Final Exam Solution Fall 2000 All figures are in millions of dollars.

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1 Final Exam Solution Fall 2000 All figures are in millions of dollars. 1. Locate or estimate the following items for fiscal year 1995 (the year ended December 31, 1995). Indicate where you found your answers or how you estimated them. (10 points, 2 for each item) 1a 1b 1c Amount Where Found In $MM Income Tax Expense $3,635 Inc. St. (Provision for Inc. Tax) Cash Received for disposition of PP&E $1,561 SCF - Investing Section Advertising Expense $1,219 Note I 1d Work-in-process inventory at yearend $4,990 Note D 1e Gross goodwill at year-end $1,783 Note F ($870 Net + $913 acc. Amort) 2. Transaction Analysis (19 points, see individual questions) 2a. As of 12/31/95, IBM reports a Marketable Securities portfolio of $442 million. Assuming they are all classified as Available-for-Sale, identify or estimate the following: i) The market value of these securities as of 12/31/1995. (2 points) $442 : AFS securities are reported at their Market Value as of the balance sheet date. ii) The original cost of these securities when they were purchased. (4 points) Original cost = current market value - gross unrealized gain = $442 - ($57 / [1 - tax rate]) = $442 - ($57 /.65) = $354 iii) The impact that the change in these securities value had on IBM s 1995 income statement. (2 points) No effect. Value changes for AFS securities do not flow to the income statement until they are sold.

2 2 2b. IBM s balance of accumulated depreciation associated with PP&E decreased from $28,156 to $27,402 during Yet, according to the SCF, depreciation charges of $3,955 were incurred. Explain (and reconcile numerically) what caused this account balance to fall. (3 points) Per the SCF, Investing section, IBM sold PP&E during Hence, we can infer that the Accum. Deprec. Associated with PP&E disposals was $3,955 + ($28,156 - $27,402) = $4,709 2c. Refer to note G (Debt). Unamortized discount increased from $21 million at 12/94 to $23 million at 12/95. For debt issued during 1995, identify which value was greater (by circling the appropriate sign) and briefly explain: i) the face value > = < the amount of cash raised? (2 points) > : For existing debt, discounts reduce over time. So for the balance to have increased, new debt must have been issued at a discount, which by definition means face value to be repaid > market price at issuance. ii) stated interest rate > = < effective (market) interest rate? (2 points) < : Discounts arise because the market requires a higher rate of return than an instrument is structured to pay, hence stated rate < effective rate. 2d. During 1993, IBM recognized restructuring charges of $8,945 million on its income statement. How much cash did IBM spend for restructuring activities in each of the years 1993, 1994, and 1995? How do you know? (4 points) Year Amount Explanation 1993 $3,715 Add-back of $5,230 to Net income in the SCF - Operating section, therefore cash effect was expense of $8,945 - $5, $2,772 Subtraction of $2,772 from Net income in the SCF. Since expense was zero in that year, cash effect was $2, $2,119 Same logic as for 1994 above.

3 3 3. Ratios (11 points, see individual questions) 3a. IBM capitalizes part of its interest costs as PP&E instead of expensing interest in full. Specify and briefly explain the effect on the following three ratios in 1995 if instead IBM had expensed all of that year s interest costs. (2 points each). Effect Explanation i Current ratio No Effect Curr. Assets: No effect Curr. Liab. : No effect ii Return on equity Decr Net Income : Decr Equity: Decr but ratio < 1 to start iii Debt to assets Incr Debt: no effect Assets: Decr 3b. Currently, IBM capitalizes little or none of the development costs associated with creating new software products. Instead, those costs are expensed as R&D. If IBM had capitalized a majority of software development costs, the subsequent amortization expense would in classified as part of COGS for software. i) Compare IBM s 1995 reported gross profit margins ([Revenue COGS] / Revenue) for hardware versus software. (3 points) Hardware: (35,600-21,862) / 35,600 = 38.6% Software: (12,657-4,428) / 12,657 = 65.0% Software appears substantially more profitable than hardware ii) Explain qualitatively how capitalizing/amortizing development costs as described above would affect the relative profitability of these two product lines. (2 points) No change to hardware GPM. Software COGS would increase while revenues would not change, therefore software GPM would be reduced. In essence, software appears more profitable under current accounting because development costs hit the R&D line rather than COGS.

4 4 4. Leases (10 points) Footnote P discloses lease commitments, which IBM treats as operating leases. In addition to the footnote information, assume that All disclosed leases were initiated on 12/31/95 and end on 12/31/05. Annual payments occur at year-end. 10% approximates IBM s incremental annual borrowing rate. Based on these assumptions, the present value of gross rental commitments is approximately $4,800 million as of 12/31/95. 4a. If IBM were to begin applying capital lease treatment to the "gross rental commitments" outstanding on12/31/95, what balance sheet account(s) would be affected and by what amount(s)? (4 points) Leased Assets: + $4,800 MM Current portion of lease commitment: + $711 MM ($1,191 - interest of $480) Long-term Lease liability: + $4,089MM ($4,800 - $711) 4b. IBM reported 1996 Earnings before income taxes of $8,587 million. What would that number have been if these leases had been capitalized? (3 points) $8,587 + $1,191 - $480 - $480 = $8,818MM Add back rent expense of $1,191. Subtract interest expense of $480 (.10 * $4,800) Subtract depreciation expense of $480 ($4,800 / 10 years) 4c. How would capitalizing these leases affect IBM's 1996 statement of cash flows? Provide line item(s) and dollar amount(s). (3 points) Operating: + $480M add back depreciation to net income No line item needed re interest component (income effect = cash effect) Financing: (711) Cash used to pay lease obligation

5 5 5. Taxes (10 points) 5a. Note H indicates that IBM has Deferred Tax Assets related to Restructuring charges. Identify and briefly explain for the time periods indicated below, which amount was greater: (A) the restructuring expense IBM recognized for financial reporting purposes or (B) the tax deductions related to restructuring. (2 points each) Time Greater: period (A) or (B)? Cumulative through 12/31/95 (A) During fiscal year 1995 (B) Explanation Existence of DTA means that the originating difference resulted in financial reporting income < taxable income and that this difference has not fully reversed. The balance of the DTA declined during 1995, indicating that the originating difference described above has partially reversed. 5b. During 1993, tax legislation increased the U.S. corporate tax rate from 34 to 35 percent. IBM reported that this change had a beneficial impact of $170 million in Briefly explain what gave rise to this benefit. (3 points) In 1995 and 1995, IBM's Def. Tax Assets exceeded Def. Tax Liabilities. This probably was true in 1993 as well. This means IBM's taxable income > financial reporting income in earlier periods when tax rates were lower. When the differences reverse, IBM's tax deductions will result in a greater amount of tax savings, causing a net benefit to the firm. 5c. During 1995, IBM expensed for financial reporting purposes $1.84 billion of purchased in-process R&D. Was this charge deductible for tax purposes? Provide evidence from IBM s statements or notes to support your answer. (3 points) No. Note H (p. 13) shows that the effective tax rate increased by 9 points due to the non-deductibility of this charge. Effective tax rates differ from the statutory rate because of permanent differences between the tax code and financial reporting rules.

6 6 6. Acquired R&D (19 points, see individual questions) 6a. Suppose that acquiring firms were not allowed to write off a part of the purchase price as acquired R&D, but instead had to include the value of purchased R&D in goodwill. What amount of Net Income (after taxes and preferred dividends) would IBM have reported for 1995 under this scenario? (Assume the purchase of Lotus occurred at mid-year. Specify any other assumptions you think are necessary.) (5 points) Goodwill would increase by $1,840. Since GW is amortized over 5 years (per note A, p. 9), amortization expense would increase by $184 every six month period. From question 5c, we know that the R&D charge was not tax deductible. We can assume the same is true of goodwill (otherwise IBM would have a powerful incentive NOT to recognize in-process R&D). Hence, restated NI = $4,116 (reported NI) + 1, $5,772 6b. In 1996, IBM reported Net Income applicable to common shareholders of $5,304 million. Compare the percent change in income from 1995 to 1996 using reported numbers to the percent change that results when income is adjusted as described in Question 6a. Which of these two measures do you believe is more relevant to answering the question did IBM s performance in 1996 improve over 1995? Why? (7 points) Reported change: $5,304 vs. $4,116 or 29% increase Restate 1996 NI as $5,304 - $368 (additional GW amortization) = $4,936 Restated change: $4,936 vs. $5,772 or 14% decrease The latter measure is arguably more appropriate for assessing whether IBM did better in 1995 or 1996, since the restated numbers treat the two years more consistently. One could also argue that amortization of goodwill should be ignored altogether, since it s not clear that goodwill declines in value over time.

7 7 6c. Exhibit 4 provides a hypothetical income projection for one of the software products that Lotus was developing at the time of the acquisition. Since this product had not yet achieved technological feasibility, its value as determined by this income stream was included in the $1.84 billion write-off. Using an annual discount rate of 16% (and any other reasonable assumptions you believe necessary), estimate the present value as of 12/31/95 for the income forecasts associated with WordSpeak (Exhibit 4). (7 points) Any of the following income timing alternatives is acceptable, as long as an assumption is specified: all at the beginning of each year, all at the end, equally throughout the year. For illustration purposes, assume the income occurs at the end of each year. Then, one applies t to each year s income, t = 2 to 9, since the income for 2005 and thereafter has already been stated in year 9 dollars (12/31/2004). The calculation is: PV(12/31/95) = (30) * (81) * (180) * (78) * * * * * *.26295» $1,318 If you assumed that all income occurs at the start of the year, the PV should be» $1,530 million. If you assumed that income occurs evenly throughout each year, the PV should be the average of these two calculations, or» $1,424 million. 7. Qualitative Analysis (21 points) 7a. The historical cost model of accounting is often criticized as reporting numbers that, while highly objective, lack relevance for decision-making. The approach taken by IBM (as illustrated in Exhibit 4) is an exception because IBM used discounted cash flows to estimate a market value for Lotus s assets instead of recording them at historical cost. IBM then used these market values and an assessment of the products technological feasibility at the time of the acquisition to determine how much of the purchase price that it paid for Lotus was attributable to in-process R&D. As a user of financial statements, evaluate the relevance and reliability of IBM s write-off of the in-process R&D acquired from Lotus. (12 points) 7b. Suppose accounting standards-setters were proposing that companies must disclose the assumptions used to determine the write-off for acquired in-process R&D, i.e., data analogous to Exhibit 4. Give arguments in favor of and against such a requirement from the viewpoints of regulators (e.g., SEC) and acquirers (e.g., IBM). (9 points) Write your answers to questions 7a and 7b on pp You need not fill the entire space provided. If absolutely necessary, continue on the back of the appropriate page.

8 8 7a: Relevance Versus Reliability: Relevance (other points may be valid as well) May be useful for investors to assess how much of the purchase price IBM paid for Lotus is attributable to ongoing R&D projects Provides insight into IBM s business operations, e.g., hurdle (discount) rate, planning horizon DCF approach should place a ceiling on what IBM is willing to pay for R&D; users could infer that IBM would have to pay more to develop this technology themselves (i.e., without the purchase) Since some consider goodwill to be an amorphous concept, breaking R&D out separately could give investors a better handle on what IBM really acquired by purchasing Lotus: R&D written off represents expected cash flows from projects under development, while Goodwill (the smaller component) could represent synergies/creative potential that IBM hasn t explicitly identified or tied to projects. Future follow-on products sounds more like creative potential (goodwill) then current R&D. Is classifying R&D separately from goodwill meaningful for users? Including the R&D as part of goodwill and amortizing it over coming years may result in better matching (measurement of performance) than the immediate write-off. Reliability (other points may be valid as well) The forecasts used to estimate the R&D value extend 8-9 years into the future one would question how well IBM could gauge the potential, let alone success, of such products that many years from now. In particular, all the value of WordSpeak comes from the revenues assumed to occur in perpetuity after 2004 (it has negative NPV up until then). IBM used an outside appraiser, so there is other (objective?) expertise involved in producing these forecasts and values. However, this appraiser isn t named, and we have no benchmark for assessing their forecasting ability. IBM has a reputation for integrity which should increase our confidence in their estimation procedures. The R&D write-off was audited by Price Waterhouse this provides another objective assessment of the number s credibility. As the article excerpts point out, there seem to be incentives for managers to exaggerate the R&D write-off to avoid recognizing goodwill, since the latter gives rise to amortization expenses in subsequent years. This could fuel skepticism about the R&D figure that IBM used. On the other hand, $1.84 B is less than 60% of the entire purchase price, which is somewhat less than the 75-80% Novell has been cited as expensing. We do not know how IBM evaluated this project compared to others in fact, as a real user, we wouldn t have any of the detail in Exhibits 4a and 4b.

9 9 7b: Pros and Cons Regulators Pro: Given the concerns cited in 7a, regulators might prefer to have acquiring firms be more forthcoming with investors about how they determine the R&D write-off. Regulators could be expected to view this disclosure as highly relevant for investors, since it reflects of IBM's expectations about the future benefits embedded in its purchase of Lotus. Regulatory concerns about the reliability of the write-offs could be allayed by requiring disclosure of some of the underlying assumptions. Con: If regulators are more concerned about backlash from companies than about investors, they might not push for this level of disclosure. Acquiring companies Con: These forecasts could be considered proprietary disclosing them may divulge too much information to competitors who might change their own strategies if details of IBM s plans and expectations become available. Con: Managers may fear that detailed disclosure will raise more questions from investors than it resolves. Pro: If acquiring firms believe competitors have other means of getting this type of information anyway, they might prefer that everyone be forced to reveal some level of detail behind the R&D numbers to enhance their credibility with users and to make it easier to assess what their competitors are doing. (Other reasonable arguments are acceptable as well.)