Chapter01Sol_6e2005F

Chapter 1Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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CHAPTER 1

OVERVIEW OF FINANCIAL REPORTING, FINANCIALSTATEMENT ANALYSIS, AND VALUATION

Solutions to Questions, Exercises and Problems, and Teaching Notes to Cases

1.1 Value Chain Analysis Applied to Timber and Timber Products Industry.Schedule 1.1 of this Instructor’s/Solutions Manual contains a depiction of the valuechain. The links in the value chain are as follows:

1. Timber Tracts: Plants and maintains timber tracts (Weyerhauser).

2. Logging: Harvests timber (Weyerhauser).

3a. Sawmills: Cuts timber into various grades of wood (Weyerhauser).

3b. Pulp and Paper Manufacturing: Grinds timber into pulp and converts the pulpinto various grades of paper and cardboard (International Paper).

4a. Intermediate Users of Wood: Engage in construction, furniture manufacturing,etc. (Masco).

4b. Intermediate Users of Paper: Manufacture containers and packaging (Owens-Illinois) and various commodity and specialty papers (Georgia-Pacific).

5a. Retailers of Lumber and Wood Products: Sells such products to the finalconsumer (Home Depot).

5b. Retailers of Paper Products: Sells such products to the final consumer (OfficeDepot).

Schedule 1.1Value Chain for the Timber and Timber Products Industry

TimberTracts

Logging

Sawmills

Pulp and PaperManufacturing

Intermediate Usersof Wood

IntermediateUsers of Paper

Retailers ofLumber and

Wood Products

Retailers of PaperProducts

Chapter 1Overview of Financial Reporting, FinancialStatement Analysis, and Valuation

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1.2 Porter’s Five Forces Applied to Air Courier Industry.

Buyer Power. Air courier services are a commodity. Firms in the industry offersimilar overnight or two-day deliveries. Firms also provide opportunities to trackshipments. Business customers can negotiate favorable shipping terms based on thevolume of shipments. Thus, buyer power is high.

Supplier Power. The principal inputs are labor services, equipment, andinformation systems. Except for pilots and some information processingspecialists, the skill required to offer air courier services is relatively low.Competition for jobs, therefore, reduces supplier power. The principal items ofequipment are airplanes and trucks. The number of suppliers of this equipment isrelatively small, but the equipment offered is largely a commodity. Thus, supplierpower is relatively low. Information systems are critical to scheduling, tracking, anddelivery of parcels. Hiring individuals with the skills needed to design and maintainthis information system is somewhat difficult only because of the high level ofcompetition in the economy for such individuals. Thus, supplier power is low tomoderate.

Rivalry Among Existing Firms. Seven air couriers now carry a 90 percent marketshare. Fed Ex and UPS have the largest market shares and compete heavily. Smallerfirms compete more in particular geographical or customer markets. Thus, rivalry isrelatively high.

Threat of New Entrants. The cost of equipment, developing national andinternational delivery networks, and overcoming entrenched firms in an alreadycrowded market makes the threat of new entrants low.

Threat of Substitutes. The main threat to transportation of letter parcels is digitaltransmission. The threat of substitutes for transportation of packages is low.

1.3 Economic Attributes Framework Applied to Specialty Retailing ApparelIndustry.

Demand. Firms attempt to compete on design, colors, and other productattributes, but apparel is largely a commodity. Demand is somewhat cyclical witheconomic conditions; customers tend to either delay purchases or trade down duringeconomic downturns. Demand is seasonal within the year. Demand grows at thegrowth rate in population, which suggests that apparel retailing is a relativelymature market. To the extent that retailers can generate customer loyalty, demand is



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not highly price sensitive. However, given the similarity of product offerings acrossfirms, firms cannot price their goods too much out of line with competitors.

Supply. There are many firms selling similar apparel in most markets. The barriersto entry are not particularly high, since an apparel line and retail space are the mostimportant ingredients.

Manufacturing. The manufacturing process is labor intensive. The manufacturingprocess is relatively simply and firms source their apparel from Asia, which has lowwage rates.

Marketing. Because of the large number of suppliers selling similar products,apparel-retailing firms must stimulate demand with attractive store layouts, colorfulproduct offerings, and various sales promotions.

Investing and Financing. Firms must finance inventory, usually with acombination of supplier and bank financing. The risk of inventory obsolescence issomewhat high if the product offerings in a particular season do not catch on. Firmstend to rent retail space in shopping malls, so they need to engage in extensive long-term borrowing.

1.4 Identification of Commodity Businesses.Dell. The products of Dell, computers, servers and printers, are commodities. Delltends not to develop the technologies underlying these products. Instead, itpurchases the components from firms that develop the technologies(semiconductors, computer software). Dell’s direct-to-customer marketing strategyis not unique, but the extent to which Dell performs this strategy better than anyoneelse in the industry gives it a competitive advantage. Its size, purchasing power,quality control, and efficiency permit it to operate as a low-cost provider.

Southwest Airlines. Airline transportation services are a commodity product inthe sense that one cannot differentiate seats on one airline from another. SouthwestAirlines’ strategy is to be the lowest cost provider of such services, therebydifferentiating itself on low prices.

Microsoft. The basic idea of a commodity product is that the product offerings ofone firm are so similar to those of other firms that customers can easily switch tocompetitors’ products if price becomes an issue. The technological attributes ofcomputer software are duplicated relatively easily, a commodity attribute.However, Microsoft’s size permits it to invest in new technology development andkeep it on the leading edge of new technologies. Microsoft also has a huge


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advantage in terms of installed base that most customers are almost forced topurchase its software to be able to use application programs and communicate withother computer users. Thus, its products are inherently commodities but Microsoftis able to overcome some of the disadvantages of commodity status.

Johnson & Johnson. Johnson & Johnson operates in three business segments:consumer healthcare, pharmaceuticals, and medical equipment. It derives themajority of its revenue and profits from the latter two industries. Patents protectthe products of these two industries, which give the firm a degree of market power.Until another firm creates a new product that dominates the patented product ofJohnson & Johnson, its products are not commodities. Rapid technological change,however, makes most products obsolete earlier than the end of the patent’s life.The products of Johnson & Johnson probably have fewer commodity attributesthan the other three firms in this question.

One of the purposes of this question is to illustrate that firms can pursue bothproduct differentiation strategies and low cost leadership strategies and, ifperformed well, can gain “most admired status”.

1.5 Identification of Company Strategies. The strategies of Home Depot andLowe’s Companies are marked more by their similarities than by their differences.Both firms sell to the do-it-yourself homeowner and the professional builder,plumber, or electrician at competitively low prices. Their in-store product offeringsare similar, roughly evenly split between building materials, electrical and plumbingsupplies, hardware, paint, and floor coverings. Their store sizes are approximatelythe same. They both use sales personnel with expertise in a particular homeimprovement area to offer advice to customers. They both rely on third partycredit cards for a large portion of their sales to customers. Home Depot is slightlyless than twice the size of Lowe’s in terms of number of stores. Home Depot’sstores span the United States, whereas Lowe’s tends to locate in the eastern UnitedStates. Lowe’s, however, is expanding westward.

1.6 Researching the FASB Web Site. The answer to this question will change overtime as the FASB updates its activities. The purpose of the question is tofamiliarize students with the FASB web site and the kinds of information they canfind there.

1.7 Researching the IASB Web Site. The answer to this question will change overtime as the IASB updates its activities. The purpose of the question is to



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familiarize students with the IASB web site and the kinds of information they canfind there.

1.8 Effect of Industry Economics on Balance Sheet. Intel faces the greatest risk oftechnological change for its products among the three firms. Although themanufacture of semi-conductors is capital intensive, Intel does not add financial riskto its already high business risk. Thus, Firm B is Intel. The revenues of bothAmerican Airlines and Walt Disney change with changes in economic conditions,subjecting them to cyclical risk and thereby reducing their use of long-term debt.Walt Disney produces movies, in addition to operating theme parks, which the firmdoes not include in property, plant and equipment. This will reduce its property,plant and equipment to total assets percentage. American Airlines has few assetsother then its flight and ground support equipment. Thus, Firm A is Walt Disneyand Firm C is American Airlines. It may seem strange that Walt Disney has suchsmaller proportions of long-term debt in its capital structure than AmericanAirlines. One possible explanation is that the assets of American Airlines have amore ready market in case a lender repossessed and sold them than the more uniqueassets of Walt Disney. The more ready market reduces the borrowing cost. In thiscase, however, the explanation lies in the fact that American Airlines has operated ata net loss for several years and has negative shareholders’ equity. The result is ahigher long-term debt to assets ratio for American Airlines than for Walt Disney.

1.9 Effect of Business Strategy on Common-Size Income Statement. Firm A isDell and Firm B is Apple Computer. The clues appear below.

Cost of Goods Sold to Sales Percentages. One would expect Dell to have ahigher cost of goods sold to sales percentage because it adds less value, essentiallyfollowing an assembly strategy, and competes based on low prices. AppleComputer can obtain a higher markup on its manufacturing costs because it createsmore unique products with somewhat of a unique consumer following.

Selling and Administrative Expense to Sales Percentages. Apple Computerengages in more promotion to market its somewhat unique products to consumers;thereby increasing its selling expenses. Apple Computer is also considerablysmaller than Dell, which creates some diseconomies of scale with respect toadministrative expenses.

Research and Development Expense to Sales Percentages. Apple Computer ismore of a technology innovator than Dell, thereby giving Apple Computer a highresearch and development expense to sales percentage.


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Net Income to Sales Percentages. These percentages do not appear consistentwith the strategies of these firms. One would expect Apple Computer to have ahigher profit margin, given its product innovations. Dell appears to execute itsstrategy more effectively, at least in this particular year.

1.10 Effect of Business Strategy on Common-Size Income Statements. Firm A isDollar General and Firm B is Federated Department Stores (Federated).Department stores sell branded products for which the stores can obtain a highermarkup on their acquisition cost. Discount stores price low in an effort to gainvolume. Thus, the cost of goods sold to sales percentage of Federated should belower than that of Dollar General. Department stores engage in advertising andother promotions to stimulate demand. They also have higher cost of space. Thesefactors should increase their selling and administrative expense to sales percentage.One would expect that the department stores should have a higher net income tosales percentage. In this case, the profit margin percentages are the same.

1.11 Effect of Industry Characteristics on Financial Statement Relationships.There are various strategies for approaching this problem. One strategy begins witha particular company, identifies unique financial characteristics (for example, hoteland casino companies have a high proportion of property, plant and equipmentamong their assets), and then searches the common-size data in Exhibit 1.15 toidentify the company with that unique characteristic. Another approach beginswith the common-size data in Exhibit 1.15, identifies unusual financial statementrelationships (for example, Firm (12) has a high proportion of receivables), and thenlooks over the list of companies to identify the one most likely to have substantialreceivables among its assets. We follow both strategies here.

The two financial services firms will have balance sheets dominated by cash,securities, and loans receivable. Firms (11) and (12) meet this description. Cashand securities present 75.5 percent (= 1,507.2/1,996.0) of the assets of Firm (12),typical of a securities firm, suggesting that it is Merrill Lynch. Receivablescomprise a higher percent of total assets for Firm (11) than for Firm (12) (36.2percent for Firm (11) versus 19.3 percent for Firm (12)), suggesting that Firm (11)is Citigroup. Firm (11) also has a high percentage of its assets in cash and securities,consistent within Citigroup’s involvement in a wide range of financial services.Firm (11) has a much higher percentage of revenues in selling and administrativeexpenses than firm (12). Citigroup’s involvement in a wider range of financialservices likely increases its administrative expenses. In addition, managing itsbranch-banking network likely increases administrative costs. Firm (11) has a lowerpercentage of revenues for interest expense, consistent with using low-interestyielding customer deposits as a main source of funds. Neither firm is fixed-asset



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intensive, although Citigroup’s branch network of banks increases its fixed assetintensity relative to Firm (12).

Three firms have high percentages of property, plant and equipment relative tosales, Firms (7), (8), and (10). These firms in some order are Carnival Corporation,Harrah’s Entertainment, and Verizon Communications. Firm (10) has the highestpercentage of property, plant and equipment to revenues, yet Firm (8) has thehighest depreciation and amortization expense to revenues percentage. Thepercentage of accumulated depreciation to the cost of property, plant andequipment is higher for Firm (8) than for Firm (10), so Firm (8)’s higherdepreciation and amortization expense to revenues percentage is not likely due tonew, more expensive depreciable assets. The likely explanation is that Firm (8) hasa shorter depreciable life for its depreciable assets than Firm (10). Due totechnological obsolescence, the depreciable assets of Verizon likely have a shorterlife then either the casinos and hotels of Harrah’s or the ships of Carnival. Thus,Firm (8) is Verizon. Note that Verizon does not amortize its wireless licenses, sothat amortization of these licenses will not explain the higher depreciation andamortization expense to revenues percentage for Firm (8). Another distinguishingcharacteristic of Firm (8) is that it has a lower cost of sales to revenue percentagethan Firm (7) or Firm (10). Verizon’s services are more capital, instead of labor,intensive compared to those of Carnival or Harrah’s, which lowers Verizon’soperating expense line. Also, Carnival and Harrah’s sell meals as part of itsservices, the cost of which they include in cost of sales. Firm (8) has the highestselling and administrative expense to revenues percentage of the three firms.Telecommunication services are more competitive than luxury entertainment, whichboth increases marketing expenses and lowers revenues for Verizon.

This leaves Firm (7) and Firm (10) to be Carnival and Harrah’s in some order.Firm (10) is more fixed-asset intensive. Firm (7) on the other hand finances moreheavily with long-term debt. Firm (7) has a higher selling and administrativeexpense to revenues percentage and thereby a lower net income to revenuespercentage. Distinguishing these two firms is a close call. The land-based servicesof Harrah’s are probably more competitive because of the direct competition locatedphysically nearby and the low switching costs for customers. Once customerscommit to a cruise, their switching costs are higher. Thus, one would expectHarrah’s to have higher marketing costs and a lower net income to revenuespercentage. This reasoning suggests that Firm (7) is Harrah’s and Firm (10) isCarnival. One wonders though why Carnival would be twice as fixed-assetintensive as Harrah. One possible explanation is that the cost per square foot of aship is larger than that of hotels and casinos. Another possibility is that thecapacity utilization of ships is less on average than that of hotels and casinos. Theproblem does not provide information to assess these possibilities. Firm (7)’shigher proportion of long-term debt might suggest that hotels and casinos serve as


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better collateral for loans than ships. Another possibility is that Harrah’s simplychose to use debt more extensively than Carnival.

Three firms have research and development expenses, Firms (5), (6), and (9).These firms are likely to be ebay, Johnson & Johnson, and Cisco Systems. Allthree numbered firms have high profit margins, high proportions of cash andmarketable securities, low proportions of property, plant and equipment, and lowlong-term debt, consistent with technology-based firms. These firms differ on theirR&D to revenues percentages, with Firm (9) having the lowest percentage. BothJohnson & Johnson and Cisco invest in R&D to create new products, whereas ebayinvests in technology to support the offering of its online services. The cluesuggests that ebay is Firm (9). Firm (9) differs from Firm (5) and Firm (6) in theamount of intangibles. Intangibles dominate the balance sheet of Firm (9). Theproblem indicates that ebay has grown its network of online services largely byacquiring other firms, which increases goodwill and other intangibles. Thus, Firm(9) is ebay. Note that ebay amortizes some of its intangibles, which increases itdepreciation and amortization expense to revenues percentage relative to Firm (5)and Firm (6).

Firm (5) and Firm (6) are Johnson & Johnson and Cisco in some combination.The principal difference between the percentages for these two firms is in the othernoncurrent assets to revenues percentage. The problem states that Cisco hasexpanded by making minority equity investments in emerging technology firms,which it would include in other noncurrent assets. Cisco would realize equityearnings from such investments, which increases its other revenues percentage,relative to Johnson & Johnson. This suggests that Johnson & Johnson is Firm (5)and Cisco is Firm (6). One would expect that R&D to revenues for apharmaceutical company would be higher than for a computer company, which runscounter to the conclusion that Firm (5) is Johnson & Johnson. Johnson & Johnson,however, generates revenues from branded, over-the-counter consumer healthproducts, which do not require as much R&D investment.

This leaves four firms, Firms (1) to (4). The four remaining firms areAmazon.com, Anheuser-Busch, Kellogg, and Yum Brands. Amazon.com is likelythe least fixed asset intensive of these firms. It must invest in information systems,but does not need either manufacturing or retailing assets, as does the other three.This suggests that Firm (1) is Amazon.com. Also consistent with the conclusionthat Firm (1) is Amazon.com is that its shareholders’ equity is negative.Amazon.com is a relatively new firm with a record of startup losses. Note that itsincome taxes percentage is negative, indicating a tax savings instead of a tax expense.Amazon.com likely benefited from the carryforward of net operating losses. Firm(1) has the highest cost of sales to revenue percentage of the four firms, consistentwith Amazon.com’s low value added for its online services. It is interesting tocompare the cost of sales to revenues percentages for Amazon.com and ebay [Firm(9)]. Amazon.com includes the full selling price of goods sold in its revenues



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whenever it takes product risk and the cost of the product sold in the cost of sales.On the other hand, ebay does not assume product risk, so its revenue includes onlycustomer posting and transaction fees and advertising fees. Its cost of salespercentage primarily includes compensation of personnel maintaining its auctionsites. One other item to note for Firm (1) is its heavy use of long-term debt. Thelack of collateral for borrowing would seem to dictate low long-term debt. The debtin this case is mostly convertible debt, which permits the holder to convert intoshares of common stock if the firm does well, but provides greater protection to theinvestor in the event of bankruptcy than investing in the firm’s common stock.

This leaves Firm (2), Firm (3) and Firm (4). Firm (2) has the smallestinventories to revenues percentage, consistent with a restaurant selling perishablefoods. The cost of sales to revenues percentage for Firm (2) is the highest of thesethree remaining firms. The extent of competition in the restaurant business is likelyhigher than that for the branded food products of Anheuser-Busch and Kellogg,consistent with a perceived lower value added (higher cost of sales to revenuespercentage) for Firm (2). Thus, Firm (2) is Yum Brands.

Firm (3) has a significantly higher property, plant and equipment to revenuespercentage than Firm (4), consistent with the theme parks of Anheuser-Busch.Firm (4) has a significantly higher intangibles to revenues percentage than Firm (3),consistent with Kellogg’s strategy of acquiring other branded foods companies andrecognizing goodwill. Thus, Firm (3) is Anheuser-Busch and Firm (4) is Kellogg.Note that Anheuser-Busch uses long-term debt to a greater extent, with its themeparks serving as collateral. Kellogg has a significantly higher percentage of sellingand administrative expense to revenues percentage than Anheuser-Busch. Bothfirms advertise heavily. One possible explanation is that Anheuser-Busch has amore narrow range of products to advertise than Kellogg does.

1.12 Effect of Industry Characteristics on Financial Statement Relationships.There are various strategies for approaching this problem. One strategy begins witha particular company, identifies unique financial characteristics (for example, electricutilities have a high proportion of property, plant and equipment among theirassets), and then searches the common-size data in Exhibit 1.16 to identify thecompany with that unique characteristic. Another approach begins with thecommon-size data in Exhibit 1.16, identifies unusual financial statementrelationships (for example, Firm (10) has a high proportion of receivables), and thenlooks over the list of companies to identify the one most likely to have substantialreceivables among its assets. We follow both strategies here.

Firm (10) has a high proportion of receivables among its assets and substantialborrowing in its capital structure. This balance sheet structure is typical of thefinance company, HSBC Finance. We ask students why the capital markets allow afinance company to have such a high proportion of borrowing in its capital


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structure. The answer is threefold: (1) finance companies have contractual rights toreceive cash flows in the future from borrowers; the cash flow tends to be highlypredictable, (2) finance companies lend to many different individuals, whichdiversifies their risk, and (3) borrowers often pledge collateral to back up the loan,which provides the finance companies with an alternative for collecting cash ifborrowers default on their loans. Thus, the low risk in the asset structure allows thefirm to assume high risk on the financing side. We use this opportunity to askstudents how this firm can justify recognizing interest revenue on its loans as itaccrues each period when it has an uncollectible loan provision of 27.1 percent ofrevenues. Two points are noteworthy: (1) the concern with uncollectibles is notwith the size of the provision but with how much uncertainty there is in the amountof the provision (a high mean with a low standard deviation is not a concern but ahigh mean with a high standard deviation is a concern), and (2) revenues representinterest revenues on loans whereas the provision for uncollectibles includes bothunpaid principal and interest; thus, the 27.1 percent provision does not mean thatthe firm experiences defaults on 27.1 percent of its customers each year. Thepercentage for depreciation and amortization includes the amortization of the cost ofestablishing loans. HSBC Finance capitalizes these costs (included in Other Assets)and amortizes them over the term of the loan. The cash flow from operations tocapital expenditures ratio is high because of the low capital intensity of this firm.

Firm (12) has a high proportion of cash and marketable securities among itsassets and a high proportion of liabilities in its capital structure. This balance sheetstructure is typical of the insurance company, Allstate Insurance. Allstate receivescash from policyholders each period as premium revenues. It pays out the cash topolicyholders as they make insurance claims. There is a lag between the receipt anddisbursement of cash, which for a property and casualty insurance company canspan periods up to several years. Allstate invests the cash in the interim to generatea return. The high proportion of current liabilities represents Allstate’s estimate ofthe amount of future claims arising from insurance coverage in force in the currentand previous periods. We ask students at this point to comment on the quality ofearnings of an insurance company. Our objective is to get students to see the extentof estimates that go into recognizing claims expenses in a particular period. Claimsmade from accidents or injuries during the current year related to insurance in forceduring that year require relatively little estimation. However, policyholders maysustain a loss during the current period but not file a claim immediately. Also,estimating the cost of a claim may present difficulties if the policyholders contestthe amount Allstate is willing to pay and the case goes through adjudication. Thus,the potential for low quality earnings is present with insurance companies. We thenpoint out that the amount shown for other assets represents the unamortizedportion of the cost of writing a new policy (costs of investigating new policyholdersto assess risk levels, commissions paid to insurance agents for writing the newpolicy, filing fees with state insurance regulators). We ask why insurance



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companies do not write this amount off in the year of initiating the policy. Theexplanation is one of matching. Insurance companies recognize premium revenuesover several future periods and should match both policy initiation costs and claimscosts against these revenues. The cash flow from operations to capital expendituresratio is high because of the low capital intensity of this firm.

Four firms report research and development (R&D) expenditures, Firm (4), Firm(5), Firm (6), and Firm (9). Dupont, Hewlett-Packard, Merck and Procter &Gamble will all incur costs to discover new technologies or develop new products.Firm (9) has the highest R&D expense to revenues percentage, the most fixed assetsper dollar of sales, and the highest profit margin. This firm is Merck.Pharmaceutical companies must invest heavily in new drugs to remain competitive.The drug development process is also lengthy, which increases R&D costs.Pharmaceutical companies have patents on most of their drugs, providing such firmswith a degree of monopoly power. The demand for most pharmaceuticals is alsorelatively price inelastic, both because customers need the drugs and because thecost of the drugs is often covered by insurance. The manufacturing process forpharmaceuticals is capital-intensive, in part because of the need for precisemeasurement of ingredients and in part because of the need for purity. Note thatMerck has a relatively high selling and administrative expenses to revenuespercentage. This high percentage reflects both the cost of maintaining a sales staffto market products to physicians and hospitals and heavy advertising outlays tostimulate demand from consumers.

Hewlett-Packard, on the other hand, outsources many of its computercomponents and will therefore not have as much property, plant and equipment.Thus, Firm (4) is Hewlett-Packard. We ask students why Hewlett-Packard hassuch a small proportion of long-term debt in its capital structure. Computer firmsexperience considerable technological risk related to the introduction of newproducts by competitors. Products life cycles are short, approximately one to twoyears. Hewlett-Packard does not want to add financial risk to its already highbusiness (asset side) risk. Also, computer firms have relatively few assets (otherthan property, plant and equipment) that can serve as collateral for borrowing.Their most important resources, their technologies and their people, do not show upon the balance sheet. The relatively low profit margin evidences the increasinglycommodity nature of most computer products and the intense competition in theindustry.

This leaves Firm (5) and Firm (6) as being Dupont and Procter & Gamble insome combination. Firm (5) has a lower cost of sales to revenues percentage and ahigher selling and administrative expense to revenues percentage. It also has a higherprofit margin than Firm (6). Firm (5) is Procter & Gamble. The high profit marginreflects the brand names of Procter & Gamble’s products. The high selling andadministrative expense percentage results from advertising and other expenditures tostimulate demand and to maintain and enhance brand names. The low cost of sales


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percentage reflects the relatively low cost of ingredients in most of its products andthe high selling prices it can charge. One final clue is that investments in R&D areless critical for a consumer products company than for firms where technologydevelopment is important. Note that Procter & Gamble shows a high percentage forintangibles, the result of goodwill and other intangibles from companies it hasacquired.

This leaves Firm (6) as Dupont. Its income statement percentages are similar tothose for Hewlett-Packard. It carries more debt than Hewlett-Packard, related toDupont’s borrowing to finance its more capital-intensive operations.

We move next to Pacific Gas & Electric. Utilities are very capital intensive andcarry high levels of debt. Firm (11) displays these characteristics. Note thatdepreciation and amortization as a percentage of revenues is the highest for thisfirm, reflective of its capital intensity. Its interest expense to revenues percentage isalso the second highest among these firms, which one would expect from the highlevels of debt.

We move next to the two service firms, Kelly Services and Omnicom Group.Neither firm will have a high proportion of property, plant and equipment. Thus,Firms (1), (2), and (8) are possibilities. Kelly Services should have no inventoriesand inventories for Omnicom Group should be small, representing advertising workin process. This suggests that Firm (1) and Firm (8) are the most likely candidates.One would expect the value added by employees of Kelly (temporary help services)would be less than that of Omnicom (creative advertising services). Thus, Firm (1)is Kelly and Firm (8) is Omnicom. Another clue that Firm (1) is Kelly is thatreceivables relative to operating revenues indicate a turnover of 6.8 (=100.0%/14.6%) times per year and current liabilities relative to operating expensesindicate a turnover of 8.7 (= 84.0%/9.7%) times per year. The correspondingturnovers for Firm (8) are 2.0 (= 100.0%/50.4%) and .8 (= 70.2%/89.7%). Onewould expect faster turnovers for a temporary help business that pays itsemployees more regularly for temporary work done. One would expect even higherturnovers for Kelly Services than those above for Firm (1). The turnovers forOmnicom are difficult to interpret because its operating revenues represent thecommission and fee earned on advertising work whereas accounts receivablerepresent the full amount (media time plus commission or fee) billed to clients andaccounts payable represent the full amount payable to various media. The higherpercentages for receivables and current liabilities for Firm (8) indicate the agencynature of advertising firms. Firm (8) shows a relatively high proportion forintangibles, consistent with recognizing goodwill in the acquisition of othermarketing services firms by Omnicom in recent years. Neither firm has much long-term debt, consistent with the low collateral value of its assets (primarilyemployees). The surprising result is that the cash flow from operations to capitalexpenditures ratio for Kelly is so low. Given its low capital intensive, one would



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expect a high ratio. The explanation relates to its very low profitability, which leadsto low cash flow from operations.

We move next to the fast-food restaurant, McDonalds. The firm should haveinventories but its inventories should turn over rapidly. The remaining firm withthe lowest inventory percentage is Firm (7), representing McDonalds. Note thatthe firm has a high proportion of its assets in property, plant and equipment.McDonalds owns its company-operated restaurants and owns but leases otherrestaurants to its franchisees. The relatively high profit margin percentage resultsfrom McDonalds dominance in its market and its brand name.

We are left with two unidentified firms in Exhibit 1.16, Firm (2) and Firm (3)and they are Abercrombie & Fitch and Best Buy in some combination. Both ofthese firms have inventories. Firm (3) has substantially more property, plant andequipment per dollar of sales and a much higher profit margin than Firm (2).Abercrombie & Fitch sells brand name clothing products with a degree of fashionemphasis, whereas Best Buy sells electronic products with near-commodity statusat low prices. One would expect the cost of store space for Best Buy to be lessthan that of Abercrombie & Fitch, since the latter firm tends to locate in malls.Thus, Firm (2) is Best Buy and Firm (3) is Abercrombie & Fitch.

1.13 Effect of Industry Characteristics on Financial Statement Relationships—Global Perspective. There are various approaches to this problem. Oneapproach begins with a particular company and identifies unique financialcharacteristics (for example, steel companies have a high proportion of property,plant, and equipment among their assets), and then searches the common-sizefinancial data to identify the company with that unique characteristic.

Another approach begins with the common-size data and identifies unusualfinancial statement relationships (for example, Firm (12) has a high proportion ofcash, marketable securities, and receivables among its assets), and then looks overthe list of companies to identify the one most likely to have that unusual financialstatement relationship. This teaching note employs both approaches.

The high proportions of cash, marketable securities, and receivables for Firm(12) suggest that it is Fortis, the Dutch insurance and banking company. Insurancecompanies receive cash from premiums each year and invest the funds in variousinvestment vehicles until needed to pay insurance claims. They recognize premiumrevenue from the cash received and investment income from investments each year.They must match against this revenue an appropriate portion of the expected costof insurance claims from policies in force during the year. Fortis includes thisamount on the line labeled Operating Expenses in Exhibit 1.17. Operating revenuesalso include interest revenue on loans made. One might ask: why does Fortis havesuch a high proportion of financing in the form of current liabilities? This balancesheet category includes the estimated cost of claims not yet paid from insurance in


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force. It also includes deposits by customers in its banks. One might also ask:What types of quality of earnings issues arise for a company like Fortis? One issuerelates to the measurement of insurance claims expense each period. The ultimatecost of claims will not be known with certainty until customers make claims andsettlement is made. Prior to that time, Fortis must estimate what that cost will be.The need to make such estimates creates the opportunity to manage earnings andlowers the quality of earnings. Another issue relates to estimated uncollectibleloans. Fortis recognizes interest revenue from loans each year and must matchagainst this revenue the cost of any loans that will not be repaid. The need to makesuch estimates also provides management with an opportunity to manage earningsand therefore lowers the quality of earnings.

There are four firms with research and development (R&D) expenses, Firms (2),(3), (5), and (9). These are likely to be Nestle, Roche Holding, Sun Microsystems,and Toyota Motor in some combination.

Roche Holding and Sun Microsystems are more technology-oriented andtherefore likely to have a higher percentage of R&D to sales. This suggests thatthey are Firms (2) and (9) in some combination. The inventories of Firm (9) turnover more slowly at 1.4 times per year (= 27.2/20) than those of Firm (2) at 16.1times per year (= 45.2/2.8). Firm (9) is also more capital intensive than Firm (2).This suggests that Firm (2) is Sun Microsystems and Firm (9) is Roche Holdings.Sun uses only 11.8 cents in fixed assets for each dollar of sales generated. Theseratios are consistent with Sun's strategy of outsourcing most of its manufacturingoperations. The inventory turnover of Roche is consistent with the making of fewerproduction runs on each pharmaceutical product to gain production efficiencies.The manufacture of pharmaceuticals is highly automated, consistent with the slowerfixed asset turnover of Roche. These two firms have the highest profit margins ofthe 12 firms studied. Sun is a technology leader in engineering workstations andservers. Roche sells products protected by patents. These advantages permit thefirms to achieve high profit margins. Roche has a very high proportion of its assetsin cash and marketable securities. It generates interest revenue from theseinvestments, which it includes in other revenues. It is interesting to observe therelatively small cost of goods sold to sales percentage for Roche. The manufacturingcost of pharmaceutical products primarily includes the cost of the chemical rawmaterials, which machines combine into various drugs. Pharmaceutical firms mustprice their products significantly above manufacturing costs to recoup theirinvestments in R&D. Note also that Sun has very little long-term debt in its capitalstructure. Computer products have short product life cycles. Lenders are reluctantto lend for a long period because of the concern for technological obsolescence.Computer companies that outsource their production also have few assets that canserve as collateral for long-term borrowing.

This leaves Firms (3) and (5) as Nestle and Toyota Motor in some combination.Firm (5) has a larger amount of receivables relative to sales than Firm (3), consistent



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with Toyota Motor providing financing for its customers' purchases of automobiles.Nestle will have receivables from wholesales and distributors of its food products aswell, but not to the extent of the multi-year financing of automobiles. Theinventory turnover of Firm (3) is 4.5 times a year (= 44.5%/9.9%), whereas theinventory turnover of Firm (5) is 10.6 times a year (= 68%/6.4%). One might atfirst expect a food processor to have a much higher inventory turnover than anautomobile manufacturer, suggesting that Firm (3) is Toyota Motor and Firm (5) isNestle. Toyota Motor, however, has implemented just-in-time inventory systems,which speeds its inventory turnover. Nestle tends to manufacture chocolates tomeet seasonal demands, and therefore carries inventory somewhat longer than onemight expect. Firm (3) has a much higher percentage of selling and administrativeexpense to sales than Firm (5). Both of these firms advertise their products heavily.It is difficult to know why one would have a substantially different percentage thanthe other. The profit margin of Firm (3) is substantially higher than that of Firm(5). The auto industry is more competitive than at least the chocolate side of thefood industry. However, other food products encounter extensive competition.Firm (5) has a high proportion of intercorporate investments. Japanese companiestend to operate within groups, called kieretsu. The members of the group makeinvestments in the securities of other firms within the group. This would suggestthat Firm (5) is Toyota Motor. Another characteristic of Japanese companies istheir heavier use of debt in their capital structures. One of the members of theseJapanese corporate groups is typically a bank, which lends to group members asneeded. With this more-or-less assured source of funds, Japanese firms tend to takeon more debt. Although the ratios give somewhat confusing signals, Firm (3) isNestle and Firm (5) is Toyota Motor.

Firms (10) and (11) are unique in that they are both very fixed intensive.Electric utilities and telecommunication firms both utilize fixed assets in the deliveryof their services. Firm (11) is the most fixed-asset intensive of the two firms andcarries a higher proportion of long-term debt. Electric-generating plants are morefixed asset intensive than the infrastructure needed for distribution oftelecommunication services. This would suggest that Firm (10) is DeutscheTelekom and Firm (11) is Tokyo Electric Power. The telecommunication industryis going through deregulation whereas Tokyo Electric Power still has a monopolyposition in Japan. Thus, the selling and administrative expense to operatingrevenues percentage for Deutsche Telekom is substantially higher than for TokyoElectric Power. The difference in the accounts receivable turnovers is somewhatsurprising, given that both firms bill their customers monthly. One would expect anaccounts receivable turnover of approximately 12 times a year for each firm. Theaccounts receivable turnover for Deutsche Telekom is in this ballpark, but not forTokyo Electric Power. Japan was in a recession during the period studied and thisfactor may account for its slower receivables turnover. Payment policies in Japanmay also be more lenient than in other countries.


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Firms (6) and (8) represent two of the remaining industries that are also capitalintensive, but not to the extent of Deutsche Telekom and Tokyo Electric Power.These firms are Accor, a hotel group, and Arbed-Acier, a steel manufacturer. Firms(6) and (8) require the next highest fixed assets per dollar of sales after Firms (10)and (11). Thus, Firms (6) and (8) are Accor and Arbed-Acier in some combination.Firm (8) has virtually no inventories, whereas Firm (6) has substantial inventories.This suggests that Firm (6) is Arbed-Acier, the steel company, and Firm (8) isAccor, the hotel group. Accor has grown in recent year by acquiring establishedhotel chains. Accor allocates a portion of the purchase price to goodwill in theiracquisitions, which accounts for its higher percentage for Other Assets. Steelproducts are commodities, whereas hotels have some brand recognition appeal.These factors may explain the higher profit margin for Firm (8) than for Firm (6).

Firm (7) has an unusually high proportion of its assets in receivables and incurrent liabilities. Although this pattern would be typical for a commercial bank, weidentified Firm (12) earlier as the financial institution. The pattern is also typicalfor an advertising agency, which creates and sells advertising copy for clients (forwhich it has a receivable) and purchasing time and space from various media todisplay it (for which it has a current liability). Additional evidence that Firm (7) isInterpublic Group is the high percentage for Other Assets, representing goodwillfrom acquisitions. Firm (7) also has a relatively high profit margin percentage,reflective of its ability to differentiate its creative services.

Firm (1) is distinguished by its high cost of goods sold to sales and small profitmargin percentages. This pattern suggests commodity products with low valueadded. Of the remaining firms, this characterizes a grocery business. Firm (1) isCarrefour. Its combination of a rapid receivables turnover of 11.8 times per year(=100/8.5) and rapid inventory turnover of 8.9 times per year (=87.8/9.9) are alsoconsistent with a grocery business. Current liabilities comprise more than half of itsfinancing. Current assets make up a similarly high proportion of its current assets.

The remaining firm is Firm (4), which is Marks & Spencer, the department storechain. Firm (4) has substantial receivables, consistent with having a credit card.

1.14 Value Chain Analysis and Financial Statement Relationships. Four Firms(1), (2), (3), and (5) incur research and development (R&D) expenditures and threedo not. Wyeth, Amgen, Mylan, and Johnson & Johnson engage in research todevelop new products. Thus, they represent these four numbered firms in somecombination. One would expect that the firms enjoying patent protection (Wyethand Amgen) would have the highest profit margins (that is, net income divided bysales). This would suggest that Firms (1) and (2) are Wyeth and Amgen in someorder and that Firms (3) and (5) are Mylan and Johnson & Johnson in some order.The perplexing aspect of this logic, however, is the common-size income statementpercentages for Firm (1). Its cost of goods sold percentage is the highest of the four



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companies and its R&D percentage is the lowest, which are inconsistent with thisbeing either Wyeth OR Amgen. Products with patent protection should have thelowest cost of goods sold percentages (resulting from high markups on cost to arriveat selling prices). Thus, following another line of logic, the need to continuallydiscover new drugs should lead Wyeth and Amgen to have the highest R&Dpercentages, which would be either Firm (2) or Firm (3) as discussed below.

With this being the case, the other two firms—Firm (1) and Firm (5) are Mylanand Johnson & Johnson in some combination. The brand recognition of Johnson &Johnson’s products should give it a high profit margin and competition amonggeneric firms, which compete on the basis of low prices, should give Mylan a lowerprofit margin. This reasoning would suggest that Johnson & Johnson is Firm (1)and Mylan is Firm (5). The contradictory aspect of this conclusion is the lowselling and administrative expenses for Firm (1) versus Firm (5). Mylan will notneed to advertise its products, although it will use a sales force. Johnson &Johnson, on the other hand, advertises extensively. Thus, Firm (1) is Mylan andFirm (5) is Johnson & Johnson. The high profit margin of Mylan results fromoffering generic drugs for ethical drugs that have recently come off patent and moreaggressive management of drug cost by health care plans (that is, requiringpharmacists to substitute generic drugs for ethical drugs whenever possible). Notethat Mylan has a high proportion of cash, relatively small current liabilities, andminimal long-term debt. With the major ethical drug firms now competingaggressively in the generic market, one might expect the profit margin of Mylan todecrease in the future.

This leaves Firms (2) and (3) as Wyeth and Amgen in some order. Thebiotechnology industry is significantly less mature than the ethical drug industry.Few biotechnology drugs have received FDA approval and research to develop newdrugs is intensive. Given the few biotechnology drugs available on the markets,Amgen’s profit margin should be higher and its R&D expense percentage shouldalso be higher than those of Wyeth. Thus, Firm (2) is Amgen and Firm (3) isWyeth. Amgen has a higher proportion of cash on the balance sheet than Wyeth,reflecting its growth phase and the need to fund R&D. Wyeth’s higher selling andadministrative expense percentage results from it need to maintain a sales force. Thebiotechnology products of Amgen are fewer in number and are essentially pulledthrough the distribution process by customer demand at this point. Thus, it hasless need for a sales force.

We are now left with Quintiles, Cardinal Health, and Walgreen and Firms (4),(6), and (7). Quintiles will have no inventories, whereas both Cardinal Health(wholesaler) and Walgreen (retailer) will have inventories. Thus, Firm (4) isQuintiles. This firm will need property, plant, and equipment to conduct thetesting of new drugs. Of the remaining two firms, Cardinal Health and Walgreen,Walgreen will likely have a higher proportion of its assets in property, plant andequipment for retail space. Cardinal Health needs only warehousing facilities for its


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drug wholesaling activities. Thus, Firm (6) is Walgreen and Firm (7) is CardinalHealth. Advertising expenditures by Walgreen drive up its selling andadministrative expense percentage relative to that of Cardinal Health. Walgreen sellsfor cash or third party credit cards and will therefore have less receivables thanCardinal Health, which sells to businesses on credit.

It is interesting to note that the highest profit margins in the pharmaceuticalindustry occur with the upstream activities (discovery of new drugs) instead of thedownstream activities (wholesaling and retailing). It is also interesting to note thatthe profit margin of Quintiles lies between the high profit margins of the creators ofnew drugs and the low profit margins of those firms involved in distribution.Quintiles must possess some technical expertise in order to offer drug-testingservices, thus providing the rationale for a higher profit margin than those achievedby the wholesalers and retailers. The higher profit margin for Walgreen overCardinal Health is probably attributable to brand name recognition and the largenumber of retail stores nationwide. The wholesaling function of Cardinal is lowvalue added. The pharmaceutical benefit management services are somewhatdifferentiable but quickly copied by competitors.

It is also interesting to note the extent that these firms use long-term debtfinancing. The firms involved in upstream activities must invest in research andmanufacturing facilities, which can serve as collateral for borrowing. These firms,however, have high profit margins (which should enhance cash flow fromoperations) and high product risks (introduction of superior products bycompetitors, legal liability exposure). Thus, these firms tend not to add financialrisk to their already high asset-side risk. However, note that all the firms operatingin the various sectors of the pharmaceutical industry generally carry relatively lowamounts of debt.

1.15 Recasting the Financial Statements of a U.K. Company into U.S. Formats,Terminology, and Accounting Principles. The recast consolidated balance sheetis presented below. The instructor may wish to ask if there are any unusualrelationships between the structure of the assets and the structure of the financingof WPP Group. One unusual feature is the excess of current liabilities over currentassets. WPP Group serves as an intermediary between its clients desiring mediatime or space and the providers of that space. Accounts receivable includes theamounts receivable from clients and accounts payable includes amounts payable tomedia providers. The excess liability suggests a degree of short-term credit risk forWPP Group. A second issue is the amount of long-term debt. WPP Group has fewtangible assets to serve as collateral for this borrowing. Most of its long-term assetsare in the form of goodwill. This debt, coupled with the excess of current liabilitiesover current assets, suggest considerable financial risk. However, profitability did



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improve between Year 10 and Year 11. In addition, the WPP Group is one of themost established advertising groups in the world.

The recast consolidated income statement follows the balance sheet. Aninteresting issue to discuss is the classification of operating expenses. Commonpractice in the U.K. classifies expenses by their nature. The largest expense for amarketing services firm like WPP Group is compensation. The firm includes thisexpense in operating expenses rather than cost of goods sold. For WPP Group, theamount for cost of goods sold is only the cost of materials used in preparingadvertising copy for clients. Students will likely use a variety of single-step andmultiple-step income statement formats.

The recast consolidated statement of cash flows follows the income statement.The statement of cash flows in the U.K. uses five types of activities instead of theusual three categories in the U.S. Cash inflows from investments and cash outflowsfor interest and dividends appear as a separate category, as does cash outflows forincome taxes. The cash inflows from investments and the cash outflows for incometaxes are part of cash flow from operations in the U.S. The cash outflow fordividends is a financing activity in the U.S. The calculation of cash flow fromoperations appears at the bottom of the consolidated statement of cash flowsreported here.

Note that the WPP Group made significant acquisitions in both Year 11 andYear 10. It appears that the acquisitions in Year 11 were financed by mainly bankloans and to a lesser extent issuance of stock. The large swings in accountsreceivable and accounts payable during this two-year period is probably related tothese acquisitions made by WPP Group. The firm also increased its investment inproperty, plant and equipment during the year.

Students will often ask why the changes in various accounts on the balance sheet(for example accounts receivable, inventories) do not precisely equal the changes onthe statement of cash flows. The usual reason for this difference is that a firm hasacquired or sold another firm during the year. The purchase or sale causes individualaccounts to change (for example, accounts receivable, inventories). Such changes,however, appear as an investing activity on the statement of cash flows. Thus, partof the change in accounts receivable is an operating activity and part is an investingactivity.


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WPP GroupConsolidated Balance Sheet

(amounts in millions of pounds)(Problem 1.15)

December 31 Assets Year 10 Year 11Cash..................................................................................... £ 1,086 £ 586Marketable Securities.......................................................... -- 77Accounts Receivable ........................................................... 2,181 2,392Other Receivables................................................................ 233 248Inventories........................................................................... 223 237

Total Current Assets.................................................. £ 3,723 £ 3,540Investments in Securities..................................................... 552 553Property, Plant and Equipment (net).................................. 390 432Corporate Brands (a)........................................................... 950 950Goodwill (a) ........................................................................ 3,497 4,439

Total Assets............................................................... £ 9,112 £ 9,914

Liabilities and Shareholders' EquityAccounts Payable................................................................ £ 2,575 £ 2,506Bank Loans.......................................................................... 298 319Taxes Payable...................................................................... 164 166Other Current Liabilities ..................................................... 1,215 1,331

Total Current Liabilities............................................. £ 4,252 £ 4,322Long-term Debt................................................................... 1,280 1,712Deferred Taxes .................................................................... 30 41Pension Liability (b)............................................................ 99 153Other Noncurrent Liabilities ............................................... 57 46

Total Liabilities .......................................................... £ 5,718 £ 6,274

Shareholders' EquityMinority Interest ................................................................ £ 24 £ 41Common Stock.................................................................... 111 115Additional Paid-in Capital (c) ............................................. 3,310 3,407Retained Earnings................................................................ (211) (48)Accumulated Other Comprehensive Income....................... 160 125

Total Shareholders' Equity......................................... £ 3,394 £ 3,640Total Liabilities and Shareholders' Equity.................. £ 9,112 £ 9,914

(a) See Note 1 to the WPP Group financial statements.(b) Year 11 = £ 18 + 135; Year 10 = £ 11 + 88.(c) Year 11 = £ 1,044 + 2,363; Year 10 = £ 1,096 + 2,214.



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WPP GroupConsolidated Income Statement(amounts in millions of pounds)

(Problem 1.15)

Year 10 Year 11Sales..................................................................................... £ 13,949 £ 20,887Cost of Goods Sold............................................................. (245) (232)Gross Profit......................................................................... £ 13,704 £ 20,655Selling, General, and Administrative Expenses ................... (13,325) (20,149)Operating Income................................................................ £ 379 £ 506Other Income (Expense)...................................................... 38 (24)Interest Expense.................................................................. (52) (71)Income before Income Taxes and Minority Interest........... £ 365 £ 411Income Taxes....................................................................... (110) (126)Income before Minority Interest......................................... £ 255 £ 285Minority Interest in Earnings.............................................. (11) (14)Net Income (Loss)............................................................... £ 244 £ 271

WPP GroupConsolidated Statement of Cash Flows


Operations Year 10 Year 11Net Income (Loss)............................................................... £ 244 £ 271Depreciation........................................................................ 79 125Increase in Provisions.......................................................... 74 27Other Adjustmentsa ............................................................ 3 138(Increase) Decrease in Receivables and Prepayments......... (434) (5)(Increase) Decrease in Inventories....................................... (15) (18)Increase (Decrease) in Trade Creditors ............................... 539 (473)

Cash Flow from Operationsb..................................... £ 490 £ 65

InvestingAcquisition of Fixed Assets................................................ £ (112) £ (218)Acquisitions ........................................................................ (230) (696)Other Investing Activities................................................... (51) (125)

Cash Flow from Investing.......................................... £ (393) £ (1,039)


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FinancingIncrease (Decrease) in Bank Loans...................................... £ 128 £ 439Issue of Capital Stock ......................................................... 78 69Dividends ............................................................................ (26) (44)

Cash Flow from Financing ......................................... £ 180 £ 464Effect of Exchange Rate Changes on Cash and Cash Equivalents........................................................................ £ 35 £ 10Net Change in Cash and Cash Equivalents.......................... 312 (500)Cash and Cash Equivalents—Beginning of Year................. 774 1,086Cash and Cash Equivalents—End of Year .......................... £ 1,086 £ 586

aThe amount for "Other Adjustments" is a plug amount.bCash flow from operations includes the following from WPP Group's cash flowstatement:

Year 10 Year 11Net Cash Flow from Operating Activities.......................... £ 624 £ 174Net Cash Flow from Investments and Servicing of Finance (excluding dividends paid) ............................... (53) (31)Taxation............................................................................... (81) (78)

Cash Flow from Operations....................................... £ 490 £ 65



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1.16 Comprehensive Income.a. Changes in the recognition and valuation of assets and liabilities that do not

immediately affect net income and retained earnings—but will at some point inthe future—are reported as part of comprehensive income. Stated differently,comprehensive income equals net income for a period plus or minus the changein shareholders’ equity accounts other than changes from net income andtransactions with owners. For WPP Group, comprehensive income for Year 11is £236 as reported in the statement below.

WPP GroupConsolidated Statement of Comprehensive Income


Year 11Net income .................................................................................................. £ 271Foreign currency translation adjustment (a)................................................ (53)Pension benefit reserve (b).......................................................................... 18Comprehensive income ............................................................................... £ 236

(a) £133 – £80 as reported in Note 5 of WPP Group’s financial statements.(b) £27 – £45 as reported in Note 5 of WPP Group’s financial statements.

b Net income as a percent of turnover, or revenues, for Year 11 is 1.3 percent (=£271/£20,887). Comprehensive income as a percent of turnover for Year 11 is1.1 percent (= £236/£20,887). Although the ratio is lower using comprehensiveincome, the difference between the two is not significant. Furthermore, as youwill learn in subsequent chapters, analyzing the appropriate level for the ratioinvolves assessing the trend of the ratio over time, as well as comparing it toratios of other firms operating in similar industries. The difference between netincome and comprehensive income varies across firms, but regardless, to date itappears that analysts have not embraced the concept of comprehensive income.In addition, very few databases report comprehensive income and none of thecredit rating agencies (S&P, for example) emphasize comprehensive income intheir assessment of a firm’s profitability and risk.


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1.17 Recasting the Financial Statements of a German Company into U.S.Reporting Formats and Terminology.a. The recast balance sheet appears below. Several items on the balance sheet

require elaboration.

Leased Vehicles Note 2 indicates that this account captures the vehiclesleased to customers by Volkswagen. The leases are for a short duration and thus,the vehicle remains on the balance sheet of the company. An alternativedisclosure could be to include the leased vehicles in a separate category underproperty, plant and equipment.

Provisions Note 6 indicates that this account includes pension, warranties,restructuring, taxes and other provisions. With the exception of taxes payable, itis unclear whether these provisions should appear as current or as noncurrentliabilities. Pensions clearly are noncurrent. Warranties and restructuringprovisions likely have at least some current portion. Given the limited disclosuresmade by Volkswagen, we cannot delve any more deeply into this question. Weclassified all the provisions as noncurrent liabilities except for the taxes payablewhich we classify as current.

Deferred Income Volkswagen likewise does not disclose the term over whichit will recognize deferred income. Some of the amounts will almost certainly becurrent. We classify the entire amount as current.

Retained Earnings U.S. firms do not separate earnings available versusunavailable for dividends. Thus, retained earnings at the end of each year is acombination of Accumulated Profits and Revenue Reserves.

The instructor may wish to point out certain aspects of the assets andfinancing of Volkswagen. Accounts receivable and property, plant and equipmentdominate the asset side of the balance sheet. The accounts receivable relate toamounts due from both dealers and customers for assets leased. Note also theheavy proportion of debt in the capital structure. A large portion of currentliabilities represents bank borrowing. Industrial companies in Germany workclosely with their banks and tend to have higher proportions of their financingcome from this source. Other noncurrent liabilities also comprise a major portionof total financing. Included here are obligations to employees for pensions,warranty estimates, and other provisions unspecified by Volkswagen (see Note6).



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Balance Sheet for Volkswagen Group AG(in millions of €)(Problem 1.17)

December 31 Year 9 Year 10

AssetsCash............................................................................... € 2,156 € 4,285Marketable Securities.................................................... 3,886 3,610Accounts Receivable ..................................................... 41,432 45,166Inventories..................................................................... 9,335 9,945Prepayments ................................................................. 299 378

Total Current Assets............................................... € 57,108 € 63,384Investments in Securities............................................... 4,216 3,999Leased Vehicles ............................................................. 4,783 7,284Property, Plant, and Equipment (net)........................... 19,726 21,735Deferred Tax Assets...................................................... 1,377 1,426Goodwill and Other Intangibles .................................... 5,355 6,596

Total Assets............................................................ € 92,565 € 104,424

Liabilities and Shareholders’ EquityAccounts Payable.......................................................... € 7,435 € 7,055Bank Loans Payable...................................................... 26,201 30,044Advances from Customers............................................ 204 285Other Current Liabilities ............................................... 5,699 6,161Taxes Payable................................................................ 1,424 1,418

Total Current Liabilities.......................................... € 40,963 € 44,963Long-term Debt............................................................. 8,383 12,750Deferred Tax Liabilities................................................. 2,095 2,299Other Noncurrent Liabilities ......................................... 19,704 20,364

Total Liabilities ....................................................... € 71,145 € 80,376Shareholders’ EquityMinority Interest .......................................................... € 49 € 53Preferred Stock.............................................................. 268 272Common Stock.............................................................. 803 815Additional Paid-in Capital............................................. 4,296 4,415Retained Earnings.......................................................... 16,004 18,493

Total Shareholders’ Equity ..................................... € 21,420 € 24,048Total Liabilities and Shareholders’ Equity.............. € 92,565 € 104,424


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b. The recast income statement appears below. Different income statementformats are followed by U.S. companies that engage in both the manufacturingand sales financing of passenger and commercial vehicles. The format presentedbelow is similar to that followed by Ford Motor Company. However, Fordbreaks out selling and administrative expenses separately for its automotive andfinancial services division, whereas Volkswagen Group AG does not providethis breakdown.

Income Statement for Volkswagen Group AG(in millions of €)(Problem 1.17)

December 31 Year 9 Year 10

AutomotiveRevenues ....................................................................... € 83,127 € 88,540Cost of Goods Sold....................................................... (71,130) (75,586)

Gross profit—automotive....................................... € 11,997 € 12,954Financial ServicesRevenues ....................................................................... € 3,025 € 3,208Interest Expense............................................................ (1,812) (1,880)

Gross profit—financial services.............................. € 1,213 € 1,328Selling and Administrative Expense (a)......................... € (9,820) € (10,593)Other Operating Items (net) (b).................................... (105) 850Operating Income.......................................................... € 3,285 € 4,539Equity in Earnings of Affiliates..................................... 335 289Other Income (expense) ................................................ 99 (419)Income before Taxes and Minority Interest.................. € 3,719 € 4,409Income Tax Expense...................................................... (1,105) (1,483)Income before Minority Interest................................... € 2,614 € 2,926Minority Interest in Earnings........................................ (7) (11)Net Income.................................................................... € 2,607 € 2,915

(a) Consists of €7,554 + €2,154 + €885 for Year 10, and €7,080 + €2,001 + €739 forYear 9.

(b) Consists of €4,118 – €3,268 for Year 10, and €3,656 – €3,761 for Year 9.



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Integrative Case 1.1: Starbucks

I. Objectives

A. Identify the economics characteristics of the specialty coffee retail industryand Starbucks’ strategy for competing in this industry as background for theintegrative case on Starbucks used throughout the book.

B. Review the purpose, format, terminology and accounting principlesunderlying the balance sheet, income statement, and statement of cash flows.

C. Introduce common-size and percentage-change income statements andbalance sheets and the insights such statements provide.

II. Teaching Strategy—We have taught this case with two approaches. If anopportunity exists to assign students to prepare this case prior to the first class,we give students the solutions to the questions involving the balance sheet, incomestatement, statement of cash flows, and relations between financial statements. Weask them to review these parts on their own and then prepare solutions to thequestions under the sections labeled industry and strategy analysis and interpretingfinancial statement relationships. We devote the first class period to discussingthese two sections of the case. If students do not have access to the case prior tothe first class session, we devote approximately three hours of class to discuss theentire case. Alternatively, the instructor can choose to emphasize particularquestions based on the amount of time available and refer students to the solutionfor the remaining parts.

Industry and Strategy Analysisa. Porter’s five forces applied to the specialty coffee retail industry:

1. Buyer Power: Buyer power for specialty coffees is less than for commoditycoffees because consumers view specialty coffees as higher quality and moreunique. These characteristics of specialty coffees increase consumers’willingness to pay more for such coffees and make them less price sensitive.Combining the specialty coffee with a unique setting (the “Starbucksexperience”) in which consumers purchase and enjoy the coffee decreases stillfurther consumers’ price sensitivity. Thus, buyer power appears to berelatively low.

2. Supplier Power: Suppliers of the high-quality coffee beans used in specialtycoffees have a degree of power over their customers because of their customers’needs for such coffee beans. Commodity coffee beans are not an attractivealternative for such customers. Starbucks indicates that it sources its coffeebeans from suppliers around the world. It is not clear though whether this


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worldwide sourcing means that there are many suppliers of similar specialtycoffee beans, which would give firms like Starbucks an ability to switchsuppliers to gain an advantage, or because there are few suppliers of a varietyof specialty coffee beans, which give these suppliers more pricing power. Thefact that Starbucks negotiates annually with its suppliers at a fixed pricesuggests that both the availability of the specialty coffee beans and thevolatility of their prices puts the firm at risk. Thus, supplier power ismoderate.

3. Rivalry Among Existing Firms: There are few direct competitors in thespecialty coffee retail industry. However, firms such as Panera BreadCompany, Krispy Kreme, and others combine specialty coffees with otherofferings (sandwiches, donuts) and therefore compete with Starbucks. Theissue for Starbucks is whether the “Starbucks experience” sufficientlydifferentiates the firm from competitors whose specialty coffees might be ofequal quality. Rivalry among firms appears to be moderate.

4. Threat of New Entrants: Brand name and the number and location of retailstores appear to be the main barriers to entry. Starbucks certainly has theadvantage of an established brand name. It has also saturated the United Stateswith retail stores and is growing its business in other countries. The threat ofnew entrants offering a similar retail concept as Starbucks appears low.However, other established retail food chains have the ability to add specialtycoffees. Whether they could add the equivalent of the Starbucks experience”remains an open question. Thus, the threat of new entrants appears to be lowto moderate.

5. Threat of Substitutes: There are numerous beverage substitutes to specialtycoffee, which would tend to make the threat of substitutes high. However,there are fewer substitutes for the “Starbucks experience”, which lower thethreat of substitutes. Thus, the threat of substitutes appears to be low tomoderate.

b. Starbucks combines the sale of specialty coffees and other high-quality beverageswith a unique setting in which to enjoy the beverages. This combination hasallowed the firm to differentiate itself from direct competitors. Its marketsaturation in the United States has permitted the firm to establish a brand name,which it is now exporting to other countries. Its use of licensing arrangements hasfostered the rapid growth. Starbucks is now leveraging its brand name by sellingcoffee beans and ground coffees through grocery stores, warehouse clubs, and fooddistributors. It is also leveraging its brand name by forming partnerships withother established, brand name firms to sell various high-quality beverages.



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Starbucks appears to be aggressively pursuing multiple avenues to maintain itsgrowth, discourage new entrants, and leverage its brand name.

Balance Sheetc. Cash includes cash on hand and in checking accounts. Cash equivalents include

amounts that a firm can easily convert into cash. Cash equivalents usually have amaturity date of less than three months at the time of purchase, so that changes ininterest rates have an insignificant affect on their market value. Cash equivalentsmight include investments in United States Treasury bills, commercial paper, andmoney market funds.

d. Securities that are marketable and that a firm intends to sell within one year of thebalance sheet date appear in Marketable Securities. Securities for which there isnot a ready market in which to sell them and securities that a firm expects to holdfor more than one year appear in the noncurrent asset, Investment in Securities.

e. The allowance of uncollectible accounts account arises because Starbucksrecognizes revenue earlier than the time when it collects cash. Because Starbucks isnot likely to collect 100 percent of the amount reported as revenue, it mustrecognize an expense for estimated uncollectible accounts and reduce grossaccounts receivable to the amount it expects to collect in cash. Starbucks increasesthe balance in the allowance account for estimated uncollectible accounts arisingfrom revenue each year. It reduces the balance in the allowance account for actualcustomers’ accounts deemed uncollectible. Starbucks reports the balance in theallowance account as a subtraction from gross accounts receivable on the balancesheet.

f. The Accumulated Deprecation accounts reports the cumulative depreciationrecognized since the firm acquired depreciable assets that appear on the balancesheet. Depreciation Expense reports only the amount of depreciation recognizedfor a particular accounting period.

g. Deferred tax assets arise when a temporary difference between net income andtaxable income provides a future tax benefit to the firm. This occurs either (1)when a firm recognizes revenue earlier of tax reporting than for financial reporting(subsequent recognition of the revenue for financial reporting will not give rise to atax payment), or (2) when a firm recognizes expenses earlier for financial reportingthan for tax reporting (subsequent recognition of the expense for tax reporting willreduce income tax payments). Deferred tax liabilities arise when a temporarydifference will require a firm to make a tax payment in the future. This occurseither (1) when a firm recognizes revenue earlier for financial reporting than for taxreporting (subsequent recognition of the revenue for tax reporting will require the


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firm to pay taxes), or (2) when a firm recognizes an expense earlier for tax reportingthan for financial reporting (subsequent recognition of the expense for financialreporting does not give rise to a tax deduction, thereby increasing taxable incomeand taxes payable). Note that the classification of deferred taxes on the balancesheet for a particular revenue or expense depends on (1) whether temporarydifferences give rise to a deferred tax asset or a deferred tax liability, and (2) thetiming of the likely reversal of the temporary difference (less than one year orlonger than one year).

h. Generally accepted accounting principles (GAAP) require firms to reportmarketable securities and investments in securities at market value at the end ofeach accounting period. GAAP also requires firms in some circumstances totranslate the assets and liabilities of their foreign subsidiaries and branches intoU.S. dollars using the current exchange rate. Changes in the valuations of assetsand liabilities from these accounting principles give rise to unrealized gains andlosses that firms will not realize until they convert the assets into cash or settletheir liabilities with cash. The ultimate realized gain or loss depends on the marketprices of securities and the exchange rate at the time of sale or settlement. GAAPdoes not permit firms to include the unrealized gains or losses in net income, butinstead must include them in accumulated other comprehensive income. At thetime of sale or settlement, the amount of the gain or losses becomes established andrealized. At that time, the firm includes the realized gain or loss in net income.

Income Statementi. Revenues from company-owned stores represent the revenues from sale of

specialty coffees and other products in the retail stores that they own and manage.Revenues from licensing represent various fees Starbucks receives from retail storesthat it does not own or manage. Starbucks likely receives a fee based on revenuesof these stores. It also likely receives fees for paper products sold to the licenseesand for various services provided. Revenues from foodservice represent amountsreceived from the sale of products to grocery stores, warehouse clubs, and foodservice distributors. Note the Starbucks’ income from its partnerships ventureswith PepsiCo and Dreyer’s Grand Ice Cream, Inc.

j. Cost of sales likely includes the cost of the raw materials, such as coffee beans,teas, milk, and similar items, that make up its products. Occupancy costs includesrent, property taxes, insurance, utilities and maintenance costs of its company-owned stores. Store operating expenses include compensation of its employeesworking in the company-owned stores, as well as advertising and other marketingexpenses.



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k. As indicated in the answer to Part i. above, the Income of Equity Investeesrepresents Starbucks’ share of the earnings of partnerships with PepsiCo andDreyer’s Grand Ice Cream, Inc. Note that this amount is a revenue to Starbucks,but its represents Starbucks’ share of the bottom line of the income statements ofthe partnerships, not the top line (that is, the partnerships’ revenue). Starbucksreports its investments in these partnerships under Investments in Securities in thenoncurrent assets section of the balance sheet.

Statement of Cash Flowsl. Firms use the accrual basis of accounting in measuring net income. Firms usually

recognize revenue at the time of sale of goods and services, not necessarily whenthey receive cash from customers. Firms attempt to match expenses withassociated revenues, regardless of when they expend cash. The accrual basis givesa better indication of a firm’s operating performance than the cash basis because ofthe matching of inputs and outputs. The statement of cash flows reports theamount of cash received from customers net of amounts paid to suppliers of goodsand services.

m. Depreciation and amortization reduces net income but does not require a cashexpenditure in the year of their recognition (the cash effect occurred in the year afirm acquired the depreciable or amortizable asset; the firm classified the cashoutflow as an investing activity in the statement of cash flows at that time). Theaddition adds back to net income the amount subtracted in calculating earnings forthe year, in effect zeroing out its effect on cash flow from operations.

n. Net income on the first line of the statement of cash flows includes revenuesrecognized each year. Starbucks does not necessarily collect cash each year in anamount exactly equal to revenues. The subtraction for the increase in accountsreceivable means that Starbucks received less cash than it recognized as revenue.

o. Net income on the first line of the statement of cash flows includes a subtractionfor the cost of sales during each year. Starbucks likely purchases a differentamount of inventory than it uses or sells. An increase in inventories means thatStarbucks purchased more than it used or sold. Thus, the cash outflow forpurchases potentially exceeds cost of sales and requires a subtraction from netincome for the additional cash required. Whether additional cash was in factrequired in any year depends on the change in accounts payable, discussed next.

p. Accounts payable reflects amounts owed to suppliers for inventory itemspurchased. Purchases of inventory items increase this liability and cash paymentsreduce it. The adjustment for inventory in Part o. above converts cost of sales topurchases. The adjustment for accounts payable converts purchases to cash


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payments to suppliers. An increase in accounts payable means that Starbuckspurchased more than its cash expenditure for purchases. Thus, the adjustments forthe change in inventories and the change in accounts payable convert cost of salesincluded in net income to cash payments to suppliers of inventory items.

q. The Financial Accounting Standards Board requires firms to report most changes inmarketable securities as an investing activity, not an operating activity. Therationale is that firms derive operating cash flows by selling goods or services tocustomers, not from selling marketable securities.

r. The Financial Accounting Standards Board requires firms to report changes inshort-term borrowing as a financing activity, not an operating activity. Therationale is that firms derive operating cash flows by selling goods or services tocustomers, not by borrowing cash.

Relations Between Financial Statementss. Retained Earnings, September 30, Year 3............................................ $ 1,058.3

Net Income for Fiscal Year 4............................................................... 390.6Retained Earnings, September 30, Year 4............................................ $ 1,448.9

The fact that net income fully explains the change in retained earnings means thatStarbucks did not declare a dividend. The absence of a dividend in the financingsection of the statement of cash flows tends to confirm this conclusion.

t. Property, Plant and Equipment, September 30, Year 3 ...................... $ 2,516.3Plus Acquisition of Property, Plant and Equipment during Year 4

(See Statement of Cash Flows) .................................................... 412.5Less Acquisition Cost of Property, Plant and Equipment Sold or

Retired during Year 4 (Plug)......................................................... (51.1)Property, Plant and Equipment, September 30, Year 4 ...................... $ 2,877.7

We cannot determine the amount of accumulated depreciation on the property,plant and equipment sold because Starbucks does not report depreciationseparately from amortization.

Interpreting Financial Statement Relationsu. The difficulty with interpreting common-size percentages is that the amounts for a

particular account are not independent of the amounts for all other accounts. Notein Exhibit 1.27 that property, plant and equipment, net increased 11.2 percentbetween fiscal Year 2 and fiscal Year 3 and 7.2 percent between fiscal Year 3 andfiscal Year 4. Other assets, particularly cash and cash equivalents, investments in



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securities, and other noncurrent assets increased at a faster rate, thereby causing thecommon-size percentages for property, plant and equipment, net to decline.

v. The increased percentage for liabilities between fiscal Year 2 and fiscal Year 3results from an increase in the amount of other noncurrent liabilities and theincrease between fiscal Year 3 and fiscal Year 4 results from an increase in othercurrent liabilities. Although the amount of total shareholders’ equity increasedbetween these years, the amount of total liabilities increased even more.

w. Starbucks issued and repurchased common stock in each year. The net change incommon stock and additional paid-in capital was a 7.3 percent increase betweenfiscal Year 2 and fiscal Year 3 and a decline between fiscal Year 3 and fiscal Year 4.Retained earnings increased each year by the amount of net income, since Starbucksdid not pay a dividend. The rapid growth in net income led to a significant increasein the amount and thereby the common-size percentage for retained earnings.

x. The proportion of revenue from company-operated stores and foodservice declinedwhile the proportion from licensing increased, although the dollar amounts ofrevenue from these three sources all increased. Starbucks has licensed more newstores than it has opened new company-operated stores in recent years in an effortto expand quickly, leading to an increase in the common-size percentage ofrevenues for licensing.

y. The main contributing factors for the increase in the net income to revenuespercentage are the decline in the percentages for depreciation and amortizationexpense and general and administrative expense. The costs for these items tend tobe more fixed than for other operating expenses. As Starbucks has grown itsrevenues, it has spread these relatively fixed costs over a larger revenue base,resulting in declining expense percentage for these two expense items. The expensepercentages for cost of sales including occupancy costs increased, suggesting thatStarbucks has not passed along increases in the cost of raw materials or occupancyto its customers in the company-operated stores.


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Case 1.2: Nike: Somewhere Between a Swoosh and a Slam Dunk

I. ObjectivesA. Review the purpose, format, terminology and accounting principles

underlying the balance sheet, income statement, and statement of cash flows.

B. Introduce common-size and percentage-change income statements andbalance sheets and the insights such statements provide.

II. Teaching Strategy—We have taught this case with two approaches. If anopportunity exists to distribute the case prior to the first class session, we givestudents the solution to the questions involving the income statement, balancesheet, statement of cash flows, and relations between financial statement items.We ask them to review these parts on their own and then prepare the questionsunder the section labeled interpreting financial statement relationships. We devotethe first class session to discussing this last section of the case. If we cannotdistribute the case ahead of time, we devote approximately three hours of class todiscussing the case. Alternatively, the instructor can choose to emphasize certainquestions based on the amount of time available and refer students to the solutionfor the remaining parts.

Income Statementa. Nike apparently recognizes revenues from the sale of products at the time of sale.

It recognizes revenue from license fees as earned, which is probably at the time ofdelivery of products to licensees. The criteria for revenue recognition are (1)substantial performance of services to be provided, and (2) receipt of cash or areceivable whose cash-equivalent value a firm can measure with reasonableaccuracy. The sale of products to retailers constitutes substantial performanceunless Nike is required to take back unsold items. There is no indication thatreturns are substantial, and furthermore, Nike recognizes a reduction for returnsales at the time of sales. The “futures” ordering program likely matches productsto specific customer needs. Nike carries substantial accounts receivable from itscustomers. The allowance for uncollectible accounts had a balance equal to 4.3percent of gross accounts receivable [$95/($2,120 + $95)] at the end of Year 4 and3.8 percent [$82/($2,084 + $82)] at the end of Year 3. Thus, Nike’s revenuerecognition appears appropriate.

b. The Notes indicate that Nike uses FIFO for domestic and international inventories.Firms are free to select their inventory cost-flow assumption from the set deemedacceptable by standard-setting bodies. These bodies do not provide a set of criteriathat firms must apply to determine which inventory cost-flow assumption is“appropriate”. The Financial Accounting Standards Board permits firms in the



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United States to use FIFO, LIFO, weighted average, and several other methods.Nike probably uses FIFO because the physical flow of its inventory is FIFO.Also, Nike saves record keeping costs by using FIFO for both reporting to foreigngovernments and reporting to its shareholders in the U.S.

c. Nike does not conduct any of its own manufacturing. Thus, depreciation expenserelates to buildings and equipment used in selling and administrative activities.Nike’s income statement classifies expenses by their function instead of by theirnature. Thus, Nike includes depreciation expense in selling and administrativeexpenses.

d. The Notes indicate that income tax expense of $504 includes $495 payablecurrently and a decrease in deferred tax assets or an increase in deferred taxliabilities of $9. Firms recognize deferred taxes for temporary differences betweentaxable income and income for financial reporting. The taxable income of Nike forYear 4 is less than its income before taxes for financial reporting. This probablyoccurred because Nike recognized revenues for financial reporting in Year 4 that itwill recognize in later years for tax reporting and because it recognized expensesduring Year 4 for tax reporting that it will not recognize for financial reporting untillater years. The basis for measuring the amount of income tax expense is theamount of revenues and expenses recognized during the year for financial reporting.The basis for measuring income tax payable is the amount of revenues and expensesrecognized during the year for tax reporting. Because these amounts are usuallydifferent, firms are required to recognize deferred tax assets and deferred taxliabilities on their balance sheets. Governmental laws dictate the manner ofmeasuring taxable income. As long as firms apply these laws correctly inmeasuring their taxable income each year and pay the required taxes, they have noadditional obligation to governmental entities at this time. The presence of adeferred tax asset or a deferred tax liability on the balance sheet is not an indicationthat governmental bodies have permitted firms to delay paying taxes. Rather, itindicates the desire of standard-setters to match income tax expense with incomebefore taxes for financial reporting.

Balance Sheeta. The allowance for uncollectible accounts account arises because Nike recognizes

revenue earlier than the time when it collects cash. Because Nike is not likely tocollect 100 percent of the amount reported as sales revenue, it must recognize anexpense for estimated uncollectible accounts and reduce gross accounts receivableto the amount it expects to collect in cash. Nike increases the balance in theallowance account for estimated uncollectible accounts arising from sales each year.It reduces the balance in the allowance account for actual customers’ accounts


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deemed uncollectible. Nike reports the balance in the allowance account as asubtraction from gross accounts receivable.

b. The Notes indicate that Nike uses the straight-line method for buildings andleasehold improvements and the declining balance method for machinery andequipment. As with the inventory cost-flow assumption, standard-setting bodiesgive firms freedom to select any depreciation method from the set deemedacceptable. These bodies do not provide criteria as to which method is more“appropriate” for a particular firm. The methods that Nike uses for financialreporting closely coincide with the methods it uses for tax reporting. Thus, Nikesaves record-keeping costs by using similar depreciation methods for financial andtax reporting.

c. Generally accepted accounting principles in the United States require firms toexpense in the year incurred any expenditures (for example, advertising, promotion,quality control) to develop intangibles (patents, trademarks, goodwill). Thus,expenditures made to develop the Nike name or its trademarks will not appear onthe balance sheet as assets. Expenditures made to purchase intangibles from otherfirms will appear on the balance sheet as assets (in some cases subject toamortization). Most of the identifiable intangible assets and goodwill appearing onNike’s balance sheet arose from the acquisition of Converse, Inc. during Year 4 andBauer, Inc. several years ago.

d. Deferred tax assets arise when a temporary difference provides a future tax benefitfor a firm. This occurs either (1) when a firm recognizes revenue earlier for taxreporting than for financial reporting (subsequent recognition of the revenue forfinancial reporting will not give rise to a tax payment), or (2) when a firmrecognizes expenses earlier for financial reporting than for tax reporting(subsequent recognition of the expense for tax reporting will reduce income taxpayments). Deferred tax liabilities arise when a temporary difference will require afirm to make a tax payment in the future. This occurs either (1) when a firmrecognizes revenue earlier for financial reporting than for tax reporting (subsequentrecognition of the revenue for tax reporting will require the firm to pay taxes), or(2) when a firm recognizes an expense earlier for tax reporting than for financialreporting (subsequent recognition of the expense for financial reporting does notgive rise to a tax deduction, thereby increasing taxable income and taxes payable).Note that the classification of deferred taxes on the balance sheet depends on (1)whether temporary differences give rise to a deferred tax asset or deferred taxliability, and (2) the timing of the likely reversal of the temporary difference (lessthan one year or longer than one year).



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e. The Financial Accounting Standards Board concluded that firms should reportchanges in assets and liabilities that do not immediately affect net income andretained earnings—but may affect them in the future—as a separate component ofshareholders’ equity in the account Accumulated Other Comprehensive Income. Inthis case, Nike’s “losses” relate to foreign currency translation and derivatives.

Statement of Cash Flowsa. Firms use the accrual basis of accounting in measuring net income. Firms usually

recognize revenue at the time of sale of goods and services, not necessarily whenthey receive cash from customers. Firms attempt to match expenses withassociated revenues, regardless of when they expend cash. The accrual basis givesa better indication of a firm’s operating performance than the cash basis because ofthe matching of inputs and outputs. The statement of cash flows reports theamount of cash received from customers net of amounts paid to suppliers of goodsand services.

b. Depreciation expense reduces net income but does not require a cash expenditure inthe year of their recognition (the cash effect occurred in the year a firm acquired theproperty, plant, equipment; the firm classified the cash outflow as an investingactivity in the statement of cash flows at that time). The addition adds back to netincome the amount subtracted in calculating earnings for the year.

c. Question d. in the Income Statement questions indicated that NIKE paid lessincome taxes during Year 4 than it recognized as income tax expense. Net incomeon the first line of the statement of cash flows reflects a subtraction for theTOTAL amount of income tax expense, whereas only a portion of it was paid outin cash in Year 2, Year 3 and Year 4. The difference is added back to net income incalculating cash from operation to correct for the portion of income tax expensethat did not use cash.

d. Net income on the first line of the statement of cash flows includes revenuesrecognized each year. Nike does not necessarily collect cash each year in anamount exactly equal to revenues. It may collect cash during Year 4 from salesmade in prior years and it may not collect cash on some sales made in Year 4 untillater years. The addition for the decrease in accounts receivable means that Nikereceived more cash than it recognized as sales revenue.

e. Net income on the first line of the statement of cash flows includes a subtractionfor the cost of goods sold during each year. Nike will likely purchase a differentamount of inventory than it sells. An increase in inventories means that Nikepurchased more than it sold. Thus, the cash outflow for purchases potentiallyexceeds cost of goods sold and requires a subtraction from net income for the


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additional cash required. Whether additional cash was in fact required in any yeardepends on the change in accounts payable, discussed next.

f. Accounts payable reflects amounts owed to suppliers for inventory itemspurchased. Purchases of inventory items increase this liability and cash paymentsreduce it. The adjustment for inventory in Part e. above converted cost of goodssold to purchases. The adjustment for accounts payable converts purchases tocash payments to suppliers. An increase in accounts payable means that Nikepurchased more than its cash expenditure for purchases. Thus, the adjustments forthe change in inventories and the change in accounts payable convert cost of goodssold included in net income to cash payments to suppliers for inventory items.The accrued liabilities and income tax payable accounts reflect amounts owed tosuppliers of various services. Purchases of these services increase these liabilitiesand cash payments reduce them. Net income on the first line of the statement ofcash flows includes an expense for the cost of these services consumed during theyear. An increase in the liability for these items means that the cash expenditureduring the year was less than the amount recognized as an expense. The additionto net income indicates that the cash outflow was less than the expense. Cash flowfrom operations did not decrease by the full amount of the expense.

g. The Financial Accounting Standard Board requires firms to report the proceedsfrom selling property, plant and equipment as an investing activity. Their rationalefor this classification is two-fold: (1) selling such noncurrent assets is not theprimary operating activity of most companies, and (2) cash expenditures topurchase these assets appear as investing activities. If a firm sells such assets at again or loss, it must subtract the gain from net income or add back the loss to netincome when computing cash flow from operations. This subtraction or additionnets the effect of the gain or loss to zero in the operating section of the statementof cash flows and shows the full cash proceeds as an investing activity. Any gainsor losses for Nike were sufficiently small that it did not disclose them separately.

h. The Financial Accounting Standards Board requires firms to report changes inshort-term bank borrowing as a financing activity. Their rationale for not includingsuch borrowing as an operating activity, which is the classification of changes inother current liabilities, is that a firm does not generate operating cash flows byborrowing from banks. Operating cash flows come from selling goods and servicesto customers. Changes in other current liabilities on the other hand relate directlyto purchases of goods and services used in operations, justifying their inclusion inthe operating section of the statement of cash flows.



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Relations between Financial Statement Items (amounts in millions)a. Sales Revenue ................................................................................ $ 12,253

Decrease in Accounts Receivable* ................................................ 83Cash Collected from Customers.................................................... $ 12,336

b. Cost of Goods Sold ....................................................................... $ 7,001Increase in Inventories*................................................................. 56Cost of Inventories Purchased....................................................... $ 7,057Increase in Accounts Payable**.................................................... (191)Cash Paid for Purchases of Inventory........................................... $ 6,866

*Amount taken from the Consolidated Statement of Cash Flows.**Amount taken from the Consolidated Balance Sheet. It represents an approximation

because Nike combines the change in Accounts Payable with the change in OtherCurrent Liabilities. The change in Accounts Payable on the balance sheet includesthe effect of both operating activities and a corporate acquisition during the year.

c. Property, Plant and Equipment (at cost):Balance, May 31, Year 3 ($1,621 + $1,368) ................................. $ 2,989Purchases of Property, Plant and Equipment ............................... 224Book Value of Property, Plant and Equipment Disposed (plug).. (81)Balance, May 31, Year 4 ($1,587 + $1,545) ................................. $ 3,132

Accumulated Depreciation:Balance, May 31, Year 3 ............................................................... $ 1,368Depreciation Expense for fiscal Year 4.......................................... 252Accumulated Depreciation of Property, Plant and Equipment Disposed for fiscal Year 4 (plug)................................................ (75)Balance, May 31, Year 4 ............................................................... $ 1,545

Cash Proceeds from Disposal of Property, Plant and Equipment .................................................................................. $ 12Book Value of Property, Plant and Equipment Disposed: ($81 – $75) .................................................................................. (6)Gain on Sale of Property, Plant and Equipment ........................... $ 6

Nike likely includes the gain in Other Income (Expenses), net on the incomestatement. It subtracted the gain from net income in calculating cash flow fromoperations, probably on its line labeled “other”.


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d. Retained earnings increased during Year 4 by $338 million (= $3,977 – $3,639).Net income increased retained earnings by $946 million, dividends reduced retainedearnings by $179 million, for a net increase of $767 million (= $946 – $179). Therepurchase and retirement of Nike common stock must have resulted in a chargeagainst retained earnings of $429 million (= $338 – $767). Note that mostcompanies report the cost of treasury stock purchased on a separate line in theshareholders’ equity section of the balance sheet. Nike chooses to report suchrepurchases as the retirement of the stock. The charge against retained earningsreflects the increases in the stock price in previous years resulting from theretention of earnings.

Interpreting Financial Statement Relationshipsa. The improved net income/sales percentage over the three-year period results from

the net effect of a decrease in the cost of goods sold to sales percentage and anincrease in the selling and administrative expenses to sales percentage.

b. The move to apparel changes the product mix and could result in sales of morehigher-margin products. The move to Europe and other countries may also resultin higher margin sales. The introduction of more upscale shoes would also likelyincrease the gross margin, although there is no evidence in the case that thisoccurred. Another factor may be favorable exchange rate changes. This in factoccurred, but most students will not likely have the background to understand thisexplanation. During this period, the Euro increased in value relative to the U.S.dollar. Nike denominates its purchases in U.S. dollars. It denominates sales inEurope in Euros. A higher gross margin results from an increase in the value of theEuro.

c. The increase in selling and administrative expense to sales percentages betweenYear 2 and Year 4 likely results from the need to increase marketing efforts(advertising and celebrity endorsements) in a period of slower growth in sales.

d. Nike outsources its manufacturing and also outsources most of the retailing of itsproducts. Thus, the principal fixed assets are corporate headquarters, researchfacilities, warehouses, and transportation equipment. One might think of Nike asserving essentially a wholesaling function along with product development andpromotion.

e. Nike has few fixed assets to serve as collateral for borrowing. Also, Nike generatesmore than sufficient cash flow from operations to finance the small amount ofinvestments in fixed assets. Thus, Nike does not need significant long-term debtfinancing.



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f. As discussed in Question d., Nike outsources the production of its products tomanufacturers located in Asia. The property, plant and equipment needs of Nikeare minimal, and probably represent warehouses and distribution facilities. Assuch, one might expect minimal increases or even decreases in property, plant andequipment each year.

g. Nike experienced a substantial increase in accounts receivable and inventories thatexceeded the increase in sales and net income. Cash flow from operations thereforedeclined between the two years.

h. In each year, Nike reported a significant addback for depreciation. Althoughdepreciation is not a source of cash, it is deducted as an expense on the incomestatement to arrive at net income. For firms that have depreciation charges,inevitably cash flows from operations will be greater than net income because netincome includes this expense, whereas it is excluded (added back) as a cash flowfrom operations.

i. Cash flow from operations exceeded expenditures on property, plant andequipment each year, so Nike did not need to rely on external financing for itscapital expenditures.

j. The repurchases of common stock substantially exceeded the issue of new stockunder stock option plans and other stock issues in all three years. Thus,repurchasing shares to maintain a level number of shares outstanding to avoiddilution does not appear to be the primary reason for the stock repurchases. It islikely that Nike had excess cash and felt that its stock price was undervalued. Suchstock repurchases often result in an increase in the market price of the stock.

k. In fact, Nike approximately maintained its dividend payout rate (dividends as apercentage of net income) during this three-year period. The total amount ofdividends paid out each year increased with the increase of net income. Note thatthe dividend rate per outstanding share of common stock had to increase as a result.


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