bs.hun.afc.060 Analyzing balance sheets and financial condition (Analysis Mini-Case Series)

Transcription

1 Balance Sheets» How Do I Use the Numbers» Financial Condition» Exercises EXERCISES bs.hun.afc.060 Analyzing balance sheets and financial condition (Analysis Mini-Case Series) This exercise has an open-ended question that allows for several good alternative responses. While there aren t correct responses to the question, some are definitely better than others. Generally, responses are better to the extent they identify and fully vet arguments, counterarguments, and rebuttals, include appropriate qualifiers, and provide insights regarding the way you assessed the relative merits of the arguments, counterarguments and rebuttals. See The Toulmin Model of Argumentation as a reference. Additionally, responses must cite sources and use quotation marks when copying word for word. Admittedly, this is overkill here because you can only use the provided information and the companies balance sheets. However, citing here is good practice for situations where there are fewer or no restrictions on the admissible information. Still, you needn t cite the provided tabular data or the companies balance sheets. Usage This exercise helps you learn how to use accounting information. Required In this exercise, you will explore the financial health of two leading retailers: American Eagle Outfitters and Urban Outfitters. Your analysis will be based solely on the background information, tabular data herein and on the companies balance sheets. (We explain how you can locate these balance sheets later.) Based solely on concepts covered thus far in the course, the provided information and the companies balance sheets, which company, American Eagle Outfitters or Urban Outfitters, appears to have had stronger financial health at the end of January 2015? Note: January 31, 2015 is the most recent fiscal for both companies. However, American Eagle refers to this as fiscal 2014 and Urban Outfitters as fiscal Respond to this question by completing Parts I - II. Write your responses in the template posted with the exercise materials, complying with the word limits stated therein. Use the Analysis Consideration Map (on the last page) to help you develop a response that integrates the qualitative and quantitate background information. You may customize this work, as long as you credit G. Peter & Carolyn R. Wilson and respect the Creative Commons Attribution-Noncommercial-Share Alike United States license NavAcc LLC. All brands and product names are trademarks of their respective owners.

2 2 NAVIGATING ACCOUNTING Background Information- American Eagle Outfitters Excerpts from American Eagle Outfitters s K and Annual Report Founded in 1977, American Eagle Outfitters is a leading apparel and accessories retailer... Through its brands, the Company offers high quality, on-trend clothing, accessories and personal care products at affordable prices. We have company operated stores in the United States, Canada, Mexico, Hong Kong, China and the United Kingdom. American Eagle Outfitters and aerie merchandise is also available at international store locations managed by third party operators. As of January 31, 2015, we operated 955 American Eagle Outfitters stores and 101 aerie stand-alone stores. Our third party operated store base has grown to 99 stores in 16 countries and products purchased through our online business, AEO Direct, ship to 81 countries worldwide. Brands American Eagle Outfitters Brand American Eagle Outfitter s K, page 3 The American Eagle Outfitters brand targets 15 to 25 year old men and women. Denim is the cornerstone of the American Eagle Outfitters product assortment, which is complemented by other key categories including pants, shorts, sweaters, fleece, outerwear, graphic t-shirts, footwear and accessories. American Eagle Outfitters is honest, real, individual and fun. American Eagle Outfitters is priced to be worn by everyone, everyday, delivering value through quality and style. Gaining market share through differentiated fashion, product innovation, and having the right product, in the right size for every customer are the main focuses within the AEO Brand. Delivering value, variety and versatility to our customers remains a top priority. We strive to offer quality and value at all levels of the assortment, punctuated with promotions. aerie The aerie brand is a collection of intimates and personal care products for women that want to feel good about who they are, inside and out. The collection is available in 101 stand-alone aerie stores throughout the United States and Canada, online... and at select American Eagle Outfitters stores. American Eagle Outfitter s K, pages 3-4

3 EXERCISE BS.HUN.AFC AEO Direct & Omni-Channel Capabilities We sell merchandise via ae.com and aerie.com, which are the digital manifestation of the lifestyle that our brands represent. In addition to purchasing items directly from our digital channels, customers can experience AEO Direct in-store through our Store-to-Door program. This program enables store associates to sell any item available online to an in-store customer in a single transaction. Customers are taking advantage of Store-to-Door by purchasing extended sizes that are not available in-store, as well as finding a certain size or color that happens to be out-of-stock at the time of their visit. The ordered items are shipped to the customer s home free of charge. Additionally, in Fiscal 2014, we began fulfilling online orders at stores through our Buy Online Ship-from-Store program We are focused on delivering an omni-channel approach to customer engagement, which will eventually lead to a single view of the customer and inventory. We have made investments including a relaunched mobile app and enhanced websites. We will continue to invest in initiatives geared towards integration of our shopping channels as well as expanded product line offerings. American Eagle Outfitter s K, page 4 In Fiscal 2015, we plan to open approximately 20 to 25 AEO stores primarily in the Factory store format and continue our international expansion. Competition American Eagle Outfitter s K, page 5 The retail apparel industry is highly competitive both in stores and on-line. We compete with various individual and chain specialty stores, as well as the casual apparel and footwear departments of department stores and discount retailers, primarily on the basis of quality, fashion, service, selection and price. American Eagle Outfitter s K, page 8 American Eagle reports its total selling space at the end of fiscal 2014 was 5,294,744 square feet. American Eagle Outfitter s K, page 19 American Eagle s income statements report American Eagle s revenues as $3,282,867, $3,305,802, and $3,475,802 thousand, respectively, during these years. American Eagle Outfitter s K, page 42 American Eagle s statements of cash flows report American Eagle paid $245,002, $278,499, and $93,939 thousand for capital expenditures, respectively, during these years. American Eagle Outfitter s K, page 42 NOTE: Capital expenditures pertains to the cost to acquire or construct long-term assets. American Eagle s statements of cash flows report American Eagle paid shareholders $7,464, $56,437, and $177,679 thousand to repurchase shares, respectively, during these years. American Eagle Outfitter s K, page 42 American Eagle s statements of cash flows report that American Eagle paid shareholders $97,224, $72,280, and $403,490 thousand of cash dividends, respectively, during these years. American Eagle Outfitter s K, page 42 NOTE: Share repurchases and cash dividends decrease cash and owners equity. American Eagle records share repurchases by decreasing cash and increasing Treasury shares, which is a negative owners equity account (or contra equity) that is included in Other stockholders equity in the balance sheet information provided later. This is one of two acceptable methods to record share repurchases under US GAAP (Urban Outfitters uses the other method, which is described later.)

4 4 NAVIGATING ACCOUNTING Background Information- Urban Outfitters Excerpts from Urban Outfitters s K and Annual Report We are a leading lifestyle specialty retail company that operates under the Urban Outfitters, Anthropologie, Free People, Terrain and Bhldn brands. We also operate a Wholesale segment under the Free People brand. We have over 44 years of experience creating and managing retail stores that offer highly differentiated collections of fashion apparel, accessories and home goods in inviting and dynamic store settings. Our core strategy is to provide unified environments that establish emotional bonds with the customer. In addition to our retail stores, we offer our products and market our brands directly to the consumer through our e-commerce websites, mobile applications Our omni-channel strategy enhances our customers brand experience by providing a seamless approach to the customer shopping experience. We have substantially integrated all available shopping channels, including stores, websites online and through mobile devices) and catalogs... Store sales are primarily fulfilled from that store s inventory, but may also be shipped from any of our fulfillment cen

5 EXERCISE BS.HUN.AFC ters or from a different store location if an item is not available at the original store. Direct-to-consumer orders are primarily shipped to our customers through our fulfillment centers, but may also be shipped from any store, or a combination of fulfillment centers and stores depending on the availability of a particular item... As our customers continue to shop across multiple channels, we have adapted our approach towards meeting this demand. Retail Segment Urban Outfitters. Urban Outfitters targets young adults aged 18 to 28 through its unique merchandise mix and compelling store and website environment. We have established a reputation with these young adults, who are culturally sophisticated, self-expressive and concerned with acceptance by their peer group. The product offering includes women s and men s fashion apparel, intimates, footwear, beauty and accessories, activewear and gear, electronics, as well as an eclectic mix of apartment wares and gifts Our stores are located in large metropolitan areas, select university communities, specialty centers and enclosed malls. Our stores accommodate our customers propensity not only to shop, but also to congregate with their peers. As of January 31, 2015, we operated 238 Urban Outfitters stores, of which 179 were located in the United States, 16 were located in Canada and 43 were located in Europe. We plan to open approximately 4 Urban Outfitters stores in fiscal 2016 Urban Outfitters North American and European Retail segment net sales accounted for approximately 32.9% and 8.8% of consolidated net sales, respectively, for fiscal Anthropologie Group. The Anthropologie Group consists of the Anthropologie and Bhldn brands Anthropologie tailors its merchandise and inviting store environment to sophisticated and contemporary women aged 28 to 45. Anthropologie s unique and eclectic product assortment includes women s casual apparel and accessories, intimates, shoes, beauty, home furnishings and a diverse array of gifts and decorative items. The home furnishings range from furniture, rugs, lighting and antiques to table top items, bedding and gifts... Our stores are located in specialty retail centers, upscale street locations and enclosed malls. The Bhldn brand emphasizes every element that contributes to a wedding. Bhldn offers a curated collection of heirloom quality wedding gowns, bridesmaid frocks, party dresses, assorted jewelry, headpieces, footwear, lingerie and decorations. The standalone Bhldn stores are located in a specialty retail center and an upscale street location. As of January 31, 2015, we operated 204 Anthropologie Group stores, of which 185 were located in the United States, 12 were located in Canada and seven were located in Europe. We plan to open approximately 13 Anthropologie Group stores, globally, in fiscal The Anthropologie Group s North American and European Retail segment net sales accounted for approximately 40.1% and 1.5% of consolidated net sales, respectively, for fiscal Free People. Our Free People retail stores primarily offer private label branded merchandise targeted to young contemporary women aged 25 to 30. Free People offers a unique merchandise mix of casual women s apparel, intimates, shoes, accessories, activewear and gifts... Our stores are located in enclosed malls, upscale street locations and specialty retail centers. As of January 31, 2015, we operated 102 Free People stores, of which 98 were located in the United States and four were located in Canada. We plan to open approximately 15 new Free People stores in fiscal 2016 Free People s Retail segment net sales accounted for approximately 9.2% of consolidated net sales for fiscal Terrain. Terrain is designed to appeal to women and men interested in a creative, sophisticated outdoor living and gardening experience Terrain s product offering includes home furnishings and decorative items, garden products including live plants and flowers, outdoor living furnishings and entertainment products and a wide variety of gifts.... Terrain also offers a variety of landscape and design service solutions to our customers. As of January 31, 2015, we operated two Terrain garden centers and a website that offers customers a portion of the product assortment found at the Terrain garden centers. Terrain s Retail segment net sales accounted for less than 1.0% of consolidated net sales for fiscal 2015.

6 6 NAVIGATING ACCOUNTING Wholesale Segment The Free People wholesale division was established in 1984 to develop, in conjunction with Urban Outfitters, private label apparel lines of young women s casual wear that could be effectively sold at attractive prices in Urban Outfitters stores. In order to achieve minimum production lots, Free People wholesale began selling to other retailers throughout the United States. We distribute our Free People products in certain department stores using a shop-within-shop sales model. We believe that the shopwithin-shop model allows for a more complete merchandising of our Free People products and will give us greater freedom in differentiating the presentation of our products and further strengthening of our brand image. During fiscal 2015, Free People s range of tops, bottoms, sweaters, dresses, intimates and shoes were sold worldwide through approximately 1,600 better department and specialty stores worldwide, including Macy s, Nordstrom, Bloomingdale s, Lord & Taylor, Selfridge s, and our own Free People stores. We monitor the styles and products that are popular with our wholesale customers to give us insight into current fashion trends, helping us to better serve our retail customers... Free People s wholesale sales accounted for approximately 6.8% of consolidated net sales for fiscal Competition Urban Outfitters K, pages 2-4 The specialty retail and the wholesale businesses are each highly competitive in both the domestic and international markets. Our Retail segment competes on the basis of, among other things, the location of our stores, website, mobile application and catalog presentation, website design, the breadth, quality, style, price and availability of merchandise and the level of customer service offered. Although we believe that the eclectic mix of products and our unique store and website experiences offered by our Retail segment help differentiate us, it also means that our Urban Outfitters, Anthropologie, Free People, Terrain and Bhldn stores compete against a wide variety of smaller, independent specialty retailers, as well as department stores and national specialty chains Our Anthropologie, Free People and Bhldn stores also face competition from small boutiques that offer an individualized shopping experience similar to the one we strive to provide to our target customers. In addition, some of our suppliers offer products directly to consumers and certain of our competitors. Our direct-to-consumer channel competes against numerous websites and catalogs, which may have a greater volume of circulation and web traffic or more effective marketing through online media and social networking sites. Our Free People wholesale business competes with numerous wholesale companies based on the quality, price and fashion of our wholesale product offerings. Many of our wholesale business competitors products have a wider distribution network. In addition, certain of our wholesale competitors have greater name recognition, financial and other resources. Urban Outfitters K, page 8 Urban Outfitters total selling space at the end of fiscal 2015 was approximately 3,760,000 square feet. Urban Outfitter s K, page 18 Urban Outfitters income statements report Urban Outfitters revenues as $3,323,077, $3,086,608, and $2,794,925 thousand, respectively, during these years. Urban Outfitters K, page 54 Urban Outfitters statements of cash flows report Urban Outfitters paid $229,804, $186,101 and $168,875 thousand for capital expenditures, respectively, during these years. Urban Outfitters K, page 42 Urban Outfitters statements of cash flows report Urban Outfitters paid shareholders $615,422 $11,092, and $0 thousand to repurchase shares, respectively, during these years. Urban Outfitters K, page 42 Urban Outfitters statements of cash flows report that Urban Outfitters did not pay dividends during that period. Urban Outfitters K, page 42

7 EXERCISE BS.HUN.AFC NOTE: These are the same periods as for American Eagle. However, the companies refer to their fiscal years differently, e.g., fiscal 2014 vs NOTE: Urban Outfitters records share repurchases by decreasing cash, decreasing common stock by the amount the shares were originally issued for at an earlier date, and decreasing retained earnings for the amount the shares increased in value since they were originally issued. This is one of two acceptable methods to record share repurchases under US GAAP (American Eagle uses the other method, which was described earlier.) Urban Outfitters 2015 balance sheet reports marketable securities of $104,246 and $104,448, classified as current and non-current assets, respectively. In a footnote, the company discloses that these highly liquid investments are classified as available-for-sale and consists of bonds, certificates of deposit, and treasury bills. Excerpts from Wall Street Journal Articles Urban Outfitters K, page F-15 Urban Outfitters Inc. said its earnings fell 9.5% as stronger sales were offset by increased expenses and weaker margins, which were mostly caused by higher markdowns during a highly promotional holiday quarter for retailers. Shares rose as per-share earnings beat expectations and Urban Outfitters Chief Executive Richard Hayne offered a sign of encouragement for the current quarter. In the company s fiscal-fourth-quarter earnings release on Monday, Mr. Hayne said Urban Outfitters was pleased to report its first billion-dollar quarter, fueled by positive retail segment comps, or comparable sales, at all of it brands. It is encouraging to see this sales trend continue into [the current quarter], Mr. Hayne added. Mall-based retailers such as Urban Outfitters have continued to offer discounts and promotions to attract customers, which has weighed on margins. For the latest period, Urban Outfitters said gross margins fell to 34.6% from 36.7%, mostly due to lower initial merchandise markups followed by higher markdowns primarily driven by weakness at its namesake brand At the time, Mr. Hayne said promotional activity was higher than expected but added that the retailer was entering the spring selling season in a clean inventory position. Profit at Urban Outfitters Falls 9.5% amid Higher Markdowns, Expenses By Tess Stynes, WSJ, March 19th, 2015 American Eagle Outfitters Inc. on Wednesday reported its first quarter of year-over-year revenue growth in two years, lifted by a new line of one-size-fits-all clothes that boosted the retailer in the competitive teen market Longtime retailers of teen apparel have struggled in recent quarters as their customers turn to cheaper, unbranded clothes, such as those sold at fast-fashion stores including Hennes & Mauritz AB [H&M]and Forever 21 Inc. American Eagle on Wednesday credited the company s Don t Ask Why collection in part for its 3% increase in revenue. The retailer called the collection a cost-effective testing lab that helps it spot trends and increase demand. By experimenting with new fabrics, washes and styles in the one-size-fits-all collection, it believes it can better gauge which styles are gaining favor and add them to the regular collection. American Eagle said the process was a key part of turning around the company s tops business, which was one of the bestperforming segments in the past quarter. It also said sales rose on demand for such items as blanket scarves and knit tops. The company said its improved merchandise also allowed it to scale back promotions. American Eagle has been working to revamp its business after losing market share. The company in May unveiled plans to shutter 150 North American stores over the next three years and is evaluating another 300 stores that have leases expiring over the period. American Eagle Shows Strength Among Teens, By Angela Chen and Chelsey Dulaney, WSJ, March 4, 2015

8 8 NAVIGATING ACCOUNTING Improved merchandise assortments, combined with a better customer experience, drove strengthened sales trends, and we successfully reduced promotions, Interim Chief Executive Jay Schottenstein said. Inventory at the end of the quarter fell 4% to $279 million, and the company expects the trend to continue. American Eagle Revenue Rises amid Fewer Promotions, By Angela Chen, WSJ, March 4, 2015 Accounting for Leases: Capitalizing Operating Leases Both American Eagle and Urban Outfitters lease all of their stores. Here s some background on accounting for leases and related considerations for your analyses. Investors often adjust for off-balance sheet leases For accounting purposes, both American Eagle and Urban Outfitters classify their leases as operating leases. This means, consistent with current accounting standards, the companies don t recognize these leases on their balance sheets, i.e., the leases are off-balance sheet. However, to get more accurate assessments of companies financial positions, rating agencies (such as Moody s and Standard & Poor s) and sophisticated investors use companies footnote information to create adjusted balance sheets that include operating leases. For retailers, ratios based on these adjusted balance sheets are generally quite different than those based on reported balance sheets. Including operating leases on adjusted balance sheets is called capitalizing operating leases. This means adding assets and liabilities on the adjusted balance sheets. For example, for American Eagle and Urban Outfitters, the assets (the benefit) represent the non-cancellable right to use the stores during the remaining years of the lease, which is initially ten years for both companies, and the liabilities (the obligation) represent the non-cancellable commitment to make the lease payments. Not everyone agrees that operating leases should be capitalized on balance sheets, which is one of the primary reasons capitalizing operating leases is not required under current accounting standards. Opponents to capitalizing operating leases have argued leases are similar to service or supplier contracts that extend over multiple years, which are not recognized on balance sheets. Nevertheless, after debating this issue for nearly twenty years, standard setters in the U.S. and elsewhere are expected to issue new standards in early 2016 that will require capitalization starting at a yet-to-be specified date. Investors or others who decide operating leases should be capitalized to better reflect the underlying economics use ratios based on the adjusted balance sheets when assessing a company s financial health. In contrast, those who decide operating leases should NOT be capitalized use ratios based on reported balance sheets. However, this decision is beyond the scope of this exercise. You are required to use the balance sheets that have been adjusted for capitalized operating leases for your analyses. To underscore the importance of making these balance sheet adjustments when operating leases are prevalent, we included adjustment estimates for American Eagle and Urban Outfitters in the first table in the Quantitative Tabular Data section of this exercise. In addition, the process investors or others follow to estimate the assets and liabilities to add to the balance sheet when operating leases are capitalized is far beyond the scope of this exercise and explained later in Navigating Accounting. Indeed, our goals are much more modest. What should you know about leases? We want you to learn how ratios commonly used to assess a company s financial health can differ significantly depending on whether operating leases are capitalized. We also want you to learn how comparisons across companies ratios can be altered by capitalizing operating leases. For example, we want you to understand why one company may have higher (lower) financial leverage than another when the ratios are based on adjusted (reported) balance sheets. At the same time, we want you to be prepared for the implications of the pending accounting standard requiring capitalization of leases on balance sheets. Before discussing the exercise case companies, there are a few more things you need to understand about the asset and liability adjustments related to capitalizing operating leases. First, they are assumed to be the same for the assets and liabilities. One way to think about this is the value of the future benefits to be received from the leased property (the asset) is equal to the value of the future lease payments (the liability). Second, the estimates are not as precise as they would be if the outsiders had access to the same information as company insiders. In particular, outsiders need to make assumptions to compensate for information that is not disclosed in the company s footnotes. Still, these measurement errors tend to be small relative to the estimates themselves. Third, here is how the adjusted balance sheets are created: Reported Assets + Capitalized Operating Lease Asset = Reported Liabilities + Capitalized Operating Lease Liability + Reported Owners Equity

9 EXERCISE BS.HUN.AFC More precisely, the lease asset is included in property, plant and equipment (PP&E) and the lease liability is split into two parts: the part associated with lease payments due within a year is classified current and remainder is non-current. How does this affect the case companies? For the case companies, American Eagle and Urban Outfitters, the asset and liability adjustments from capitalizing the operating leases are very significant. For example, at January 31, 2015, American Eagle s balance sheet reports approximately $1.4 billion of total assets and $.6 billion of liabilities. But when the assets and liabilities associated with capitalizing operating leases are added, the adjusted balance sheet reports $3.1 billion of total assets and $1.9 billion of total liabilities. As a result, financial leverage, measured as total liabilities divided by total assets almost doubles when the operating leases are capitalized (from 33% to 63%). This means investors or others who don t know about off-balance sheet operating leases will significantly underestimate the risks associated with the company s financial leverage. Similarly, they will significantly underestimate the balance-sheet changes that will occur when the proposed new lease accounting standards become effective. Notwithstanding the importance of capitalizing the case companies operating leases when assessing their financial positions, the overall conclusions (for the most part) are not affected by the adjustments. This is generally not true for most companies. What s unique here is the case companies adjustments and reported balance sheets are comparable in size each year. Thus, the ratios don t change much. For example, Urban Outfitters balance sheet reports $1.9 billion of total assets and $.56 billion of total liabilities on January 31, 2015, which are close to the $1.4 billion of total assets and $.56 billion of total liabilities American Eagle reports on the same date. In addition, the capitalized operating lease adjustments are similar ($1.4 billion for American Eagle and $1.5 billion for Urban Outfitters). As a result, regardless of whether we base our analysis on reported or adjusted numbers, we would conclude American Eagle has slightly higher financial leverage than Urban Outfitters (33% versus 30% based on the reported numbers and 66% versus 61% based on the adjusted numbers). Because your analyses of this case will be largely unaffected by whether your arguments use ratios or other measures based on reported numbers versus adjusted numbers, to reduce your workload and facilitate the class discussion, we want you to base your written report entirely on the adjusted numbers. Still, in other contexts where the adjustments are not comparable in size, conclusions based on ratio comparisons across companies can change when operating leases are capitalized. For this reason, we re going to spend the remainder of this section discussing factors that can explain differences in the size of the adjustments across companies. Hopefully, we will find time during class to elaborate on these issues. What might affect other companies? We re going to start with a factor that can significantly distort comparisons between companies if they are based on reported numbers rather than adjusted numbers: the portion of stores or other properties owned vs leased under operating leases. As an extreme example, suppose two retailers have similar business models except one owns all of its stores that it paid for with cash and the other leases the same number of stores and accounts for them as operating leases. Further assume both companies have similar financial leverage ratios based on reported numbers. This is a situation where conclusions about the relative financial leverage of the companies based on reported numbers would differ dramatically from conclusions based on adjusted numbers. A related factor with similar consequences is the portion of leases classified as capital leases rather than operating leases. For now, all you need to know is for capital leases, assets and liabilities are already reported on companies balance sheets. These assets and liabilities are the same conceptually as the ones outsiders add to balance sheets when they capitalize operating leases, but more accurate because they are based on insiders superior information. The key point is capital leases (often called finance leases outside the US) are already capitalized on reported balance sheets while operating leases are not (an adjustment is required). As a result, if the portion of leases classified as capital versus operating differs significantly for two companies, ratio comparisons based on reported numbers can lead to different conclusions than comparisons based on adjusted numbers. The two factors discussed thus far aren t relevant to American Eagle and Urban Outfitters because both companies lease all of their stores under operating leases. (There are minor differences in the portion of distribution centers and other properties that are owned versus leased under operating leases, but these differences are likely not consequential.) How does the business context affect the analyses of the case companies? Here we will tell you of our journey into digging deeper into the case companies business context. In doing so, we will discuss factors that have different effects on the estimated adjustments for American Eagle and Urban

10 10 NAVIGATING ACCOUNTING Outfitters: total square footage of properties under operating leases, average cost per square foot of these properties, and the average number of years remaining on the leases as of the balance sheet date when the estimates are made. First, we start with the observation that American Eagle has considerably more square footage under operating leases than Urban Outfitters. Thus, if the average cost per square foot and average time remaining on the leases were similar for the two companies, then we would hypothesize that American Eagle would be obligated to make much higher lease payments in future years than Urban Outfitters. In other words, our outsider s estimate of the adjustments associated with capitalizing operating leases would be considerably higher for American Eagle. But in fact, this is not true. Much to our surprise, digging deeper into the companies footnotes, we observed that the reported future operating lease payments were comparable in size for the two companies. Thus, the related capitalized lease adjustment estimates are comparable. This left us with a puzzle to solve: what factors other than total square footage (because this was similar) must be affecting Urban Outfitters future operating lease payments more than they affect American Eagle s future lease payments? The way you solve puzzles like this is you hypothesize possible explanations and then search for evidence that either refutes or confirms your hypothesizes. To this end, the first factor we hypothesized was that the average remaining years on the leases was longer for Urban Outfitters. While there was some confirming evidence, we concluded this factor wasn t significant enough to solve the puzzle. The second factor we hypothesized was that the average cost per square foot for Urban Outfitters leased stores was probably sufficiently higher than American Eagle s cost per square foot. Yet, neither company reports average cost per square foot. Notwithstanding the lack of disclosure, we re reasonably confident this factor does solve most, if not all, of the puzzle. So why are we confident this factor (cost per square foot) resolves the puzzle? There s information in the background section of this case that describes the companies business strategies. These strategies differ in ways that likely lead to Urban Outfitters opening stores in locations that have higher lease rates (on average). Understanding these business strategy differences will help you respond to the assigned questions and integrate the business context with your quantitative analyses. For this reason, we will defer discussing them until class. Quantitative Tabular Data and Locating Companies Reported Balance Sheets The quantitative tabular data provided on the few pages summarizes information from the companies annual reports and computes related ratios. To facilitate comparison across the companies, the tabular data combines related line items and includes some line items in other. For example, other current assets in the tabular data includes all current asset line items reported by the company not presented elsewhere in the tabular data. You may want to locate and download the companies actual annual reports for your analysis to determine what the tabular data summarized. To learn how to locate and download these documents and find the balance sheets therein, watch Searching and Locating Annual Reports 1.

11 EXERCISE BS.HUN.AFC Comparing Balance Sheets in the Retail Industry - Adjusted for Capitalizing Operating Leases Adjustments: Capitalized lease asset is classified as non-current (PP&E). Thus, the reported and adjusted current assets are the same. Capitalized lease liability is split: part associated with lease payments due within a year is classified current and remainder is non-current, consistent with the proposed standard. ADJUSTED BALANCE SHEET NUMBERS Assets Current assets American Eagle Outfitters, Inc. Urban Outfitters, Inc. 31-Jan-15 1-Feb-14 2-Feb Jan Jan Jan Jan Jan-12 USD Thousands $ USD Thousands $ Cash and cash equivalents 410, , , , , , , ,273 Receivables 67,894 73,882 46,321 40,310 70,458 55,161 39,519 36,673 Inventories 278, , , , , , , ,073 Other current assets 132, , , , , , , ,973 Total current assets 890, ,991 1,141,800 1,287, , , , ,992 Property, plant and equipment net 2,089,859 2,065,784 1,868,594 1,983,733 2,364,028 2,248,741 1,993,527 1,800,004 Goodwill and intangible assets 60,302 62,801 49,620 51,301 Other non-current assets 51,237 70,386 55,000 29, , , , ,737 Total assets 3,091,911 3,126,962 3,115,014 3,352,373 3,363,537 3,663,046 3,057,322 2,598,733 Liabilities Current liabilities Accounts payable 191, , , , , ,036 99,059 95,754 Other current liabilities 541, , , , , , , ,947 Total current liabilities 732, , , , , , , ,701 Long-term debt (less current maturities) Other noncurrent liabilities 1,219,652 1,284,518 1,212,646 1,286,715 1,439,225 1,404,527 1,245,181 1,122,764 Total liabilities 1,952,165 1,960,784 1,893,827 1,935,522 2,035,568 1,968,876 1,702,734 1,532,465 Stockholders' equity Common stock (paid-in capital less treasury stock) (393,395) (415,830) (361,168) (383,272) 13 97,699 48, Retained Earnings 1,543,085 1,569,851 1,553,058 1,771,464 1,343,383 1,597,439 1,315,079 1,077,765 Other stockholders' equity (9,944) 12,157 29,297 28,659 (15,427) (968) (8,782) (11,512) Noncontrolling interests Total stockholders' equity 1,139,746 1,166,178 1,221,187 1,416,851 1,327,969 1,694,170 1,354,588 1,066,268 Total liabilities and shareholders' equity 3,091,911 3,126,962 3,115,014 3,352,373 3,363,537 3,663,046 3,057,322 2,598,733 RATIOS BASED ON ADJUSTED BALANCE SHEET NUMBERS Level 1 Financial leverage (year-end) Liabilities/assets 63% 63% 61% 58% 61% 54% 56% 59% Level 2 Working capital 158, , , , , , , ,291 Current assets current liabilities Current ratio Current assets/ current liabilities Level 3 Common Size Balance Sheet Line item/total assets Assets Cash and cash equivalents 13% 13% 16% 21% 5% 7% 8% 6% Receivables 2% 2% 1% 1% 2% 2% 1% 1% Inventories 9% 9% 11% 11% 11% 8% 9% 10% Other current assets 4% 5% 8% 5% 7% 11% 10% 6% Total current assets 29% 30% 37% 38% 24% 27% 29% 23% Property, plant and equipment net 68% 66% 60% 59% 70% 61% 65% 69% Goodwill and intangible assets 2% 2% 2% 2% 0% 0% 0% 0% Other non-current assets 2% 2% 2% 1% 6% 11% 6% 8% Total assets 100% 100% 100% 100% 100% 100% 100% 100% Liabilities Accounts payable 6% 7% 6% 5% 5% 4% 3% 4% Other current liabilities 18% 15% 16% 14% 13% 12% 12% 12% Total current liabilities 24% 22% 22% 19% 18% 15% 15% 16% Long-term debt (less current maturities) 0% 0% 0% 0% 0% 0% 0% 0% Other noncurrent liabilities 39% 41% 39% 38% 43% 38% 41% 43% Total liabilities 63% 63% 61% 58% 61% 54% 56% 59% Stockholders' equity Common stock (paid-in capital less treasury stock) 13% 13% 12% 11% 0% 3% 2% 0% Retained Earnings 50% 50% 50% 53% 40% 44% 43% 41% Other stockholders' equity 0% 0% 1% 1% 0% 0% 0% 0% Noncontrolling interests 0% 0% 0% 0% 0% 0% 0% 0% Total stockholders' equity 37% 37% 39% 42% 39% 46% 44% 41% Total liabilities and shareholders' equity 100% 100% 100% 100% 100% 100% 100% 100% Market's perception of missed or incorrectly measured BS items Market-to-book ratio Shares outstanding (issued - treasury) 194, , , , , , , ,633 Fiscal year-end price per share (historical quote) $ $ $ $ $ $ $ $ Market value of stockholders' equity 2,731,005 2,613,306 3,899,678 2,711,934 4,549,330 5,276,629 6,249,475 3,832,775 Book value of stockholders' equity 1,139,746 1,166,178 1,221,187 1,416,851 1,327,969 1,694,170 1,354,588 1,066,268 Market-to-book ratio Source: Companies' websites See accompanying notes in annual reports.

12 12 NAVIGATING ACCOUNTING Comparing Properties in the Retail Industry Numbers below are disclosed in the company's footnotes. American Eagle Outfitters, Inc. Urban Outfitters, Inc. 31-Jan-15 1-Feb-14 2-Feb Jan Jan Jan-13 PROPERTIES Number of stores, beginning of year 1,066 1,044 1, Stores opened and other expansions Stores closed (70) (42) (41) (3) (3) (2) Number of stores, end of year 1,056 1,066 1, Source: Companies' websites See accompanying notes in annual reports. Capitalizing Operating Leases: Balance Sheet Effects Adjustments: Capitalized lease asset is classified as a non-current asset (PP&E). Thus, the reported and adjusted current assets are the same. Capitalized lease liability is split: part associated with lease payments due within a year is classified current and remainder is non-current, consistent with the proposed new accounting standard. American Eagle Outfitters, Inc. Urban Outfitters, Inc. 31-Jan-15 1-Feb-14 2-Feb Jan Jan Jan Jan Jan-12 Assets USD Thousands $ USD Thousands $ Estimated non-current asset associated with capitalizing operating leases 1,395,003 1,432,798 1,358,961 1,401,571 1,474,796 1,441,832 1,260,111 1,115,025 Liabilities Estimated current liability associated with capitalizing operating leases 273, , , , , , , ,235 Estimated non-current liabiltiy associated with capitalizing operating leases 1,121,583 1,172,010 1,113,682 1,158,165 1,232,193 1,209,313 1,052, ,790 Estimated total liability associated with capitalizing operating leases 1,395,003 1,432,798 1,358,961 1,401,571 1,474,796 1,441,832 1,260,111 1,115,025 Source: Companies' websites See accompanying notes in annual reports. Capitalizing Operating Leases: Balance Sheet and Ratio Effects Adjustments: Capitalized lease asset is classified as a non-current asset (PP&E). Thus, the reported and adjusted current assets are the same. Capitalized lease liability is split: part associated with lease payments due within a year is classified current and remainder is non-current, consistent with the proposed new accounting standard. American Eagle Outfitters, Inc. Urban Outfitters, Inc. 31-Jan-15 1-Feb-14 2-Feb Jan Jan Jan Jan Jan-12 REPORTED & ADJUSTED BALANCE SHEET NUMBERS Assets Current assets USD Thousands $ USD Thousands $ Reported and adjusted current assets (are the same) 890, ,991 1,141,800 1,287, , , , ,992 Total assets Total assets based on book values or adjusted book values: Reported total assets 1,696,908 1,694,164 1,756,053 1,950,802 1,888,741 2,221,214 1,797,211 1,483,708 Estimated non-current asset associated with capitalizing operating leases 1,395,003 1,432,798 1,358,961 1,401,571 1,474,796 1,441,832 1,260,111 1,115,025 Total assets adjusted for capitalizing operating leases 3,091,911 3,126,962 3,115,014 3,352,373 3,363,537 3,663,046 3,057,322 2,598,733 Total assets based on market values assuming operating leases NOT capitalized: Assumed market value of liabilities: reported liabilities (see below) 557, , , , , , , ,440 Market value of owners' equity 2,731,005 2,613,306 3,899,678 2,711,934 4,549,330 5,276,629 6,249,475 3,832,775 Estimated market value of total assets assuming operating leases NOT capitalized 3,288,167 3,141,292 4,434,544 3,245,885 5,110,102 5,803,673 6,692,098 4,250,215 Total assets based on market values assuming operating leases capitalized: Assumed market value of liabilities: reported plus capitalized (see below) 1,952,165 1,960,784 1,893,827 1,935,522 2,035,568 1,968,876 1,702,734 1,532,465 Market value of owners' equity 2,731,005 2,613,306 3,899,678 2,711,934 4,549,330 5,276,629 6,249,475 3,832,775 Estimated market value of total assets assuming operating leases capitalized 4,683,169 4,574,090 5,793,505 4,647,455 6,584,898 7,245,505 7,952,209 5,365,240 Liabilities Current liabilities based on book values or adjusted book values: Reported total current liabilities 459, , , , , , , ,466 Estimated current liability associated with capitalizing operating leases 273, , , , , , , ,235 Total current liabilities adjusted for capitalizing operating leases 732, , , , , , , ,701 Total liabilities based on book values or adjusted book values: Reported total liabilities 557, , , , , , , ,440 Estimated total liability associated with capitalizing operating leases 1,395,003 1,432,798 1,358,961 1,401,571 1,474,796 1,441,832 1,260,111 1,115,025 Total liabilities adjusted for capitalizing operating leases 1,952,165 1,960,784 1,893,827 1,935,522 2,035,568 1,968,876 1,702,734 1,532,465 RATIOS BASED ON REPORTED & ADJUSTED BALANCE SHEET NUMBERS Financial leverage (year-end) Liabilities/assets Based on book values or adjusted book values: Based on reported assets and liabilities 33% 31% 30% 27% 30% 24% 25% 28% Based on reported assets and liabilities adjusted for capitalized operating leases 63% 63% 61% 58% 61% 54% 56% 59% Based on market values: Assuming operating leases are NOT capitalized 17% 17% 12% 16% 11% 9% 7% 10% Assuming operating leases are capitalized 42% 43% 33% 42% 31% 27% 21% 29% Current ratio Current assets/ current liabilities Based on book values or adjusted book values: Based on reported assets and liabilities Based on reported assets and liabilities adjusted for capitalized operating leases Source: Companies' websites

13 EXERCISE BS.HUN.AFC Comparing Balance Sheets in the Retail Industry - As reported Numbers below are either disclosed on the company's balance sheets with similar captions or they combine numbers with related captions. Assets Current assets American Eagle Outfitters, Inc. Urban Outfitters, Inc. 31-Jan-15 1-Feb-14 2-Feb Jan Jan Jan Jan Jan-12 USD Thousands $ USD Thousands $ Cash and cash equivalents 410, , , , , , , ,273 Receivables 67,894 73,882 46,321 40,310 70,458 55,161 39,519 36,673 Inventories 278, , , , , , , ,073 Other current assets 132, , , , , , , ,973 Total current assets 890, ,991 1,141,800 1,287, , , , ,992 Property, plant and equipment net 694, , , , , , , ,979 Goodwill and intangible assets 60,302 62,801 49,620 51,301 Other non-current assets 51,237 70,386 55,000 29, , , , ,737 Total assets 1,696,908 1,694,164 1,756,053 1,950,802 1,888,741 2,221,214 1,797,211 1,483,708 Liabilities Current liabilities Accounts payable 191, , , , , ,036 99,059 95,754 Other current liabilities 267, , , , , , , ,712 Total current liabilities 459, , , , , , , ,466 Long-term debt (less current maturities) Other noncurrent liabilities 98, ,508 98, , , , , ,974 Total liabilities 557, , , , , , , ,440 Stockholders' equity Common stock (paid-in capital less treasury stock) (393,395) (415,830) (361,168) (383,272) 13 97,699 48, Retained Earnings 1,543,085 1,569,851 1,553,058 1,771,464 1,343,383 1,597,439 1,315,079 1,077,765 Other stockholders' equity (9,944) 12,157 29,297 28,659 (15,427) (968) (8,782) (11,512) Noncontrolling interests Total stockholders' equity 1,139,746 1,166,178 1,221,187 1,416,851 1,327,969 1,694,170 1,354,588 1,066,268 Total liabilities and shareholders' equity 1,696,908 1,694,164 1,756,053 1,950,802 1,888,741 2,221,214 1,797,211 1,483,708 RATIOS BASED ON REPORTED BALANCE SHEET NUMBERS Level 1 Financial leverage (year-end) Liabilities/assets 33% 31% 30% 27% 30% 24% 25% 28% Level 2 Working capital 431, , , , , , , ,526 Current assets current liabilities Current ratio Current assets/ current liabilities Level 3 Common Size Balance Sheet Line item/total assets Assets Cash and cash equivalents 24% 25% 29% 37% 8% 11% 14% 10% Receivables 4% 4% 3% 2% 4% 2% 2% 2% Inventories 16% 17% 19% 19% 19% 14% 16% 17% Other current assets 8% 8% 14% 8% 12% 17% 17% 11% Total current assets 52% 55% 65% 66% 43% 45% 49% 40% Property, plant and equipment net 41% 37% 29% 30% 47% 36% 41% 46% Goodwill and intangible assets 4% 4% 3% 3% 0% 0% 0% 0% Other non-current assets 3% 4% 3% 2% 10% 19% 11% 14% Total assets 100% 100% 100% 100% 100% 100% 100% 100% Liabilities Accounts payable 11% 12% 10% 9% 8% 6% 6% 6% Other current liabilities 16% 12% 15% 11% 10% 9% 8% 9% Total current liabilities 27% 25% 25% 21% 19% 15% 14% 16% Long-term debt (less current maturities) 0% 0% 0% 0% 0% 0% 0% 0% Other noncurrent liabilities 6% 7% 6% 7% 11% 9% 11% 12% Total liabilities 33% 31% 30% 27% 30% 24% 25% 28% Stockholders' equity Common stock (paid-in capital less treasury stock) 23% 25% 21% 20% 0% 4% 3% 0% Retained Earnings 91% 93% 88% 91% 71% 72% 73% 73% Other stockholders' equity 1% 1% 2% 1% 1% 0% 0% 1% Noncontrolling interests 0% 0% 0% 0% 0% 0% 0% 0% Total stockholders' equity 67% 69% 70% 73% 70% 76% 75% 72% Total liabilities and shareholders' equity 100% 100% 100% 100% 100% 100% 100% 100% Market's perception of missed or incorrectly measured BS items Market-to-book ratio Shares outstanding (issued - treasury) 194, , , , , , , ,633 Fiscal year-end price per share (historical quote) $ $ $ $ $ $ $ $ Market value of stockholders' equity 2,731,005 2,613,306 3,899,678 2,711,934 4,549,330 5,276,629 6,249,475 3,832,775 Book value of stockholders' equity 1,139,746 1,166,178 1,221,187 1,416,851 1,327,969 1,694,170 1,354,588 1,066,268 Market-to-book ratio Source: Companies' websites See accompanying notes in annual reports.

14 14 NAVIGATING ACCOUNTING Part I: Your overall claim, qualifier, and opening remarks Analyze the two companies financial health at the most recent balance sheet dates, taking into consideration the expected future liquidity risk, asset risk, and financial leverage. Importantly, base your analyses solely on concepts covered thus far in the course and the provided background information and tabular data (summarized from the company s financial statements). You may use the companies balance sheets from their annual reports (to identify details not included in the tabular data), however, other information in their annual reports or elsewhere is beyond the scope of this exercise. Write your responses in the template posted with the exercise materials, complying with the word limits stated therein. Overall Claim: Fill in the blank with either American Eagle Outfitters or Urban Outfitters: appears to have had stronger financial health at the end of January [American Eagle Outfitters or Urban Outfitters] Qualifier: Put an X at the spot on the scale below that indicates the likelihood your overall claim is correct. Absolute Uncertainty Absolute Certainty Unlikely Possibly Likely Probably The Toulmin Method of Argumentation: The Second Triad, Keith Green Put an X at the spot on the scale that indicates the likelihood your overall claim is correct, given the available information and concepts covered thus far. Your response should depend on the strength of your arguments, counterarguments, and rebuttals. For example, when you conclude your arguments and counterarguments are equally strong, your X will be near the middle of the scale. By contrast, when you conclude your arguments are very strong and there are no viable counterarguments, your X will be near the right end of the scale. Given these directions, your response should ignore the possibility that other relevant information exists that could change your arguments, counterarguments, or rebuttals, and thus the confidence you have in your claim. As the course progresses and you learn how to acquire and use a wider range of information, your confidence will become more informed and your certainty will increase. Your assessment of the likelihood the overall claim is correct (and thus where you place the X) may not agree with an expert s assessment (conditional on the same background information and concepts covered thus far). For example, you will be too confident if you overlook important counterarguments. Similarly, you will not be confident enough if you overlook strong rebuttals to your counterarguments. Learning how to make informed claims by identifying and thoroughly vetting more arguments, counterarguments and rebuttals is the first step towards making good decisions based on these claims. For example, deciding whether you should invest in a stock after concluding it will outperform other stocks. The second step, which is equally important, is properly assessing the confidence you should attribute to a claim. The third is convincing others your analysis is solid and your confidence is justified. Opening Remarks: Assume you are presenting your analysis to an audience and your opening remarks will present your overall claim and briefly preview the way you assess the relative strengths of your arguments, counterarguments, and rebuttals without explicitly stating them. For example, if one company s future prospects didn t dominate in all three factors (future liquidity risk, asset risk, and financial leverage), select the best overall company and explain how you weighed the factors for your overall claim. You might also state Based on my analysis of available information, I have concluded that XX Company likely had stronger financial health than YY Company. I will present three supporting arguments for this claim, two of which are very compelling. I will also present two counterarguments. I will thoroughly refute one of these, but I can t provide a reasonable rebuttal for the other, which has sufficient merit for me to qualify my claim as likely rather than probable.

15 EXERCISE BS.HUN.AFC Part II: Your arguments, counterarguments and rebuttals Write your responses in the template posted with the exercise materials, complying with the word limits stated therein. Your response should be organized around the three factors considered in this exercise: expected future liquidity risk, asset risk, and financial leverage. For each factor: Identify which company appears to have the better expected future prospects for the factor considered (expected future liquidity risk, asset risk, and financial leverage). Provide at least one, but no more than two, arguments supporting the company you identified as having the better expected future prospects for the factor considered, arranged according to your assessment of the company s strength for the factor (from strongest to weakest). Provide at least one, but no more than two, counterarguments, arranged according to your assessment of their challenge to the argument (from strongest to weakest). If possible provide rebuttals for your counterarguments. Optional: Include other compelling points beyond those associated with the above three factors that bolster your analyzes, but still keeping within the allotted word limit. Consistent with The Toulmin Model, each argument should provide evidence, and possibly a warrant and backing for the warrant. You need not identify the components. For example, you needn t state here is my evidence and here is its warrant. However, both must be present for each argument and while the warrant can be implied, the evidence and backing must be explicit. Keep in mind that the quality of your response depends more on the strength of the arguments you present rather than the number of arguments. For example, one concise, exceptional argument may be all you need.

16 This work is by The Pathways Commission and is licensed under a Creative Commons Attribution-NoDerivs 3.0 Unported License. 16 NAVIGATING ACCOUNTING Analysis Consideration Map - Phase 1 Qualitative information about past performance Use qualitative information about business activities that already affect the financial statements to assess the extent to which the ratios and related trends are likely to persist in the future. Qualitative information about expected future changes Use qualitative information about changes in plans or circumstances or other factors that have not yet affected the financial statements to assess the extent to which the ratios and related trends will likely change. Balance sheets Financial leverage Asset risk Balance sheets Balance sheets Asset risk other than liquidity risk Liquidity risk Working capital Current ratio Common size BS Consequences of financial leverage on riskiness of owners claims, which depends on financial leverage and asset risk. Forecasted risks