CASE 1-1 Analysis of Contingent Obligation: Bristol-Myers Squibb

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1 CASE 1-1 Analysis of Contingent Obligation: Bristol-Myers Squibb INTRODUCTION In 1992, Bristol-Myers Squibb [BMY], a major U.S. based drug company, reported substantial litigation against the company by recipients of breast implants manufactured and sold by a subsidiary of the company. In 1993, BMY made a provision for losses expected from such litigation. 1 In succeeding years, as the litigation proceeded, the company added to that provision for loss. Eight years later, as of December 31, 2000, while many of these claims had been settled, the amount of BMY s ultimate cash outflows remained uncertain. This case illustrates the difficulty in assessing the impact of such litigation on reported income and financial position. EXHIBIT 1C1-1. BRISTOL-MYERS SQUIBB Breast Implant Litigation Footnotes Note 17: Contingencies The company is a defendant in a substantial number of actions filed in various U.S. federal and state courts and in certain Canadian provincial courts by recipients of two types of breast implants, formerly manufactured and sold by a subsidiary of the company, alleging damages for personal injuries of various types. Certain of these cases are class actions, some of which seek to allege claims on behalf of all breast implant recipients. All federal court actions have been consolidated for pre-trial proceedings in federal District Court in Birmingham, Alabama. In the case of Pamela Jean Johnson v. Medical Engineering Corporation, tried in state Court in Harris County, Texas, a jury on December 23, 1992 awarded plaintiff compensatory and punitive damages totaling $25 million. Absent settlement, the company s subsidiary will appeal this verdict. Source: Bristol-Myers Squibb Annual Report, December 31, 1992 Note 17 Litigation Breast Implant The Company, together with its subsidiary, Medical Engineering Corporation (MEC), and certain other companies, has been named as a defendant in a number of claims and lawsuits alleging damages for personal injuries of various types resulting from polyurethane-covered breast implants and smooth-walled breast implants formerly manufactured by MEC or a related company. Of the more than 90,000 claims or potential claims against the Company in direct lawsuits or through registration in the nationwide class action settlement approved by the Federal District Court in Birmingham, Alabama (the Revised Settlement ), most have been dealt with through the Revised Settlement, other settlements, or trial. In the fourth quarter of 1993, the Company recorded a charge of $500 million before taxes ($310 million after taxes) in respect of breast implant cases. The charge consisted of $1.5 billion for potential liabilities and expenses, offset by $1.0 billion of expected insurance proceeds. In the fourth quarters of 1994 and 1995, the Company recorded additional special charges of $750 million before taxes ($488 million after taxes) and $950 million before taxes ($590 million after taxes), respectively, related to breast implant product liability claims. In the fourth quarter of 1998, the Company recorded an additional special charge to earnings in the amount of $800 million before taxes and increased its insurance receivable in the amount of $100 million, resulting in a net charge to earnings of $433 million after taxes in respect to breast implant product liability claims.... At December 31, 2000, $186 million was included in current liabilities for breast implant product liability claims. Source: Bristol-Myers Squibb Annual Report, December 31, As an offset to the loss provisions for the company also provided estimates for amounts recoverable from insurance. W64

2 CASE OBJECTIVES CASE OBJECTIVES: W65 1. Discuss the value to financial analysts of the initial disclosures in BMY s 1992 financial statement footnotes. 2. Examine the impact on BMY s financial statements and ratios of the 1993 loss provision and additional loss provisions in following years. 3. Consider the impact on BMY s financial statements and ratios of alternative financial reporting (timing and measurement) of the loss. Exhibit 1C1-1 contains excerpts from the Annual Reports of Bristol-Myers Squibb for the years 1992 and These extracts provide a review of the firm s disclosures on breast implant litigation. Exhibit 1C1-2 contains data, extracted from annual reports for the years 1993 through 2000, regarding the income statement and balance sheet consequences of the accounting for this litigation. Required: 1. The firm did not record a liability for the breast implant litigation for the year ended December 31, Discuss the usefulness of the footnote disclosure in The firm recorded a special charge and related liability in the fourth quarters of 1993, 1994, 1995, and The 1993 charge was offset by $1.0 billion of expected insurance proceeds; the 1998 charge was offset by $100 million of expected insurance recovery. The firm engaged in litigation with some of its insurers regarding the extent of insurance coverage for these losses. Describe the impact of this offset on the income statement and the balance sheet. 3. Estimate the actual cash inflows and outflows related to this litigation for the years 1993 through 2000, using the income statement and balance sheet information provided. 4. Restate reported earnings for the years 1993 through 2000 assuming that Bristol-Myers had recorded an expense for each year equal to the (net of insurance recovery) cash outflow for that year. [Use a marginal tax rate of 35% for each year.] EXHIBIT 1C1-2. BRISTOL-MYERS SQUIBB Selected Financial Statement Data Years Ended December 31 ($ in millions) Income Statement Breast Implant Litigation Special charge: gross $1,500 $ 750 $ 950 $ 800 (Expected insurance recovery) (1,000) $1,5 $1,5 $1(100) Net charge (pretax) $ 500 $ 750 $ 950 $ 700 Net charge (after-tax) Net earnings* $1,378 $1,696 $1,542 $1,517 $2,484 $2,744 $2,750 $3,789 $4,096 *Continuing operations, using restated data from 2000 annual report Balance Sheet Non-Current Assets: Insurance recoverable $1,000 $ 968 $ 959 $ 853 $ 619 $ 523 $ 468 $ 262 Product Liability: Current portion Non-current portion $1,370 $1,201 $1,645 $1,031 $1,171 $1,244 $3,167 $1,1 Total $1,470 $1,836 $2,345 $1,831 $1,036 $1,121 $ 354 $ 186 Source: Bristol-Myers Squibb Annual Reports,

3 W66 CASE 1-1 ANALYSIS OF CONTINGENT OBLIGATION: BRISTOL-MYERS SQUIBB 5. Discuss the effect of the restatement in part 4 on the level and trend of BMY earnings over the 1992 to 2000 time period. 6. Discuss the effect of the restatement in part 4 on Bristol-Myers reported return on equity (ROE) for the years 1993 through [Hint: consider the effect of the restatement on stockholders equity as well as income.] 7. Based on information available at December 31, 2000, describe how to compute the charge that Bristol-Myers should have recorded in December 31, Describe the impact of that charge on BMY earnings and ROE in 1992 and subsequent years. 8. Based on your answers to parts 1 through 7, discuss the advantages and disadvantages to the company of recording expense equal to (i) The actual cash flows estimated in part 3 (ii) The charge described in part 7 rather than the special charges actually recorded.

4 CASE 2-1 Revenue and Expense Recognition Orthodontic Centers of America CASE OBJECTIVES INTRODUCTION The objective of this case is to evaluate the revenue and expense recognition methods used by the company. The following information was extracted from the 1999 and 2000 annual reports of Orthodontic Centers of America [OCA]. The company provides practice management services to orthodontic practices in the United States. OCA acquires and develops orthodontic centers and manages the business operations and marketing aspects of affiliated orthodontic practices. At December 31, 2000, there were 592 orthodontic centers, of which the company developed 306 and acquired 361 (75 were consolidated into another center). The affiliated orthodontists control the orthodontic practices, determine which personnel, including orthodontic assistants, to hire or terminate, and set their own standards of practice in order to promote quality orthodontic care. A typical patient receives an initial consultation and preliminary procedures (teeth impressions, x-rays, and the placing of spacers between the teeth for braces) in advance of the next appointment. The patient signs a contract for treatment in the event the orthodontist recommends orthodontic treatment. Generally, braces are applied two weeks later and subsequent adjustments to the braces are made every four to eight weeks. The contract specifies the terms and the length of the treatment as well as the total fees. The average contract length is 26 months. No initial down payment is required; the patient makes equal monthly payments followed by a final payment on completion of the treatment. OCA provides the following services to its affiliates: 1999 REVENUE RECOGNITION 1. Staffing 2. Supplies and inventory 3. Computer and management information services 4. Scheduling, billing, and accounting services An unrelated financial institution finances operating losses and capital improvements for newly developed orthodontic centers; OCA guarantees the related debt. The Company earns its revenue from long-term service or consulting agreements with affiliated orthodontists. Through December 31, 1999 OCA recognized monthly fees equal to approximately: 24% of the aggregate amount of all new patient contracts entered into during that particular month, plus The balance of contract amounts allocated equally over the remaining term of the contract. Gross amounts are reduced by the portion of contract amounts expected to be retained by the orthodontist. OCA recognizes operating expenses as incurred. Required: 1. OCA believes that at least 24% of its services relate to the first month of the patient contracts. Given the services provide by OCA and the terms of the service and consulting agreements: Evaluate the revenue recognition method used by OCA. Propose and justify a more appropriate revenue recognition method. W67

5 W68 CASE 2-1 REVENUE AND EXPENSE RECOGNITION ORTHODONTIC CENTERS OF AMERICA 2. Estimate OCA s average contract balance for new patients in 1999, using the operating data in Exhibit 2C Estimate the first year revenue that OCA recognizes from a new patient contract, assuming that OCA s share of the contract amount is $3,000, the contract length is 26 months, and the contract is signed on (i) January 1 of the first year (ii) July 1 of the first year (iii) December 1 of the first year 4. Estimate the second year revenue that OCA recognizes from a new patient contract, under the same assumptions as Question 3, for each of the three signing dates. 5. Explain why, using your answers to Questions 3 and 4, OCA must expand its operations rapidly to maintain revenue growth Revenue Recognition Effective January 1, 2000, OCA changed its revenue recognition method citing SEC Staff Accounting Bulletin No. 101 (see page 45 of text). OCA now recognizes net revenue using a straight-line allocation of patient contract revenue over the duration of the patient contract (typically 26 months). The company reported that The cumulative effect of this accounting change, calculated as of January 1, 2000, was $50.6 million, net of income tax benefit of $30.6 million. The effect of this accounting change in 2000 was to reduce revenue by $26.3 million. In 2000, the Company recognized revenue of $57.3 million that was included in the cumulative effect adjustment. 1 The company also reported the pro forma effect of the accounting change on net income, assuming it had been in effect in prior years. Results for those years were not, however, restated. Exhibit 2C-1 contains operating and income statement data for OCA for the years 1997 through The exhibit also shows reported balance sheet data for 1998 through 2000, and restated data for 1999 (see Question 15). Use the exhibit to answer the questions that follow. Required: 6. Redo Questions 3 and 4, using the revenue recognition method that OCA adopted in Compare the first and second year revenue recognized under the 2000 and 1999 methods. Note: use an average of the three signing assumptions. 8. The accounting change had two effects on year 2000 revenue: Revenue recognized from new patients was reduced. Revenue from patients signed in prior years, included in the cumulative effect adjustment, was recognized in (i) From the company s disclosure of the effect of the accounting change, compute each of these effects. (ii) Use your answer to Question 7 to estimate the second of these effects. 9. Compute OCA s 2000 revenue and net income assuming that it had not changed its revenue recognition policy. 10. Explain why OCA s revenue recognition policy has a disproportionate effect on net income. 11. Discuss the effect of the accounting change on your answer to Question Compute the annual percent changes in each of the following statistics for 1997 to 2000, and discuss their trend and their implications for future revenue growth: Number of orthodontic centers Total case starts Number of patients under treatment 13. Describe the effect of the accounting change on OCA s receivables. 1 Source: footnote 2 to 2000 financial statements.

6 1999 REVENUE RECOGNITION W69 EXHIBIT 2C-1. ORTHODONTIC CENTERS OF AMERICA Reported Operating and Financial Data Years Ended December 31 Operating Data Number of orthodontic centers Total case starts 70,611 95, , ,639 Number of patients under treatment 130, , , ,373 New patient contract balances ($ millions) $ $ Income Statement Years Ended December 31 (Amounts in $ Thousands, Except Per Share Data) Net revenue $117,326 $171,298 $226,290 $268,836 Operating expense $(81,368) (117,012) (149,366) (188,834) Operating profit $ 35,958 $ 54,286 $ 76,924 $80,002 Net interest income (expense) $331,143 $444,280 $1 (2,204) $8 (3,731) Pretax income $ 37,101 $ 54,566 $ 74,720 $ 76,271 Income tax expense $ (14,469) $ (20,753) $ (28,206) $ (28,549) Net income* $ 22,632 $ 33,813 $ 46,514 $ 47,722 *Before cumulative effect of accounting changes Diluted earnings per share $ 0.50 $ 0.70 $ 0.96 $ 0.96 Provision for bad debt expense $ 1,851 $ 2,295 $ 2,079 $ 373 Pro Forma for 2000 Accounting Change Net income $ 12,013 $ 22,276 $ 32,326 n/a Diluted earnings per share $ 0.26 $ 0.46 $ 0.66 n/a Balance Sheet Data December 31 (Amounts in $ Thousands) Reported Restated Patient receivables 1 $ 20,163 $ 25,976 Unbilled patient receivables 2 46,314 65,793 Service fees receivable 3 $ 87,563 $ 35,350 Total assets 296, , , ,947 Patient prepayments 4,326 4,206 Deferred revenue 2,516 Total debt 20,055 50,632 50,632 58,575 Total liabilities 65,639 88,495 84,289 80,751 Stockholders equity 231, , , ,196 1 Net of allowance for uncollectibles of $5,356 in 1998 and $6,403 in Net of allowance for uncollectibles of $2,209 in 1998 and $3,241 in Net of allowance for uncollectibles of $9,644 in 1999 and $2,598 in Compute each of the following statistics for 1997 to Discuss their trend, their impact on reported income, and their implications for future revenue and income growth. Discuss the effect of the accounting change on the 2000 statistics. (i) Revenue, expense, and operating profit per patient under contract (ii) Revenue, expense, and operating profit per center 15. In 2000, OCA restated its 1999 balance sheet to aggregate billed and unbilled patient receivables (as service fee receivables). It also reduced that amount by patient prepayments,

7 W70 CASE 2-1 REVENUE AND EXPENSE RECOGNITION ORTHODONTIC CENTERS OF AMERICA previously shown as a current liability. Compute the ratio of the allowance for uncollectible amounts to gross receivables for: Billed and unbilled patient receivables for 1998 and 1999 Service fees receivable for 1999 (restated) and (i) Discuss whether the differences between the ratios for billed and unbilled receivables accord with the nature of the receivables. (ii) Discuss the trend in the allowance ratios over the 1998 to 2000 period. (iii) Explain why the aggregation is a loss of information useful for financial analysis. 16. Compare the trend of earnings per share for 1997 to 2000 using the pro forma data with the trend as originally reported. Explain which time series better represents the operating results over that time period. 17. Discuss two reasons why the time series that is your answer to question 16 may not be a reliable basis for forecasting future results.

8 CASE 3-1 Cash Flow Analysis Orthodontic Centers of America [OCA] This case is a continuation of Case 2C-1, which provides information about the business conducted by OCA and describes the revenue recognition method used by OCA (both before and after the January 2000 accounting change). Use the data provided in Case 2C-1 and Exhibit 3C-1 to answer the following questions. Required: 1. Calculate the actual cash collections for the years Compare the cash collection amounts computed in question 1 with revenues (i) Reported for each year (ii) Calculated using the pre-january 1, 2000 revenue recognition method (see Case 2-1, question 9). (iii) Calculated using the post-january 1, 2000 revenue recognition method. (Hint: To adjust reported 1998 and 1999 revenue, use the pro forma earnings provided and assume a 35% tax rate.) 3. Discuss how the answers to question 2 provide insight as to the appropriate revenue recognition method. 4. Analyze the trends in the company s cash from operations, cash for investing, free cash flows, and cash from financing. Exhibit 3C-1 also provides information as to how the company acquires new affiliated orthodontists. 5. (a) Explain how these acquisition costs affect the company s cash from operations, cash for investing, and free cash flows. State where the remaining acquisition costs are reported in the cash flow statement. (b) Explain how the reporting of the cash flows associated with the acquisition of affiliated practices differs from the reporting of cash flows associated with newly developed practices. 6. Describe the effect of the company s treatment of the affiliated practice acquisition costs on the analysis of the company s cash flows. Suggest an alternative approach to cash flow analysis and redo question 4 after making the required adjustments to the cash flow statement for the acquisition costs. W71

9 W72 CASE 3-1 CASH FLOW ANALYSIS ORTHODONTIC CENTERS OF AMERICA [OCA] EXHIBIT 3C-1. ORTHODONTIC CENTERS OF AMERICA Financial Statement Disclosures Consolidated Statements of Cash Flows ($ in thousands) Years Ended December 31 OPERATING ACTIVITIES Net income (loss) $ (2,854) $ 45,836 $ 33,813 Adjustments Provision for bad debt expense 373 2,079 2,295 Depreciation and amortization 15,175 12,238 9,124 Deferred income taxes (7,792) 1,273 (2,767) Cumulative effect of changes in accounting principles 50, Changes in operating assets and liabilities: Service fee receivables (13,549) (27,491) (22,733) Supplies inventory 889 (2,305) (2,663) Prepaid expenses and other (2,309) (1,342) 228 Advances to/amounts payable to orthodontic entities (8,233) (2,420) (1,756) Accounts payable and other current liabilities $(17,368 $1(5,199) $(26,568 Cash from operations $ 39,644 $ 23,347 $ 22,109 INVESTING ACTIVITIES Purchases of property and equipment (20,271) (22,520) (17,638) Proceeds from (sales of ) available-for-sale investments (16) ,674 Intangible assets acquired (28,246) (17,178) (42,216) Advances to orthodontic entities (3,951) (4,906) Payments from orthodontic entities $(48,5 $$(48,370 $(41,927 Cash used in investing activities $(48,533) $(43,075) $(43,159) FINANCING ACTIVITIES Repayment of notes payable to affiliated orthodontists and long-term debt (6,530) (6,742) (7,864) Proceeds from long-term debt 7,483 30,577 20,055 Repayment of loans from key employee program 2,632 Issuance of common stock $(14,299 $(23,114 $(43,595 Cash provided by financing activities $ 7,884 $ 23,949 $ 12,786 Foreign currency translation adjustment $11,(127) $(48,5 $(48,5 Change in cash and cash equivalents $ (1,132) $ 4,221 $ (8,264) Cash and cash equivalents: beginning of year $(15,822 $(11,601 $(19,865 end of year $ 4,690 $ 5,822 $ 1,601 SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES Notes payable and common stock issued to obtain Service Agreements $ 5,974 $ 4,512 $ 13,609 Transactions with Orthodontic Entities The following table summarizes the Company s finalized agreements with orthodontic entities to obtain Service Agreements and to acquire other assets for the years ended December 31, 2000, 1999 and 1998: Total Remainder Share Value Common Acquisition Notes Payable (Primarily (at average Stock Shares Costs Issued Cash) cost) Issued 2000 $34,220,000 $1,255,000 $28,246,000 $4,719, , ,700,000 3,600,000 17,190, ,000 80, ,900,000 8,700,000 43,994,000 4,206, ,000

10 CASH FLOW ANALYSIS ORTHODONTIC CENTERS OF AMERICA [OCA] W73 EXHIBIT 3C-1 (continued) At December 31, 2000 and 1999, advances to orthodontic entities totaled $16,701,000 and $20,530,000, respectively. Of these amounts, approximately $1,208,000 and $5,045,000 related to orthodontic entities that generated operating losses during the three months ended December 31, 2000 and 1999, respectively. At December 31, 2000 and 1999, advances to orthodontic entities in international locations totaled $6,196,000 and $1,413,000, respectively. Intangible Assets The Company affiliates with a practicing orthodontist by acquiring substantially all of the non-professional assets of the orthodontist s practice, either directly or indirectly through a stock purchase, and entering into a Service Agreement with the orthodontist. The terms of the Service Agreements range from 20 to 40 years, with most ranging from 20 to 25 years. The acquired assets generally consist of equipment, furniture, fixtures and leasehold interests. The Company records these acquired tangible assets at their fair value as of the date of acquisition, and depreciates or amortizes the acquired assets using the straight-line method over their useful lives. The remainder of the purchase price is allocated to an intangible asset, which represents the costs of obtaining the Service Agreement, pursuant to which the Company obtains the exclusive right to provide business operations, financial, marketing and administrative services to the orthodontist during the term of the Service Agreement. In the event the Service Agreement is terminated, the related orthodontic entity is generally required to purchase all of the related assets, including the unamortized portion of intangible assets, at the current book value. Source: 2000 Annual Report

11 CASE 4-1 Integrated Analysis of Pfizer, Takeda Chemical, and Roche INTRODUCTION CASE OBJECTIVES Ratio analysis should not be simply a mechanical exercise but a means to an end. It can be used in two different ways. The first method is to compute a number of ratios and then look for changes over time or differences among companies. Such analysis leads to an understanding of the level and trend of profitability as measured by return on equity (ROE). The second method is to start with ROE and then, by analyzing the components that comprise this measure, explain changes over time or differences among companies. 1. Compute the financial statement ratios for two companies in the same industry, using the following categories: activity, liquidity, solvency, and profitability. 2. Discuss the factors that limit the usefulness of such comparisons. 3. Show how ratios can be aggregated to explain differences in ROE among companies. 4. Show how top-down ratio analysis can be used to explain changes in ROE for a company over time as well as differences between companies. Takeda operates in the same industry as Pfizer and its 1999 financial statements are contained in the CD (and web site) accompanying the text. Note that the Takeda statements are prepared in Japanese yen and in accordance with Japanese GAAP. Required 1. For Takeda, compute ratios for 1999 in the following categories, using the Pfizer exhibits cited as a guide: Activity (Exhibit 4-4) Liquidity (Exhibit 4-6) Solvency (Exhibit 4-8) Profitability (Exhibit 4-10) 2. Using your answers to Question 1 and the corresponding Pfizer data, compare the ratios of the two companies in each of these categories. Discuss factors that limit the usefulness of this comparison and additional data that would be needed to improve it. 3. Prepare an integrated ratio analysis of Takeda, using Exhibits 4-12 and 4-14 as a guide. 4. Compare the 1999 ROE of Pfizer and Takeda, and determine the key ratios that explain the difference in ROE. Discuss other factors that might explain the differences in ROE and any additional data needed to adjust for these factors. Roche also operates in the same industry as Pfizer and Takeda. Its year 2000 annual report is available on the CD (and web site) accompanying the text. Its financial statements are denominated in Swiss francs (CHF) and prepared according to IAS GAAP. 5. Using the top-down approach suggested by the discussion relating to Exhibit 4-13, determine the key ratios that explain the (i) changes in Roche s ROE from 1999 to 2000 (ii) difference between the 1999 ROE for Pfizer and Roche W74

12 CASE 6-1 Inventory Analysis of Nucor INTRODUCTION CASE OBJECTIVES Nucor [NUE] is one of the largest steel companies in the United States. Exhibit 6C-1 contains financial data for the five years ended December 31, Nucor has used the LIFO method for all inventories during the entire time period. The objectives of this case are to 1. Show the impact of Nucor s use of the LIFO inventory method on its: Balance sheet Income statement Cash from operations Financial ratios 2. Discuss the advantages and disadvantages of use of the LIFO method. 3. Discuss the relationship between price trends and use of the LIFO method. The following questions should be answered using the data provided in Exhibit 6C-1. Assume a marginal tax rate of 35% for all years. 1. Calculate gross margin (both level and as a percent of sales) under both the LIFO and FIFO methods for the years EXHIBIT 6C-1. Nucor Selected Financial Data Years Ended December 31 Data in $millions Income Statement Sales $3,462,046 $3,647,030 $4,184,498 $4,151,232 $4,009,346 Cost of products sold 2,900,168 3,139,158 3,578,941 3,591,783 3,480,479 Pretax 432, , , , ,189 Net income 274, , , , ,589 Earnings per share $ 3.14 $ 2.83 $ 3.35 $ 3.00 $ 2.80 Tax rate 35% 35% 35% 35% 35% Balance Sheet LIFO inventory $ 243,027 $ 306,773 $ 385,799 $ 397,048 $ 435,885 $ 464,984 LIFO reserve 81,662 93,932 73, ,576 5,121 28,590 Current assets 830, ,381 1,125,508 1,129,467 1,538,509 Current liabilities 447, , , , ,031 Stockholders equity 1,122,610 1,382,112 1,609,290 1,876,426 2,072,522 2,262,248 Per share $ $ $ $ $ $ Statement of Cash Flows Cash from operations $ 447,160 $ 450,611 $ 577,326 $ 641,899 $ 604,834 Source: Nucor Annual Reports, W75

13 W76 CASE 6-1 INVENTORY ANALYSIS OF NUCOR 2. Discuss the differences in the level, trend, and variability of gross margins under the two methods. 3. Calculate net income assuming Nucor had used the FIFO method of reporting for and discuss differences in the level, growth rate, and variability of net income under the two methods. 4. Calculate stockholders equity per share assuming Nucor had used the FIFO method of reporting for Compare your results to reported equity and discuss the difference in level and growth rate. 5. Calculate Nucor s cash from operations assuming Nucor had used the FIFO method of reporting for Compare your results to reported cash from operations and discuss the difference in level and growth rate. 6. Calculate the following ratios for Nucor, using both reported data and assuming it had used the FIFO method of reporting, for : Current ratio Return on (average) equity Discuss the effect of using LIFO on the level and variability of both ratios. 7. Calculate Nucor s inventory turnover ratios for , using: (i) LIFO data (ii) FIFO data (iii) Current cost data Discuss the differences among these three turnover ratios and select the method that provides the best measure of economic turnover. Discuss the trend in Nucor s inventory turnover over the period. Discuss factors that might account for the variability of reported turnover. 8. Using the results of Questions 1 7 and the data in Exhibit 6C1-1, discuss the advantages and disadvantages to Nucor of use of the LIFO method over the time period. 9. Nucor s LIFO reserve at December 31, 1999 was less than 6% of gross inventory (FIFO basis) compared with a peak of more than 27% at December 31, There have been no LIFO liquidations during this time period. (a) What information does this decline provide about the price trend in steel scrap (Nucor s major raw material input)? (b) Discuss how this decline affects the advantages and disadvantages to Nucor of using the LIFO method. 10. If Nucor were considering switching from LIFO to FIFO, what date would it have chosen to make the change? Why? 11. If Nucor did switch from LIFO to FIFO, what information would that convey about the company s price expectations? Explain. 12. Steel Dynamics [STLD], a Nucor competitor, uses the FIFO inventory method. Selected data for 1997 through 1999 follow ($ in thousands): Sales $514,786 $618,821 Cost-of-goods-sold 428, ,629 Net Income 31,684 39,430 Ending Inventory $ 60, , ,742 Ending Equity 337, , ,370 (a) Using reported data, compute each of the following ratios for 1998 and 1999 for Steel Dynamics: Gross profit margin Return on equity Inventory turnover ratio (b) Assume that Steel Dynamics used the LIFO inventory method. Redo (a) using adjusted ratios for Steel Dynamics. For each ratio, use the method(s) you deem most appropriate and justify your choice.

14 CASE OBJECTIVES W77 (c) Explain why the adjustments improve the apparent performance of Steel Dynamics for 1998 but reduce it for (d) Explain why the adjusted ratios provide a more useful comparison for the two years. (e) Explain why the adjusted ratios provide a more useful comparison between Steel Dynamics and Nucor for the two years.

15 CASE 7-1 Analysis of Software Capitalization: International Business Machines INTRODUCTION CASE OBJECTIVES: The capitalization of computer software costs affects reported net income and stockholders equity in each accounting period. Because capitalized amounts must be amortized, the capitalization decision affects future accounting periods as well. In addition, while capitalization does not affect cash flow, it does change the allocation between cash from operations and cash for investment. In this case we explore these issues using International Business Machines [IBM], the world s largest computer manufacturer. 1. Compute the effect of IBM s capitalization of software expenditures on its reported balance sheet, income, cash flows, and financial ratios. 2. Show how changes in IBM s capitalization affected the level and trend of measures of income and cash flow. 3. Show how capitalization obscures trends in total spending on software and on research and development. 4. Show how capitalization affects segment profitability measures. 5. Discuss the possible effect of changes in corporate profitability on accounting policies. Exhibit 7C1-1 contains corporate financial data, software segment data, and data regarding the capitalization of computer software costs by IBM over the period IBM capitalized a portion of computer software costs as permitted by accounting standards discussed in the chapter. Use the information provided to answer the following questions. 1. Compute the effect on IBM s net income of software capitalization for the years Assume a 35% tax rate. 2. Compute the effect of software capitalization on IBM s (i) Cash from operations (ii) Cash for investment for the years Discuss the effect of capitalization on the trend of both cash flow measures. 3. Compute IBM s total spending on computer software (whether expensed or capitalized) over the period Compute the percentage of spending that was capitalized each year. 4. Compute the year-to-year percentage change in IBM s software segment external revenues for Discuss the trend over that time period. Note that IBM redefined that segment in 1996 so that revenues are not comparable to amounts. 5. Compute the gross profit and gross profit percentage for IBM s external software revenues for Discuss the trend in segment profitability over that period. 6. IBM started disclosing total software revenues in Compute the pretax profit margin for IBM s total software revenues for Discuss the trend in segment profitability over that time period. 7. Compute the return on assets for IBM s software segment over the period. Discuss the trend in segment ROA over that period. Explain how the level and trend of segment ROA are affected by IBM s accounting policies on R&D. Hint: consider the effect on ROA of capitalizing either all software-related R & D or none. 8. Discuss how the capitalization of software affects ROA in (i) Years with large capitalized amounts (ii) Years with small capitalized amounts W78

16 CASE OBJECTIVES W79 EXHIBIT 7C1-1 International Business Machines Amounts in $millions Corporate Financial Data Revenue $64,523 $62,716 $64,052 $71,940 $75,947 $78,508 $81,667 $87,548 $88,396 $85,866 Net income* (6,865) (7,987) 3,021 4,178 5,429 6,093 6,328 7,712 8,093 7,723 *Before accounting changes Cash from operations 6,274 8,327 11,793 10,708 10,275 8,865 9,273 10,111 9,274 14,265 Cash for investing (5,878) (4,202) (3,426) (5,052) (5,723) (6,155) (6,131) (1,669) (4,248) (6,106) Stockholders equity 27,624 19,738 23,413 22,423 21,628 19,816 19,433 20,511 20,624 23,614 Total R & D Expense* 6,522 5,558 4,363 4,170 4,654 4,877 5,046 5,273 5,151 5,290 *IPRD included in expense 1, Software-related R & D 1,161 1, ,157 1,726 2,016 2,086 2,036 1,948 1,926 Software Segment Not comparable to External revenue $11,103 $10,953 $11,346 $12,657 $11,426 $11,164 $11,863 $12,662 $12,598 $12,939 Internal revenue $12,593 $12,671 $12,749 $12,767 $12,828 $12,981 Total revenue $12,019 $11,835 $12,612 $13,429 $13,426 $13,920 Cost of external revenue 3,924 4,310 4,680 4,428 2,946 2,785 2,260 2,240 2,283 2,265 Pretax segment income 2,466 2,034 2,742 3,099 2,793 3,168 Segment assets 2,813 2,642 2,57 2,527 2,488 3,356 Statement of Cash Flows CFO: Addback to Net Income Amortization of software 1,466 1,951 2,098 1,647 1, CFI Investment in software 1,752 1,507 1, Source: Data from International Business Machines Annual and 10-K Reports, Compute IBM s total R&D expenditures (including amounts capitalized) over the period and compute total expenditures as a percentage of total corporate revenues. Discuss the trend in that percentage, the possible reasons for that trend, and the questions you would want to ask IBM management about that trend. Note: IBM reclassified some R&D expenditures in 2001; our data for prior years is not restated. 10. Compute IBM s after-tax profit margin and return on average stockholders equity over the period 1992 to [1991 equity was $36,679 million.] 11. The capitalization of software expenditures reflects accounting standards in effect each year, the nature of software expenditures, and changes in corporate policy. Discuss the possible effects of each of these three factors on the amount of software capitalization by IBM over the time period. Your answer should incorporate your answers to parts 1 through 10 of this case.

17 CASE 10-1 Analysis of Debt Capitalization: Read-Rite INTRODUCTION Read-Rite [RDRT] is one of the largest manufacturers of magnetic recording heads for computer disk drives, a highly competitive business characterized by rapid technological change. In August 1997, Read-Rite issued $345 million of convertible subordinated notes. Over the next three years, the company s operating results and financial condition deteriorated, bringing the company close to insolvency. Early in 2000, the company offered to exchange new notes for the old ones. That exchange, accompanied by improved operations, resulted in the retirement of virtually all of the old notes in exchange for common stock, with beneficial effects on the company s financial statements. CASE OBJECTIVES The objectives of this case are to: 1. Analyze the financial condition of Read-Rite over time. 2. Show the effects of the exchange offer on Read-Rite s financial condition. 3. Discuss the economic significance and the financial statement relevance of the recognized gain from the exchange offer. 4. Discuss the significance of the difference between carrying value and market value of debt. 5. Analyze, from the note holder perspective, the decision to accept the note exchange. In August 1997, Read-Rite issued $345 million of 6.5% subordinated notes, due in September The notes were convertible into Read-Rite common shares at $40.24 per share. As shown in Exhibit 10C-1, the company reported substantial losses in 1998 and As a result, Read- Rite s auditor opinion at September 30, 1999 had a going concern qualification (Exhibit 1-3). Because of its large losses, Read-Rite violated the financial covenants of its bank debt facility, which it had drawn down in 1998 and 1999 to fund its cash needs and provide adequate liquidity. Threatened with default and the possibility of having to file for bankruptcy, Read-Rite made an exchange offer for the 6.5% notes. For each $1,000 of old notes, holders were offered $500 of new notes, convertible into Read-Rite common shares at $4.51 per share (15% above the current stock price). Interest at 10% could be paid in cash or Read-Rite shares, at the company s election. The new notes were due September, In March 2000, Read-Rite completed the exchange of $325.2 million of old notes for $162.6 million of new notes, and sold an additional $61.2 million of new notes for cash. Read- Rite wrote off $5 million of unamortized issuance costs of the old notes. The new notes provided for automatic conversion into common shares if the Read-Rite share price exceeded $9.02 for a specified time period. When that condition was achieved, Read-Rite invoked the automatic conversion provision and the notes were converted to common shares in October The pro forma balance sheet at September 30, 2000 reflects that conversion as well as the sale of new common shares for $18.9 million cash and $28.8 million of bank debt repayments. The auditor s opinion at September 30, 2000 has no qualification. Exhibit 10C-1 contains Read-Rite financial data for the four fiscal years ended September 30, Use the information provided to answer the following questions. 1. Compute each of the following ratios at December 31, : (i) Total debt to equity (both as reported) (ii) Net debt to equity (both as reported) (iii) Total debt to equity (both at market) (iv) Net debt to equity (both at market) where net debt is total debt less cash and marketable securities and equity is defined as shareholders equity plus minority interest. W80

18 EXHIBIT 10C-1 Read-Rite Selected Financial Data Amounts in $millions Years Ended September 30 Balance Sheet Data * Cash and equivalents $ $ 62.4 $ 80.5 $ 54.6 Short-term investments Other current assets $1,285.2 $1,172.9 $1,183.2 $1,127.6 Total current assets $ $ $ $ Property, plant, equipment Intangible and other assets $1,145.4 $1,124.9 $1,117.7 $1,119.9 Total assets $1,301.5 $ $ $ *Pro forma for debt conversion and related transactions. Short-term debt $ 12.6 $ 22.5 $ $ 11.1 Other current liabilities $1,227.5 $1,161.1 $1,132.8 $1,125.3 Total current liabilities $ $ $ $ Convertible debt Other long-term debt Other long-term liabilities $1,138.7 $1,132.0 $1,115.8 $1,115.1 Total liabilities $ $ $ $ Minority interest Stockholders equity 2 $1,545.7 $1,233.9 $1,184.2 $1,271.2 Total equities $1,301.5 $ $ $ Fair value Includes retained earnings (129.2) (284.3) (409.1) Income Statement Data Net sales $1,162.0 $ $ $ Cost of sales (923.2) (941.4) (739.7) (616.9) Operating expenses 3 (119.1) (220.1) (159.0) (213.0) Interest expense (15.7) (29.6) (31.9) (33.0) Debt conversion expenses (29.4) Interest income Income tax expense (29.3) Minority interest (((((((7.1) $( $( $( Net income before extrod.item $ 76.2 $ (319.7) $ (155.7) $ (283.4) Gain on debt conversion $1,158.6 Net income $ (124.8) 3 Includes PPE write-downs (70.0) (29.7) (106.5) Cash Flow Data Operating activities $ $ (8.8) $ 76.2 $ (67.7) Investing activities 4 (392.8) (54.4) (200.8) 52.2 Financing activities (0.6) Foreign currency effects $111,3.3 $$$,.1 $$$,.1 $$$,.1 Net cash flow $ 36.3 $ (56.2) $ 18.1 $ (16.1) 4 Includes capital expenditure (272.8) (186.2) (101.0) (93.6) Stock price high low year end Year-end shares (millions) Source: Read-Rite data from annual reports. W81

19 W82 CASE 10-1 ANALYSIS OF DEBT CAPITALIZATION: READ-RITE 2. Discuss the trend in these four ratios over the period State and justify which of the ratios computed in (1) best represented the company s financial condition. 4. Justify the auditor s decision to give a going concern qualification at September 30, Your response should include the computation and discussion of Read-Rite s: (i) Gross margin (ii) Interest coverage ratio (iii) Cash flow over the period. 5. Discuss three benefits that Read-Rite obtained from the exchange offer. State the cost to the company of the exchange offer. 6. When the note exchange became effective in 2000, Read-Rite recognized a gain of $158.6 million. Show how that gain was computed. 7. Discuss whether the $158.6 million gain should have been recognized in fiscal 2000 rather than fiscal 1998 and Discuss whether, in economic terms, there was any gain at all. 8. From the note holder perspective, explain one advantage and two disadvantages of the new notes. Discuss why most note holders accepted the exchange offer. Evaluate that decision based on subsequent events.

20 CASE 11-1 Off-Balance-Sheet Financing Techniques for Texaco and Caltex The objective of this case is to extend the analysis of the off-balance-sheet financing activities of Texaco begun in Exhibit 11-7 of the text. Specifically the case focuses on Texaco s affiliates and their OBS activities and the adjustments to reported financial statements required to reflect these activities. Caltex is a joint venture between Texaco and Chevron [CHV] (another oil multinational); each partner owns 50%. Exhibit 11C-1 contains the 1999 condensed balance sheet, income statement, and selected footnotes of Caltex as well as general information, all extracted from Texaco s K report. Relevant financial information relating to Texaco can be obtained from Texaco s 1999 Annual Report (on the website/cd) and from the information provided in Exhibits 11-6 and 11-7 in the text. Required: 1. Exhibit 11-7 shows Texaco s reported and adjusted debt-to-equity ratios. To extend the analysis, compute the following ratios on a reported and adjusted basis for 1999: Return on assets (Use 1999 year end total assets) Times interest earned 2. (a) Using the Caltex reported balance sheet and income statement (without any adjustments), prepare a capitalization table for Caltex for the year ended December 31, (b) Compute the following Caltex ratios for 1999: Debt-to-equity Return on assets Times interest earned 3. (a) Using the footnote data from Exhibit 11C-1, compute the appropriate adjustments to Caltex debt for its off-balance-sheet obligations. (b) Using the result of part (a), recompute the ratios in question 2(b). (c) Discuss the significance of your results. 4. Use the results of Questions 2 and 3 to further adjust Texaco s debt and equity, and ratios calculated in Question Describe the information not contained in the Texaco and Caltex financial data that would help you evaluate the impact of their off-balance-sheet obligations on future cash flows. (Your discussion should include both financial and operational factors.) In addition to Caltex, Texaco s major affiliates are Equilon Enterprises LLC (44% owned) and Motiva Enterprises LLC (32.5% owned). 1 A description of these affiliates follows. Equilon was formed and began operations in January 1998 as a joint venture between Texaco and Shell. Equilon, which is headquartered in Houston, Texas, combines major elements of Texaco s and Shell s western and midwestern U.S. refining and marketing businesses and their nationwide transportation and lubricants businesses. Texaco owns 44% and Shell owns 56% of the company. Equilon refines and markets gasoline and other petroleum products under both the Texaco and Shell brand names in all or parts of 32 states. Equilon is the seventh largest refining company in the U.S. (Continued on page W87.) 1 Equilon and Motiva are limited liability companies (LLC) and do not pay income taxes directly. Taxes are the responsibility of the limited partners. As such, their financial statements do not record a provision for taxes. W83

21 EXHIBIT 11C-1. CALTEX GROUP OF COMPANIES Excerpts from 1999 Financial Statements ($millions) Condensed Consolidated Income Statement Year Ended December 31, 1999 Sales and other operating revenue $14,583 Cost of sales 12,775 Selling, general and administrative 582 Depreciation, depletion, and amortization 459 Maintenance and repairs $13,154 Total expenses $13,970 Operating income 613 Income in equity affiliates 252 Dividends, interest, and other income 80 Foreign exchange, net (11) Interest expense (152) Minority interest $1211(2) Total other income (deductions) $ 167 Income before income taxes 780 Income taxes $13,390 Net income $ 390 Condensed Consolidated Balance Sheet December 31, 1999 Assets Current assets $ 2,705 Investments and advances 2,223 Net property 5,170 Other $10,211 Total assets $10,309 Liabilities and Equity Short-term debt $ 1,588 Accounts payable 1,545 Other $10,262 Current liabilities $ 3,395 Long-term debt 1,054 Deferred income taxes 206 Other 1,356 Minority interest $10,223 Long-term liabilities $ 2,639 Stockholders equity $14,275 Total liabilities and equity $10,309 General Information The Caltex Group of Companies (Group) is jointly owned 50% each by Chevron Corporation and Texaco Inc. (collectively, the Stockholders) and was created in 1936 by its two owners to produce, transport, refine, and market crude oil and petroleum products. Note 4 Equity in Affiliates Investments in affiliates at equity include the following: Equity % Caltex Australia Limited 50% $ 260 $ 324 Koa Oil Company, Limited (sold August, 1999) 50% 298 LG-Caltex Oil Corporation 50% 1,441 1,170 Star Petroleum Refining 64% All other Various $2,157 $2,158 $2,127 $2,254

22 OFF-BALANCE-SHEET FINANCING TECHNIQUES FOR TEXACO AND CALTEX W85 EXHIBIT 11C-1 (continued) Shown below is summarized combined financial information for equity affiliates: 100% Equity Share Current assets $3,005 $3,689 $1,535 $1,855 Other assets 6,333 7,689 3,287 4,004 Current liabilities (3,351) (3,547) (1,816) (1,795) Other liabilities.(1,883).(3,505)..$(937).(1,866) Net worth $4,104 $4,326 $2,069 $2, % Equity Share Operating revenues $12,796 $11,811 $14,669 $6,511 $5,968 $7,452 Operating income 726 1,101 1, Net income Cash dividends received from these affiliates were $71 million, $50 million, and $43 million in 1999, 1998, and 1997, respectively. Retained earnings as of December 31, 1999 and 1998 includes $1.4 billion which represents the Group s share of undistributed earnings of affiliates at equity. Note 7 Operating Leases The Group has operating leases involving various marketing assets for which net rental expense was $112 million, $103 million, and $105 million in 1999, 1998, and 1997, respectively. Future net minimum rental commitments under operating leases having non-cancelable terms in excess of one year are as follows (in Millions of U.S. Dollars): 2000 $66; 2001 $42; 2002 $30; 2003 $13; 2004 $10; and 2005 and thereafter $37. Note 9 Commitments and Contingencies....A Caltex subsidiary has a contractual commitment until 2007 to purchase petroleum products in conjunction with the financing of a refinery owned by an affiliate. Total future estimated commitments under this contract, based on current pricing and projected growth rates, are approximately $700 million per year. Purchases (in billions of U.S. dollars) under this and other similar contracts were $0.7, $0.8, and $1.0 in 1999, 1998, and 1997, respectively....caltex is contingently liable for sponsor support funding for a maximum of $278 million in connection with an affiliate s project finance obligations. The project has been operational since 1996 and has successfully completed all mechanical, technical, and reliability tests associated with the plant physical completion covenant. However, the affiliate has been unable to satisfy a covenant relating to a working capital requirement. As a result, a technical event of default exists which has not been waived by the lenders. The lenders have not enforced their rights and remedies under the finance agreements and they have not indicated an intention to do so. The affiliate is current on these financial obligations and anticipates resolving the issue with its secured creditors during further restructuring discussions. During 1999, Caltex and the other sponsor provided temporary short-term extended trade credit related to crude oil supply with an outstanding balance owing to Caltex at December 31, 1999 of $149 million. Environmental Matters The Group s environmental policies encompass the existing laws in each country in which the Group operates, and the Group s own internal standards. Expenditures that create future benefits or contribute to future revenue generation are capitalized. Future remediation costs are accrued based on estimates of known environmental exposure even if uncertainties exist about the ultimate cost of the remediation. Such accruals are based on the best available undiscounted estimates using data primarily developed by third party experts. Costs of environmental compliance for past and ongoing operations, including maintenance and monitoring, are expensed as incurred. Recoveries from third parties are recorded as assets when realizable.