109

Chapter 09 - The Analysis of the Balance Sheet and Income Statement

CHAPTER NINE

The Analysis of the Balance Sheet and Income Statement

Concept Questions

C9.1. Without the reformulation, operating profitability is confused with financing profitability,

and the return on financial assets (and borrowing cost for financial obligations) is

typically different from operating profitability. Operations add value whereas financing

typically does not, so financing activities need to be separated out to uncover the

operating profitability.

C9.2.

(a) operating

(b) operating

(c) operating

(d) financing

(e) financing

(f) financing

(g) operating (these are investments in the operations of another company)

(h) operating

(i) operating

(j) operating

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C9.3.(a) operating

(b) operating

(c) financing

(d) operating

(e) financing

(f) financing – if interest is at market rates.

C9.4. Not correct. In a sense, minority interest is an obligation for common shareholders to give

the minority in a subsidiary a share of profits. But it is not, like debt, an obligation that

is satisfied by free cash flow from operations. Rather, it is equity that shares in a

portion of profits after net financing costs.

C9.5. Interest is deductible for taxes so issuing debt shields the firm from taxes.

C9.6 A firm losses the tax benefit of debt when it cannot reduce taxable income with interest on

debt. This can happen if a firm has losses in operations (and thus has no income to reduce with the

interest deduction). In the U. S. this situation is unlikely because firms can carry losses forward or

backward against future or past income.

C9.7. The operating profit margin is the profitability of sales, the percentage of a dollar of sales

that ends up in operating income after operating expenses.

9-2


Exercises

Drill Exercises

E9.1. Basic Calculations

a. Reformulated balance sheet

Operating assets $547 Financial obligations $190 Operating liabilities 132 Financial assets 145

Net financial obligations 45Common shareholders’ equity 370

Net operating assets $415 $415

Operating liabilities = $322 – 190 = $132 million.

b. Reformulated income statement

Revenue $4,356Cost of goods sold 3,487Gross margin 869Operating expenses 428Operating income 441Net financing expense: Interest expense $132

Interest income 56 76Earnings $ 365

E9.2 Tax Allocation

Net interest after tax = $140 x 0.65 = $91 millionOperating income after tax = Net income + net interest after tax

= $818 + $91 = $909 million

(This is the bottom-up method on Box 9.2)

E9.3 Tax Allocation: Top-Down and Bottom-Up Methods

Top-down method:

Revenue $6,450Cost of goods sold 3,870

2,580Operating expenses 1,843Operating income before tax 737

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Tax expense: Tax reported $181 Tax on interest expense 50 231Operating income after tax 506

Net interest: Interest expense 135

Tax benefit at 37% 50 85Earnings 421

Bottom-down method:

Earnings $421Net interest:

Interest expense 135 Tax benefit at 37% 50 85Operating income after tax $506

E9.4 Reformulation of a Balance Sheet and Income Statement

Balance sheet:

Operating cash $ 23Accounts receivable 1,827Inventory 2,876PPE 3,567Operating assets 8,293

Operating liabilities:Accounts payable $1,245Accrued expenses 1,549Deferred taxes 712 3,506Net operating assets 4,787

Net financial obligations:Cash equivalents $( 435)Long-term debt 3,678Preferred stock 432 3,675Common shareholders’ equity $1,112

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Income statement:

Revenue $7,493Operating expenses 6,321Operating income before tax 1,172

Tax expense: Tax reported $295 Tax on interest expense 80 375 Operating income after tax 797

Net financial expense: Interest expense 221

Tax benefit at 36% 80 141

Preferred dividends 26 167Net income to common $630

E9.5. Reformulation of a Balance Sheet, Income Statement, and Statement of Shareholders’ Equity

a. Reformulated balance sheet

Operating cash $ 60Accounts receivable 940Inventory 910PPE 2,840Operating assets 4,750

Operating liabilities:Accounts payable $1,200Accrued expenses 390 1,590Net operating assets 3,160

Net financial obligations:Short-term investments $( 550)Long-term debt 1,840 1,290Common shareholders’ equity $1,870

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Reformulated equity statement:

Balance, end of 2008 $1,430Net transactions with shareholders: Share issues $ 822 Share repurchases (720) Common dividend (180) ( 78)

Comprehensive income: Net income $ 468 Unrealized gain on debt investments 50 518Balance, end of 2009 $1,870

b. Reformulated statement of comprehensive income

Revenue $3,726Operating expenses, including taxes 3,204Operating income after tax 522

Net financing expense: Interest expense $ 98

Interest income 15 Net interest 83 Tax at 35% 29 Net interest after tax 54 Unrealized gain on debt investments 50 4Comprehensive income $ 518

After calculating the net financial expense, the bottom-up method is used to get operating income after tax. That is, net interest expense is calculated first (= $4 million). Then, as comprehensive income is $518 million, operating income must be 518 + 4 = 522. The number for operating expense (3,204) is then a plug to get back to the $3,726 million revenue number. Bottom up.

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E9.6. Testing Relationships in Reformulated Income Statements

The solution has to be worked in the following order:

A = Operating revenues – operating expenses= 5,523 – 4,550= 973

E = Interest expense after tax/ (1 – tax rate)= 42/0.65= 64.6

F = E – 42= 22.6

D = 610 + 42= 652

C = F= 22.6

B = A – C – D= 973 – 22.6 – 652= 298.4

Effective tax rate on operating income

= Tax on operating income/ Operating income before tax= (B + C)/A= 33.0%

9-7


Applications

E9.7. Price of “Cash” and Price of the Operations: Realnetworks, Inc.

a.

Total price of equity = $3.96 × 142.562 million shares = $564.5 million Book value of shareholders’ equity = 876.0 million Price/book = 564.5/876 = 0.64

b.

NOA = CSE – NFA = 876 – 454 = 422 millionc.

Price of operations = Price of equity – Price of net financial assets

As the price of net financial assets are close to their market value,

Price of operations = 564.5 – 454 = 110.5 million

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E9.8. Analysis of an Income Statement: Pepsico Inc.

a. The reformulation:

c. Effective tax rate on

operating from sales = %0.46883,2

327,1 =

You might ask why the tax rate is so high: Pepsico had a special 10.6 percent extra tax charge on its bottling operations in 1999.

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Net Sales 20,367Operating expenses 17,484Operating income from sales (after tax)(before tax) 2,883Tax reported 1,606Tax benefit of debt 88Tax on non-core itemson other operating income (367) 1,327Operating income from sales (after tax) 1,556Other operating income

Gain on asset sales 1,083Restructuring charge 65

1,018Tax on other operating income(37%)income, 36.1 367 651

Operating income (after tax) 2,207

Net financial expense:Interest expense 363Interst income 118

245Tax on net interest (37%)interest (36.1%) 88 157

Net Income 2,050


E9.9. Financial Statement reformulation for Starbucks Corporation

a.

Reformulated Statement of Shareholders’ Equity(in millions)

Balance, October 1, 2006 $ 2,228.5

Net payout to shareholders:Stock repurchase 1,012.8Sale of common stock (46.8)Issue of shares for employee stock options (225.2) (740.8)

Comprehensive Income:Net income from income statement 672.6Unrealized loss on financial assets (20.4)Currency translation gains 37.7 689.9

Balance, September 30, 2007 $2,177.6

Note: The closing balance excludes $106.4 million for “Stock-based compensation expense” which is a liability rather than equity. (It is added to operating liabilities in the reformulated balance sheet).

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b.

Reformulated Comprehensive Income Statement, 2007 (in millions)

Net revenues $ 9,411.5Cost of sales and occupancy costs 3,999.1Store opening expenses 3,215.9Other operating expenses 294.1Depreciation and amortization 467.2General and administrative expenses 489.2Operating income from sales (before tax) 946.0

Tax reported $ 383.7Tax benefit of net interest 5.6Tax on other operating income (6.6) 382.7

Operating income from sales (after tax) 563.3

Other operating income, before-tax item

Gain on asset sales 26.0Other operating charges (8.9)

17.1Tax at (38.4%) 6.6

10.5

Operating income, after tax-itemsIncome from equity investees 108.0Currency translation gains 37.7 156.2

Operating income (after tax) 719.5

Net financing expensesInterest expense 38.2Interest income (19.7)Net interest expense 18.5Realized gain on financial assets (3.8)

14.7Tax (at 38.4%) 5.6

9.1Unrealized loss on financial assets 20.4 29.5

Comprehensive income 689.9

Note: Interest income and interest expense are given in the notes to the financial statements in the exercise. That note also identifies the other operating income here.

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Reformulated Balance Sheets(in millions)

2007 2006Operating Assets

Cash and cash equivalents 40.0 40.0Short-term investments—trading securities 73.6 53.5Accounts receivable, net 287.9 224.3Inventories 691.7 636.2Prepaid expenses and other current assets 148.8 126.9Deferred income taxes, net 129.5 88.8Equity and other investments 258.8 219.1Property, plant and equipment, net 2,890.4 2,287.9Other assets 219.4 186.9Other intangible assets 42.0 37.9Goodwill 215.6 161.5

Total operating assets 4,997.7 4,063.0

Operating liabilitiesAccounts payable 390.8 340.9Accrued compensation and related costs 332.3 288.9Accrued occupancy costs 74.6 54.9Accrued taxes 92.5 94.0Other accrued expenses 257.4 224.2Deferred revenue 296.9 231.9Other long-term liabilities 460.5 262.9Total operating liabilities 1,905.0 1,497.7

Net operating assets 3,092.7 2,565.3

Net financial obligationsShort-term borrowing 710.2 700.0Current maturities of long-term debt 0.8 0.8Long-term debt 550.1 2.0Cash equivalents (281.3-40.0 in 2008) (241.3) (272.6)Short-term investments (available for sale) (83.8) (87.5)Long-term investments (available for sale) (21.0) (5.8)Net financial obligations 915.0 336.9

Common shareholders’ equity 2,177.6 2,228.5

Notes:

1. Short-term investment (trading securities) is operating assets connected to employees.

2. Stock-based compensation, excluded from the equity statement, has been added to other liabilities.

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c.

ROCE = 689.9 / 2,228.5 = 30.96%RNOA = 719.5 / 2,565.3 = 28.05%NBC = 29.5 / 336.9 = 8.76%

E9.10. Reformulation and Effective Tax Rates: Home Depot, Inc.

First establish the firm’s marginal tax rate. This is the statutory rate (federal plus state) at which

interest income is taxed (or interest expense gets a tax saving). The footnote gives the effective

rate (36.8% for 2005), which is the effective rate from the income statement (2,911/7,912 =

36.8%). But this is not the marginal rate for it includes tax credits and foreign tax benefits,

amongst other things. The marginal rate is the statutory rate, federal and state combined (with the

state rate recognizing that state taxes are deductible in federal tax returns).

The federal statutory rate is 35%, but the state rate is not given. (Many firms do report it.)

Home Depot operates in many states; without more information, the statutory rate is somewhat of

a guess. Home Depot reports a ratio of state-to-federal taxes of 215/2,769 = 7.79% for 2005.

Applied to the federal rate of 35%, this implies a state rate of 2.72%, or a total rate of 37.72%.

In the reformulation below, this 37.72% rate is used for the tax allocation. The top-down

approach proceeds as follows:

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Reformulated Income Statement, January 30, 2005($ millions)

Net sales 73,094Cost of sales 48,664Gross profit 24,430Selling and store operating costs 15,105General and administrative 1,399 16,504Operating income before tax 7,926Tax as reported 2,911Tax benefit of net debt 5 2,916Operating income after tax 5,010

Interest expense 70Interest income 56Net interest expense 14Tax on net interest (37.72%) 5 9

Net income 5,001

Effective tax rate on operating income = 2,916 = 36.79%7,926

This effective rate is almost the same as the reported rate because the net interest is almost zero.

The bottom-up approach proceeds as follows (in millions of dollars):

Net income 5,001

Interest expense 70Interest income 56Net interest expense 14Tax on net interest (37.72%) 5 9

Operating income after tax 5,010

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Minicases

M9.1 Financial Statement Analysis: Procter & Gamble

This is the first in a series of cases on Procter and Gamble that end in Chapter 12.

This first installment asks the student to reformulate the financial statements,

compare them to statements for General Mills, Nike, and Dell in the chapter, and to

make some elementary calculations that start the financial statement analysis that

continues in Chapter 11. Students should be encouraged to put the reformulated

statements into a spreadsheet to facilitate the later analysis. BYOAP on the book’s

web site provides a guide.

Reformulated Statement of Common Shareholders’ EquityYear ended June 30, 2008

Balance, June 30, 2007 reported 66,760Less Preferred Stock1 (1,406)Plus ESOP reserve2 1,308Balance of common equity 66,662

Transactions with common shareholdersDividends (4,479)Share repurchase (10,047)Share issue 2,480Preferred stock conversion4 329 (11,717)

Comprehensive incomeNet income 12,075Other comprehensive income3 3,129Loss for FIN48 (232)Preferred dividend5 (176)Loss on conversion of preferred stock4 (289) 14,507

Balance, June 30, 2008 69,453

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Notes:

1. Preferred stock is moved to debt portion of the balance sheet.

2. An ESOP is an Employee Stock Ownership Plan. In the reformulation, the ESOP reserve is taken out of the equity statement and netted against the ESOP loan in the balance sheet. P&G is guaranteeing the loan to the ESOP, and accounting rules (SOP 76-3) require the firm record the loan as a liability and to set up a reserve in equity for this contingency. However, it is highly unlikely that P&G will have to honor the guarantee (and, in any case, the reserve is not a reduction of equity to the full face amount). If one deemed that P&G has a reasonable probability of having to honor the guarantee, the liability would be retained, but with the debit recorded as an asset (claim on the ESOP) rather than in equity.

3. Other comprehensive income is listed in the equity statement (largely foreign currency translation gains and hedging losses).

4. Preferred stock was converted into equity with a loss to shareholders. The loss from issuing 4.982 million common shares is calculated as follows (based on an average of $66 per share during the year):

Market value of common shares issued, $66 x 4.982 million = 329Preferred cancelled 40

289 million

Details of common issued and preferred cancelled are in the equity statement. Note that the common shares are issued at the market price in “transaction with shareholders.”

The conversion of the preferred shared was done by the ESOP, so the cost of conversion is essentially wage cost: P&G pays employees by using common shares in conversion of preferred shares held by ESOP. So we treat the $289 million as an expense of operations in the reformulated income statement. (The ESOP loan is a loan to purchase the preferred shares.)

5. Preferred dividends are after tax. Preferred dividends get a tax deduction because they are paid to the ESOP.

One could reformulate the equity statement for 2007 and 2006, but we need only extract the comprehensive income:

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The comprehensive income for 2007 and 2006 is as follows:

2007 2006Net income 10,340 8,684OTC 1,468 1,048Effect of accounting charge (333) ----Preferred dividends (161) (148)Loss on conversion of preferred stock by ESOP (261) (173)

11,053 9,411

The reformulated income statements for 2006-2008 follow:

Reformulated Income Statements

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9-18

2008 2007 2006Net sales 83,50

376,476 68,22

2Cost of products sold 40,69

536,686 33,12

5Gross margin 42,80

839,790 35,09

7Advertising 8,667 7,937 7,122Research and development 2,226 2112 2,075General and administrative 14,83

214,291 12,65

1Loss on ESOP preferred stock conversion 28

9 261 17

3Operating income (from sales before tax) 16,79

415,189 13,07

6Tax reported 4,003 4,370 3,72

9Tax on net interest 480 386 286Tax on other OI (98) 4,385 (105) 4,651 32 4,047Operating income from sales (after tax) 12,40

910,538 9,029

Other operating income:Gains on asset sales 258 277 (84)Tax at 38% (98) 160 (105) 172 32 (52)

Other operating income after tax:Other comprehensive income 3,129 1,468 1,048Effect of accounting change (232) (333) ------

Operating income 15,466

11,845 10,025

Net Financing ExpenseInterest expense 1,467 1,304 1,119Interest income 204 287 367Net interest expense 1,263 1,017 752Tax at 38% 480 386 286

783 631 466Preferred dividends 176 161 148Net financial expense 959 792 614

Comprehensive income 14,507

11,053 9,411


Notes: Loss on conversion of preferred shares by ESOP (Employee Stock Option Plan) is effectively wages paid to employees, so is included in operating expenses.

OTC items are listed in the equity statement. They are all after tax.

Here are the reformulated balance sheets:

Reformulated Balance Sheets

2008 2007 2006 2005Operating Assets:Operating cash1 120 120 120 120Accounts receivable 6,761 6,629 5,725 4,185Inventories 8,416 6,819 6,291 5,006Deferred income taxes 2,012 1,727 1,611 1,081Prepaid expenses and other 3,785 3,300 2,876 1,924Property, Plant and Equipment 38,086 34,721 31,881 26,325Accumulated depreciation (17,446)

)(15,181)

)(13,111)

)(11,993)

)Goodwill 59,767 56,552 55,306 19,816Other intangibles 34,233 33,626 33,721 4,347Other assets 4,837 4,265 3,564 2,703

140,571 132,578 127,989 53,494Operating Liabilities:Accounts payable 6,775 5,710 4,910 3,802Accrued liabilities 10,154 9,586 9,587 7,531Taxes payable 945 3,382 3360 2,265Deferred taxes 11,805 12,015 12,354 1,896Other liabilities 8,154 5,147 4,472 3,230

37,833 35,840 34,685 18,724Net Operating Assets (NOA) 102,738 96,738 93,306 34,770

Financial Obligations:Debt due in one year 13,084 12,039 2,128 11,441Long-term debt 23,581 23,375 35,976 12,887 Less ESOP reserve (1,325) (1,308) (1,288) (1,259)Preferred stock 1,366 1,406 1,451 1,483

36,706 35,512 38,267 24,552Financial Assets:Cash equivalents 3,193 5,234 6,573 6,269Investment securities 228 202 1,133 1,764

3,421 5,436 7,706 8,033Net financial obligations 33,285 30,076 30,561 16,519

Common Equity 69,453 66,662 62,745 18,251

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Note: ESOP reserve in equity has been offset against ESOP loan (in long-term debt). See notes to equity statement.

$120 million of cash on cash equivalents has been treated as working cash.

Other liabilities are largely pension obligations and other employee benefits and thus operating liabilities.

Comparison with General Mills, Inc. (GIS)

(Note that some analysis is done on GIS in Exhibits 9.12 and 9.13)

Although P&G is a considerably larger firm (by asset and sales) than General Mills, the two firms have similar balance sheets. This, of course, reflects their similar (consumer brand) business. P&G sales in 2008 were 6.2 times the sales for GIS; if one multiplies each line item for GIS operating assets and liabilities by 6.2, one gets approximately the amount for which that line item is carried on the PG balance sheet. So, PG carries assets and liabilities in the same proportion to sales as GIS. In 2005, PG had proportionally less goodwill and intangibles assets on its balance sheet than GIS, but subsequent acquisitions of other consumer product companies (notably Gillette) and purchase of brands led to goodwill and intangibles significantly above those for GIS (as a percentage of sales and assets). PG moved to growth through acquisition rather than internal development and maintenance of brands. This difference in strategy shows up in the comparison of their “strategic balance sheets.” Otherwise the operating parts of the balance sheets very similar (standardizing for scale).

(Students may calculate and compare the various turnover ratios for the two companies, for example, the inventory turnover ratio, the PPE turnover. You will find these numbers for GIS in the body of Chapter 11, and for PG in the solution to the Minicase M11.1.)

As for financing strategy, both firms are positively levered; they borrow to finance operations. However, PG is less highly levered, with a financing leverage ratio, FLEV of 0.479 compared to almost 1.0 for GIS. Note that PG issued considerable equity for the Gillette purchase in 2006, reducing its leverage. Both firms maintain about the same amount of cash on hand (relative to debt).

The two reformulated income statements also look similar. Note the advertising expense and R&D lines, important to brand companies. Go down the income statement and calculate common-size ratios. Those for GIS are in Exhibit 9.12. Some of the most pertinent ratios for PG (with comparison to GIS) are:

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2008 PG GIS Gross margin ratio 51.3% 35.7% Advertising-to-sales 10.4% 4.6% R&D-to-sales 2.7% 1.5%* Operating PM from sales (after tax) 14.9% 10.6% Operating PM (after tax) 18.5% 13.9% *The “other expense” in Exhibit 9.12 is R&D expense.

PG is more profitable, per dollar of sales, than GIS, but spends more on advertising and R&D to maintain that profitability. PG benefited more from exchange rate gains in 2008 (reported in other comprehensive income) than did GIS. Comparison with Nike, Inc.

The comparison here is between firms with different types of products. Note, however, that the types of assets and liabilities on the balance sheet are quite similar. See Exhibits 9.12 and 9.13 do some Nike analysis and compare to PG.

The two firms differ in their financing: Nike is a net creditor (it has net financial assets) and thus has a negative FLEV.

Comparison with Dell, Inc.

Again, a different product and, in this case, quite a different strategic balance sheet. Note the considerably low turnover ratios for Dell and, most importantly, its negative net operating assets. See the commentary on both its strategic balance sheet and income statement in the text. The firms are organized to “add value” (ReOI) in very different ways.

Also note that the difference in financing position: Like Nike, Dell has net financial assets (and a pile of cash).

Answers to Questions

To calculate profitability measures, first calculate average balance sheet amounts for each year:

2008 2007 2006

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Operating assets 136,575 130,284 109,366 Operating liabilities 36,837 35,262 30,695 NOA 99,738 95,022 78,672 NFO 31,681 30,319 27,051 CSE 68,057 64,703 51,621

PG acquired Gillette on October 1, 2005. Thus Gillette in included in the financial statements for 9 months of the year ending June 30, 2006. Accordingly, the average balance sheet amounts for 2006 are calculated as (0.25 × Beginning balance) + (0.75 ×Ending balance).

2008 2007 2006 A. ROCE (CI/CSE) 21.32% 17.08% 18.23%

B. RNOA (OI/NOA) 15.51% 12.47% 12.74%

C. Operating PM from sales 14.86% 13.78% 13.33%

D. Advertising/Sales 10.38% 10.38% 10.44% R&D/Sales 2.67% 2.76% 3.04%

Advertising/sales has been very constant while R&D/Sales has declined somewhat. Is PG acquiring new products and brands through acquisition rather than through internal R&D -- and then maintain the brands with advertising?

E. Sales growth rate 9.19% 12.10% OI (from sales) growth rate 17.75% 15.90%

F. NOA growth rate 6.20% 3.68% 168.35%

Clearly the Gillette acquisition in 2008 added substantially to NOA.

G. FLEV (end of year) 0.479 FLEV (ave. for year) 0.466

H. PG has many overseas subsidiaries whose assets and liabilities are converted to US$ in the consolidation. During 2008, the US $ value of net assets overseas increased as exchange rates changed.

I. The equity statement for 2006 shows $53,371 million common stock issued for the acquisition. This was a pure acquisition by a share exchange (no cash), so $53,371 is the purchase price. (If cash had been involved, it would show up in the cash flow statement as part of cash investment.)

J. The increase in goodwill is from the Gillette acquisition. Review acquisition accounting in Accounting Clinic V.

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The financial statements for the case are below, to be used in the presentation of the case:

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9-24


M9.2Understanding the Business Through Reformulated Financial Statements: Chubb Corporation

Introduction

This case is well worth covering if you plan to work the Chubb valuation case, M13.1 in Chapter

13. It sets up the reformulated financial statements for that case and, more importantly, gets

students to understand (via those reformulated statements) how an insurance company adds value.

This case and M13.1 can be rolled into one presentation.

Take the students through the business model for a property-casualty insurer and how that

business model should be reflected in the (reformulated) financial statements:

A property-casualty insurer underwrites losses by collecting cash from insurance premiums and paying out cash for loss claims. There is a timing difference between cash in (from premiums) and cash out (in claims paid) – the float – and the insurer plays the float by investing it in securities and other investments. Effectively the policyholders provide cash that is invested in investment assets. In the reformulated balance sheet, the float is represented by negative net operating assets. So the reformulated balance sheet depicts the two aspects of the business – the negative net operating assets in underwriting and the positive investment in securities (which is also part of operations). Accordingly, the reformulated balance sheet takes the following form:

Net operating assets in underwriting operations + Net operating assets in investments

= Total net operating assets - Financing debt = Common equity

NOA in underwriting is negative.

The investment assets also serve as reserves against claims in the underwriting business and the

type of investments are constrained by regulation to make sure the reserves are not too risky.

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Corresponding to the reformulated balance sheet, the reformulated income statement

separates income from underwriting activities from income from investment activities. The

reformulated income statement combines net income with other comprehensive income (of

course), which is quite important for insurance companies (and other institutions with investment

portfolios): This negates any effects of cherry picking into the income statement.

The Reformulated Balance Sheet

Here is Chubb’s reformulated statement. It follows the reported statement closely as that

statement clearly separates investment assets from operating assets used in underwriting and real

estate.

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Chubb Corp.Reformulated Balance Sheet, December 31, 2007

($ millions)2007 2006

Underwriting operationsOperating assets:Cash 49 38 Premiums receivable 2,227 2,314 Reinsurance recoverable on unpaid claims 2,307 2,594 Prepaid reinsurance premiums 392 354 Deferred policy acquisition costs 1,556 1,480 Deferred income tax 442 591 Goodwill 467 467 Other assets 1,366 1,715

8,806 9,553 Operating liabilities:

Unpaid claims and loss expenses 22,623 22,293 Unearned premiums 6,599 6,546 Accrued expenses and other liabilities 2,090 31,312 2,385 31,224

Net operating assets- underwriting (22,506) (21,671)

Investment operations:

Short-term investments 1,839 2,254 Fixed maturity investment-held to maturity - 135 Fixed maturity investment-available for sale 33,871 31,831 Equity investments 2,320 1,957 Other invested asets 2,051 1,516 Accrued investment income 440 40,521 411 38,104

Total net operating assets 18,015 16,433

Long-term debt 3,460 2,466

Common shareholders' equity 14,555 13,967

As reported 14,455 13,863 Dividends payable 110 104

14,565 13,967

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Notes:

1. Dividends payable has been reclassified as shareholders’ equity.

2. “Other invested assets” ($2,051 in 2007) are investments in private equity limited partnerships are carried in the balance sheet as Chubb’s share in the partnership based on valuation provided by the private equity manager. Changes in these valuations are recorded as part of realized investment gains and losses in the income statement.

The negative NOA in underwriting activities represents the float. The investment assets,

though they look like financial assets, are operating assets because a firm cannot run a risk

underwriting business without the reserves in the assets. Indeed, insurers typically make their

money from investing the float in these assets. The separation identifies two aspects of the

business, one where value is created (or lost) through underwriting and one where value is

created (or lost) in investment operations.

The Reformulated Income Statement

Rather than reporting other comprehensive income within the equity statement, Chubb reports a

separate comprehensive income statement (below the income statement in the case). The

reformulated statement combines the two statements and separates the two types of operations.

Like the reformulated balance sheet, it separates the earnings from investing from earnings from

insurance underwriting. With this reformulation, one gets a better insight into the business.

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Reformulated Income Statement, Year Ended December 31, 2007 (in $ millions)

Underwriting operations:

Premiums earned 11,946

Claims and expenses:

Insurance losses 6,299 Amortization of deferred policy acquisition costs 3,092 Other operating costs 444 9,835

Operating income before tax-underwriting 2,111

Corporate and other expenses 300

Operating income before tax, underwriting and other 1,811

Income tax reported 1,130 Tax on investment income 663 (467) Core operating income after tax - underwriting 1,344

Currency translation gain, after tax 125 Additional pension cost (17) 108

Operating income after tax, underwriting and other 1,452

Investment operations:

Before-tax revenues:

Investment income-taxable 2 (1738-232) 1,506 Realized investment gains 374

Other revenue 49

1,929 Investment expenses 35

Income before tax 1,894 Tax (at 35%) 663

Income after tax 1,231 Investment income-tax exempt 232 Unrealized investment gain after tax 134 1,597

Comprehensive income 3,049

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Notes:

1. Currency translation gains are identified with underwriting in other countries. These gains are reported after tax in the comprehensive income statement.

2. Realized investment gains include gains and losses from revaluations of interests in private equity partnerships. See note to the reformulated balance sheet.

3. Taxable investment income is total investment income minus tax-exempt income of $232 million. The $232 million of tax-exempt income is added after tax is assessed.

Note the following:

1. Placing the income statement on a comprehensive basis gives a more complete picture. The

net income is misleading because it omits unrealized gains and losses from available-for-sale

securities. A firm can “cherry pick” realized gains by selling the securities in its portfolio that

have appreciated. Comprehensive income includes the income from (available-for-sale)

securities that have dropped in value, so one gets the results for the whole investment

portfolio. For Chubb in 2007, unrealized gains (not losses) are reported, so there is no

indication of cherry picking (at least on a net basis).

2. Taxes are allocated between the investment operations and the underwriting (and other)

operation. The tax rate of 35% is applied only to taxable investment income (not the tax

exempt income).

Note further, that the income from underwriting is usually quite small. Indeed, in many years,

insurance firms make losses on underwriting. Yet they add value: Minicase M13.1 provides the

explanation.

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Here are answers to the questions in the case:

A. All available-for-sale securities and trading securities must be market to market. Only

held-to-maturity securities are carried at cost. See Accounting Clinic III.

B. See the explanation in the discussion above: insurance companies generate a “float” which

they then invest in securities.

C. The two types of income come from activities that add value quite differently. Further, the

investment activity can usually be valued using mark to market accounting, not so the

underwriting activity. Minicase 13.1 takes this a lot further.

D. Yes, to pick up any cherry picking. Comprehensive income reporting gives the

performance for the whole investment portfolio, whether returns were realized or not.

E. The value of the equity is made up as follows:

Value of equity = Value of underwriting operation + Value of investments – Debt

As the investment operation is marked to market (for the large part), its value is

approximately its book value ($40,521 million). (There is a question regarding the private

equity investments in “other invested assets” that are revalued by the private equity

manager (but may not always to marked to market of fair value.) Similarly, the book value

of the debt is close to market value. The market value of the equity can be calculated by

looking up the per-share price ($54) of the 374.65 million outstanding shares: $54 ×

374.65 = $20,231 million. Thus

$20,231 = Value of underwriting business + $40,521 - $3,460

Accordingly, the value of the underwriting business is -$16,830.

How can the value be negative?? Well, it can. This is a case of operating liability leverage

adding value. Go to Minicase 13.1.

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The original financial statements are below, for use in the case presentation:

(continued)

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