Case 9–2: Innovative Engineering Company

Note: This case is unchanged from the Twelfth Edition.

Approach

This fairly brief case is intended to show the effect on income and on capital structure of various financing alternatives. In order to focus on these relationships, the information is highly simplified. Students should appreciate this fact and not attempt to complicate the issue by raising such realistic possibilities as allowing for the growth of earnings through time, the retention of earnings instead of paying dividends, and so on. If the question of retained earnings arises, it can be answered by stating that the most straightforward calculation is to assume that dividends equal to net income are paid. Although this is unrealistic, it is a roughly accurate way of allowing for the expectation of equity investors that their return will be equal to income, whether this income is immediately paid in dividends or is instead reinvested and an equivalent return realized later or through capital gains.

Answers to Questions

The calculations are shown in Exhibits A and B. After going through the calculations, I focus on the results as summarized in Exhibit C. Some of the points implied by these exhibits are given below.

Preferred stock is not a good financing device. From the viewpoint of Innovative, it is more expensive than debt, not only because of its higher rate (10 percent instead of 8 percent), but also, and more importantly, because the dividend is not tax deductible. Income is considerably lower than that from an equivalent amount of debt, and this probably more than offsets the reduced risk of preferred stock as compared with debt. (The preferred stock would probably contain restrictive provisions that, in the event of difficulty, would permit Arbor as a preferred stockholder to cause about as much trouble for Innovative as it would cause if it were a bondholder. For example, in either case Arbor almost certainly would take control.)

The leverage provided by a heavy proportion of debt is tempting. In the optimistic assumption, the return is 44 percent, compared with 27 percent of Proposal D with little debt. In the “best guess,” Proposal A has significantly more return than D. Offsetting this temptation should be the realization that a high proportion of debt is risky, as shown by the low return in the pessimistic assumption, and the possibility that the company could not meet its interest obligations if income fell much below $100,000.

As a venture capital firm, Arbor accepts risks in order to obtain a higher return than would be possible in “safer” securities. It therefore will insist on common stock because higher profitability shows up only as a return on this common stock. At the “best guess” income estimate, Arbor makes a pretax return of close to 15 percent (which is probably the minimum that it expects from an investment) only under Proposal D. Moreover, D gives Arbor effective control of Innovative.

EXHIBIT ACalculations for Innovative

($000)Proposals

A B C DCommon equity.......................................................................................................................................................................................$1,000 $1,000 $1,500 $1,800

Operating income $100,000

Income.....................................................................................................................................................................................................100 100 100 100Aftertax debt............................................................................................................................................................................................58 11 32 16Preferred dividend..................................................................................................................................................................................._____ 90 _____ _____Available to common..............................................................................................................................................................................42 (1) 68 84Return on common..................................................................................................................................................................................4.2% (.1%) 4.5% 4.7%

Operating Income $300,000

Income.....................................................................................................................................................................................................300 300 300 300Aftertax debt............................................................................................................................................................................................58 11 32 16Preferred dividend..................................................................................................................................................................................._____ 90 _____ _____Available to common..............................................................................................................................................................................242 199 268 284Return on common..................................................................................................................................................................................24.2% 19.9% 17.9% 16%

Operating Income $500,000

Income.....................................................................................................................................................................................................500 500 500 500Aftertax debt............................................................................................................................................................................................58 11 32 16Preferred dividend..................................................................................................................................................................................._____ 90 _____ _____Available to common..............................................................................................................................................................................442 399 468 484Return on common..................................................................................................................................................................................44.2% 39.9% 31.2% 26.9%

EXHIBIT BCalculations for Arbor Capital Corporation (Pretax)

($000)Proposals

A B C DInvestment Debt (8%)................................................................................................................................................................................................$1,100 200 600 300

Preferred (10%).......................................................................................................................................................................................900Common..................................................................................................................................................................................................100 100 600 900

Operating Income $100,000

Income from: Debt.........................................................................................................................................................................................................88 16 48 24Preferred..................................................................................................................................................................................................90Common*................................................................................................................................................................................................ 4 ___ 27 42Total.........................................................................................................................................................................................................92 106 75 66

Pretax ROI ($1,200)................................................................................................................................................................................7.7% 8.8% 6.3% 5.5%Operating Income $300,000

Income from: Debt.........................................................................................................................................................................................................88 16 48 24Preferred..................................................................................................................................................................................................90Common.................................................................................................................................................................................................. 24 20 107 142Total.........................................................................................................................................................................................................112 126 155 166

Pretax ROI...............................................................................................................................................................................................9.3% 10.5% 12.9% 13.8%

Operating Income $500,000

Income from: Debt.........................................................................................................................................................................................................88 16 48 24

Preferred..................................................................................................................................................................................................90Common..................................................................................................................................................................................................__44 __40 _187 _242Total.........................................................................................................................................................................................................132 146 235 266

Pretax ROI...............................................................................................................................................................................................11% 12.2% 19.6% 22.2%

*Available to common equity (from Exhibit A) times Arbor’s percentage share of common equity ownership.

EXHIBIT CSummary of Returns

Return on Equity A B C DPessimistic........................................................................................................................................................................................4.2 % (.1 %) 4.5 % 4.7 %Best Guess.........................................................................................................................................................................................24.2 % 19.9 % 17.9 % 16.0 %Optimistic..........................................................................................................................................................................................44.2 % 39.9 % 31.2 % 26.9%

Return to Arbor Capital:Pessimistic........................................................................................................................................................................................7.7 % 8.8 % 6.3 % 5.5 %Best Guess.........................................................................................................................................................................................9.3 % 10.5 % 12.9 % 13.8 %Optimistic..........................................................................................................................................................................................11.0 % 12.2 % 19.6 % 22.2 %

Case 9-4: Maxim Integrated Products, Inc.Note: This case is unchanged from the Twelfth Edition.

Approach

The case provides a platform to explore accounting, managerial and valuation issues related to accounting for employee stock options. It is recommended that the instructor begins the class with a discussion of how stock options work (grant price, exercise price, tax treatment, vesting period, etc.) and how they differ from common stock (issued, dividends, ownership claim, etc.).

Once the class appears to have an understanding of the financial instrument nature of stock options, the instructor should spend some time covering the basic accounting entries for employee stock options under FAS 123 R. For this purpose, the class should assume a value for the option. How this fair value is determined is discussed later in Question 2.

The basic accounting entries for an option granted (grant date) to acquire a single share of common stock for $25 (exercise price) with an initial fair value option price of $10 and a 5 year vesting period which is exercised at the end of year 6 when the company’s stock price is $40 are (tax accounting ignored1).

1. At the grant dateNo entry

2. Each year during the 5-year vesting periodDr Compensation expense 2

Cr Paid-in-capital (stock options) 23. At the Exercise date

Dr Cash 25Paid-in-capital (stock option) 10Cr Common stock or 35

Paid-in-capital

Once the instructor feels students are comfortable with the accounting entries, the class discussion should move onto covering the seven assigned questions. Since there are so many questions, the instructor must maintain tight control over the case discussion if the plan is to cover all of the questions.

Question 1

Gifford makes it very clear at the JP Morgan conference that Maxim’s continued success requires hiring the “best engineers in the world.” Stock options are an effective way to attract, motivate and retain such employees. Stock options should also align these key employees’ interests with those of the shareholders. Viewed in this light, stock options are a form of compensation for services rendered.1 Considering tax accounting is not recommended. The accounting is complex and not relevant to the case discussion. The instructor may wish to point out the tax benefit shown on the statement of cash flows and to briefly describe how it is earned.

Question 2

The discussion of assumptions should be intuitive rather than mathematical. This discussion should focus on Exhibit 4’s (Maxims 2005 Stock-Based Compensation Note) weighted average assumptions table. The impact on the fair value option price of each assumption should be discussed in turn. At the end of this discussion, the class should have an appreciation of the role of management judgment in the Black-Scholes option pricing model’s determination of the fair value of an option. Possible intuitive explanations are:

Variable Direction Fair Value ImpactExpected holding period Longer Higher – there is a greater

chance that the options will be “in the money”

Risk-free interest rate Higher Lower – present value of any future payoff is lower because the payoff is discounted at a higher discount rate

Stock price volatility Higher Higher – there is a greater chance the option will be “in the money”

Dividend yield Higher Lower – the option holder does not receive dividends

Question 3

“Wall Street” is split on how to include the cost of employee stock options in the valuation of equities and the measurement of company performance. Some analysts include them while others ignore them. Those that include them in valuation and/or net income tend to believe options are a valuable form of compensation and/or a contingent-type liability. Those that exclude options tend to focus on their non-cash nature, the potential for significant measurement error in their valuation, and the probability that the granted options may expire worthless.

Question 4

Finance theory defines free cash flow as the discretionary cash available to the firm. Based on the proposition that management, in pursuit of maximizing shareholder value should invest in all available net present value projects, discretionary cash or free cash flow is the excess of cash available after the investment potential of all available positive net present value projects is exhausted. This is a powerful idea, but it presents conceptual and managerial issues. For example:

o Equity value is a function of how managers employ free cash flow, not the amount generated.

o Free cash flow may not be a useful valuation metric across industries, companies, and different times in the economic cycle.

o Free cash flow – along with cash flow measures in general – may not be the best indicator of future free cash flows. Academic research suggests accrual based net income may be a better indicator of future cash flows.

o Free cash flow can be manipulated by managers with the result that investors are misled.

oo Free cash flow can be an important consideration in assessing a company’s financial

flexibility for such purposes as forecasting corporate performance and financial condition as well as determining a company’s potential as an acquisition candidate, but its significance must be considered along with the other financial flexibility determinants that enter into this assessment.

o Free cash flow stock yields and free cash flow stock multiples have low information value to investors and, as such, can be dubious stock valuation metrics.

o In practice, the concepts, definitions, and measurements of free cash flow employed fall short of finance theory’s definition, which cannot be estimated by investors with reasonable confidence. As a result, in practice as investors seek a workable alternative, there is considerable confusion and diversity associated with free cash flow definitions and measurements.

If Gifford believes free cash flow is the appropriate measure of Maxim’s performance, he should deduct the current or future cash outflow to buy back shares to avoid shareholder dilution from the employee exercise of stock options. Each option granted has an inherent probability that a share buyback will be required.

Question 5

Gifford has a fiduciary responsibility to shareholders. If a significant segment of “Wall Street” believes stock options have equity valuation significance, it could be argued Gifford should pay attention to what GAAP requires.

Question 6

Along with the switch to the requirement to expense employee stock options, many firms changed their compensation packages for employees below the level of senior management. For these employees, restricted stock grants and cash bonuses became a more significant component of their compensation. This trend was the result of the loss of the stock option’s non-expensing advantage over other forms of compensation, the negative governance consequences associated with stock options in a number of the accounting fraud scandals, and the decline in the stock market that left many option grants hopelessly “under water.”

Question 7

Respondents to the FAS 123 Exposure Draft suggested a number of alternative ways to measure employee stock option compensation expense.

A variety of views were expressed to support non-recognition. Some argued that an expense should not be recognized, primarily because the granting of stock options does not result in the occurrence of liability. Others noted the issuance of a stock option is a capital transaction and as such could not be an expense since capital transactions do not give rise to expenses. Another non-expense argument rested on the assertion that the issuance of a stock option was a transaction between the stockholders and employees and as such should not impact the reporting company’s financial statements.

Those supporting recognition proposed several approaches other than the Black-Scholes model to measure employee stock-option expense. Some of these proposals came as a result of suggesting measurement dates other than the grant date adopted by the FASB. For example, some proposed the exercise date. On this date, the gain realized by the employee is known and as such it was argued it is the appropriate measurement of total compensation received. In addition, it was noted the measurement is simple and straightforward.

Postscript

Maxim adopted FAS 123R during the quarter ended September 24, 2005. The quarter’s stock-based compensation charge was $41.5 million. In contrast, the same quarter for the prior year’s charge was zero. The company’s stock option tax benefit was now included in the financing section of the statement of cash flows. Previously, it had been reported as a component of operating cash flow.

The value of Maxim’s stock options granted under its stock option plans during the three months ended September 24, 2005 and September 24, 2004 was estimated at the date of grant using the following weighted average assumptions:

Three Months Ended

Sept. 24, 2005 Sept. 25, 2004Expected option holding period (in years) 4.5 4.3Risk-free interest rate 3.9% 2.7%Stock price volatility 28% 36%Dividend yield 1% 1%

Maxim included in its Form 10-Q pro forma calculation of net income excluding stock based compensation expense ($133,228 thousand versus GAAP $105,368 thousand). The company noted this pro forma presentation is given in part to enhance the understanding of the Company’s historical financial performance and comparability between periods in light of a change in accounting standards particularly since the Company has not included stock-based compensation as an expense in its financial statements before and most companies have not yet adopted SFAS 123 (R). In addition, the Company strongly believes that the pro forma presentation to exclude stock-based compensation is relevant and useful information that will be widely used by analysts, investors, and other interested parties in the semiconductor industry. Accordingly, the Company is disclosing this information to permit addition analysis of the Company’s performance2.Maxim also included a reconciliation of free cash flow to net income in its September 2005 Form 10-Q. The following table reconciles free cash flow to net income, and it depicts the Maxim’s free cash flow for the three months ended September 24, 2005 and September 25, 2004, respectively.

2 Form 10-Q September 24, 2005

RECONCILIATION OF FREE CASH FLOW TO NET INCOMEFor the three months ended

September 24, 2005

September25,2004

(Amounts in millions)

Net income, as reported $ 105.4 $ 144.5Add adjustments to reconcile net income to net cash provided by operating activities: Stock based compensation 41.5 ---- Depreciation, amortization, and other 20.6 18.7 Tax benefit related to stock plans 5.6 23.8 Accounts receivable (20.6) (3.3) Accounts payable 8.4 (3.9) Inventories (7.8) (18.0) Income taxes payable 19.5 25.5 Other assets and liabilities 3.5 21.0

Total of adjustments 70.7 63.8

Cash generated by operating activities, as reported 176.1 208.3Adjustments: Capital expenditures (18.0) (66.3) Additional tax benefit related to stock plans 16.3 ---- -

Free cash flow $ 174.4 $ 142.0

Management noted in the September 2005 Form 10-Q

Free cash flow is used by management to evaluate, assess, and benchmark the Company’s operating results, and the Company believes that free cash flow is relevant and useful information that is often widely used by analysts, investors, and other interested parties in the semiconductor industry. Accordingly, the Company is disclosing this information to permit a comprehensive and objective analysis of the Company’s operating performance, to provide an additional measure of performance and liquidity, and to provide additional information with respect to the Company’s ability to meet future share repurchases, dividend payments, and working capital requirements3.

3 Form 10-Q September 24, 2005

Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) MAXIM INTEGRATED PRODUCTS, INC.

Three Months Ended

(Amounts in thousands) September 24, 2005

September 25, 2004

Cash flows from operating activities:

Net income $ 105,368 $ 144,545

Adjustments to reconcile net income to net cash provided by operating activities:

Stock based compensation 41,459 —

Depreciation, amortization and other 20,568 18,685

Tax benefit related to stock based compensation plans

21,860 23,788

Excess tax benefit related to stock based compensation plans

(16,259) —

Changes in assets and liabilities:

Accounts receivable (20,604) (3,333)

Inventories (7,736) (18,033)

Deferred taxes (9,562) 4,041

Income tax refund receivable — (239)

Other current assets (1,741) 366

Accounts payable 8,429 (3,852)

Income taxes payable 19,528 25,511

Deferred income on shipments to distributors

(978) 136

All other accrued liabilities 15,777 16,651

Net cash provided by operating activities 176,109 208,266

Cash flows from investing activities:

Additions to property, plant and equipment (17,971) (66,344)

Other non-current assets (238) (109)

Purchases of available-for-sale securities (245,432) (278,936)

Proceeds from sales/maturities of available-for-sale securities

149,000 294,323

Net cash used in investing activities (114,641) (51,066)

Cash flows from financing activities:

Issuance of common stock 53,620 25,907

Excess tax benefit related to stock based compensation plans

16,259 —

Repurchase of common stock (81,309) (58,490)

Dividends paid (32,789) (25,946)

Net cash used in financing activities (44,219) (58,529)

Net increase in cash and cash equivalents 17,249 98,671

Cash and cash equivalents:

Beginning of period 185,551 147,734

End of period $ 202,800 $ 246,405

Supplemental disclosures of cash flow information:

Income tax paid 19,911 18,738

See accompanying Notes to Condensed Consolidated Financial Statements.

Case 10-2: Silver Appliance Company *

Note: This case has been updated from the Twelfth Edition.

Approach

This case enables students to get some “hands-on” experience in dealing with the complex matter of deferred taxes, and also in applying the installment method that was described in Chapter 5. It also requires them to think through how these complexities can be explained to a nonaccountant, and to recognize that a change in accounting method for tax purposes may involve transitional problems relating to potential double taxation of income.

Many students will have difficulties figuring out the calculations required for Question 1. These difficulties can be mitigated by including on the assignment sheet a worksheet format like that used in Exhibit A of this note. Alternatively, we can hand out in class a copy of Exhibit A, or have them copy it from a transparency. In any event, in class I go through an example for one year using T accounts, as follows:

“Book” TaxSales.........................................................................................................................................................................................................$1,000 $900Cost of sales @ 70%............................................................................................................................................................................... 700 630Gross margin........................................................................................................................................................................................... 300 270Other expenses........................................................................................................................................................................................ 200 200Pretax income.......................................................................................................................................................................................... 100 70Income tax expense @ 34%.................................................................................................................................................................... 34 23.8Actual taxes as percent of pretax “Book” income...................................................................................................................................34% 23.8%

Cash (or TaxesPayable)

Income TaxExpense

DeferredTaxes

23.8 34 10.2

This illustrates both the basic concept of deferred taxes, and also the rationaletaxes as a percent of pretax income would be understated (23.8% instead of the “true” 34%) if the “book” income tax expense amount were the amount of actual taxes rather than the actual tax rate applied to “book” pretax income. This example uses the deferral method--rather than the liability method--to compute deferred taxes. Students find this deferral method easier to understand.

Comments on Questions

Question 1

The required calculations are displayed in Exhibit A. Line 8 shows how much less Silver’s taxes would have been in 2005-10 and that taxes would have been higher in 2010 using the installment method. Line 9 shows each year’s year-end balance of Deferred Taxes; again, note that the reversal in 2010 causes the balance to decrease.

**This teaching note was prepared by James S. Reece. Copyright © James S. Reece.

Exhibit ASILVER APPLIANCE COMPANY

(In Thousands)

2006 2007 2008 2009 2010(1) Year-end installment receivables............................................................................................................................................................$190.1 $351.9 $526.2 $559.4 $489.1(2) Gross margin %....................................................................................................................................................................................... 34.6% 35.1% 34.2% 33.4% 32.2%(3) Deferred gross margin (= 1 * 2).............................................................................................................................................................. 65.77 123.52 179.96 186.84 157.49(4) Pretax profit, delivery basis..................................................................................................................................................................... 332.6 415.3 478.2 492.5 461.3(5) Income taxes, delivery basis (34% of 4)................................................................................................................................................. 113.08 141.20 162.59 167.45 156.84(6) Pretax profit, installment basis (= 4 - 3 +

previous year’s 3) 47.31.......................................................................................................................................................................... 266.83 357.55 421.76 485.62 490.65(7) Income taxes, installment basis (34% of 6)............................................................................................................................................. 90.72 121.57 143.40 165.11 166.82(8) Tax deferred (5 - 7)................................................................................................................................................................................. 22.361 19.632 19.19 2.34 (9.98)(9) Cumulative tax deferred.......................................................................................................................................................................... 22.36 41.99 61.18 63.52 53.54

1Liability method calculations is Line 3 ($65.77) times 34 percent.2Liability method calculations is $41.99 minus $22.36 (see line 9).

Question 2

The balance in the deferred tax account is best described as the cumulative amount of taxes that the company has postponed by using the installment method rather than the delivery method for tax purposes. Some people refer to this as “an interest-free loan from the government.” This is true in the sense that these funds would have been paid in taxes if the tax laws did not permit use of the installment method. In another sense, it is not true: if the company used the installment method for both “book” and tax purposes, the company would have the same cash-flow benefit, but would not show any deferred tax accounting (ignoring other possible book-tax accounting differences); that is, it would have the same “loan,” even though the “loan” would not be reflected in the balance sheet.

I also feel it should be explained to Mr. Silver that deferred taxes are a liability, but not in the same sense that taxes payable are. Personally, I find the APB’s analogy in Opinion No. 11 very compelling: like accounts payable, deferred taxes do come due and get paid, even though the balance in the account may grow because each year’s credits (new payables or deferrals) exceed that year’s debits (accounts paid or deferral reversals). Indeed 2010’s simultaneous drop in installment sales and gross margin percentage relative to 2009 clearly illustrates the phenomenon of turnover within the Deferred Taxes account. Like Mr. Silver’s architect friend, Silver’s taxes could remain essentially constant even though delivery-basis sales and profit have declined (see lines 4 and 6 of Exhibit A).

The instructor may wish to indicate in advance that he or she does not expect students to check the tax code regarding the double taxation issue. The point of the question is to make students realize that there can be transitional problems surrounding a change in accounting method for tax purposes. Students should at least be able to answer, “There will be double taxation on installment sales recognized in 2010 under the delivery method, but not collected until 2011 when the installment method is adopted, unless the tax laws recognize this problem and provide relief for it.” In fact, the tax law (Sec. 453) says that Silver would have to report in 2011 all installment collections made in 2011, but could adjust 2011 taxes downward for those 2011 collections that were taxed under the delivery method in 2010. In effect, then, Silver would get a refund of that

portion of 2010 taxes that related to installment sales that were reported in both 2010 and 2011, and would be taxed on these collections only in 2011.

Although the question is not explicitly asked, the discussion should end with resolution of the issue as to whether Silver should change to the installment method. If students have previously raised a similar question on a switch from FIFO to LIFO, having seen here that 2010 taxes would have been higher on the installment basis than the delivery basis, they are tempted to answer, “It depends on the expected future relationship between income on the installment basis and the delivery basis.” However, in this instance that answer is not correct. Unless tax rates are expected to be increased, the installment method will always provide some advantage: there is no way (given no double taxation in the year of change) that a change from the delivery basis to the installment basis could result at any time in a negative (debit) balance in Deferred Taxes. Thus, the change should be made.

Case 10-4: Proxim Inc. * Note: This case is unchanged from the Twelfth Edition..

ApproachAccounting earnings have long been the key summary measure of corporate performance. Investors have focused on earnings computed in accordance with generally accepted accounting principles—GAAP-for many years. However, recent years have brought a dramatic increase in the use of alternative definitions of earnings, known by such names as pro forma, core or cash earnings. Although such earnings definitions are part of management voluntary disclosure and not under the purview of the FASB, these new definitions of earnings frequently appear in corporate news releases and are disseminated widely in the financial press.

**This teaching note in an excerpt from a longer note, Management Earnings Discloses and Pro Forma Reporting prepared by Professor Mark T. Bradshaw.

Copyright © 2003 President and Fellow of Harvard College. Harvard Business School teaching note 103-082.

The purpose of Proxim, Inc. is to expose students to the quarterly earnings disclosures that play such an important role in the managerial reporting environment among publicly traded firms and to use the pro forma disclosure phenomenon to get students thinking about the trade-offs between strict regulation of management communication versus a more hands-off approach.

Teaching Objectives

This case works best when introduced after students have learned basic financial accounting concepts and specific accounting rules, particularly rules pertaining to revenue and expense recognition. The structure of the case is to begin with a broad but brief discussion of the importance of the quarterly earnings announcement season, followed by an introduction to alternative definitions of earnings used in management press releases, and closing with a discussion of regulatory and market responses to these disclosures at both the national and international level. For specific case discussions, the financial statement and press release information are included for Proxim, Inc., a company that excludes a variety of different expenses and gains from its reported earnings. At the end of the case discussion, students should:

Be aware of the importance of reported earnings for public companies

Understand that Pro Forma Earnings = GAAP Earnings + SOME EXPENSES

View the pro forma debate is symbolic of the difficulty in establishing accounting rules

Appreciate the trade-off inherent in regulation vs. non-regulation

Structure of Class Discussion

The order in which material is discussed in this case does not seem particularly crucial to the success of the case. Class discussion can occur in any order, ranging from specific discussion of Proxim and then moving to a more general discussion of the pro forma phenomenon and regulatory issues. Alternatively, the class can begin at the broad level, discussing the general issues and then moving into a specific discussion of Proxim. The teaching note is structured along the latter method, although the experience of different instructors varies widely.

Summary questions that might be addressed are as follows:

1. How and why do managers communicate their financial performance?

2. What are pro forma earnings?

3. Are pro forma earnings good or bad?

4. What do you think of the Proxim earnings announcement?

5. Should pro forma earnings be regulated?

What follows is a list of questions that support these six primary questions, along with brief comments that instructors should elicit from members of the class.

Discussion questions

1. How and why do managers communicate their financial performance?

a. Why are there earnings announcements?i. These are exchange rules, not rules imposed by the SEC or FASB.

ii. Earnings summarize financial performance, which is important to investors interested in the earnings power of a company and its ability to pay interest and dividends.

iii. Earnings realizations help predict future earnings.

iv. Earnings are a better proxy for future cash flows than current cash flows (e.g., see Accounting Earnings and Cash flows as Measures of Firm Performance: The Role of Accounting Accruals” by Patricia M. Dechow, Journal of Accounting and Economics, 1994, pp. 3-42).

b. How frequently are accounting earnings reported?

i. Quarterly.

ii. Since most firms have December fiscal year ends, peak periods are April, July, October, and January/February.

c. Why not report earnings more frequently, say monthly?

i. The SEC requires quarterly statements filed on form 10-Q, making it natural to announce summary information from them to the market via press releases.

ii. Quarterly reporting is an attempt to provide a balance between timeliness and the cost of more frequent reporting.

iii. That being said, some firms do report more frequently, such as retailers who often announce monthly results.

d. How else do managers communicate with investors?

i. Informational press releases.

1) e.g., new products, regulatory approvals, etc.

ii. Earnings preannouncements.

1) These are particularly more common in the case of ‘bad news.’

2) There is an implicit belief that announcing bad news earlier results in less negative impact than waiting to announce it later.

3) Preannouncements are presumably a memo for managers to signal that they are forthcoming and credible communicators of financial performance.

iii. Conference calls.

1) Press releases often announce the date and time of upcoming conference calls.

2) Conference calls provide an opportunity for analysts, the press, and investors to ask more probing questions regarding results of operations.

3) Conference calls are believed to be part of the new compliance with Regulation FD.

iv. Mailings to investors.

1) Form 10-Qs.

2) Form 10-Ks and annual reports.

v. Interviews on business programs

1) e.g., CNBC Squawk Box, etc.

2. What are pro forma earnings?

a. For the longest time, it meant ‘what earnings would have been if two merging companies had been merged in prior periods’ or ‘what earnings would have looked like if some division/company that was recently sold/disposed had been gone in prior periods.’

b. Generally, any ‘what if’ scenario qualifies as ‘pro forma’ earnings.

c. Pro forma disclosures are often referred to as “non-GAAP” disclosures.

d. Actually, it is more descriptive to call them “incomplete-GAAP” disclosures.

e. Simply a different calculation of Revenues - Expenses +/- Gains/Losses, some items excluded from the equation

f. More often than not, the items excluded from the calculation are expenses and losses rather than revenues or gains.

g. Items excluded in pro forma earnings include just about every operating expense on the income statement.

i. Restructuring charges.

ii. Asset write-offs.

iii. Depreciation and amortization.

iv. Merger-related charges.

v. Compensation-related expenses.

vi. R&D.

vii. Acquired in-process R&D.

viii.Bad debt expense.

ix. Litigation costs.

x. Interest expense.

3. Are pro forma earnings ‘good’ or ‘bad’?

a. Good.

i. One-time items are important to know about, but obscure earnings as a summary measure of recurring or core earnings, so it is appropriate and even desirable to exclude the effects of these transitory items from reported earnings.

ii. Graham and Dodd (the financial analyst ‘bible’) focuses extensively on the analysis of financial data to identify ‘earnings power,’ which is the level of recurring earnings. Accordingly, they devote extensive discussion to the assessment of non-recurring items that should be excluded from earnings when attempting to forecast future earnings.

iii. Much financial analysis is time-series in nature, and a comparable set of time-series numbers is more useful to investors.

iv. It can be argued that investors cannot be worse off by knowing pro forma earnings so long as they also know either GAAP earnings (i.e., net income) and/or the amounts of items excluded from GAAP earnings to arrive at pro forma earnings. As a simple example, let Revenue = R, Expensel = E1, Expense2 = E2, NI = Net income = R-El-E2, and PF = Pro Forma income = R-E1 or = NI+E2.

1) If an investor knows NI, then they are aware of the single GAAP summary figure only.

2) If an investor knows both NI and PF, then they also know that E2 = PF-NI.

3) If an investor knows both PF and E2; then they also know NI = PF-E2, or E2 = PF-NI as above.

4) Therefore, it seems like announcing pro forma earnings can actually give investors more information.

v. Highlighting abnormal, non-recurring, or non-cash income statement items has been done by managers for years. Thus, is ‘pro forma’ just a case of ‘old wine in new bottles’?

b. Bad

i. It appears that most financial statement line items excluded are expenses/losses, rather than revenues/gains. This asymmetric occurrence of excluded items makes it suspicious that managers are simply reporting results in an unbiased manner.

1) However, students should be reminded that GAAP is conservative by nature, resulting more frequently in the earlier recording of expenses/losses than revenues/gains.

ii. Pro forma reporting seems like another way of manipulating investors. Manipulating pro forma earnings, which are not filed with the SEC, is perhaps easier to do than manipulating GAAP financial numbers themselves, which are filed with the SEC and hence, subject to more scrutiny and potential penalties.

iii. Managers seem to be emphasizing pro forma numbers, not the GAAP numbers. The fact that pro forma numbers are almost always higher than GAAP numbers makes this seem a bit suspect.

iv. There are no ‘rules’ established, thus it is difficult to compare the pro forma earnings of one company to those of another company, or perhaps even the pro forma earnings for the same company in different quarters/years.

v. Howard Schilit (a former accounting professor who sells accounting analysis reports to Wall Street investors) says (paraphrased), “Letting managers come up with their own scorecards is like letting the inmates run the asylum.”

vi. If investors do not really pay attention to financial statement details when assessing stock values (i.e., they use a P/E multiplier to estimate fair values of share prices based on reported earnings per share), then they could be hurt by reliance on a pro forma earnings number that gives an incomplete picture of the full costs of operating the business. As an example of how reported earnings can affect aggregate assessments of economy-wide economic activity,

vii. If one does not consider the effects of ‘excluded’ charges in calculating pro forma earnings numbers in a particular period, then when should these costs be considered?

4. What do you think of the Proxim earnings announcement?

a. It is helpful to have presented the students with a poll before class, in which students are asked to quantify the earnings figure that they would have reported.

b. Proxim has excluded almost every expense in their pro forma earnings.

c. $106 million of expenses are excluded on just $85 million of revenues.

i. Inventory write-down ($50 million).

ii. Restructuring charges ($14 million).

iii. Impairment loss on investments ($12 million).

iv. Goodwill impairment charge ($10 million).

v. Goodwill amortization ($5 million).

vi. Provision for doubtful accounts ($5 million).

vii. Terminated merger costs ($3 million).

viii. Patent litigation costs ($3 million).

ix. Amortization of intangibles ($3 million).

x. Purchased R&D ($1 million).

1) An interesting discussion is to address what ‘purchased’ or ‘acquired’ in process R&D is.

2) When a company buys another company, it must estimate the fair market value of all assets acquired (recall goodwill/intangibles discussions earlier in the term).

3) One intangible asset often acquired is the value of research and development (R&D) activities that are in process. Accounting rules require R&D activities to be expensed as incurred, but in a purchase situation firms are allowed to estimate the value of the ‘knowledge in process’ that is being acquired.

4) A common practice is to value such in process R&D, then ‘flash’ this value to Wall Street (i.e., ‘Hey, look at what we are buying . . . a bunch of promising research projects!’). Immediately thereafter, the manager of the acquiring company ‘flushes’ this amount (i.e., expenses it off the balance sheet). (See further discussion in the article “Flash-then-Flush: The Valuation of Acquired R&D-in-Process,” by Zhen Deng and Baruch Lev.) This practice is widely used, and the benefits to acquiring firms are threefold:

(1) Managers get to take credit for buying such promising assets (the ‘flash’).

(2) The market generally disregards the one-time write-off as nonrecurring (the ‘flush’).

(3) Future earnings will be unaffected by any amortization of the acquired goodwill asset, which would have occurred had the valued assets not been flushed.

d. About the only expenses Proxim did not exclude were COGS, SG&A, and R&D. It makes one wonder why they did not go ahead and exclude R&D, arguing that such amounts should really be viewed as investments.

i. An interesting diversion is often demonstrating the perils of ignoring certain expenses.

ii. For example, assuming that acquired R&D is an asset, the related expenses are initially added back in computing ‘pro forma’ earnings.

iii. However, what future period should investors consider the related amounts to be recognizable expenses?

iv. Managers who exclude depreciation or amortization expense are making similar arguments for why the amounts are added back to arrive at pro forma earnings (but also invoking the ‘noncash’ argument).

v. Under the same logic as above for the R&D thought exercise, how come managers never report to investors what period is the appropriate one for actually deducting the initial expenditures on PP&E or intangible assets?

e. As an investor, are you more interested in the positive $0.06 pro forma earnings per share, or the $3.87 loss per share?

i. Perhaps both.

ii. The pro forma number gives an investor a figure that hopefully reflects what to expect on an ongoing basis in the future.

iii. The GAAP figure informs the investor on what has happened to previous investments made by management.

iv. Students should be reminded of earlier discussions in class related to the accounting for goodwill and other intangibles. One of the nice aspects of the purchase method is that it keeps a ‘reminder’ on the balance sheet of the amounts managers paid for other companies. No longer applicable, since FAS 142 disallows systematic write-off or goodwill

v. Regardless of whether one believes Proxim is trying to ‘fool’ investors, the company clearly has given investors a reasonable disclosure of what they excluded from pro forma earnings.

vi. However, keep in mind that the press has the option of picking up all the details in the press release, or simply picking up the pro forma number. Given space constraints, it is unlikely that all information in the press release will be reported in the business press.

vii. Nonetheless, some weeks after the earnings announcement, Proxim will file statements with the SEC. Thus, one worst-case scenario is that investors just receive the full set of information with a delay.

5. Should pro forma earnings be regulated?

a. Do regulate.

i. If pro forma earnings were to be regulated, this would essentially be equivalent to sanctioning another method of accounting (in addition to GAAP).

ii. Further, regulating pro forma earnings would be tantamount to a tacit confession that GAAP is ‘broken’ and must be supplemented by another set of earnings figures.

iii. Economics across firms vary sufficiently that any dried rules would probably result in some firms being prevented from communicating their results effectively.

iv. If managers are using pro forma earnings strategically, they might revert to manipulation of the GAAP numbers rather than relying on the use of “pro forma’ earnings to ‘fool’ investors (e.g., this might lead to a decline in the quality of GAAP numbers).

b. Do not regulate.

i. Perhaps it is acceptable to allow continued confusion over what ‘pro forma’ means.

ii. Avoiding specific regulation of how ‘pro forma’ earnings should be computed allows managers freedom to communicate to investors in a manner that best fits their results and operations, which as noted above, vary widely across companies.

iii. It is possible that the SEC could use a ‘heavy hand’ to punish blatant abuses as a means of keeping a check and balance on managerial freedom to report such ‘incomplete-GAAP’ numbe