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sub79433_front.qxd 4/5/08 12:44 AM Page Analysis Feature An article featuring a company launches each chapter to highlight the relevance of that chapter’s materials In-chapter analysis is performed on the feature company Analysis Objectives Chapters open with key analysis objectives that highlight important chapter goals Analysis Linkages Linkages launch each chapter to establish bridges between topics and concepts in prior, current, and upcoming chapters Analysis Preview A preview kicks off each chapter by describing its contents and their importance ANALYSIS CENTER The Analysis Center is a pedagogical framework unique to this book Its purpose is to aid in understanding, interpretating, and applying financial statement analysis by providing a cohesive, motivating framework for learning It focuses attention on key features that highlight the relevance and importance of the analysis of financial statements Analysis Viewpoint Multiple role-playing scenarios in each chapter are a unique feature that shows the relevance of financial statement analysis to a wide assortment of decision makers Analysis Excerpt Numerous excerpts from practice—including annual report disclosures, newspaper clippings, and press releases—illustrate key points throughout each chapter Excerpts reinforce the relevance of the analysis and engage the reader SUPPLEMENTS Teaching and Learning Supplements are a special part of this book Each supplement is customer driven, user friendly, and fully integrated No other financial statement analysis book offers instructors a greater wealth of instructional and learning resources • Online Learning Center: http://www.mhhe.com/subramanyam10e • Instructor’s Solutions Manual— on Online Learning Center • Test Bank— on Online Learning Center • Chapter Lecture Slides— PowerPoint version; on Online Learning Center • Case Material—Primis custom case selection: www.mhhe.com/primis • Financial Accounting Video Library Volumes through 4: ISBN: 0-07-237616-3 EAN-978-0-07-237616-6 ORGANIZATION AND FOCUS Financial statement analysis is part of the broader task of business analysis Chapters and provide an overview and describe this broader task, including industry and strategy analysis Chapters 3, 4, 5, and focus on accounting analysis and the necessary adjustments to financial statements Chapters 7, 8, 9, 10, and 11 focus on financial analysis, including prospective analysis The following diagram reflects this organization and focus: Business Environment and Strategy Analysis Analysis Research Multiple short boxes in each chapter discuss current research relevant to analysis and interpretation of financial statements Industry Analysis Analysis Annotation Each chapter includes marginal annotations These are aimed at relevant, interesting, and topical happenings from business that bear on financial statement analysis Analysis Feedback End-of-chapter assignments include traditional and innovative assignments augmented by several cases that draw on actual financial statements such as those from American Airlines, Best Buy, Campbell Soup, Cendant, Citicorp, Coca Cola, Colgate, Delta Airlines, Kimberly-Clark, Kodak, Marsh Supermarkets, Merck, Microsoft, Newmont Mining, Philip Morris, Quaker Oats, Sears, TYCO, Toys “R” Us, United Airlines, Walt Disney, and Wal-Mart Assignments are of four types: Questions, Exercises, Problems, and Cases Each assignment is titled to reflect its purpose—many require critical thinking, communication skills, interpretation, and decision making Analysis Focus Companies The entire financial statements of two companies—Colgate and Campbell Soup—are reproduced in the book and used in numerous assignments Experience shows that frequent use of annual reports heightens interest and learning These reports include notes and other information ISBN: 0073379433 Author: Subramanyam Title: Financial Statement Analysis, 10e Front Endsheet Color: 1c, PMS 539M Pages: 2, • Prerequisite Skills Development: MBA Survival Kit CD, ISBN: 0-07-304454-7 EAN-978-0-07-304454-5 Essentials of Finance with Accounting CD, ISBN: 0-07-256472-5 EAN-978-0-07-256472-3 • Financial Shenanigans (casebook), ISBN: 0-07-138626-2 EAN-978-0-07-138626-5 • Customer Service— 1-800-338-3987 Strategy Analysis Financial Statement Analysis Accounting Analysis Financial Analysis Prospective Analysis Profitability Analysis of Sources Risk Analysis and Uses of Funds Analysis Cost of Capital Estimate Intrinsic Value sub79433_front.qxd 4/5/08 12:44 AM Page Analysis Feature An article featuring a company launches each chapter to highlight the relevance of that chapter’s materials In-chapter analysis is performed on the feature company Analysis Objectives Chapters open with key analysis objectives that highlight important chapter goals Analysis Linkages Linkages launch each chapter to establish bridges between topics and concepts in prior, current, and upcoming chapters Analysis Preview A preview kicks off each chapter by describing its contents and their importance ANALYSIS CENTER The Analysis Center is a pedagogical framework unique to this book Its purpose is to aid in understanding, interpretating, and applying financial statement analysis by providing a cohesive, motivating framework for learning It focuses attention on key features that highlight the relevance and importance of the analysis of financial statements Analysis Viewpoint Multiple role-playing scenarios in each chapter are a unique feature that shows the relevance of financial statement analysis to a wide assortment of decision makers Analysis Excerpt Numerous excerpts from practice—including annual report disclosures, newspaper clippings, and press releases—illustrate key points throughout each chapter Excerpts reinforce the relevance of the analysis and engage the reader SUPPLEMENTS Teaching and Learning Supplements are a special part of this book Each supplement is customer driven, user friendly, and fully integrated No other financial statement analysis book offers instructors a greater wealth of instructional and learning resources • Online Learning Center: http://www.mhhe.com/subramanyam10e • Instructor’s Solutions Manual— on Online Learning Center • Test Bank— on Online Learning Center • Chapter Lecture Slides— PowerPoint version; on Online Learning Center • Case Material—Primis custom case selection: www.mhhe.com/primis • Financial Accounting Video Library Volumes through 4: ISBN: 0-07-237616-3 EAN-978-0-07-237616-6 ORGANIZATION AND FOCUS Financial statement analysis is part of the broader task of business analysis Chapters and provide an overview and describe this broader task, including industry and strategy analysis Chapters 3, 4, 5, and focus on accounting analysis and the necessary adjustments to financial statements Chapters 7, 8, 9, 10, and 11 focus on financial analysis, including prospective analysis The following diagram reflects this organization and focus: Business Environment and Strategy Analysis Analysis Research Multiple short boxes in each chapter discuss current research relevant to analysis and interpretation of financial statements Industry Analysis Analysis Annotation Each chapter includes marginal annotations These are aimed at relevant, interesting, and topical happenings from business that bear on financial statement analysis Analysis Feedback End-of-chapter assignments include traditional and innovative assignments augmented by several cases that draw on actual financial statements such as those from American Airlines, Best Buy, Campbell Soup, Cendant, Citicorp, Coca Cola, Colgate, Delta Airlines, Kimberly-Clark, Kodak, Marsh Supermarkets, Merck, Microsoft, Newmont Mining, Philip Morris, Quaker Oats, Sears, TYCO, Toys “R” Us, United Airlines, Walt Disney, and Wal-Mart Assignments are of four types: Questions, Exercises, Problems, and Cases Each assignment is titled to reflect its purpose—many require critical thinking, communication skills, interpretation, and decision making Analysis Focus Companies The entire financial statements of two companies—Colgate and Campbell Soup—are reproduced in the book and used in numerous assignments Experience shows that frequent use of annual reports heightens interest and learning These reports include notes and other information ISBN: 0073379433 Author: Subramanyam Title: Financial Statement Analysis, 10e Front Endsheet Color: 1c, PMS 539M Pages: 2, • Prerequisite Skills Development: MBA Survival Kit CD, ISBN: 0-07-304454-7 EAN-978-0-07-304454-5 Essentials of Finance with Accounting CD, ISBN: 0-07-256472-5 EAN-978-0-07-256472-3 • Financial Shenanigans (casebook), ISBN: 0-07-138626-2 EAN-978-0-07-138626-5 • Customer Service— 1-800-338-3987 Strategy Analysis Financial Statement Analysis Accounting Analysis Financial Analysis Prospective Analysis Profitability Analysis of Sources Risk Analysis and Uses of Funds Analysis Cost of Capital Estimate Intrinsic Value sub79433_fm.qxd 4/16/08 6:32 PM Page i financial stat e m e n t a na lys i s TENTH EDITION K R SUBRAMANYAM University of Southern California JOHN J WILD University of Wisconsin at Madison Boston Burr Ridge, IL Dubuque, IA New York San Francisco St Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto sub79433_fm.qxd 4/16/08 6:32 PM Page ii FINANCIAL STATEMENT ANALYSIS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020 Copyright © 2009, 2007, 2004, 2001, 1998, 1993, 1989, 1983, 1978, 1974 by The McGraw-Hill Companies, Inc All rights reserved No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper QPD/QPD ISBN MHID 978-0-07-337943-2 0-07-337943-3 Editorial director: Stewart Mattson Executive editor: Richard T Hercher, Jr Editorial assistant: Christina Lane Associate marketing manager: Dean Karampelas Managing editor: Lori Koetters Senior production supervisor: Debra R Sylvester Design coordinator: Joanne Mennemeier Lead media project manager: Cathy L Tepper Cover design: JoAnne Schopler Cover image: Getty images Typeface: 10/12 Caslon Book BE Compositor: ICC Macmillan Inc Printer: Quebecor World Dubuque Inc Library of Congress Cataloging-in-Publication Data Subramanyam, K R Financial statement analysis/K R Subramanyam, John J Wild — 10th ed p cm Wild’s name appears first on earlier editions Includes index ISBN-13: 978-0-07-337943-2 (alk paper) ISBN-10: 0-07-337943-3 (alk paper) Financial statements I Wild, John J II Title HF5681.B2W4963 2009 657Ј.3—dc22 2008008981 www.mhhe.com sub79433_fm.qxd 4/16/08 6:32 PM Page iii D E D I C AT I O N To my wife Jayasree, son Sujay, and our parents —K R S To my wife Gail and children Kimberly, Jonathan, Stephanie, and Trevor —J J W iii sub79433_fm.qxd 4/16/08 6:32 PM Page iv P R E FAC E W elcome to the tenth edition of Financial Statement Analysis This book is the product of extensive market surveys, chapter reviews, and correspondence with instructors and students We are delighted that an overwhelming number of instructors, students, practitioners, and organizations agree with our approach to analysis of financial statements This book forges a unique path in financial statement analysis, one that responds to the requests and demands of modern-day analysts From the outset, a main goal in writing this book has been to respond to these needs by providing the most progressive, accessible, current, and user-driven textbook in the field We are pleased that the book’s reception in the United States and across the world has exceeded expectations Analysis of financial statements is exciting and dynamic This book reveals keys to effective analysis to give readers a competitive advantage in an increasingly competitive marketplace We know financial statements are relevant to the decisions of many individuals including investors, creditors, consultants, managers, auditors, directors, analysts, regulators, and employees This book equips these individuals with the analytical skills necessary to succeed in business Yet, experience in teaching this material tells us that to engage readers we must demonstrate the relevance of analysis This book continually demonstrates that relevance with applications to real world companies The book aims to benefit a broad readership, ranging from those with a simple curiosity in financial markets to those with years of experience in accounting and finance ORGANIZATION AND CONTENT This book’s organization accommodates different teaching styles While the book is comprehensive, its layout allows instructors to choose topics and depth of coverage as desired Readers are told in Chapter how the book’s topics are related to each other and how they fit within the broad discipline of financial statement analysis The book is organized into three parts: Analysis Overview Accounting Analysis Financial Analysis ANALYSIS OVERVIEW Chapters and are an overview of financial statement analysis We introduce financial statement analysis as an integral part of the broader framework of business analysis We examine the role of financial statement analysis in different types of business analysis such as equity analysis and credit analysis We emphasize the understanding of business iv sub79433_fm.qxd 4/16/08 6:32 PM Page v Preface activities—planning, financing, investing, and operating We describe the strategies underlying business activities and their effects on financial statements We also emphasize the importance of accrual accounting for analysis and the relevance of conducting accounting analysis to make appropriate adjustments to financial statements before embarking on financial analysis We apply several popular tools and techniques in analyzing and interpreting financial statements An important and unique feature is our use of Colgate’s annual report as a means to immediately engage readers and to instill relevance The chapters are as follows: Chapter We begin the analysis of financial statements by considering their relevance to business decisions This leads to a focus on users, including what they need and how analysis serves them We describe business activities and how they are reflected in financial statements We also discuss both debt and equity valuation Chapter This chapter explains the nature and purpose of financial accounting and reporting, including the broader environment under which financial statements are prepared and used We highlight the importance of accrual accounting in comparison to cash accounting We also introduce the concept of income and discuss issues relating to fair value accounting The importance and limitations of accounting data for analysis purposes are described along with the significance of conducting accounting analysis for financial analysis ACCOUNTING ANALYSIS To aid in accounting analysis, Chapters through explain and analyze the accounting measurement and reporting practices underlying financial statements We organize this analysis around financing (liabilities and equity), investing (assets), and operating (income) activities We show how operating activities are outcomes of changes in investing and financing activities We provide insights into income determination and asset and liability measurement Most important, we discuss procedures and clues for the analysis and adjustment of financial statements to enhance their economic content for meaningful financial analysis The four chapters are: Chapter Chapter begins the detailed analysis of the numbers reflecting financing activities It explains how those numbers are the raw material for financial analysis Our focus is on explaining, analyzing, interpreting, and adjusting those reported numbers to better reflect financing activities Crucial topics include leases, pensions, off-balance-sheet financing, and shareholders’ equity Chapter This chapter extends the analysis to investing activities We show how to analyze and adjust (as necessary) numbers that reflect assets such as receivables, inventories, property, equipment, and intangibles We explain what those numbers reveal about financial position and performance, including future performance Chapter Chapter extends the analysis to special intercompany investing activities We analyze intercorporate investments, including equity method investments and investments in derivative securities, and business combinations Also, in an appendix we examine international investments and their reporting implications for financial statements Chapter This chapter focuses on analysis of operating activities and income We discuss the concept and measurement of income as distinct from cash flows We v sub79433_fm.qxd vi 4/16/08 6:32 PM Page vi Preface analyze accrual measures in yielding net income Understanding recognition methods of both revenues and expenses is stressed We analyze and adjust the income statement and its components, including topics such as restructuring charges, asset impairments, employee stock options, and accounting for income taxes FINANCIAL ANALYSIS Chapters through 11 examine the processes and methods of financial analysis (including prospective analysis) We stress the objectives of different users and describe analytical tools and techniques to meet those objectives The means of analysis range from computation of ratio and cash flow measures to earnings prediction and equity valuation We apply analysis tools that enable one to reconstruct the economic reality embedded in financial statements We demonstrate how analysis tools and techniques enhance users’ decisions—including company valuation and lending decisions We show how financial statement analysis reduces uncertainty and increases confidence in business decisions This section consists of five chapters and a Comprehensive Case: Chapter This chapter begins our study of the application and interpretation of financial analysis tools We analyze cash flow measures for insights into all business activities, with special emphasis on operating activities Attention is directed at company and industry conditions when analyzing cash flows Chapter Chapter emphasizes return on invested capital and explains variations in its measurement Attention is directed at return on net operating assets and return on equity We disaggregate both return measures and describe their relevance We pay special attention to disaggregation of return on equity into operating and nonoperating components, as well as differences in margins and turnover across industries Chapter We describe forecasting and pro forma analysis of financial statements We present forecasting of the balance sheet, income statement, and statement of cash flows with a detailed example We then provide an example to link prospective analysis to equity valuation Chapter 10 This chapter focuses on credit analysis, both liquidity and solvency We first present analysis tools to assess liquidity—including accounting-based ratios, turnover, and operating activity measures Then, we focus on capital structure and its implications for solvency We analyze the importance of financial leverage and its effects on risk and return Analytical adjustments are explained for tests of liquidity and solvency We describe earnings-coverage measures and their interpretation Chapter 11 The final chapter emphasizes earnings-based analysis and equity valuation The earnings-based analysis focuses on earnings quality, earnings persistence, and earning power Attention is directed at techniques for measuring and applying these concepts Discussion of equity valuation focuses on forecasting accounting numbers and estimating company value Comprehensive Case This case is a comprehensive analysis of financial statements and related notes We describe steps in analyzing the statements and the essential attributes of an analysis report Our analysis is organized around key components of financial statement analysis: cash analysis, return on invested capital, asset utilization, operating performance, profitability, forecasting, liquidity, capital structure, and solvency sub79433_fm.qxd 4/16/08 6:32 PM Page vii Preface KEY CHANGES IN THIS EDITION Many readers provided useful suggestions through chapter reviews, surveys, and correspondence We made the following changes in response to these suggestions: Colgate Replaces Dell as a Featured Company Colgate provides a stable consumer products company to illustrate the analysis; it is also used to explain many business practices and is of interest to a broad audience Campbell Soup is retained as another company for illustrations and assignments Discussion on Fair Value Accounting (Chapter 2) The large-scale adoption of fair value accounting is one of the most significant events in the history of accounting Fair value accounting will fundamentally change the way we analyze the financial statements Chapter provides a conceptual introduction to fair value accounting by incorporating some of the material from the recent standards on fair value accounting The discussion also covers analysis implications of fair value accounting Discussion on Concept of Income (Chapter 2) The discussion on income concepts has been streamlined and moved to Chapter Covering income concepts in the overview part of the text will provide a nice framework to understand accounting analysis issues covered in Chapters to Expanded Discussion of Accrual Accounting (Chapter 2) Accrual accounting is the cornerstone of financial statement analysis This edition includes further discussion to aid students in their analysis and interpretation of company fundamentals Streamlining and updating discussion on postretirement benefits (Chapter 3) A revised Chapter further streamlines the discussion relating to pensions and other postretirement employee benefits (OPEBs) In particular, the discussion in the chapter has been considerably shortened to give an overview of pension and OPEB accounting A detailed discussion of pension accounting mechanics with the help of an integrated illustration is now provided separately in an appendix The discussion has also been updated so as to incorporate the recent changes to pension and OPEB accounting with its analysis implications Equity Carve-Outs Included (Chapter 3) Equity carve-outs, spin-offs, and split-offs have increased in frequency as companies seek to unlock shareholder value Chapter includes a new section to introduce the accounting for and interpretation of them Investments in Marketable and Derivative Securities (Chapter 5) This edition consolidates all securities investments in one chapter The discussion has been updated to incorporate some of the latest fair value–based standards The analysis of foreign currency disclosures is streamlined and placed in an appendix to Chapter Fair Value Option (Chapter 5) Companies are now allowed the option of measuring financial assets and liabilities on a fair value basis Chapter now includes a separate section regarding the fair value option with its analysis implications Employee Stock Options Updated (Chapter 6) The discussion on employee stock options has been streamlined and updated to incorporate the latest accounting pronouncements Income Tax Accounting Streamlined (Chapter 6) The discussion on income tax accounting and analysis has been thoroughly rewritten and streamlined vii sub79433_references.qxd R4 4/11/08 12:09 PM Page R4 Financial Statement Analysis Dhaliwal, D.; D Guenther; and M Trombley “Inventory 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Dividends.” Financial Analysts Journal, July/August 1994, pp 23–31 Fairfield, P M.; R J Sweeney; and T L Yohn “Accounting Classification and the Predictive Content of Earnings.” The Accounting Review, July 1996, pp 337–56 Fairfield, P M.; R J Sweeney; and T L Yohn “Non-Recurring Items and Earnings Predictions.” The Journal of Financial Statement Analysis, Summer 1996, pp 30–40 Fama, E “Efficient Markets: II.” Journal of Finance 46, 1991, pp 1575–617 Fama, E “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance, 1970 Fama, E.; and K French “Forecasting Profitability and Earnings.” Journal of Business, 2000 Fama, E.; and K French “Size and Book-to-Market Factors in Earnings and Returns.” Journal of Finance 50, 1995, pp 131–56 Fama, E.; and K French “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33, 1993, pp 3–56 Fama, E.; and K French “The Cross-Section of Expected Stock Returns.” Journal of Finance 47, 1992, pp 427–65 Feltham, J.; and J A Ohlson “Valuation and Clean Surplus Accounting for Operating and Financial Activities.” Contemporary Accounting Research, Spring 1995, pp 689–731 Fesler, R D “Disclosure of Litigation Contingencies.” Journal of Accountancy, July 1990, p 15 Finger, C “The Ability of Earnings to Predict Future Earnings and Cash Flow.” Journal of Accounting Research 32, 1994, pp 210–23 Francis, J.; D Hanna; and L Vincent, “Causes and Consequences of Discretionary Asset Write-Offs.” Journal of Accounting Research, Supplement, 1996, pp 117–34 Francis, J.; P Olsson; and D Oswald “Comparing the Accuracy and Explainability of Dividends, Cash Flows, and Abnormal Earnings Equity Valuation Models.” working paper, 1997, University of Chicago Francis, J.; and K Schipper “Have Financial Statements Lost Their Relevance?” Journal of Accounting Research 37, 1999, pp 319–52 Freeman, R.; J Ohlson; and S Penman “Book Rate-of-Return and Prediction of Earnings Changes: An Empirical 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A Reexamination.” working paper, 1997, University of Iowa Zarowin, P “What Determines Earnings-Price Ratios: Revisited.” Journal of Accounting Auditing and Finance, Summer 1990, pp 439–54 Ziebart, D A.; and D H Kim “An Examination of the Market Reactions Associated with SFAS No and SFAS No 52.” The Accounting Review, April 1987, pp 343–57 sub79433_index.qxd 4/21/08 10:06 AM Page IN1 INDEX Page numbers followed by n indicate material found in footnotes Abnormal earnings, 249 Accelerated methods of depreciation, 242–243, 246, 247 Accountability principle, 73 Accounting analysis, 12–13; see also Accounting distortions accounting distortions, 12–13, 89–90, 94, 104, 107–108 accounting risk, 13, 119 business combinations, 277–281 earnings management, 13, 108 introduction to, 106–113 need for, 106–107 OPEB accounting, 200 pension accounting requirements, 157–159 process of, 112–113 Accounting application, 119 Accounting and audit risks, 119 Accounting-based equity valuation model, 612 Accounting changes, 340–343 earnings management and, 343, 607 Accounting distortions, 12–13, 107–108 accrual accounting, 89–90, 94 fair value model, 104 income measures, 334 from securities, 271–272 Accounting Enforcement Releases (AERs), 343 Accounting equation, 19 Accounting estimates, changes in, 341–342 Accounting income, 91–95, 330 alternative measures of, 332–336 analysis implications of, 95–97 economic income vs., 94–96 measurement of, 331–332 Accounting information, 75–76 estimate changes, 341–342 stock prices and, 78, 612–613 Accounting principles, 12, 76–77, 341; see also Accrual accounting accounting distortions and, 107 accrual accounting, 76, 79–80 earnings quality and, 119 Accounting quality, 12–13, 111–112 Accounting Research Bulletins (ARB), 71 Accounting risk, 13 Accounting rules, 68 Accounting standards, 12–13, 71; see also Generally accepted accounting principles (GAAP) accounting distortions and, 107 fair value adoption, 105–106 income measures, 334 Accounts payable turnover, 462, 537, 542 Accounts receivable, 84–85, 224, 496 in current ratio, 532 liquidity measures, 537–539 securitization of, 409 Accounts receivable turnover, 37, 460–461, 496 Accrual(s), defined, 82 Accrual accounting, 76, 79–80 accounting distortions, 89–90 analysis implications of, 88–91 cash flows and accruals, 82, 87–91 earnings management, 108 framework for, 81–84 illustration of, 80–81 limitations of, 84–88 relevance of, 84–88 timing and matching problems, 82–83, 93–94 value-relevant information of, 90 Wal-Mart and Kmart example, 85–87 Accrual adjustments, 82 Accrual basis of accounting, 21 Accrual concept, 81–84 Accrued (or prepaid) pension cost, 157–159 Accumulated benefit obligation (ABO), 168, 194 Accumulated other comprehensive income, 157–158 Accumulated postretirement benefit obligation (APBO), 159, 200 Acid-test ratio, 36, 38, 543 Acquisitions, 4, 10, 409; see also Business combinations Activity methods of depreciation, 243 Actual return on plan assets, 196 Actuarial assumptions, 169–170 Actuarial gain or loss, 156, 195 Additional (or paid-in) capital, 185 Adjustments to financial statements adjusted earnings, 602–603, 618 balance sheet, 350 capital structure analysis, 551–553 earnings management and, 112–113 extraordinary items reflecting persistence, 610–611 income statement, 606 income taxes, 372 invested capital and income, 449 investment return analysis, 311–313 OPEB adjustments, 166–169 prior period adjustments, 189 year-end, 69 Adverse opinion, 115 Advertising expense, 120, 238 AICPA (American Institute of Certified Public Accountants), 71 Albertson’s, 16–19 Allocation, 237, 243 for financial reporting, 246 long-term assets, 238 for tax purposes, 246 Altman, E I., 568n Altman’s Z-score, 568–569 Altria Group, Inc., 287 Amerada Hess Corp., 244 America Online, 184 American Airlines, 174 American Express, 283 American Institute of Certified Public Accountants (AICPA), 71 American Jobs Creation Act of 2004, 30 American Shipbuilding, 142 Amortization, 237 of employee stock ownership cost, 378 of intangible assets, 238, 249 of leases, 145 of net gain or loss (OBEB), 198–199, 200 pension costs, 157–158 prior service cost, 199–200 Ampex, 141 AMR Corporation (American Airlines) postretirement benefits actuarial assumptions and sensitivity analysis, 169–170 adjusting financial statements, 166–168 cash flow implications, 172–173 footnote disclosures, 159–163 pension risk exposure, 171–172 reconciling economic/reported numbers, 164–165 Analysts’ forecasts and recommendations, 74–75; see also Earnings forecasts Annual report, 4, 68, 70 Anomalies, 45 Antidilutive securities, 361, 363, 375 AOL-Time Warner, 184 APB Opinions, 71 Applied Materials, 289 Appropriations of retained earnings, 188 Articulation of financial statements, 24 Artistic-related intangible assets, 282 Asset(s), 18–19; see also Current assets; Intangible assets; Long-term (noncurrent) assets conservatism in reported assets, 120 defined, 221 fair value option, 298 intangible assets, 281–282 long-term assets, 237–239 write-down of values, 244, 608 Asset-based measures of solvency, 556 Asset composition analysis, 556 Asset impairments, 111, 237, 238, 345–346 balance sheet adjustments, 350 Asset management, 620 Asset protection, 567 Asset turnover (utilization), 36–37, 39, 460, 539, 638 Campbell Soup case, 659–660, 669 disaggregation of, 460–462 PPE turnover, 37 profit margin and, 455–458 Asset write-ups, 350 AT&T, 188–189, 350 Audit committee, 73 IN1 sub79433_index.qxd IN2 4/21/08 10:06 AM Page IN2 Index Audit opinion, 73 Audit process, 114 Audit qualifications, 115 Audit report, 27, 114–115, 175 Audit risk, 116, 119 Auditing analysis implications from, 116–118 audit risk and implications, 116, 119 financial statement analysis and, 113–118 internal audits, 73 procedures for, 114 Auditing standards, analysis implications of, 116–117 Auditor, 69, 73 Auditor opinions, analysis implication of, 117–118 AutoNation, 16 Available-for-sale securities, 266, 269, 272 Average age, 247 Average collection period, 461 Average cost inventory method, 230 Average inventory days outstanding, 461 Average payable days outstanding, 462, 542 Average remaining life, 247 Average total life span, 247 Avis Rent-A-Car, 177 Balance sheet, 19–20 adjustments, asset impairment, 350 capitalized leases and, 146 earnings quality and, 120–121 employee stock options, 378–379 fair value model and, 105 historical cost vs fair value, 98–100 inventory costing effects on, 231 OPEB adjustments, 166–169, 200 operating vs nonoperating activities, 450 pension accounting and, 157 pension plan, recognized status on, 199 projected balance sheet, 494–498 Balance sheet identity, 19 Bankruptcy prediction models, 568 Barrett, T D., 401 Basic earnings per share (EPS), 376 Bausch & Lomb, 109 Begley, J., 568n Behavioral finance, 45 Benchmarking, 10–11 Benefit payments, 157 Berkshire Hathaway, 45, 285, 601 Best Buy Co., Inc., 143, 149–152 Big bath, 89, 108–110, 174, 244, 248, 329, 347, 607 Binomial lattice model, 362 Black, J., 445 Black-Scholes model, 102, 362, 378 Blockbuster Entertainment, 290 Bloomingdale’s, 236 Board of directors, 73 Bond(s), 139–140 Bond covenants, 141 Bond credit ratings, 150, 566–568 Bond financing, Bond indentures, 188, 557, 568 Book value, 189 Book value of common stock, 189 Book value per share, 189–191 Bottom-line income, 105 Bowie bonds, 139 Brand (trade names), valuation of, 250 Brunswick Corp., 225 Buffett, W., 9, 46, 71, 77, 93, 285, 601 Business analysis, 3–4; see also Financial statement analysis components of, 10–14 financial statement information and, 4–8 types of, 8–10 Business combinations, 185, 264, 276–290; see also Consolidated financial statements; Pooling-of-interest accounting for, 277–281 allocating total cost, 281–282 companies with stock, 409 economic motivations for, 276 gains on subsidiary IPOs, 283 goodwill, 280–281, 285–287 illusionary earnings growth and, 276–277 in-process research and development (IPR&D), 282 issues in, 281–287 pooling accounting for, 287–290 preacquisition sales and income, 283–284 Business plan, 15 Business risk, earnings quality, 119 Business segment data, 27 Buy-and-hold strategy, 45 Buy-side analysts, 74 Buybacks, 185 Call option, 186, 291 Campbell Soup Company asset turnover (utilization), 669 asset utilization, 659–660 capital structure and solvency, 654–655, 669 cash flow, 414–415 cash flow adequacy ratio, 419 common size income statement, 468 comparative financial statements, 642–651 comprehensive case, 640–671 financial market measures, 670–671 financial statements analysis, 643–651, 671 forecasting and valuation, 663–668 Form 10K (Annual Report), A35–A56 LIFO to FIFO restatement, 233–234 operating performance and profitability, 660–663, 669 preliminary financial analysis, 640 quantitative disclosures, 294–295 recasted income statements, 603–606 return on invested capital, 465–468, 655–659, 669 sales analysis by source, 640–641 short-term liquidity, 651–654, 669 summary evaluation and inferences, 668–671 turnover rates, 468 Capital asset(s), 240 Capital asset pricing model, 501n Capital donations, 185 Capital intensive industries, 461 Capital leases, 143–144 converting operating leases to, 149–151 operating lease vs., 144–146 Capital One, 137, 178–180 SPE example, 227 Capital risk, 548 Capital stock, 184–187; see also Preferred stock analysis of, 186–187 classification of, 185–186 reporting of, 184–185 Capital structure, 36, 528; see also Capital structure and solvency analysis of, adjustments for, 551–553 asset distribution and, 548 complex capital structure, 374–375 debt capital, motivation for, 549–551 debt and equity, characteristics of, 548–549 importance of, 547 interpretation, capital structure ratios, 553–600 risk and return, 555, 565–566 simple capital structure, 374 Capital structure ratios, 553 Capital structure and solvency, 36, 38, 528, 547–556, 638 Campbell Soup case, 654–655, 669 capital structure ratios and interpretation, 553–555 common-size statements, 553 CapitalCities/ABC, 280 Capitalization, 84, 237, 238 expensing vs., 239 interest capitalization, 366 long-term assets, 237–238 of retained earnings, 185 Cash, 223 Cash basis accounting, 80–81 Cash and cash equivalents, 223–224, 401, 531 relevance of, 402–403 Cash conversions, 504 Cash dividend, 187 Cash equivalents, 223 Cash flow(s), 41, 246, 401; see also Cash flow analysis; Statement of cash flows accruals and, 82, 85, 88–91 analysis implications of, 88–91 fixed charges and, 562–563 forecasting future cash flows, 373 free cash flow, 41, 82 interpretation of, 411–413 inventory costing effects, 231–232 net income and, 411–413 operating cash flows, 82, 239, 563 patterns of, 504–505 postretirement benefits, 172–173 Cash flow adequacy ratio, 418–419 Cash flow analysis, 28, 39, 401, 413–418; see also Cash flow ratios alternative cash flow measures, 415–416 analysis implications of cash flows, 411–413 Campbell Soup, comprehensive case, 414–415, 650–651 cash flow as validators, 418 company and economic conditions, 416–417 inferences from, 414–415 limitations in cash flow reporting, 411 Cash flow hedge, 292 Cash flow patterns, 504–505 Cash flow ratios, 418–419, 543 Cash flow to fixed charges ratio, 562 Cash forecast, 506–507 Cash from operations; see Operating cash flows Cash reinvestment ratio, 419 Cash to current assets ratio, 536 Cash to current liabilities ratio, 536–537 Cash turnover, 37 Caterpillar, 191, 285 Certified public account (CPA), 73 Chairperson’s letter, 15 Changes; see Accounting changes; Adjustments to financial statements Changing price levels, 121 Channel loading, 110 Chiron Corp., 346, 349 Chrysler, 607 Cigna, 175 Cisco, 362–365 CIT, 221 Citigroup, 137 Class-action suits, 272 Classificatory earnings management, 111 Clean surplus, 335–336 Coca-Cola, 273, 275, 291, 312–313 Colgate Palmolive Co., 199 analysis of solvency, 38 assets and liabilities, 1, 19 sub79433_index.qxd 4/21/08 10:06 AM Page IN3 Index balance sheet of, 21 business environment and strategies, 3–5 cash flow analysis, 39 common-size balance sheets, 34 common-size income statements, 33 comparative income statements, 29–30 consolidated statements of cash flows, 25 credit analysis, 38 creditor financing, 17 current and noncurrent assets, 18 equity financing, 17 executive overview, 15 financial statement links, 24–26 financing activities, 16–17 Form 10K (Annual Report), A1–A35 income statement of, 22 index-number trend, 31 operating divisions, operating and financing assets, 18 profitability analysis, 38–39 ratio analysis of, 36–39 revenues, expenses, and income, 19 statement of shareholders’ equity, 22–23 stock price growth vs S&P growth, summary financial data, total financing, 16 valuation, 39 Collection period, 36, 38, 538n Collection risk, 225–226 Commitments, 175–176 Common equity capital, 449 Common-size financial statement analysis, 31–33 composition of assets, 31, 556 solvency analysis, 553 Common stock, 17, 185–186 book value of, 189 Syminex valuation (example), 500–501 Company bonds, rating of, 567–568 Company information, 74 Company life cycle, cash flows and income, 85 Company performance, 446–447, 454; see also Return on invested capital (ROIC) Company value, 10, 88–89, 91 LIFO reserve and, 232 Companywide risk exposure, 296–297 Comparability, 12, 76, 103 Comparative financial statement analysis, 28 Campbell Soup, comprehensive case, 642–644 index-number trend analysis, 30–31 year-to-year change analysis, 28–30 Compensating balances, 224 Compensation expense, 361–362, 377–378 Competitive advantage, 12 Complex capital structure, 374 Compliance officers, 74 Components of cash flows, 412–413 Composition analysis, 553 Comprehensive income, 20, 22–23, 333, 335–336 Computer software expenses, 357–358 Conditional conservatism, 77 Conseco, 73 Conservatism, 77, 94–95, 97, 104, 107, 119–121, 174, 345, 616n Conservative bias, 103 Consistency, 76 Consolidated financial statements, 268, 277–281; see also Pooling-of-interest debt in, 282–283 foreign subsidiaries, 302–311 impairment of goodwill, 280–281 limitations of, 284–285 mechanics of, 277–280 Consolidation, 228, 272 Consolidation rules, 182 Continental Airlines, 607 Contingencies, 173, 174 unrecorded intangibles and, 250 Contingent consideration, 281 Contingent liabilities, 173–175 adjustments, capital structure analysis, 552 Contingent valuation, 174 Continuing income, 333 Continuing (terminal) value, 42 Contra-equity account, 185 Contracting incentives, 109, 111 Contracts, 352–353 Contributed (paid-in) capital, 20, 185 Contributed (paid-in) capital in excess of par or stated value, 185 Contributions, 156 Controlling interest, 268, 272 Convergence project, 72 Conversion period, 541 Convertible(s), 140, 272, 366 Convertible debt, adjustments, capital structure analysis, 552 Convertible debt sweetener, 140 Copyrights, 237, 248 Core earnings, 69, 96, 274 Core income, 330, 333 Corporate finance, 93 Corporate governance, 73 Corporate responsibility reports, 27 Corridor method, 199 Cosmetic earnings management, 108 Cost, lower of cost or market, 236–237 Cost approach to valuation, 102 Cost of capital, 40 Cost deferral, 332 Cost of equity capital, 501n, 614 Cost or fair (market) value, 265 Cost of goods sold (COGS), 20, 83, 228–229, 461 Counterparty, 291 Covenants, 547 Covenants on retained earnings, 188 Credit analysis, 8–9 Credit default swaps, 291 Credit rating, 527 Credit rating agencies, 75 Credit risk, 566 Credit (risk) analysis, 38 capital structure and solvency, 9, 36 predicting financial distress, 568 Credit Suisse First Boston (CSFB), 75, 182 Creditors (lenders), 8, 16–17 Creditworthiness, 8, 566 Cumulative net deferral, 158 Cumulative translation adjustment (CTA) account, 311 Current assets, 18, 20, 38, 221 cash and cash equivalents, 223–224 cash to current assets ratio, 536 defined, 529 introduction to, 222–228 inventories, 228–237 investment securities, 264 receivables, 224–228 Current exchange rate, 303 Current liabilities, 20, 137–138, 222n, 529 cash to current liabilities ratio, 536–537 liquidity of, 529, 542 Current profitability, 100 Current rate method, 302, 308–311 Current ratio, 36, 530–534 use of, for analysis, 532–533 Customer lists, 248, 282 Customers, 10 Cyclical industries, 458 IN3 Days’ sales in inventory, 540 Days’ sales in receivables, 538 Days to sell inventory, 36, 38, 540n Debentures, 139, 184–185 Debt, in consolidated financial statements, 282–283 Debt capital, 548, 549–551 Debt creditors, 17 Debt financing, 17 Debt provisions, 568 Debt ratings, 8, 557, 566–567 limitations in, 568 Debt securities, 264, 265–267 bond credit ratings, 150, 566–567 Debt to equity ratio, 36 Debt valuation, 40 Dechow, P M., 84, 88 Decimal pricing, 41 Declining-balance method, 242 Default, 547 Deferral and amortization of prior service cost, 199 Deferral of actuarial gains and losses, 198 Deferred charges, 330, 355–359 computer software expenses, 357–358 extractive industries, exploration/development costs, 358–359 income taxes, 551–552 research and development, 355–357 Deferred compensation contracts, 359 Deferred tax adjustments, 368 Deferred tax assets/liabilities, 368–370 present valuing of, 372–373 Deferred taxes, 174, 368–370, 551–552 Defined benefit plans, 153–154 economics of pension accounting, 193 pension accumulation and disbursement, 155 Defined contribution plans, 154 Dell, Inc., 137, 180–182, 236, 447 cash and cash equivalents, 224 effective tax rate, 367 goodwill, 285 income tax footnote, 371–372 intangibles, 248 inventories, 228 operating assets, 221 PPE, 240 Delta Airlines, 343 Depletion, 237–238, 240, 243 analysis of, 245–247 Depreciation, 237, 238, 240–244 allocation method, 241–243 analysis of, 245–247 defined, 240 projection of, 493 rate of, 240–243 useful life, 241 Derivative financial instruments, 290 Derivative securities, 264, 290–298 accounting for, 291–294 analysis of, 296–298 classification of, 292 defined, 291 disclosures for, 294–295 inclusion in operating/nonoperating income, 297–298 Dhaliwal, D S., 336 Diluted earnings per share, 361, 363, 374, 376–377 Dilution, 374 Dilutive securities, 361 Direct financing lease, 192 Direct (or inflow-outflow) method, 403, 409–410 Directors, 10, 12 sub79433_index.qxd IN4 4/21/08 2:36 PM Page IN4 Index Directors and officers (D&O) liability coverage, 343 Dirty surplus, 333, 335 Disaggregation, 619 Disclaimer of opinion, 115 Disclosure, 370–372 contingencies, 174–175 derivative securities, 294–295 eBay lease footnotes, 181 employee stock options, 362–363 for extractive industries, 358 fair value, 272, 299–301 investment securities, 269 leases, 147–148 merger disclosure, 185 postretirement benefits, footnotes, 162 related party transactions footnote, 183 voluntary disclosure, 74 Discontinued operations, 69, 338–340 Discount rate, 40, 169, 195 Discounted cash flow (DCF) method, 612 Discretionary expenses, 119 Disney Company, 280 Diversified companies, 470–471 Divestitures, 4, 10 Dividend(s), 16, 187 Dividend discount model, 41, 43 Dividend in kind, 187 Dividend payout, 16, 37 Dividend yield, 37 Dodd, D., 9, 491 Doubtful accounts, 539 Dow Chemical, 246 Duff and Phelps, 566 Dunlap, A., 108 Earned revenues, 83, 94 Earning management, income taxes and, 373 Earnings, 20, 91, 547; see also Earnings coverage; Earnings per share (EPS); Earnings persistence; Income; Retained earnings core earnings, 96 transitory items in, 609–611 undistributed subsidiary earnings, 276 Earnings announcements, 69–70 Earnings-based equity valuation, 612–616 Earnings before extraordinary items and discontinued operations, 20 Earnings before interest and taxes (EBIT), 334, 562 Earnings before taxes, 20 Earnings coverage, 556–566 cash flow to fixed charges, 562–563 earnings to fixed charges, 557–561 interpretation of, 564–565 preferred dividends, 563–564 pro forma computation, 560–561 Earnings distribution, 16 Earnings estimates, interim reports for, 621–622 Earnings forecasting, 602, 618–620 estimates, interim reports for, 621–622 Earnings from continuing operations, 20 Earnings from operations, 20 Earnings management, 13, 72, 95, 108–112 accounting changes, 343 accounting income and, 301 analysis implications of, 111–112 business combinations and, 276–277 defined, 607 earnings persistence and, 607–608 expected rate of return assumption, 170 investment securities distortions, 271–272 motivations for, 109–111 special charges and, 347–348 strategies for, 108–109, 248 Earnings per share (EPS), 374–377 adjustments to, 618 ESOs and diluted EPS, 361 short/long-term growth of, 614–615 Earnings persistence, 565, 601–611 company valuation and, 614 defined, 602 determinants of, 607–608 earnings, recasting and adjusting, 602–606 transitory items and, 546–611 Earnings power, 547, 557, 567, 617–618 Earnings preannouncement, 69 Earnings quality, 13, 112, 118–121 conservatism, 77 evaluating, 112–113 income taxes and, 373 Earnings reinvestment, 16 Earnings retention ratio, 16 Earnings sources, 121 Earnings surprise, 78 Earnings to fixed charges ratio, 557, 559–560 Earnings trend, 607 Earnings variability, 565 Earnings warnings, 69 Earnings yield, 37 “Earn-out” payment, 281 eBay, 180–181, 224, 236 Ebbers, B., 14 EBITDA (earnings before interest, taxes, depreciation, and amortization), 20, 415 Economic, industry, and company information, 74 Economic conditions, 416–417 economic booms, 527 Economic income, 91–93, 100, 330 accounting income vs., 94–95 adjustments for, 96 nonrecurring pension costs, 195 Economic information, 74 Economic pension cost (expense), 195 Economic profit, 230 EDGAR database, 26, 68 Effective tax rate, 367, 373 Efficient market, analysis in, 44–46 Efficient market hypothesis (EMH), 44–45 EITF (Emerging Issues Task Force) Bulletins, 71 Employee benefits; see Pension benefits; Supplementary employee benefits Employee Retirement Income Security Act (ERISA), 155, 159 Employee stock options (ESOs), 107, 359–365 accounting and reporting for, 361–362, 377–379 analysis of, 363–365 characteristics of, 360 disclosures of, 362–363 economic costs and benefits of, 360–361 Employee stock ownership plans, 185 Employer contributions, 157 Enron, 71, 119, 137, 177, 181–183 Environmental contingent liabilities, 174 Equipment, 240 Equity, 9, 19–20, 137, 548; see also Equity securities; Shareholders’ equity liability vs equity instruments, 184 Equity accounting, 264 Equity analysis, 9–10, 601 earnings-based valuation, 601–602, 612–616 earnings persistence, 601–611 earnings power and forecasting, 601–602, 617–622 fair value accounting and, 103 Equity financing, 16–17 Equity growth rate, 469 Equity investors, 9, 16 Equity method accounting, 268, 272–276 Equity method investments, 408–409 Equity risk, 153 Equity securities, 224, 264, 267–268 accounting distortions form, 271–272 Equity valuation, 40–41, 463, 602 accounting-based model, 612 earnings-based, 612–616 practical considerations in, 41–42 Errors correction of, 341 estimation errors, 12, 107 Etec Systems, 289 Excell Corporation, 449–454, 465 “Except for” qualification, 115 Exchange price, 100 Exchange rates, 302–303 Executive stock options (ESOs), 71 Executive summary, 639 Executory costs, 144 Exercise price, 360 Exit prices, 101 Expectations adjustment, 74 Expected postretirement benefit obligation (EPBO), 200 Expected rate of return, 40 Expected return on plan assets, 157, 198, 200 Expense matching, 93–94 accrual process, 83 Expenses, 331, 332 compensation expenses, 361–362 general and administrative, 460 period costs, 83 prepaid expenses, 228 product costs, 83 selling expenses, 459–460 Explanatory notes, 27 Exploration and development costs, 358–359 Export sales, 27 Exposure Draft, 71 Extended profitability, External financing, 16 Extractive industries, 358–359 Extraordinary items, 69, 336–338 adjustments reflecting persistence, 610–611 offsetting of, 607 Extrapolation, 619 Face value, 105 Factoring, 227 Fair value, 76, 265 defined, 100–101 Fair value accounting, 95, 97–106, 298–302 advantages/disadvantages of, 103–104 analysis implications, 301–302 considerations in measuring, 100–103 current status of adoption, 105–106 disclosures for, 272, 299–301 example of, 97–99 financial liabilities and, 105, 140 historical cost vs., 98–100 implications for analysis, 104–105 income reporting, 331 investment securities, 269 reporting requirements, 298 SFAS 159 and, 302 Fair-value hedge, 292 FASB; see Financial Accounting Standards Board (FASB) Feasibility tests, 508 FedEx Corp., 16–19 cash and cash equivalents, 224 effective tax rate, 367 goodwill, 285 intangibles, 248 inventories, 228 PPE, 240 sub79433_index.qxd 4/21/08 10:06 AM Page IN5 Index Feedback role, 78 Financial accounting accounting information qualities, 75–76 important principles of, 76–77 limitations of financial statement information, 79 managerial discretion, 72 nature and purpose of, 75–79 relevance and limitations of, 77–79 Financial Accounting Standards Board (FASB), 12, 71, 76, 106, 140, 277 FIN 46R (“Consolidation of Variable Interest Entities”), 178, 180–181, 228 FIN 46, 137, 180 variable interest entities (VIEs), 178–179 Financial analysis, 11, 13–14; see also Prospective analysis Campbell Soup, comprehensive case, 640–671 postretirement benefits, 167–168 Financial assets, 18, 221 Financial condition, 85 Financial flexibility, 402, 544 Financial information; see Information intermediaries Financial institutions, 271 Financial leverage (LEV) concept of, 549–550 defined, 548 return on equity (ROE) and, 463–464 return on nonoperating activities, 465 Financial leverage ratio, 551 Financial management, 10 Financial market measures; see Market measures Financial markets, 16 Financial performance, accrual accounting and, 85 Financial reporting and analysis; see also Accounting analysis accruals in, 67–68, 79–91 interim reports, earnings estimates, 621–622 nature and purpose of, 68, 75–78 reporting environment, 68–75 Financial reports; see Statutory financial reports Financial resources, 567 Financial statement(s) accounting analysis of, 11–13 additional information for analysis, 26–27 balance sheet, 19–20 business analysis and, 4–8 capitalizing vs expensing, 239 earnings management, 112–113 footnote disclosures, postretirement benefits, 162–163 income statement, 20–22 lease reclassification, restating for, 151–152 limitations of information, 79 links between, 24–26 prior period adjustments, 189 projection process of, 492–499 related party footnote, 183 reporting environment of, 68–75 statement of cash flows, 24 statement of shareholders’ equity, 22–24 translation of, 303 Financial statement analysis, 3–4 auditing and, 113–118 building blocks in, 638 business activities as basis of, 15–25 business analysis and, 14 Campbell Soup, comprehensive case, 640–671 debt valuation, 40 defined, liquidity and, 223–224 market efficiency and, 44–46 operating vs capital leases, 148–151 predicting financial distress, 568, 569 related party transaction footnote, 183 reporting on, 639 role of, 6–8 specialization in, 639–640 steps in, 636–638 use of, 671 Financial statement analysis report, 639 Financial statement analysis tools, 28 cash flow analysis, 39 common-size financial statements, 31–33 comparative financial statements, 28–31 ratio analysis, 33–39 valuation models, 40–43 Financing activities, 16–17, 93, 138, 403; see also Leases; Off-balance-sheet financing; Postretirement benefits; Shareholders’ equity commitments, 175–176 contingencies, 173–175 external financing, 16 Financing liabilities, 137 First-in, first-out (FIFO), 94, 107–108, 111, 229 FIFO to LIFO restatement, 234–235 FIFO’s phantom profits, 230 Fitch Ratings, 527, 566 Fixed assets, 240 Fixed charges; see also Earnings coverage cash flow to, 562–563 earnings available to, 557–561 illustration of, 560 pro forma computation of, 540–541 Fixed commitments, 105 Forecast horizon, 504 Forecasting, 638; see also Earnings forecasting; Prospective analysis Campbell Soup case, 663–668 cash flow, 506–510 sales forecasting, 505–506 short-term, 504–510 Foreign currency hedge, 292 Foreign currency swap, 291 Foreign currency translation accounting for, 304–307 analysis implications of, 307–311 current rate method, 302, 308–311 temporal method, 302, 303, 307, 308, 310 translation gain/loss, 306–307 Foreign earnings, 121 Foreign exchange exposure, 294 Foreign investment by parent company, 307 Foreign subsidiaries; see also International activities consolidation of, 302–307 Form 8-K, 70, 622 Form 10-K filing, 15, 68, 70, 73, 366 Form 10-Q, 68, 70, 73, 299, 622 Form 20-F, 70 Forward-looking information, 79 Franchise, 248 Franchise revenues, 352 Free cash flow (FCF), 82, 85–87, 89, 417 Free cash flow to equity, 82 Free cash flow to equity model, 41 Frequency of financial statements, 79 Frequent flyer mileage, 174 Fundamental analysis, 9, 93, 491 Fundamental principles of accounting, 12 Fundamental valuation multiples, 613–615 Fundamental value, Funded status, 156, 159, 167, 194 pension cost and, 196 Funding pension liabilities, 154 Future earning power, 567 Futures contract, 291 Gains, 331–332, 350; see also Revenue recognition Gains trading, 271 Gap, Inc., 445 General and administrative expenses, 460 General Electric, 16, 172–173, 191, 271, 608 General Electric Capital Corporation, 192 General Motors, 38, 137, 245, 271, 527, 608 Generally accepted accounting principles (GAAP), 68, 117 defined, 71 lease accounting under, 192 preacquisition sales and income, 284 pro forma earnings, 69 software development costs, 238 special purpose entities, 178 statutory financial reports, 70–72 Generally accepted auditing standards, 114 Gerstner, L., 110 Goal congruence, 297 Good faith forecasts, 620 Goodwill, 107, 184, 237, 248–249, 452 accounting for, 285–287 impairment of, 280–281 negative goodwill, 282 nonamortization of, 277 write-off of, 249–250, 263, 285 Gould Corporation, 405–407, 410–411 Graham, B., 9, 93, 491 Grant date, 360 Gross accounts receivable, 539 Gross profit (gross margin), 20, 38–39, 459 Gross profit margin, 37 Gross profit percent, 459 Growth investors, 491 Hard assets, 238 Harsco, 175 Hedges, 290 Hedging strategies, risk exposure and, 296 Hedging transactions, 290 Held-to-maturity securities, 265–266, 269, 272 Hertz, 177 Hewlett Packard, 221 Hierarchy of inputs (fair value), 101–102, 105 Historical cost, 76, 79, 94, 97, 240 fair market accounting vs., 98–99 market based vs., 99 plant assets and natural resources, 244 Historical exchange rates, 303 Holding company, 268 Holding gain, 230 Home Depot, 236 Horizontal analysis, 28; see also Comparative financial statement analysis Huizenga, H W., 16 Hypothetical transaction, 100 IBM, 110, 191–192, 221, 236, 297 Identifiable assets, 281–282 Identifiable intangibles, 248 Impairments, 111, 237, 238, 244 analysis of, 247–248 asset impairments, 111, 237, 238, 345–346 In-process research and development (IPR&D), 282 In-the-money, 360 Incentive or tax-favored qualified stock options, 360 Incentives for managing earnings, 110 Income; see also Accounting income accounting concept of, 93–95 alternative income approaches, 99–100 capitalization and, 239 IN5 sub79433_index.qxd IN6 4/21/08 10:06 AM Page IN6 Index Income; see also Accounting income—Cont concept of, 91–97 defined, 91, 329 earnings management and, 94, 109 fair value model, 105 invested capital and income, adjustments to, 449 managing income upward, 89 nonoperating, 334 operating, 334, 453 permanent (sustainable) income, 92–94 recurring and nonrecurring, 332–334 residual, 42, 499, 502, 612 Income accounting, analysis implications of, 334 Income approach to valuation, 102 Income before cumulative effects of accounting change, 333 Income before discontinued operations, 333, 339 Income before extraordinary items, 333, 337 Income capitalizing vs expensing, 239 Income growth, 85 Income measurement, 330 alternative classifications and measurements, 332–336 concepts of, 330–331 operating vs nonoperating, 332, 334 recurring vs nonrecurring, 332–334 Income shifting, 110–111 Income smoothing, 109 Income statement, 20–22, 412 accounting income on, 333–334 adjustments, special items, 348–350 earnings quality and, 119–120 leases and, 145 OPEB adjustments, 166–169 projected income statement, 492–494 purpose of, 330 recasting earnings/earnings components, 603–606 Income taxes, 366–373 accounting for, 366–370 analysis of, 372–373 deferred taxes, 368 disclosures, 370–372 temporary/permanent differences, 366–367, 373 Income volatility, 104 Independent directors, 12, 73 Index-number trend analysis, 30–31 Indexing, 45 Indirect method, 403, 410 Industrial bond, rating of, 567 Industry analysis, 11–12 Industry Audit and Accounting Guidelines, 71 Industry information, 74 Industry practices, 68, 71 Inflation factor (r) of inventory, 234–235 Information gathering, 75 Information intermediaries, 74–75 advantages of alternative sources, 79 Information interpretation, 75 Infrequent occurrence of an event/transaction, 337 Initial public offerings (IPOs), 4, 17, 40, 267 gains on subsidiary IPOs, 283 Insolvency risk, 142 Intangible assets, 222, 237, 248–250, 281–282 defined, 248 Intel, 221 Intercompany activities, 264 Intercompany comparisons, 32 Intercompany investments, 263 Intercompany transactions, 277 Intercorporate investments analysis implications of, 275–276 consolidated financial statements, 277–281 equity method accounting, 272–275 Interest, 330, 365 Interest capitalization, 366 Interest costs, 361, 365–366 lease obligation, 558 pension costs, 156, 195, 200 tax deductibility of, 550 Interest coverage ratio, 38 Interest expense, 93, 365 Interest groups, 71 Interest incurred, 558 Interest paid, 558 Interest rate risk exposure, 294–295 Interest-rate swap, 291 Interfirm comparisons, 10 Interim (quarterly) reports, 75, 621–622 Intermec Co., 176 Internal audits, 73 Internal financing, 16 Internal Revenue Code, anticipated losses, 174 Internally generated intangibles, 248, 250 International Accounting Standards Board (IASB), 72 International activities, 264, 302–311 consolidation of foreign subsidiaries, 302–307 foreign currency translation, 304–307 foreign investment by parent company, 307 International Financial Reporting Standards (IFRS), 72 Intrinsic value, 9–10 Intrinsic value approach, 361 Inventories, 97, 222, 228–237 accounting and valuation, 228–230 analysis of, 230–237 in current ratio, 532 FIFO to LIFO restatement, 234–235 inventory costing effects, 230–232 LIFO liquidations, 232–233 LIFO to FIFO restatement, 233–234 lower of cost or market, 236–237 manufacturers and production increases, 235–236 turnover measures, 539–541 Inventory cost flows, 229–230, 235 Inventory equation, 228 Inventory profits, 121 Inventory turnover, 37, 461, 539–540 conversion period or operating cycle, 541 interpretation of, 540–541 Invested capital, 448–449 Investee company earnings, 275 Investing activities, 18, 403; see also Current assets analysis of, 222 operating vs investing assets/performance, 269–271 Investment performance, evaluation of, 312–313 Investment return analysis, 311–313 Investment securities, 264–272; see also Debt securities; Equity securities accounting distortions from, 271–272 accounting for, 265–269 adjustments to financial statements, 311–313 analysis of, 269–272 classification of, 265, 272 debt securities, 265–267 disclosures for, 269–270 equity securities, 267–268 operating vs investing assets, 269–271 permanent investment income, 312 Investor fraud, 17 January effect, 45 John Deere, 231–232 Johnson & Johnson cash and cash equivalents, 224 effective tax rate, 367 goodwill, 285 intangibles, 248 inventories, 228 PPE, 240 Johnson Controls, 186, 353 Joint ventures, 177, 273 Juetter-Nauroth, B E., 614 Junk bonds, 139, 565 Kersh, R., 108 Keynes, J M., 83 Kimberly Corp., 190 Kmart, 67, 85–86, 340 KnowledgeWare, 116 Kodak, 111, 329, 347 Kozlowski, D., 72 Labor cost, 235 Labor unions, 10 Last-in, first-out (LIFO), 35, 107–108, 111, 229, 541 LIFO conformity rule, 231 LIFO liquidations, 232–233 LIFO reserve, 231–232 LIFO to FIFO restatement, 233–234 Lattice model, 378 Leaning on the trade, 462, 542 Leaseholds, 248 Leases, 142–153, 248 accounting and reporting for, 144–148 analysis of, 148–151, 191–192 Best Buy example, 147–152 capital leases, 143, 149–151 classification of, 144 disclosures, 147–148 eBay lease footnotes, 181 illustration of (example), 144–146 interest implicit in, 558 operating leases, 148–151, 153 reclassification/restating financial statements, 151–152 Legal liability, 74 Lesee (user), 142 Lessor (owner), 142, 191–192 Letter to Shareholders (Chairperson’s Letter), 15 Leverage financial, 548–550 operating leverage, 454–455 return on equity and, 463–464 Leveraged buyout, 565 Liabilities, 19–20, 137–142 adjustments to, book values, 551 analysis of, 141–142 at “edge” of equity, 191 conservatism in, 121 in consolidated financial statements, 282–283 contingent liabilities, 173–175 current liabilities, 137–138, 542 fair value model, 105, 140 fair value option, 298 noncurrent liabilities, 139–140 recognized at cost, 271 Licenses and franchises, 248, 282 LIFO conformity rule, 231 LIFO reserve, 231–232 Limited partnerships, 177 Liquidity, 9, 38, 223–224, 402, 527–537 accounts receivable measures of, 537–539 acid-test ratio, 36, 38, 543 cash-based ratio measures of, 536–537 cash flow measures, 543 collection period, 36, 38 current assets and, 223–224, 529–530, 543 current liabilities, 529, 542 current ratio, 36, 38, 530–534 sub79433_index.qxd 4/21/08 10:06 AM Page IN7 Index days to sell inventory, 36, 38 defined, 9, 537 financial flexibility, 544 inventory turnover measures of, 539–541 management’s discussion and analysis, 544 operating activities, 537–542 ratio analysis for, 36 receivables measures of, 538–539 short-term, 638 what-if analysis, 544–546 working capital and, 527–537 Litigation threat, 73 Loan agreements, 188 Loan covenants, 547 Loans, 139 Long-lived assets, impairment of, 345–346 Long-term accruals, 83–84 Long-term construction, 352 Long-term contracts, 353 Long-term credit analysis, Long-term debt to equity, 36, 38 Long-term debt to equity capital ratio, 555 Long-term liabilities; see Noncurrent (or longterm) liabilities Long-term (noncurrent) assets, 221, 222, 237–239, 345–346 accounting for, 237–238 analyzing depreciation/depletion, 245–247 impairment of, 237–238, 243–244 introduction to, 237–239 useful life of, 238, 241, 245 Long-term operating asset turnover, 461 Loss contingencies, 173 Loss reserves, 174 Losses, 331, 332 Lower of cost or market value, 97, 236–237 Lucent Technologies, 72 Lynch, P., Major League Baseball (MLB), 154 Management’s Discussion and Analysis (MD&A), 4, 15–16, 26–27, 544, 611, 619 Campbell Soup (example), 295 contingencies, 174 Managerial discretion, 72 Managerial estimates, 12 Managers and management accounting changes, 341 accounting distortions and, 13–14, 94 accounting principles selection, 119 business analysis and, 10 debt ratings and, 567 disclosure of contingencies, 174–175 earnings management motivations/ incentives, 109–113 effectiveness, ROIC as measurement of, 446 incentives for earnings management, 608 pension assumptions manipulation and, 170 quality of, 620 ratio management, 534 reputation and history of, 111 revenue recognition and, 353–355 risk propensity of, 361 statutory financial statements and, 68, 72 transitory items, 611 window-dressing and, 72, 108, 143, 170, 534 Managing of expectation, 74 Manufacturing companies, 231, 235–236 Manville, 173 Margin of safety, 142 Market, defined, 236 Market approach to valuation, 102 Market-based cost, 99 Market-based measurements, 101 Market efficiency, 44–46 Market measures, 37 Campbell Soup case, 670–671 Market risk, 290 Market risk sensitivity, 295 Market valuation, pensions, 168 Marketable securities, 27, 221–222, 264, 531 Matching problems, 83, 85 Material events, 26 Materiality, 76–77, 117 May, J J., 69 MCI, 14 Measurement date, 97, 100 Merchandising companies, 231 Mergers, 4, 10 Mergers, acquisitions, and divestitures, 10 Merrill Lynch, 7, 13, 75, 182 Microsoft, 10, 264, 358 investment securities disclosures, 269–270 MicroStrategy, 72 Miller, R S., 329 Ming, J., 568n Minimum lease payments (MLP), 142–144 Minority interest, 191, 279, 280 adjustments, capital structure analysis, 552 Mixed attribute model, 103 Modified Accelerated Cost Recovery System (MACRS), 242 Momentum strategies, 78 Monetary assets/liabilities, 303 Moody’s, 372, 566 Morgan Stanley, 75 Motorola, 109, 236 Multiperiod allocation, 332 Mutual fund industry, 40 National Car Rental, 177 Natural resources, 222, 239–240; see also Extractive industries analysis of, 244–245 depletion, 243 Negative goodwill, 282 Net cash flow, 82, 87 Net cash from operations, 404–405 Net deferral, 158 Net financial expense (NFE), 464 Net financial obligations (NFO), 450, 452, 464 Net financial return (NFR), 464 Net gain or loss, 198 Net income, 20, 82, 86–88, 333, 411–413 Net income plus depreciation and amortization, 415 Net operating asset turnover (NOA turnover), 454, 456–458 Net operating assets (NOA), 417, 448, 450–451, 454 Net operating profit after tax (NOPAT), 93, 334, 417, 448, 452–453 Net operating profit margin (NOPAT margin), 454, 456–458 Net operating working capital turnover, 462 Net periodic pension cost, 157, 198 Net periodic postretirement cost, 159 Net profit margin, 37, 39, 503 Net realizable value, 224 Net trade cycle analysis, 535–536 Neutrality, 75, 103 New entrants, 12 News surprises, 78 No influence holding, 267 Noncompete clauses, 282 Noncompetition agreements, 281 Noncore items, 70 Noncurrent assets, 18, 221, 264 Noncurrent (or long-term) liabilities, 137, 139–140 IN7 Nonfinancial institutions, 271 Nonoperating assets, 450–452, 465 Nonoperating income, 93, 334 derivatives, 297–298 Nonqualified stock options, 360 Nonrecurring income, 332–334 Nonrecurring items, 70, 330, 336–350, 609–610 accounting changes, 340–343 asset impairments, 345–346 discontinued operations, 338–340 extraordinary items, 336–338 operating gains and losses, 609–610 restructuring charges, 346–347 special items, 343–350 Nonrecurring pension cost, 195 Nontrade creditors (or debt holders), Nonvoting rights, 186 Note disclosure, accounting estimate change, 341 Notes, 139 Notes receivable, 224 Objectivity, 104, 240 Observable inputs, 101 Obsolescence, 241 Off-balance-sheet financing, 143, 153, 157 adjustments, capital structure analysis, 552 examples of, 176–177, 179–183 securitizations, 178–179, 226–228 Offsetting, 607 Ohlson, J A., 614 O.M Scott & Sons, 226 One-line consolidation, 273, 275 One-time charge, 109, 345, 348 OPEBs; see Other postretirement employee benefits (OPEBs) Operating activities, 18–19, 329, 403, 448, 450 analysis of, 330 cash from operations, 563 income measurement, 330 liquidity analysis, 537–542 nonrecurring items, 330, 609–610 Operating assets, 18, 221, 461 Operating cash flows, 82, 85, 87–88, 401–402, 412–413 capitalization and, 239 components of, 415 net cash from operations, 404–405 permanence of cash from operations, 563 worksheet for, 420 Operating creditors, 8, 17 Operating cycle, 221–223, 541 Operating income, 93, 334, 453 adjustments for, 96–97 derivatives, 297–298 Operating leases, 143 adjustments, capital structure analysis, 552 capital lease vs., 144–146 converting to capital leases, 149–151 risk and, 153 Operating leverage, 454–455 Operating liabilities, 137 Operating liability leverage ratio (operating liabilities/NOA), 455 Operating performance, 36–39, 638 Campbell Soup case, 660–663, 669 investing performance vs., 269–271 Operating profit margin (OPM), 37, 39, 458 Operating segments, 470–471 Operations, 20 563 Opinion shopping, 118 Option contract, 291 Option cost, 361 Option overhang, 363 Options pricing model, 362 sub79433_index.qxd IN8 4/21/08 10:06 AM Page IN8 Index Orderly transaction, 100–101 Other comprehensive income (OCI), 157–158, 269, 303, 335–336 Other postretirement employee benefits (OPEB), 153, 159–163 accounting for, 200 OPEB risk exposure, 172 Out-of-the money, 360 Overfunded pension, 156, 194 Overhead, 235 Overprovision, 121 Overstatement of earnings, 120–121 Owners, 16 Paid-in capital, 185 Partnerships, 273 Patents, 237, 248, 282 Payment in kind (PIK) securities, 565–566 PEG ratio, 615 Pension accounting actuarial assumptions and, 169–170 economics of, 155–157, 193 pension costs, 156, 195–196 pension obligation, 154–156, 193–194 requirements for, 157–159, 196–197 sensitivity analysis, 169–170 Pension assets, funded status, 194 Pension benefits, 153–159 economics of pension accounting, 155–157 nature of pension obligations, 154–155 other postretirement employee benefits, 159 pension assets and funded status, 194 pension risk exposure, 171–172 Pension cost, 156, 195–196 recognized OPEB cost, 200 recognized pension cost, 198–199 Pension crisis, 153, 171 Pension fund, 154 Pension intensity, 171 Pension obligation, 154–156, 193–194 accumulated benefit obligation (ABO), 168, 194 projected benefit obligation (PBO), 157, 194 Pension plan, 154, 199 Pension risk exposure, 171–172 Percentage-of-completion method, 352–353 Period costs, 83 Permanence of cash from operations, 563 Permanent component (of accounting income), 95 Permanent component of income, 330 Permanent differences, 367, 373 Permanent income, 92–94, 100, 330 adjustments for, 95–96 Permanent income tax differences, 366–367 Permanent investment income, 311 Plan assets, 156 Planning activities, 15–16, 447 Plant assets, 222, 239–248; see also Property, plant, and equipment (PP&E) valuation of, 240 Pooling-of-interests, 287–290 Porter, M E., 11 Porter’s industry (value chain) analysis, 11 Post-earnings announcement drift, 45, 78 Postretirement benefits, 153–173 accounting specifics for, 193–200 actuarial assumptions and sensitivity analysis, 169–170 adjusting income statement/balance sheet, 166–169 AMR Corporation (example), 160–173 analysis of, 163–173 cash flow implications of, 172–173 footnote disclosures, 162–163 other postretirement employee benefits (OPEB), 153, 159–163 pension benefits, 154–159 pension obligations, 154–155 pension risk exposure, 171–172 reconciling economic and reported numbers, 163–165 reporting of, 159–163 statement of cash flows, 409 types of, 153 Preacquisition sales and income, 283–284 Predicting financial distress, 568 Preferred dividends, earnings coverage of, 563–564 Preferred stock, 184–186 adjustments, capital structure analysis, 552 dividends, 558, 563–564 redeemable preferred stock, 191 Prepaid expenses, 222, 228, 532 Prepaid pension cost, 157, 159 Present value of an annuity, 501n Present value theory, 40 Pressler, P., 445 Pretax profit margin, 37, 458 Price-to-book (PB) ratio, 37, 613–614 Price-to-earnings (PE) ratio, 37, 614–615 PricewaterhouseCoopers, 27, 72 Principal repayment obligations, 558 Prior period adjustments, 189 Prior service cost, 156, 195 deferral and amortization of, 199 OPEB accounting, 200 Pro forma earnings, 20, 69, 601 Pro forma financial statements, 506 cash flow forecasting, 506–510 Procter & Gamble cash and cash equivalents, 224 effective tax rate, 367 goodwill, 285 intangibles, 248 inventories, 228 PPE, 240 Product costs, 83 Product financing arrangements, 352 Profit, 91 Profit margin, 37–38 asset turnover and, 455–458 Profitability, 9, 20, 100, 221–223, 416, 638 Campbell Soup case, 660–663, 669 diversified companies and segment reports, 470–471 inventory costing effects on, 230–231 return on invested capital and, 447 Profitability analysis, 13, 36, 38–39; see also Return on invested capital general and administrative expenses, 460 gross profit, 459 selling expenses, 459–460 Projected benefit obligation (PBO), 157, 194 Projected income statement, 492–494 Projection process, 492–499 balance sheet, 494–498 income statements, 492–494 sensitivity analysis, 498–499 statement of cash flows, 498 Property, 240 Property, plant, and equipment (PPE), 222, 237, 238, 239–248 analysis of, 244–245 asset impairments, 344 valuation of, 240 Property, plant, and equipment (PPE) turnover, 37 Prospective analysis, 10, 14, 75, 491–492 feasibility tests, 508 projected balance sheet, 494–498 projected income statement, 492–494 projected statement of cash flows, 498 projection process, 492–504 residual income valuation model and, 499–501 short-term forecasting, 504–510 value drivers, trends in, 502–504 Prospective application, 341 Prospectus, 70 Provisions conservatism in, 121 for doubtful accounts, 539 taxes on undistributed subsidiary earnings, 276 Proxy, 27 Proxy statements, 27, 70 Public Company Accounting Oversight Board (PCAOB), 118 Public offerings, 17 Purchase agreements, 176 Purchase method of accounting, 277, 287, 289 Purchased intangibles, 248 Push-down accounting, 284 Put option, 291 Qualifying special purpose entity (QSPE), 181 Qualitative disclosures, 294 Quantitative disclosures, 294 Quarterly financial data, 27, 68, 70 Quarterly report, 70 Quick ratio, 543 Ratio analysis, 28, 33–39; see also Current ratio Best Buy lease restatement example, 152 capitalizing vs expensing, 239 cash-based ratio measures of liquidity, 536–537 Colgate example, 36–39 factors affecting, 35 illustration of, 36–37 interpretation of, 35 valuation, 36, 39 Ratio management, 534 Raw materials, 235 Realized/realizable revenues, 83, 94, 427 Realized ROI (return on Investment), 312–313 Recasting, 603; see also Earnings persistence Receivables, 222, 224–228, 460; see also Accounts receivable; Notes receivable analysis of, 225–228 authenticity of, 226 collection risk, 225 liquidity measures, 537–539 patterns of, 507 securitization of, 226–228 valuation of, 224 Receivables collection period, 538n Recognition lags, 79 Recommendation, 75 Recourse, 227 Recoverability test, 245 Recurrence (of events), 609 Recurring component of income, 330 Recurring income, 93, 330, 332–334 Recurring and nonrecurring income, 332–334 Recurring pension cost, 195 Red flags, 112–113 Redeemable preferred stock, 191 Regina Company, 237 Registration statement, 70 Regulation 14-A, 70 Regulation S-X, 284 Regulators, 10, 12, 68 Regulatory environment, 121 Related party footnote, 183 Relevance, 75, 107–108 Reliability, 75, 107–108 Remeasurement gains and losses, 303 Reported income, 91, 93–95 sub79433_index.qxd 4/21/08 10:06 AM Page IN9 Index Reporting environment, 68–75 reporting strategy, 112–113 statutory financial reports, 68–70 Representational faithfulness, 75 Research and development costs (R&D), 107–108, 120, 238 accounting for, 356 analysis of, 356–357 in-process research and development (IPR&D), 282 Reserve recognition accounting, 358 Residual earnings, 462 Residual income, 42, 249, 499, 502, 612 Residual income model, 42–43 prospective analysis in, 499–501 Residual interests, 9, 186 Restrictions (or covenants) on retained earnings, 188 Restructuring charges, 4, 69, 93, 109, 111, 329, 344, 346–347, 349–351 Retained earnings, 16, 20, 187–189 Retention ratio, 16 Return, 16 Return on assets (ROA), 37–38, 467 analysis of, 456–457 disaggregation of, 455, 467 total asset turnover (TAT) and, 503 Return on common equity (ROCE), 37–38, 449, 453–454, 462–469, 614 analysis of, 462–463 disaggregation of, 463–465, 467 time horizon and, 469 value drivers, trends in, 502–504 Return on invested capital (ROIC), 445, 638 Campbell Soup case, 655–659, 669 components of, 446–454 computation of, 447, 449, 465–468 importance of, 446–447 return on common equity, 446, 449, 453–454 return on net operating assets, 446, 448, 450–453 Return on investment (ROI), 36–37, 311–313, 446 capitalizing vs expensing, 239 Return on net operating assets (RNOA), 271, 448, 450–454, 463 analysis of, 454–462 Campbell Soup example, 466 computation of, 450 disaggregating of, 454, 457 NOPAT margin, NOA turnover, and, 456–457 operating leverage effect, 454–455 profit margin and asset turnover, 455–458 Return on plan assets, 156 Revenue, 331–332, 350 franchise revenue, 352 right of return and, 351–352 timing of, 77 under contracts, 352–353 unearned revenue, 353 Revenue recognition, 93–94, 330, 332, 350–355 accrual process and, 83, 85–86 analysis implications of, 353–355 guidelines for, 351–353 timing, 608 Reverse stock splits, 185 Right of merchandise return, 226 Right of return, 351–352 Risk accounting risk, 13 audit risk, 116 business risk, 119 of capital structure, 555, 565–566 collection risk, 225 companywide risk exposure, 296–297 credit risk, 566 default risk, derivatives and, 297 interest rate risk exposure, 295 market risk sensitivity, 295 market risks, 290 operating leases and, 153 pension risk exposure, 171–172 Risk analysis, 13–14 Risk of default, Risk exposure, 296–297 Risk profile, 171 Risk propensity of manager, 361 Rite Aid, 401 RJR Nabisco, 286 Royalty, 282, 352 Safe harbor rules, 74, 620 Sale-leaseback transaction, 192 Sales analysis by source, Campbell Soup case, 640–641 Sales forecasting, 505–506 Sales-type lease, 192 Salvage value, 238, 241–242, 247 Sampling approach, 116 Sarbanes-Oxley Act of 2002, 12, 27, 72, 118, 137 Screening devices, 555 Sears, Roebuck and Company, 227 Seasonality, 69 in business activities, 621 Securities Acts of 1933, 71 Securities Acts of 1934, 71 Securities and Exchange Commission (SEC), 12–13, 15, 26, 35, 68, 71, 174 auditors/auditing standards and, 117–118 disclosure of liabilities, 141 earnings to fixed charges ratio, 557, 559–560 GAAP and, 71–72 interim reporting requirements, 622 key SEC filings, 70 monitoring and enforcement mechanisms, 72–73, 89 role in statutory financial reports, 71–72 special charges, 347 Staff Accounting Bulletin 51, 283 Securitizations, 271 off-balance sheet effects, 178–180, 227 of receivables, 226–228 special purpose entities (SPEs), 409 Security analysis, prospective analysis and, 492, 499–501 Security valuation, 492 Segment reports, 470–471 Sell-side analysts, 74–75 Selling expenses, 459–460 Semistrong form EMH, 44–45 Sensitivity analysis postretirement benefits, 169–170 projection financial statements, 498–499 Service cost, pension cost, 156, 195, 200 Settlement date, 291 Share capital, 9, 22 Shareholders, 16 Shareholders’ equity, 20, 184–191; see also Return on common equity (ROCE) capital stock, 184–187 prior period adjustments, 189 retained earnings, 187–189 statement of, 22–24 Shell companies, 137 Short selling, 45 Short-term, 528 Short-term accruals, 83–84 Short-term borrowings, 27 Short-term cash forecasting, 504 IN9 Short-term credit analysis, Short-term debt to total debt, 555 Short-term forecasting, 504–510 cash flow patterns, 504–505 pro forma analysis, cash flow forecasting, 506–510 Short-term liabilities; see Current liabilities Short-term liquidity, 638 Campbell Soup case, 651–654, 669 Signaling, 74 Significant influence holding, 267–268, 272 Simple capital structure, 374 Smith Barney, 75 Soft assets, 238 Software development costs, 238 Solvency, 9, 36, 38, 402, 445, 528; see also Capital structure and solvency analysis of, 38 asset-based measures of, 556 Campbell Soup case, 654–655, 669 capital structure and, 36, 38, 547, 553 defined, Solvency ratios, capitalization effects and, 239 Soros, G., Sources and uses of funds, analysis of, 39 Special items, 343–350 analysis of, 347–350 asset impairments, 345–346 frequency and magnitude of, 344 restructuring charges, 346–347 types of, 347 Special methods of depreciation, 243 Special purpose entities (SPEs), 137, 177–179, 227 concept of, 177 consolidation rules and, 228 examples of, 177–183, 227 securitization of receivables, 226–228, 409 Specific exchange rate, 303 Spin-off, 188 Split-off, 188 Spread, 464–465 Standard & Poor’s (S&P) credit ratings, 566 Statement of cash flows (SCF), 24, 401–411 acquisitions of companies with stock, 409 analytical cash flow worksheet, 419–420 cash flows as validators, 418 construction of, 403–408 direct method, 403, 409–410 equity method investments, 408–409 free cash flow, 417 indirect method, 403, 410 interest incurred, 558 limitations in cash flow reporting, 411 postretirement benefit costs, 409 preparation of, 404–408 projected, 498 relevance of cash, 402–403 reporting by activities, 403 securitization of accounts receivable, 409 Statement of Financial Accounting Concepts No 1, 79 Statements of Financial Accounting Standards (SFAS), 71 SFAS 87, 94, 153, 157–159, 162 SFAS 109, 370 SFAS 115, 94, 265, 269, 271 SFAS 121, 244, 345 SFAS 123, 71, 361–363 SFAS 123(R), 361–363, 378 SFAS 128, 374 SFAS 130, 333, 335 SFAS 131, 470 SFAS 133, 291, 296 sub79433_index.qxd IN10 4/21/08 10:06 AM Page IN10 Index SFAS 140 (“Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”), 178, 228 SFAS 141 (“Business Combinations”), 277, 281 SFAS 142 (“Goodwill and Other Intangible Assets”), 277 SFAS 144, 244, 338 SFAS 145, 336 SFAS 151, 341 SFAS 154, 341 SFAS 157, 97, 100–101, 106, 298 SFAS 158, 23, 106, 153, 157–159, 162, 166–167, 197, 199–200 SFAS 159 (“fair value option” standard), 97, 106, 140, 269, 298, 301–302 SFAS 160, 280 Statements of Position (SOP), 71 Statutory financial reports, 68–70 factors affecting, 70–75 factors affecting SEC’s role in, 71–72 SEC interim reporting requirements, 622 Statutory tax rate, 367 Stock appreciation rights (SARs), 359 Stock-based compensation, 359 Stock buybacks, 185 Stock dividends, 184–185, 187 Stock market, as efficient, 45 Stock options, 184–185 Stock prices, 109–110 accounting data and, 612–613 accounting information and, 78 income and cash flow measures, 85–88 Stock splits, 184 Straight-line depreciation, 241–242, 246 Strategy analysis, 11–12; see also Business environment and strategy analysis Stride Rite Corporation, 233 Strong form EMH, 44–45 Subramanyam, K R., 336 Subsidiary, 268, 275–276 gains on subsidiary IPOs, 283 preferred stock dividend, 558 Substitute products, 12 Substitution hypothesis, 149 Successful efforts accounting, 358 Sum-of-the-years’-digits method, 242 Sunbeam, 108 Supervisory analysts, 74 Supplementary employee benefits, 359–365 Supplementary information, 27 Sustainable earnings power, 9, 13, 93, 95, 105, 330 Sustainable equity growth rate, 469 Sustainable income, 92–93, 330 Swaps, 291 Swartz, M., 72 Synthetic lease, 178, 180 Take-or-pay arrangements, 177 Tangible fixed assets, 237, 238 Target Corp., 16–19, 137 cash and cash equivalents, 224 effective tax rate, 367 intangibles, 248 inventories, 228 PPE, 240 projected balance sheet, 494–498 projected income statement, 492–494 projected statement of cash flows, 499 Tarkenton, F., 116 Tax incentives, 30 Taxable income, 367 Taxes, 330; see also Income taxes deductibility of interest, 550 deferred taxes, 174, 368–370, 551–552 leasing and, 149 undistributed subsidiary earnings, 276 Technical analysis, Technological feasibility, 238, 358 Templeton, J., Temporal method, 302–303, 307, 308, 310 Temporary differences, 367, 373 Temporary income tax differences, 366–367 Tenneco, 191 Terminal value, 42 Through-put agreements, 176–177 Tice, D., 263 Time horizon for earnings power, 617–618 Time value of money, 40, 195 Time Warner, Inc., 184 Timeliness, 75, 79, 87–88 Times interest earned, 36, 38, 562 Timing problems, 83, 608 Toro Company, 236 Total assets turnover (TAT), 37, 503 Total debt ratio, 554 Total debt to equity ratio, 36, 38, 554 Total debt to total capital ratio, 554 Trade (or operating) creditors, 8, 462 Trade names, 248 Trademarks, 237, 248, 281–282 Trading on the equity, 549 Trading securities, 266, 272 Transaction basis, 94, 99–100 Transaction-specific risk, 296 Transactions-based accounting, 76 Transitory component of accounting income, 95 Transitory component of income, 330 Transitory items in earnings, 609–611 Translation adjustment, 303 Translation adjustment account, 310 Translation gain or loss, 306–307 Treasury activities, 93 Treasury stock, 17, 22–23, 185 Trend statements, 607 Trezevant, R H., 336 Truth-in-Lending Act, 142 Turnover (capital utilization), 13 Tyco International Ltd., 27, 283 Tycom, Ltd., 283 Uncollectible accounts, 224 Unconditional conservatism, 77 Unconsolidated affiliates, 273 Underfunded pension, 156, 194 Understatement of earnings, 120–121 Undistributed subsidiary earnings, 276 Unearned revenue, 353 Unidentifiable intangibles, 248–249 United Airlines, 153 Units-of-production methods, 243 Unmanaged earnings, 109 Unobservable inputs, 101 Unrealized gains/losses, 94 Unrecognized capital investment, 275 Unrecorded intangibles, 250 Unusual nature event/transaction, 337 Useful life of assets, 238, 241, 245 Valuation, 14, 36, 39–40, 88, 638 brand and trade names, 250 Campbell Soup case, 663–668 common stock, prospective analysis, 500–501 earnings-based equity valuation, 612–616 fair value, 102–103 of inventories, 228–230 natural resources, 240 property, plant, and equipment, 240 receivables, 224 transaction vs current valuation, 99 valuation techniques, 102 Valuation accounts, 27 Valuation allowance, 370 Valuation models, 10, 40–43 debt valuation, 40 equity valuation, 40–41, 612–613 fundamental valuation multiples, 613–615 Value chain analysis, 11 Value drivers, trends in, 502–504 Value investors, 491 Value irrelevant component of accounting income, 95 Value irrelevant component of income, 330 Variable interest entities (VIEs), 178, 180–181 Verifiability, 75 Vertical analysis, 31; see also Common-size financial statement analysis Vesting, 154 Vesting date, 360 Vesting periods, 360 Viacom, 249, 263, 611 Voluntary disclosure, 74 Wage costs, 238 Wal-Mart, 67, 85–86 Warrants, 184–185 Warranties, 173 Waste Management, 329 Wasting assets, 240 Watts, S., 568n Weak form EMH, 44–45 Weighted-average exchange rate, 303 Welch, J., 16 Wells Fargo Bank, 176, 299–301 Wendt, G., 73 What-if analysis, 544–547 Willens, R., 263 Window-dressing, 72, 94, 108, 143, 169, 341, 343, 534 Working capital, 20, 222–223 defined, 529 liquidity and, 528–537 net operating working capital turnover, 462 net trade cycle analysis, 535–536 Working capital accruals, 83–84 Working capital turnover, 37 WorldCom, 110, 119 WR Grace, 138–139 Write-down, 95–96, 337 Write-down of asset values, 244, 248, 329, 608 Write-offs of goodwill, 249–250, 263, 285, 344 Xerox, 119, 192 Year-end adjustments, 69 Year-to-year change analysis, 28–30 Yield to maturity, 40 Z-score (Altman’s), 568–569 Zero coupon bonds, 565 ... practical illustrations and case materials are abundant in the text, more are available These include (1) Primis custom case selection [www.mhhe.com/primis] and (2) Financial Shenanigans—ISBN: 978-0-07-138626-5(0-07-138626-2)... Development There are materials to aid readers in understanding basic accounting and finance concepts: (1) MBA Survival Kit—Accounting Interactive CD—ISBN: 978-0-07-304454-5(0-07-304454-7), and (2) Essentials... accounting information from the underlying economics These distortions occur in at least three forms (1) Managerial estimates can be subject to honest errors or omissions This estimation error is sub79433_ch01.qxd