) noncontrolled affiliates
Cash proceeds from sale of PBG stock 318 214 -
Divestitures 37 3 52
Short-term investments, by original maturity
More than three months purchases (29 ) (83 ) (44 )
More than three months maturities 25 84 38
Three months or less, net 2,021 (992 ) (963 )
Net Cash Used for Investing Activities (194 ) (3,517 ) (2,330 )
(Continued on following page)
PAGE 71 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Consolidated Statement of Cash Flows (continued)
PepsiCo, Inc. and Subsidiaries Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
(in millions) 2006 2005 2004
Financing Activities
Proceeds from issuances of long-term $ 51 $ 25 $ 504 debt
Payments of long-term debt (157 ) (177 ) (512 )
Short-term borrowings, by original maturity
More than three months proceeds 185 332 153
More than three months payments (358 ) (85 ) (160 )
Three months or less, net (2,168 ) 1,601 1,119
Cash dividends paid (1,854 ) (1,642 ) (1,329 )
Share repurchases common (3,000 ) (3,012 ) (3,028 )
Share repurchases preferred (10 ) (19 ) (27 )
Proceeds from exercises of stock 1,194 1,099 965 options
Excess tax benefits from share-based 134 - - payment arrangements
Net Cash Used for Financing Activities (5,983 ) (1,878 ) (2,315 )
Effect of exchange rate changes on cash 28 (21 ) 51 and cash equivalents
Net (Decrease)/Increase in Cash and (65 ) 436 460
Cash Equivalents
Cash and Cash Equivalents, Beginning of 1,716 1,280 820
Year
Cash and Cash Equivalents, End of Year $ 1,651 $ 1,716 $ 1,280
See accompanying notes to consolidated financial statements.
PAGE 72 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Consolidated Balance Sheet PepsiCo, Inc. and Subsidiaries December 30, 2006 and December 31, 2005
(in millions except per share amounts) 2006 2005
ASSETS
Current Assets
Cash and cash equivalents $ 1,651 $ 1,716
Short-term investments 1,171 3,166
Accounts and notes receivable, net 3,725 3,261
Inventories 1,926 1,693
Prepaid expenses and other current assets 657 618
Total Current Assets 9,130 10,454
Property, Plant and Equipment, net 9,687 8,681
Amortizable Intangible Assets, net 637 530
Goodwill 4,594 4,088
Other nonamortizable intangible assets 1,212 1,086
Nonamortizable Intangible Assets 5,806 5,174
Investments in Noncontrolled Affiliates 3,690 3,485
Other Assets 980 3,403
Total Assets $ 29,930 $ 31,727
LIABILITIES AND SHAREHOLDERS EQUITY
Current Liabilities
Short-term obligations $ 274 $ 2,889
Accounts payable and other current liabilities 6,496 5,971
Income taxes payable 90 546
Total Current Liabilities 6,860 9,406
Long-Term Debt Obligations 2,550 2,313
Other Liabilities 4,624 4,323
Deferred Income Taxes 528 1,434
Total Liabilities 14,562 17,476
PAGE 73 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Commitments and Contingencies
Preferred Stock, no par value 41 41
Repurchased Preferred Stock (120 ) (110 )
Common Shareholders Equity
Common stock, par value 12/3 per share (issued 30 30
1,782 shares)
Capital in excess of par value 584 614
Retained earnings 24,837 21,116
Accumulated other comprehensive loss (2,246 ) (1,053 )
23,205 20,707
Less: repurchased common stock, at cost (144 and 126 (7,758 ) (6,387 ) shares, respectively)
Total Common Shareholders Equity 15,447 14,320
Total Liabilities and Shareholders Equity $ 29,930 $ 31,727
See accompanying notes to consolidated financial statements.
PAGE 74 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Consolidated Statement of Common Shareholders Equity PepsiCo, Inc. and Subsidiaries Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
2006 2005 2004
(in millions) Shares Amount Shares Amount Shares Amount
Common Stock 1,782 $ 30 1,782 $ 30 1,782 $ 30
Capital in Excess of Par Value
Balance, beginning of year 614 618 548
Stock-based compensation expense 270 311 368
Stock option exercises (300 ) (315 ) (298 )
Balance, end of year 584 614 618
Retained Earnings
Balance, beginning of year 21,116 18,730 15,961
Net income 5,642 4,078 4,212
Cash dividends declared common (1,912 ) (1,684 ) (1,438 )
Cash dividends declared preferred (1 ) (3 ) (3 )
Cash dividends declared RSUs (8 ) (5 ) (2 )
Balance, end of year 24,837 21,116 18,730
Accumulated Other Comprehensive Loss
PAGE 75 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Balance, beginning of year (1,053 ) (886 ) (1,267 )
Currency translation adjustment 465 (251 ) 401
Cash flow hedges, net of tax:
Net derivative (losses)/gains (18 ) 54 (16 )
Reclassification of (gains)/losses to net income (5 ) (8 ) 9
Unamortized pension and retiree medical, net of tax (1,782 ) - -
Minimum pension liability adjustment, net of tax 138 16 (19 )
Unrealized gain on securities, net of tax 9 24 6
Other - (2 ) -
Balance, end of year (2,246 ) (1,053 ) (886 )
Repurchased Common Stock
Balance, beginning of year (126 ) (6,387 ) (103 ) (4,920 ) (77 ) (3,376 )
Share repurchases (49 ) (3,000 ) (54 ) (2,995 ) (58 ) (2,994 )
Stock option exercises 31 1,619 31 1,523 32 1,434
Other - 10 - 5 - 16
Balance, end of year (144 ) (7,758 ) (126 ) (6,387 ) (103 ) (4,920 )
Total Common Shareholders Equity $ 15,447 $ 14,320 $ 13,572
PAGE 76 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
2006 2005 2004
Comprehensive Income
Net income $ 5,642 $ 4,078 $ 4,212
Currency translation adjustment 465 (251 ) 401
Cash flow hedges, net of tax (23 ) 46 (7 )
Minimum pension liability adjustment, net of tax 5 16 (19 )
Unrealized gain on securities, net of tax 9 24 6
Other - (2 ) -
Total Comprehensive Income $ 6,098 $ 3,911 $ 4,593
See accompanying notes to consolidated financial statements.
PAGE 77 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Notes to Financial Statements
Note 6 - Stock-Based Compensation
A summary of our stock-based compensation activity for the year ended December 30, 2006 is presented below:
Our Stock Option Activity
Options(a) Average Average Aggregate
Price Life Intrinsic
(b) (years) Value(d)
(c)
Outstanding at January 1, 2006 150,149 $ 42.03
Granted 12,519 57.72
Exercised (31,056 ) 38.61
Forfeited/expired (3,863 ) 49.06
Outstanding at December 30, 127,749 $ 44.24 5.46 $ 2,339,562
2006
Exercisable at December 30, 91,381 $ 41.02 4.42 $ 1,967,843
2006
(a) Options are in thousands and include options previously granted under Quaker plans. No additional options or shares may be granted under the Quaker plans.
(b) Weighted-average exercise price.
(c) Weighted-average contractual life remaining.
(d) In thousands.
PAGE 78 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Our RSU Activity
RSUs(a) Average Average Aggregate
Intrinsic Life Intrinsic
Value(b) (years) Value(d)
(c)
Outstanding at January 1, 2006 5,669 $ 50.70
Granted 2,992 58.22
Converted (183 ) 50.00
Forfeited/expired (593 ) 53.17
Outstanding at December 30, 2006 7,885 $ 53.38 1.38 $ 493,201
(a) RSUs are in thousands.
(b) Weighted-average intrinsic value at grant date.
(c) Weighted-average contractual life remaining.
(d) In thousands.
PAGE 79 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Other Stock-Based Compensation Data
2006 2005 2004
Stock Options
Weighted-average fair value of options $ 12.81 $ 13.45 $ 12.04 granted
Total intrinsic value of options exercised(a) $ 686,242 $ 632,603 $ 667,001
RSUs
Total number of RSUs granted(a) 2,992 3,097 3,077
Weighted-average intrinsic value of RSUs $ 58.22 $ 53.83 $ 47.28 granted
Total intrinsic value of RSUs converted(a) $ 10,934 $ 4,974 $ 914
(a) In thousands.
At December 30, 2006, there was $301 million of total unrecognized compensation cost related to nonvested share-based compensation grants. This unrecognized compensation is expected to be recognized over a weighted-average period of 1.5 years.
PAGE 80 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
TAXES
Most of financial accounting is concerned with determining: a. which inflows of resources of should be considered revenues for financial accounting purposes b. when to recognize those revenues for financial accounting purposes c. which outflows of resources should be considered expenses for financial accounting purposes d. when to recognize those expenses for financial accounting purposes.
In income tax accounting you have the same recognition and timing decisions to make. However, the way we decide the recognition and timing issues for financial accounting has almost nothing to do with the decisions regarding these same issues for tax accounting purposes.
As a result, this gives rise to two differences between tax accounting income (taxable income) and financial accounting income (pre-tax financial income or book income)4
permanent differences The decision as to what a revenue or an expense is for financial reporting purposes is different than for tax reporting purposes. Examples include: interest on municipal bonds that represents income for financial accounting purposes but not for federal tax purposes.
temporary differences The decision as to what a revenue or an expense is for financial reporting purposes is the same as for tax reporting purposes but the decision as to when to recognize it is different. Examples include: using straight line depreciation for financial reporting purposes but an accelerated method for tax reporting purposes; or using the delivery method for financial reporting purposes but the installment method for tax reporting purposes. In the first example, you are recognizing more depreciation expense earlier for tax purposes than for financial, but over the life of the depreciable property the total depreciation expense for tax and
4 Another difference between tax expense and tax payments can arise because the government can reduce your tax bill by allowing tax credits in return for taking certain actions. These tax credits reduce the amount that you owe the government in the year in which they are granted. The financial accounting issue is when to recognize the corresponding reduction in tax expense: now or over the future.
PAGE 81 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
financial purposes will be the same. In the second example, you are recognizing less revenue for tax purposes in the early years than for financial, but over the collection period the total revenue recognized for tax and financial purposes will be the same. The effect of both examples is to defer the recognition of income for tax purposes relative to that for financial purposes and hence to defer the payment of taxes relative to what you would have paid if you had used the same method of depreciation and revenue recognition for tax purposes as you used for financial purposes
We know how to compute the additional amount that we owe the taxing authorities as a result of this year's operations; it is our taxable income times the appropriate statutory tax rate. However, how should we compute our tax expense on the financial report? Financial Accounting Standards No. 109 states that we compute each period's income tax expense for financial reporting purposes using a balance sheet approach. Essentially, we do the following: 1. At each balance sheet date determine those assets and liabilities whose book and tax bases (i.e., net book values for financial reporting and tax purposes) are different as a result of temporary (not permanent ) differences. 2. Group these assets and liabilities into two groups: Group A in which the financial net book value of the asset (liability) is less than (exceeds) the tax net book value of the asset (liability); Group B in which he financial net book value of the asset (liability) exceeds (is less than) the tax net book value of the asset (liability) 3. Multiply the differences in Group A by the statutory tax rate expected to apply in the future periods in which the differences are expected to reverse. The result is a deferred tax asset.5 Multiply the differences in Group B by the statutory tax rate expected to apply in the future periods in which the differences are expected to reverse. The result is a deferred tax liability. 4. Income tax expense each period is then: (1) the income tax currently due on this period's taxable income, plus (minus) (2) the change in the deferred tax asset and deferred tax liability between the beginning and end of the period.6
5If the probability of actually receiving the future tax benefits from the Group A assets and liabilities is less than 50%, then the deferred tax asset must be reduced to reflect this. This reduction is accomplished by setting up a valuation allowance account. 6Of course, the computation is not really this straight-forward. Complicating factors include: tax-free business acquisitions, FCTAs, etc.
PAGE 82 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Notice that in the above approach, you compute your tax payable as your taxable income times the current statutory tax rate and you compute the change in your deferred tax assets and liabilities. The plug number is then your tax expense. An alternative and simpler approach, which works if there are no scheduled future change in the statutory tax rate or other complicating events is: compute your tax payable as before, compute your tax expense as your pre-tax financial income - after adjusting for permanent differences - times the statutory tax rate, compute the change in your deferred tax asset and liability accounts as the plug number. In journal entry form, this is:
TAX EXPENSE (FIN. INC. X STAT. TAX RATE)
TAX PAYABLE (TAX INC. X STAT. TAX RATE)
NET DEFERRED TAX LIABILITY Plug=({FIN. INC. - TAX INC.} X STAT. TAX RATE)
Where FIN. INC. = FINANCIAL INCOME ADJUSTED FOR PERMANENT DIFFERENCES
Tax expense, which is the number that appears on the financial income statement, represents the tax assessment as a result of this year’s operations, regardless of when you pay for it. You may have already paid this tax, or will pay it this year, or will pay it sometime in the future.
Note that because deferred tax assets and liabilities arise because of timing differences, they will reverse and go to zero over the life of the asset or liability giving rise to them. However, because transactions giving rise to permanent differences have the same effect on tax expense as tax payable, they do not give rise to deferred tax assets/liabilities.
To see how to compute tax expense and taxes payable, work through the following example.
Example — Deferred taxes on plant assets: A merchandising firm purchases a delivery truck on January 1, year 1 for $100. The estimated salvage value is $20, and the useful life is four years. The firm uses straight-line depreciation for book purposes and ACRS for tax purposes. Assume that the truck belongs to the three-year ACRS asset class with depreciation rates of 33.3, 44.4, 14.8, and 7.5 percent. Finally, assume that the current income tax rate is 40 percent and that there is no expectation that it will change in the future.
PAGE 83 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
year 1 year 2 year 3 year 4 total ——————— ——————— ——————— ——————— ——————— book tax book tax book tax book tax book tax ——— ——— ——— ——— ——— ——— ——— ——— ——— ——— revenue 200 200 200 200 200 200 200 200 800 800 cgs 120 120 120 120 120 120 120 120 480 480 gross margin 80 80 80 80 80 80 80 80 320 320 tax-free income7 10 - 10 - 10 - 10 - 40 - dep'n exp 20 33.3 20 44.4 20 14.8 20 7.5 80 100 pretax income 70 46.7 70 35.6 70 65.2 70 72.5 280 220 tax expense 24 18.68 24 14.24 24 26.08 24 29 96 88 net income 46 28.02 46 21.36 46 39.12 46 43.5 184 132 tax expense current 18.68 14.24 26.08 29 88
deferred 5.32 9.76 (2.08) (5) 8
total 24 24 24 24 96
Deferred Tax Asset or (Liability) (5.32) (15.08) (13) (8) (8)
Suppose the firm's only activity during year 5 is to sell the truck on January 1, year 5 for $15. book tax ———— ———— proceeds 15 15 book value 20 -0- gain (loss) (5) 15 tax expense (refund) (2) 6 income (loss) (3) 9 total tax expense: 94 total book income: 181 total taxes payable: 94 total tax income: 141
7The tax-free income does not appear on the tax statement.
PAGE 84 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
DISCLOSURE
Required disclosure related to income taxes includes: 1. Total of all deferred tax liabilities 2. Total of all deferred tax assets 3. Total valuation allowance 4. Net change in valuation allowance for the year Types of temporary differences and carryforwards that cause significant portions of deferred tax assets and liabilities, as well as the approximate total tax effect.
DISCLOSURE – BEN & JERRY’S An example of financial statement disclosure of tax related information is the attached Ben & Jerry’s financial statement. Try to answer the following questions:
What was Ben & Jerry’s 1996 income tax expense?
How much of the above income tax expense was currently payable?
What was Ben & Jerry’s statutory tax rate in 1996?
By how much did Ben & Jerry’s 1996 financial income (adjusted for permanent differences) exceed their taxable income?
By how much did Ben & Jerry’s 1996 financial depreciation expense exceed their tax depreciation expense?
PAGE 85 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Ben & Jerry's Homemade, Inc. Consolidated Balance Sheets (In thousands except share data)
December 28, December 30, Assets 1996 1995 ------
Current assets: Cash and cash equivalents $ 36,104 $ 35,406 Investments 466 Accounts receivable Trade (less allowance of $695 in 1996 and $802 in 1995 for doubtful accounts) 8,684 11,660 Other 275 854 Inventories 15,365 12,616 Deferred income taxes 4,099 3,599 Income taxes receivable 2,920 2,831 Prepaid expenses 200 1,097 ------Total current assets 68,113 68,063 ------Property, plant and equipment, net 65,104 59,600 Investments 1,000 1,000 Other assets 2,448 2,411 ------$ 136,665 $ 131,074 ======
Liabilities & Stockholders' Equity Current liabilities: Accounts payable and accrued expenses $ 17,398 $ 16,592 Current portion of long-term debt and capital lease obligations 660 448 ------Total current liabilities 18,058 17,040
Long-term debt and capital lease obligations 31,087 31,977
Deferred income taxes 4,835 3,526 Commitments and contingencies
Page 86 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Stockholders' equity: $1.20 noncumulative Class A preferred stock - $1.00 par value, redeemable at the Company's option at $12.00 per share; 900 shares authorized, issued and outstanding, aggregate preference on voluntary or involuntary liquidation - $9,000 1 1 Class A common stock - $.033 par value; authorized 20,000,000 shares; issued: 6,364,733 shares at December 28, 1996 and 6,330,302 shares at December 30, 1995 210 209 Class B common stock - $.033 par value; authorized 3,000,000 shares; issued: 897,664 shares at December 28, 1996 and 914,325 shares at December 30, 1995 29 30 Additional paid-in capital 48,753 48,521 Retained earnings 35,190 31,264 Cumulative translation adjustment (118) (114) Treasury stock, at cost: 67,032 Class A and 1,092 Class B shares at December 28, 1996 and December 30, 1995 (1380) (1380) ------Total stockholders' equity 82,685 78,531 ------$ 136,665 $ 131,074 ======
Page 87 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Ben & Jerry's Homemade, Inc. Consolidated Statements of Operations (In thousands except per share data)
Years Ended ------
Dec. 28, 1996 Dec. 30, 1995 Dec. 31, 1994 (52 weeks) (52 weeks) (53 weeks) ------
Net sales ...... $ 167,155 $ 155,333 $ 148,802
Cost of sales ...... 115,212 109,125 109,760 ------
Gross profit ...... 51,943 46,208 39,042
Selling, general and administrative expenses ...... 45,531 36,362 36,253
Asset write-down ...... 6,779
Other income (expense): Interest income ...... 1,676 1,681 1,034 Interest expense ...... (1,996) (1,525) (295) Other ...... 243 (597) (511) ------
(77) (441) 228 ------
Income (loss) before income taxes ...... 6,335 9,405 (3,762
Income taxes (benefit) ...... 2,409 3,457 (1,893) ------
Net income (loss) ...... $ 3,926 $ 5,948 $ (1,869) ======
Net income (loss) per common share ...... $ 0.54 $ 0.83 $ (0.26)
Weighted average common and common equivalent shares outstanding ...... 7,230 7,222 7,148
Page 88 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Ben & Jerry's Homemade, Inc. Consolidated Statements of Cash Flows (In thousands) Years Ended December 28, December 30, December 31, 1996 1995 1994 ------Cash flows from operating activities: Net income (loss) ...... $ 3,926 $ 5,948 $ (1,869) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization ...... 7,091 5,928 4,707 Deferred income taxes ...... 809 2,166 (1,564) Provision for doubtful accounts ...... 408 400 311 Loss on asset write-down ...... 6,779 Loss on disposition of assets ...... 10 171 69 Stock compensation ...... 21 Changes in assets and liabilities: Accounts receivable ...... 3,146 (1,009) (536) Income taxes receivable/payable ...... (89) (733) (2,442) Inventories ...... (2,749) 847 (10) Prepaid expenses ...... 897 (563) 313 Accounts payable and accrued expenses ...... 806 2,677 (1,159) ------Net cash provided by operating activities ...... 14,255 15,853 4,599
Cash flows from investing activities: . . Net cash used for investing activities ...... (12,951) (739) (12,901)
Cash flows from financing activities: Net proceeds from long-term debt ...... 14,936 Repayments of long-term debt and capital leases ...... (678) (547) (700) Net proceeds from issuance of common stock ...... 232 174 139 ------Net cash (used for) provided by financing activities ...... (446) (373) 14,375
Effect of exchange rate changes on cash ...... (160) (113) ------
Increase in cash and cash equivalents ...... 698 14,628 6,073 Cash and cash equivalents at beginning of year ...... 35,406 20,778 14,705 ------Cash and cash equivalents at end of year ...... $ 36,104 $ 35,406 $ 20,778
Page 89 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
======
1. SIGNIFICANT ACCOUNTING POLICIES
Income Taxes ------
The Company accounts for income taxes under the liability method in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). Under the liability method, deferred tax liabilities and assets are recognized for the tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities.
9. INCOME TAXES
The provision (benefit) for income taxes consists of the following:
Federal: 1996 1995 1994 ------Current $ 1,348 $ 873 $ (314) Deferred 681 1,695 (1,263) ------2,029 2,568 (1,577) State: Current 252 418 (15) Deferred 128 471 (301) ------380 889 (316) ------$ 2,409 $ 3,457 $(1,893) ======
Income taxes computed at the federal statutory rate differ from amounts provided as follows:
1996 1995 1994 ------Tax at statutory rate 34.0 % 34.0 % (34.0)% State tax, less federal tax effect 6.0 4.5 (5.6) Income tax credits (1.0) (2.9) (6.7) Tax exempt interest (2.4) (1.1) (5.0) Other, et 1.4 2.3 1.0 ------Provision (benefit) for income taxes 38.0 % 36.8 % (50.3)% ======
Page 90 PROFESSOR BAIMAN ACOUNTING 608 LECTURE 4 OWNERS’ EQUITY & TAXES
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and are attributable to the following:
1996 1995 ------Deferred tax assets: Accrued liabilities $ 2,297 $ 1,514 Inventories 944 1,106 Accounts receivable 526 386 Other 429 695 ------Total deferred tax assets 4,196 3,701 ------
Deferred tax liabilities: Depreciation 4,923 3,628 Other 9 - Total deferred tax liabilities 4,932 3,628 ------
Net deferred tax asset (liabilities) $ (736) $ 73 ======
Income taxes paid amounted to $1,716,000, $1,918,000 and $2,111,000 during 1996, 1995 and 1994, respectively.
Page 91 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
INTERCORPORATE INVESTMENTS - MINORITY
This session deals with accounting for equity and debt investments on the investor's financial statements.
FAS 115 SECURITIES
In this first part of the lecture, we further restrict our attention to debt and equity securities for which a fair value (usually a market value) exists.
There are three issues related to investments in other firms on an investor's financial statements a) Valuation of the investments at acquisition b) Valuation of the investments subsequent to acquisition c) Recognition of income
VALUATION AT ACQUISITION As with any other asset, at acquisition you value the debt or equity security acquired at the price which you paid for it.
The answers to b & c depend upon: the type or amount of control you exercise (in the case of an equity investment); and the anticipated duration of the holding.
The type or amount of control may be either passive or active. In general a passive investment is assumed to exist if the investor holds less than 20% of the outstanding voting shares of the investee. In general an active investment is assumed to exist if the investor holds 20% or more of the outstanding voting shares of the other firm. Active investments are further broken into: holdings of 20 - 50% and holdings of more than 50%.
The first part of today's lecture will deal with accounting for debt and equity investments in other firms on the investor's financial statements where, in the case of an equity investment, the investor holds less than 20% of the investee’s outstanding voting shares of stock.
Page 92 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
The anticipated duration refers to how long management intends to hold on to the equity or debt investment. The distinction which we make is between: a) HELD TO MATURITY This category is only for debt securities which management intends to hold until they mature. b) TRADING SECURITIES This category is for both debt and equity securities which management intends to sell in the near term. c) AVAILABLE FOR SALE This category is for all other debt and equity securities.
At acquisition, you value all debt and equity investments at acquisition cost. In addition, at acquisition (and at each reporting date subsequently) all debt and equity securities are classified into a. HELD TO MATURITY (can be divided into current asset and non-current asset) b. TRADING SECURITIES (classified as current asset) c. AVAILABLE FOR SALE (can be divided into current asset and non-current asset)
VALUATION SUBSEQUENT TO ACQUISITION a. HELD TO MATURITY securities are valued at amortized cost = the present value of all remaining future cash inflows discounted at the interest rate that held at the time that the debt was acquired.
Each six month period, each debt security accrues interest revenue equal to 1/2 x (its historical yield to maturity) x (its net book value at the start of that six month period).
Each six month period, each debt security accrues interest receivable equal to 1/2 x (its coupon rate) x (its face value).
The difference between the interest receivable and the interest revenue is the increase or decrease in the net book value (i.e., amortized cost) of the debt, that is, the amount by which the difference between the debt’s net book value and face value is reduced (i.e., amortized).
b. TRADING SECURITIES are valued at fair value c. AVAILABLE FOR SALE securities are valued at fair value.
We can summarize the above rules with the following diagram:
Page 93 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
MARKETABLE SECURITIES: CLASSIFICATION AND VALUATION
DEBT OR EQUITY?
DEBT EQUITY
INTENDED DURATION? PASSIVE OR ACTIVE INVESTOR?
HELD-TO- TRADING AVAILABLE PASSIVE ACTIVE MATURITY FOR SALE (< 20%) ( 20%)
INTENDED DURATION?
TRADING AVAILABLE FOR SALE
AMORTIZED COST FAIR FAIR FAIR FAIR EQUITY VALUE* VALUE** VALUE* VALUE** METHOD/ CONSOLIDATE * Charge unrealized gains and losses to earnings ** Exclude unrealized gains and losses from earnings (use a separate shareholders' equity account)
Page 94 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
SOURCES OF INCOME
a. HELD TO MATURITY--The sources of income are: interest earned on debt, realized gain or loss on the sale of debt, any permanent impairment of debt.8
Assume that the investor bought debt at its face value and classified it as a HELD TO MATURITY security. Assume that $10 of interest on the debt was declared and paid. The journal entry would be
cash 10 BS interest revenue 10 IS
Assume that the investor previously bought some debt and classified it as a HELD TO MATURITY security. Its net book value is now $100 and the investor sells it for $105. The journal entry would be
cash 105 BS marketable securities (held to maturity) 100 BS gain 5 IS
8A permanent impairment of value occurs when management believes that the decrease in the fair value of the security is permanent rather than transitory. One example of this would be as a result of the firm which issued the debt security declaring bankruptcy.
Page 95 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
Assume that this period one of the securities in the HELD TO MATURITY account suffered a permanent decrease in fair value. Its net book value (i.e., amortized cost) was $50 while its fair value permanently fell to $23. The journal entry for this permanent impairment would be
loss 27 IS marketable securities (held to maturity) 27 BS
b. TRADING SECURITIES--The sources of income are: interest earned on debt, dividends declared on equity securities, realized gain or loss on sale of debt or equity securities, unrealized holding gains and losses on individual debt or equity securities resulting from their change in fair value.
The journal entry recognizing interest revenue is similar to that for HELD TO MATURITY securities.
Assume that the investor bought an equity security and classified it as a TRADING security. Assume that a $10 dividend was declared and paid. The journal entry would be
cash 10 BS dividend revenue 10 IS
Assume that the investor bought an equity security several periods ago for $10 and that this period the fair value of the security in the TRADING SECURITIES account went from $13 to $15. The journal entry for this period’s unrealized gain is:
Allowance to adjust to market (trading) 2 BS unrealized holding gain 2 IS
The Allowance to adjust to market account is an adjunct/contra Balance Sheet account which is used to adjust the marketable security account from cost to market. It allows the balance in the Marketable Security (trading) account to be historical cost. Notice that a change in the fair value
of a TRADING SECURITY, whether an increase or a decrease, results in a gain or a loss on the income statement.
Page 96 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
Say that you immediately sell the security for $15. The journal entry is
Cash 15 marketable security (trading) 10 BS Allowance to adjust to market (trading) 5 BS
The balance in the Allowance to adjust to market (trading) account prior to the sale was $5 – the cumulative price change since we acquired the security for $10. Recall that the $5 holding gain was previously recognized on the income statement when the price changes occurred. The first $3 gain was recognized in the past when the security went from a fair value of $10 (at which we bought it) to a fair value of $13 (its fair value at the start of this period). The second $2 gain was already recognized this year when the security’s fair market value went from $13 to $15. So there is no additional gain to recognize at the time of the sale. In general, each period you will recognize that period’s price change as income called unrealized gain or loss and adjust the Allowance to adjust to market (trading) account.
This type of accounting is referred to as mark-to-market or fair value accounting. Notice that it reflects each period’s market price volatility of the security holding of the firm in the firm’s balance sheet and income statement, in that period.
c. AVAILABLE FOR SALE--The sources of income are: interest earned on debt, dividends declared on equity securities, realized gain or loss on sale of debt or equity securities, permanent impairment.
The journal entries for interest earned on debt and dividends declared on equity securities for AVAILABLE FOR SALE securities are similar to those for the other types of securities.
For securities classified as AVAILABLE FOR SALE, unrealized holding gains and losses resulting from changes in fair value are not a source of income and, hence, do not show up on the income
Page 97 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
statement. Rather, the unrealized gains and losses in any period are reported as a change in a Accumulated Other Comprehensive Income9 until realized.
Assume the same scenario as for the TRADING SECURITY above. This period the fair value of a
security in the AVAILABLE FOR SALE account went from $13 to $15. Assume a 40% tax rate. The journal entry for this unrealized gain is:
Allowance to adjust to market (AFS) 2 BS. Deferred Tax Liability .8 BS Accumulated Other Comprehensive Income 1.2 BS
The Accumulated Other Comprehensive Income is similar to Retained Earnings in that it is an after-tax balance. By not recognizing the income effect of the gain on the security, the firm is deferring the recognition of tax expense. Hence the firm increases the Accumulated Other Comprehensive Income account by the after-tax amount and increases the Deferred Tax Liability account by the amount of tax expense that is being deferred.
The journal entry for the sale is:
Cash 15 BS realized gain 5 IS marketable security (AFS) 10 BS
Accumulated Other Comprehensive Income 3 BS Deferred Tax Liability 2 IS Allowance to adjust to market (AFS) 5 BS
Notice that you are reducing the Allowance account for the cumulative pre-tax change in the fair market value of the security and reducing the Accumulated Other Comprehensive Income for the cumulative after-tax change in the fair market value of the security.
9The Accumulated Other Comprehensive Income account can be treated as a Shareholders’ Equity account, as above, or closed to Retained Earnings at the end of the period. There can be separate accounts for the unrealized gains and unrealized losses, or we can just net the two accounts together. For the following examples, we will net the two accounts together and just make debit and credit entries to a single Comprehensive Income account.
Page 98 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
As with TRADING SECURITIES each period’s price volatility of the firm’s holdings of AVAILABLE
FOR SALE securities is reflected in the firm’s balance sheet that period. However, it is not reflected in the firm’s income statement each period. Instead, the entire price change in the security, over the period during which the firm holds the security, is recognized as income in the period of sale, not when the price change actually occurs.
Also this period, assume that there is another security in the AVAILABLE FOR SALE account whose fair value, while the security was being held by the investor, had gone down by $45, to a fair value of $60. That means that the security would be valued on the books at (i.e., have a net book value of) $60, have an Accumulated Other Comprehensive Income – allowance to adjust to market account associated with it (again assuming a tax rate of 40%), with a debit balance of $45 x .40 = $18 and a debit balance in Deferred Tax Liability of $45 x .60 = $27. Assume that this period management decides that the price of this security has permanently decreased to the $60 at which the security is currently valued. The journal entry for this permanent impairment on which the unrealized loss has already been recognized would be
Allowance to adjust to market (AFS) 45 BS Marketable Securities (AFS) 45 BS
loss 45 IS Deferred Tax Liability (Asset) 27 BS Accumulate Other Comprehensive Income 18 BS.
d. If a company's intent with respect to a particular marketable security in which it has invested changes, then a change in classification may be necessary. For example, if a company initially purchases an equity security for its trading account, but then decides to hold it as a long-term investment, it should be transferred to the available for sale account. All transfers take place at fair value. The following rules apply:
Page 99 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
TRANSFER FROM TRANSFER TO TREATMENT OF UNREALIZED HOLDING GAIN OR LOSS trading any category entire holding gain/loss recognized in income10 any category trading entire holding gain/loss recognized in income held-to maturity available for sale entire holding gain/loss moved to shareholders’ equity account available for sale held-to-maturity entire holding gain/loss kept in shareholders’ equity account
Financial Statement Presentation of Marketable Securities Companies investing in marketable securities will commonly report the following (italicized) line items in their financial statements.
10 If the trading security had been continuously revalued, there would be no unrealized holding gain or loss.
Page 100 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
Balance Sheet Assets Liabilities and Owners' Equity
Current Assets: Current Liabilities: Marketable Securities (trading) Marketable Securities (available- for-sale) Non-Current Liabilities: Marketable Securities (held-to-maturity) Owners’ Equity: Non-Current Assets Comprehensive Income- Marketable Securities (available- for-sale) allowance to adjust to market Marketable Securities (held-to-maturity) (available-for-sale)
Income Statement Revenue: Costs and Expenses: Other Items: Dividend Income Interest Income Realized Gain/Loss on Marketable Securities (applies to all classifications) Unrealized Gain/Loss on Marketable Securities (applies only to trading) Loss on Permanent Impairment in the Value of Marketable Securities (applies only to held-to-maturity and available-for-sale)
Net Income
Page 101 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
Statement of Cash Flows
Cash from Operating Activities: Net Income +/- Realized Loss/Gain on Marketable Securities (applies only to held-to-maturity and available for sale) + Loss on Permanent Impairment of Marketable Securities (applies only to held-to- maturity and available-for-sale) - Net Change in Marketable Securities (trading) Account
Cash From Investing Activities: + Cash received from the sale of available-for-sale marketable securities - Cash used for the purchase of available-for-sale marketable securities + Cash received from the sale of held-to-maturity marketable securities - Cash used for the purchase of held-to-maturity marketable securities
T-ACCOUNT ANALYSIS The T-accounts for the three types of portfolios discussed so far would look like the following.
Page 102 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
HELD TO MATURITY BB Purchases this year Net book value of debt sold or transferred out this year Transfers in this year
Amortization of Amortization of debt discount debt premium
write downs for permanent impairment
OTHER EB
Page 103 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
TRADING SECURITIES BB
Purchases this year Historical cost of securities sold or transferred out this year Market value of transfers in this year
OTHER EB
ALLOWANCE TO ADJUST TO MARKET (TRADING) BB Cumulative holding gain or loss of securities sold or transferred out this year
Unrealized gain Unrealized loss this year this year
OTHER EB
Page 104 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
AVAILABLE FOR SALE BB
Purchases this year Historical cost of securities sold or transferred out this year Market value of transfers in this year
write downs for permanent impairment OTHER EB
ALLOWANCE TO ADJUST TO MARKET (AVAILABLE) BB Cumulative holding gain or loss of securities sold or transferred out this year
Unrealized gain Unrealized loss this year this year
OTHER EB
Converting from Available for Sale to Trading Companies can avoid reflecting the Income Statement effect of changes in market values of their marketable securities by classifying them as AVAILABLE FOR SALE. However, when a firm’s marketable security increases (decreases) in value it incurred an economic gain (loss) whether it reports it as an accounting gain (loss) or not. Therefore, it would be useful to see the effect on income of these market value changes in AVAILABLE FOR SALE securities. Given the required disclosure, this is easily done.
Page 105 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
Assume the following situation Cost Market Allowance Account Beginning 20 30 10
Sell ½ (10) (15)
End 10 18 8
Change in Allowance Account this period -2
Available for Sale Income this period = price – historical cost of securities sold this period = 15 – 10 = 5
Income this period if all securities were accounted for as Trading Securities = this period’s price change of all securities held this period price change of securities sold this period 15 – 15 = 0 price change of securities still held 18 – 15 = 3 total = 3 Trading Income this period– Available for Sale Income this period = 3 – 5 = – 2 = Change in Allowance Account this period
This rule works in general.
DISCLOSURE – DEERE & CO.
Excerpts of Deere & Co.’s 1998 Annual Report are reproduced below. Assume that all purchases and sales of marketable securities during fiscal 1998 were for cash. In addition, assume that there were no FCTAs, permanent impairments, or reclassifications associated with Deere’s holding of debt or equity securities.
Try to answer the following questions.
Page 106 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
What is the carrying value of the available-for-sale securities reported as assets on the balance sheet as of the end of fiscal 1998?
Suppose Deere’s available-for-sale investments had always been classified as trading securities ever since they were purchased. By how much would retained earnings differ from that reported by Deere at the end of fiscal 1998? (Hint: you must consider the effect of taxes in your answer.)
What was the historical cost of marketable securities purchased during fiscal 1998?
What was the historical cost of marketable securities that were sold or that matured during fiscal 1998?
What was the gain or loss on sales and maturities of marketable securities during fiscal 1998?
How much more or less would Deere’s 1998 net income before tax have been if all of its securities had been classified as Trading Securities?
How much more or less would Deere’s 1998 net income after tax have been if all of its securities had been classified as Trading Securities?
Page 107 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
DEERE & COMPANY STATEMENT OF CONSOLIDATED INCOME ------CONSOLIDATED (DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES) YEAR ENDED OCTOBER 31 (IN MILLIONS OF DOLLARS EXCEPT PER SHARE AMOUNTS) 1998 1997 1996 ------NET SALES AND REVENUES Net sales of equipment...... $11,925.8 $11,081.7 $ 9,640.0 Finance and interest income...... 1,007.1 867.4 763.4 Insurance and health care premiums...... 692.9 668.1 658.1 Investment income...... 73.1 67.2 66.2 Other income...... 122.6 107.0 101.7 ------Total...... 13,821.5 12,791.4 11,229.4 ------COSTS AND EXPENSES Cost of goods sold...... 9,233.7 8,481.1 7,460.2 Research and development expenses...... 444.4 412.3 370.3 Selling, administrative and general expenses...... 1,309.4 1,320.7 1,146.6 Interest expense...... 519.4 422.2 402.2 Insurance and health care claims and benefits...... 579.0 554.0 502.1 Other operating expenses...... 175.6 94.0 61.4 ------Total...... 12,261.5 11,284.3 9,942.8 ------INCOME OF CONSOLIDATED GROUP BEFORE INCOME TAXES...... 1,560.0 1,507.1 1,286.6 Provision for income taxes...... 553.9 550.9 479.8 ------INCOME OF CONSOLIDATED GROUP...... 1,006.1 956.2 806.8 ------EQUITY IN INCOME (LOSS) OF UNCONSOLIDATED SUBSIDIARIES AND AFFILIATES Credit...... 1 (1.4) Insurance...... Health care...... 2 Other...... 15.0 5.3 10.5 ------Total...... 15.3 3.9 10.5 ------NET INCOME...... $ 1,021.4 $ 960.1 $ 817.3 ------
PAGE 108 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
DEERE & COMPANY CONSOLIDATED BALANCE SHEET CONSOLIDATED (DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES) ------(IN MILLIONS OF DOLLARS EXCEPT PER SHARE AMOUNTS) OCTOBER 31 ASSETS 1998 1997 ------Cash and short-term investments...... $ 309.7 $ 330.0 Cash and cash equivalents...... 309.7 330.0 Marketable securities...... 867.3 819.6 Receivables from unconsolidated subsidiaries and affiliates...... 36.2 14.6 Trade accounts and notes receivable - net...... 4,059.2 3,333.8 Financing receivables - net...... 6,332.7 6,404.7 Other receivables...... 536.8 412.7 Equipment on operating leases - net...... 1,209.2 774.6 Inventories...... 1,286.7 1,072.7 Property and equipment - net...... 1,700.3 1,524.1 Investments in unconsolidated subsidiaries and affiliates... 172.0 149.9 Intangible assets - net...... 217.6 157.8 Prepaid pension costs...... 674.3 592.9 Other assets...... 109.7 107.2 Deferred income taxes...... 396.3 543.6 Deferred charges...... 93.5 81.6 ------Total...... $18,001.5 $16,319.8 ------
PAGE 109 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
LIABILITIES AND STOCKHOLDERS' EQUITY ------LIABILITIES Short-term borrowings...... $ 5,322.1 $ 3,774.6 Payables to unconsolidated subsidiaries and affiliates...... 31.1 48.7 Accounts payable and accrued expenses...... 2,853.2 2,839.7 Insurance and health care claims and reserves...... 411.3 414.7 Accrued taxes...... 144.9 117.5 Deferred income taxes...... 19.7 21.4 Long-term borrowings...... 2,791.7 2,622.8 Retirement benefit accruals and other liabilities...... 2,347.7 2,333.2 ------Total liabilities...... 13,921.7 12,172.6 ------STOCKHOLDERS' EQUITY Common stock, $1 par value (authorized - 600,000,000 shares; issued - 263,852,871 shares in 1998 and 263,849,303 shares in 1997), at stated value...... 1,789.8 1,778.5 Retained earnings...... 3,839.5 3,048.4 Minimum pension liability adjustment...... (18.7) (14.0) Cumulative translation adjustment...... (80.5) (57.4) Unrealized gain on marketable securities...... 24.5 22.2 Unamortized restricted stock compensation...... (7.2) (17.4) Common stock in treasury, 31,542,845 shares in 1998 and 13,556,164 shares in 1997, at cost...... (1,467.6) (613.1) ------Total stockholders' equity...... 4,079.8 4,147.2 ------Total...... $18,001.5 $16,319.8 ------
PAGE 110 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
DEERE & COMPANY STATEMENT OF CONSOLIDATED CASH FLOW ------CONSOLIDATED (DEERE & COMPANY AND CONSOLIDATED SUBSIDIARIES) ------YEAR ENDED OCTOBER 31 (IN MILLIONS OF DOLLARS EXCEPT PER SHARE AMOUNTS) 1998 1997 1996 ------CASH FLOWS FROM OPERATING ACTIVITIES Net income...... $ 1,021.4 $ 960.1 $ 817.3 Adjustments to reconcile net income to net cash provided by operating activities: Provision for doubtful receivables...... 57.0 51.0 59.9 Provision for depreciation...... 418.0 365.6 311.4 Undistributed earnings of unconsolidated subsidiaries and affiliates...... (9.7) (.3) (2.6) Provision (credit) for deferred income taxes...... 141.9 (6.9) (65.0) Changes in assets and liabilities: Receivables...... (724.6) (175.2) 89.9 Inventories...... (192.6) (255.2) (75.1) Accounts payable and accrued expenses...... (40.7) 186.3 162.1 Insurance and health care claims and reserves...... (3.5) (22.9) (39.7) Retirement benefit accruals...... (84.9) 41.0 72.0 Other...... (165.4) 13.2 14.2 ------Net cash provided by operating activities...... 416.9 1,156.7 1,344.4 ------CASH FLOWS FROM INVESTING ACTIVITIES Collection of financing receivables...... 5,685.3 5,324.1 4,353.4 Proceeds from sales of financing receivables...... 1,859.9 968.0 960.3 Proceeds from maturities and sales of marketable securities...... 187.3 226.0 104.4 Proceeds from sales of equipment on operating leases...... 154.5 101.9 86.0 Cost of financing receivables acquires...... (7,521.5) (6,805.0) (5,902.6) Purchases of marketable securities...... (224.9) (166.7) (127.3) Purchases of property and equipment...... (434.8) (484.9) (275.9) Cost of operating leases acquired...... (752.3) (540.8) (299.4) Acquisitions of businesses...... (103.0) (45.7) (112.4) Other...... 27.6 39.0 (2.0) ------Net cash used for investing activities...... (1,121.9) (1,384.1) (1,215.5) ------
PAGE 111 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
CASH FLOWS FROM FINANCING ACTIVITIES Increase (decrease) in short-term borrowings...... 802.3 524.5 (283.2) Change in intercompany receivables/payables...... Proceeds from long-term borrowings...... 2,067.6 1,150.0 1,190.0 Principal payments on long-term borrowings...... (1,106.4) (816.8) (661.4) Proceeds from issuance of common stock...... 22.7 34.8 39.0 Repurchases of common stock...... (885.9) (419.1) (274.7) Dividends paid...... (212.4) (204.3) (209.3) Other...... (1.2) (.2) (.4) ------Net cash provided by (used for) financing activities...... 686.7 268.9 (200.0) ------EFFECT OF EXCHANGE RATE CHANGES ON CASH...... (2.0) (3.0) (1.1) ------NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENT...... (20.3) 38.5 (72.2) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR...... 330.0 291.5 363.7 ------CASH AND CASH EQUIVALENTS AT END OF YEAR...... $ 309.7 $ 330.0 $ 291.5 ------
PAGE 112 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
MARKETABLE SECURITIES
All marketable securities are classified as available-for-sale under FASB Statement No. 115, with unrealized gains and losses shown as a component of stockholders' equity. Realized gains or losses from the sales of marketable securities are based on the specific identification method.
The amortized cost and fair value of marketable securities in millions of dollars follow:
------Amortized Gross Gross Cost Unrealized Unrealized Fair or Cost Gains Losses Value ------OCTOBER 31, 1998 Equity securities...... $ 99 $ 5 $ 7 $ 97 U.S. government and agencies . . . 125 8 133 States and municipalities. . . . . 175 11 186 Corporate...... 226 11 237 Mortgage-backed securities . . . . 203 10 213 Other...... 1 1 ------MARKETABLE SECURITIES...... $ 829 $ 45 $ 7 $ 867 ------
OCTOBER 31, 1997 Equity securities...... $ 3 $ 2 $ 5 U.S. government and agencies . . . 160 5 165 States and municipalities. . . . . 160 11 171 Corporate...... 237 9 $ 1 245 Mortgage-backed securities . . . . 224 8 232 Other...... 2 2 ------MARKETABLE SECURITIES...... $ 786 $ 35 $ 1 $ 820 ------
PAGE 113 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
The contractual maturities of debt securities at October 31, 1998 in millions of dollars follow:
------Amortized Fair Cost Value ------Due in one year or less...... $ 47 $ 48 Due after one through five years . 209 217 Due after five through 10 years. . 124 131 Due after 10 years ...... 349 373 ------DEBT SECURITIES...... $ 729 $ 769 ------
Actual maturities may differ from contractual maturities because some borrowers have the right to call or prepay obligations. Proceeds from the sales of available-for-sale securities were $105 million in 1998, $114 million in 1997 and $11 million in 1996.
PAGE 114 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
EQUITY METHOD OF ACCOUNTING
In the first part of the lecture notes we discussed accounting for intercorporate equity investments on the parent's books, for those investments which represent less than 20% of the outstanding voting rights of the investee. Next we will discuss accounting for intercorporate equity investments on the parent's books, for those investments which represent between 20% and 50% of the outstanding voting rights of the investee. The portfolio of such investments is typically called Investments at Equity or Investments in Affiliates.
This material is covered in Dyckman, et al. The transactions can be summarized in the Investments in Affiliates T-account:
INVESTMENTS IN AFFILIATES BB Purchase of shares this year Net book value of shares sold this year
Equity in Earnings of Affiliates for this year write downs for this year’s permanent impairment
OTHER dividends declared by affiliates EB
The income statement for the typical equity method transactions would be
sales revenue -cgs +/- equity in earnings/losses of affiliates +/- realized gain/loss on sale of investments in affiliates - loss on write down Net Income
PAGE 115 PROFESSOR BAIMAN ACCOUNTING 608 LECTURE 5 INTERCORPORATE INVESTMENTS-MINORITY
The indirect cash flow statement would be
Cash from Operations Net Income -/+ equity in earnings/loss of affiliates + cash dividends received + loss on write down +/- loss/gain on sale of investments in affiliates
Cash from Investing Activities: + cash proceeds from sale of investments in affiliates - cash acquisition of investments in affiliates
DISCLOSURE Firms with investments accounted for under the equity method will disclose the following information: 1. The name of each investee and the percentage of ownership of common stock 2. The difference between the carrying amount for each investment and its underlying equity in the investee's net assets and the accounting treatment of the difference between these amounts 3. If investments in investees are considered to have a material effect on the investor's financial position and operating results, summarized data for the investee's assets, liabilities, and results of operations 4. For those investments which have a quoted market price, the aggregate value of each investment
DISCLOSURE – THE WASHINGTON POST
To illustrate the typical disclosure of equity investments, refer to the following selected parts of The Washington Post Co.’s Annual Report. Try explain the change in the Investments in Affiliates Balance Sheet account.
PAGE 116 EXAM 10 QUESTIONS AND FINANCIAL STATEMENTS
The Washington Post Co. Consolidated Statements of Income Fiscal year ended ------January 3, December 28, December 29, (in thousands, except share amounts) 1999 1997 1996 ------
OPERATING REVENUES Advertising $1,297,621 $1,236,877 $1,172,706 Circulation and subscriber 547,450 519,620 490,973 Other 265,289 199,756 189,766 ------2,110,360 1,956,253 1,853,445 ------
OPERATING COSTS AND EXPENSES Operating 1,139,177 1,019,869 1,007,057 Selling, general and administrative 453,149 449,996 414,280 Depreciation of property, plant and equipment 89,248 71,478 65,103 Amortization of goodwill and other intangibles 49,889 33,559 29,836 ------1,731,463 1,574,902 1,516,276 ------INCOME FROM OPERATIONS 378,897 381,351 337,169 Equity in (losses) earnings of affiliates (5,140) 9,955 19,702 Interest income 1,137 3,471 5,359 Interest expense (11,538) (1,252) (1,514) Other income (expense), net 304,703 69,549 (499) ------INCOME BEFORE INCOME TAXES 668,059 463,074 360,217 PROVISION FOR INCOME TAXES 250,800 181,500 139,400 ------NET INCOME 417,259 281,574 220,817 REDEEMABLE PREFERRED STOCK DIVIDENDS (956) (956) (680) ------NET INCOME AVAILABLE FOR COMMON SHARES $ 416,303 $ 280,618 $ 220,137 ======BASIC EARNINGS PER COMMON SHARE $ 41.27 $ 26.23 $ 20.08 ======DILUTED EARNINGS PER COMMON SHARE $ 41.10 $ 26.15 $ 20.05 ======
PAGE 117 EXAM 10 QUESTIONS AND FINANCIAL STATEMENTS
The Washington Post Co. Consolidated Balance Sheets January 3, December 28, (in thousands, except share amounts) 1999 1997 ------
ASSETS CURRENT ASSETS Cash and cash equivalents $ 15,190 $ 21,117 Investments in marketable equity securities 71,676 3,366 Accounts receivable, net 236,514 244,203 Federal and state income taxes 35,395 -- Inventories 20,154 19,213 Other current assets 25,949 23,959 ------404,878 311,858 PROPERTY, PLANT AND EQUIPMENT Buildings 248,764 188,836 Machinery, equipment and fixtures 977,710 800,435 Leasehold improvements 50,556 39,017 ------1,277,030 1,028,288 Less accumulated depreciation (566,616) (577,445) ------710,414 450,843 Land 41,191 33,953 Construction in progress 89,457 168,954 ------841,062 653,750 INVESTMENTS IN MARKETABLE EQUITY SECURITIES 184,440 -- INVESTMENTS IN AFFILIATES 68,530 154,791 GOODWILL AND OTHER INTANGIBLES, less accumulated amortization of $286,135 and $241,308 883,232 679,714 PREPAID PENSION COST 256,134 194,137 DEFERRED CHARGES AND OTHER ASSETS 91,385 83,067 ------$2,729,661 $2,077,317 ======
LIABILITIES AND SHAREHOLDERS' EQUITY . . .
PAGE 118 EXAM 10 QUESTIONS AND FINANCIAL STATEMENTS
The Washington Post Co. Consolidated Statements of Cash Flows Fiscal year ended ------January 3, December 28, December 29, (in thousands) 1999 1997 1996 ------
CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 417,259 $ 281,574 $ 220,817 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation of property, plant and equipment 89,248 71,478 65,103 Amortization of goodwill and other intangibles 49,889 33,559 29,836 Net pension benefit (61,997) (30,227) (23,269) Gain from disposition of businesses, net (314,400) (44,560) (3,112) Equity in losses (earnings) of affiliates, net of distributions 9,145 (6,996) (11,099) . . . ------Net cash provided by operating activities 223,113 318,297 285,415 ------CASH FLOWS FROM INVESTING ACTIVITIES: Net proceeds from sale of businesses 376,442 120,208 3,517 Purchases of property, plant and equipment (244,219) (214,573) (79,981) Purchases of marketable equity securities (164,955) -- -- Sales and maturities of marketable securities 38,246 -- 12,821 Investments in certain businesses (320,597) (178,943) (147,471) Other (5,960) (3,187) 784 ------Net cash used in investing activities (321,043) (276,495) (210,330) ------CASH FLOWS FROM FINANCING ACTIVITIES: . . .
PAGE 119 EXAM 10 QUESTIONS AND FINANCIAL STATEMENTS
Notes to Consolidated Financial Statements A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
FISCAL YEAR. The Company reports on a 52-53 week fiscal year ending on the Sunday nearest December 31. The fiscal year 1998, which ended on January 3, 1999, included 53 weeks, while 1997 and 1996 each included 52 weeks. With the exception of the newspaper publishing operations, subsidiaries of the Company report on a calendar-year basis.
INVESTMENTS IN AFFILIATES. The Company uses the equity method of accounting for its investments in and earnings or losses of affiliates.
D. INVESTMENTS IN AFFILIATES The Company's investments in affiliates at January 3, 1999 and December 28, 1997 include the following (in thousands):
1998 1997 ------
Bowater Mersey Paper Company Limited $40,121 $ 39,995 Cowles Media Company -- 91,904 Other 28,409 22,892 ------$68,530 $154,791 ======
At January 3, 1999, and December 28, 1997, the Company's investments in affiliates include a 49 percent interest in the common stock of Bowater Mersey Paper Company Limited, which owns and operates a newsprint mill in Nova Scotia, a 50 percent common stock interest in the International Herald Tribune Newspaper, published near Paris, France, and a 50 percent common stock interest in the Los Angeles Times-Washington Post News Service, Inc.
At December 28, 1997, the Company's investment in affiliates also included a 28 percent interest in the stock of Cowles Media Company (Cowles), which at that time owned and operated the Minneapolis Star Tribune and several other smaller properties. As further described in Note K, in March 1998, the Company disposed of its 28 percent interest in Cowles in connection with the merger of Cowles and McClatchy Newspaper, Inc.
Operating costs and expenses of the Company include newsprint supplied by Bowater, Inc. (parent to Bowater Mersey Paper Company Limited), the cost of
PAGE 120 EXAM 10 QUESTIONS AND FINANCIAL STATEMENTS
which was approximately $39,800,000 in 1998, $40,100,000 in 1997 and $41,500,000 in 1996. Prior to 1998, the Company owned a 35 percent interest in Bear Island Paper Company (see Note K for discussion of disposition in December 1997) which supplied the Company with newsprint at a cost of $23,700,000 in 1997 and $25,700,000 in 1996.
The following table summarizes the status and results of the Company's investments in affiliates (in thousands): 1998 1997 ------
Beginning investment $154,791 $199,278 Additional investment 15,187 -- Equity in (losses) earnings (5,140) 9,955 Dividends and distributions received (1,587) (2,959) Foreign currency translation (1,134) (5,128) Sale of interest in Cowles (93,587) -- Sale of interest in Bear Island -- (46,355) ------Ending investment $ 68,530 $154,791 ======At January 3, 1999, the unamortized excess of the Company's investments over its equity in the underlying net assets of its affiliates at the dates of acquisition was approximately $13,100,000. Amortization included in "Equity in (losses) earnings of affiliates" in the Consolidated Statements of Income was approximately $777,000 for the year ended January 3, 1999, $2,500,000 for the year ended December 28, 1997, and $2,600,000 for the year ended December 29, 1996.
DISPOSITIONS. In March 1998, Cowles Media Company ("Cowles") and McClatchy Newspapers, Inc. ("McClatchy") completed a series of transactions resulting in the merger of Cowles and McClatchy. In the merger, each share of Cowles common stock was converted (based upon elections of Cowles stockholders) into shares of McClatchy stock or a combination of cash and McClatchy stock. As of the date of the Cowles and McClatchy merger transaction, a wholly-owned subsidiary of the Company owned 3,893,796 (equal to about 28 percent) of the outstanding common stock of Cowles, most of which was acquired in 1985. As a result of the transaction, the Company's subsidiary received $330,500,000 in cash from McClatchy and 730,525 shares of McClatchy Class A common stock. The market value of the McClatchy stock received approximated $21,600,000. The gain resulting from this transaction, which is included in 1998 "Other income (expense), net" in the Consolidated Statements of Income, increased net income by approximately $162,800,000 and basic and diluted earnings per share by $16.14 and $16.07 respectively.
During the last three quarters of 1998, the Company sold 464,700 shares of the McClatchy stock (64 percent of the total shares received) for $15.4 million.
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