ISI Accounting 10-K Notes

Joint Venture can be neither consolidated on each B.S. and would both use equity method.
Critical Acctg Policies: ones that requires significant and or subjective management
judgment. A first sign of a more aggressive policy is a new one or two sentence disclosure.
Revenue Recognition: Sell-in: recorded when shipped to distributor or dealer, more
aggressive. Sell-through: recorded upon sale to end customer.
Look at sales discount/return reserves over past several years as a quick analysis if company
is skimping on reserves to meet earnings.
Look at DSO trends over last 8 quarters. This is the most common item where less
conservative revenue recognition practices manifest themselves.
Look at other assets catch all account
Look at revenue/PP&E. Compare rate of change in rev to change in PPE. Costs may be placed
in PPE and lead to excessive cost capitalization.
This can permantly overstate OCF. Look if they ignore FCF because of higher CAPEX
expenses.
This excess depr will be added back to OCF and imperative to look at FCF and not
EBITDA.
Capitalized Interest will be depreciated slowly over time instead of interest expense. This
understate interest expense.
Ascertain the amortization period for capitalized costs and if its reasonable. ISIs view is that
start up costs and marketing/advertising costs that are capitalized is highly skeptical since
the benefit period over which the costs are expensed is highly variable and subjective.
Accounting Changes: A preferability letter from auditors is required to change from one
permissible standard to another permissible standard.
Deprecaition:: Units of production may understate economic depreciation for mature,
declining, or low capacity utilization industries.
If a companys accounting depreciation exceeds the assets real economic decline in value,
this represents and under-earning company. Usually with accelerated depr.
Depr and Amor can be included in cost of sales or SGA.
Relative Age of Assets = Gross PPE/Accd Depr
Avg Asset Depr Life= Gross PPE/Depr Expense
Avg Age of Assets= Accd Depr/Gross PPE
Remaining Depreciable Years= Gross PPE/Accd Depr

Foreign Cash Repatriation:

Next assume that the company distributes (repatriates) foreign cash domiciled in
Switzerland to its U.S. Corp. To calculate U.S. taxable income on Bull Market Corps U.S. tax
return, the companys foreign earnings are grossed-up to their pre-tax foreign amount
($100). In turn, U.S. corporate taxes are calculated at the 35% current corporate tax rate or
$35. The foreign tax credit of $20 is applied to the $35 preliminary U.S. corporate tax dues.
Therefore, incremental
taxes of $15 are due. Due to the payment of foreign taxes, the companys cash balance
available for U.S. activities is reduced from $80 to $65 ($80 less $15 U.S. taxes). Another
repatriation holiday (similar to the 2004 JOBS Act) is possible in '2H 2011 (see 1/5/11 report
for details).
OTTI impairments
Under this new model, a company always records an impairment credit loss component of
the marketable debt securitys unrealized loss in earnings. The other portion of the
unrealized loss that is due to non-credit (e.g., due to liquidity, etc.) is also recorded in
earnings only if any of the
three aforementioned criteria are met. Otherwise, the unrealized loss remains in other
comprehensive income in equity until the security is sold.
If the security subsequently recovers in fair value, it is not written-up to its fair market value.
Rather, the loss amount is recycled through the income as the written down security value
is accreted up to its par value statement through higher interest income.
Inventory
The inventory write-down is generally recorded as an inventory reserve until the inventory is
sold or scrapped. If the selling price of inventory previously written-down recovers in value,
and the product sells at
the higher price, a company would record an inflated gross margin on written-down
inventory. The gross margin improvement, all else being equal, is unsustainable since a finite
amount of inventory was written-down and new inventory produced will have a normal
gross margin.
FAS 151, Inventory Costs, (effective for 2006 calendar years) clarified that abnormal
amounts of idle facility expense, freight, handling cost and spoilage should be expensed in
earnings rather than capitalized as part of inventory cost.
Reserve Reversal Gains in Earnings
Since companies often use historical experience to calculate reserve amounts, we suggest
comparing the reserve amount to the driver of the cost (warranty to revenues, bad debt
expense to accounts receivable, sales returns to sales and inventory) to gauge year-overyear changes.
We suggest a one-year lag since companies need to expense costs in the current period to
match costs with revenues, but charge-off amounts in subsequent period(s) as the balance
sheet asset is deemed worthless. This is common with bad debt reserving and inventory.
To increase invent t:
_ Overvalue inventory
ventory account (overstate balance);
ory and, thus, reduce cost of sales, a company migh

y by:
_ Failing to write-down inventory;
_ Overstate inventory quantity;
_ Add amounts to in
_ Overproduce inventory to absorb fixed overhead costs.
Converts
The accounting rule changes require interest expense to be recorded in earnings at a
companys higher nonconvertible debt interest rate as compared to the current practice of
recording interest expense at the lower cash (effective) interest rate. changed the
accounting for cash-settled convertible debt by requiring bifurcation accounting for
convertible bonds
Since a company issues a call option as part of a convertible bond on the issuance date, the
economic cost of issuing a convertible bond is unknown until the bond is
converted/repaid/redeemed. For enterprise value and other calculations, the convertible
bond should be treated as debt or equity. For a plain vanilla convertible bond, we suggest
including the shares in
the diluted share count if the current share price or the analysts target share price is
greater than the convertible bonds exercise (strike) price. On the other hand, if the
convertible bond is out-ofthe-money and unlikely to become in-the-money, we suggest
treating the entire amount of theconvertible debt as debt without including any shares in the
diluted share count.The companys share count may not include the analytically correct
number of
shares.
Debt
Is there a cross payment default provision? Under this provision, creditors of a material
amount of debt may elect to declare that a default has occurred under their debt
instruments and to accelerate the principal amounts due such creditors. Is there a cross
accelerated provision? This provision permits a default on a second debt to be declared only
if in addition to a default occurring under the first debt instrument, the indebtedness due
under the first debt instrument is actually accelerated. Is there a subjective acceleration
clause? This provision permits a debt maturity to be accelerated if certain events occur that
are not objectively determinable (or necessarily defined).
Goodwill
Since goodwill is not amortized as a periodic expense under GAAP, companies are
incentivized to allocate a large portion of the acquisition price to goodwill. If the acquisition
doesnt work out as planned, the company simply writes-off goodwill as a one-time
impairment charge to earnings. Since goodwill is the residual (or plug number) recorded
after the fair market value of net assets
are recorded, a high level of goodwill as a percentage of the total purchase price suggests
the company is attributing a large premium to synergy value. In other words, there is high
risk the company overpaid for the acquisition. In general, we consider goodwill representing
more than 70% of the purchase price to be high and believe it suggests substantial
overpayment for assets.
For example, did a company allocate a portion of the purchase
price to an indefinite life intangible asset brand that does not have longevity? Practically
speaking, we believe that few brands and other intangible assets have indefinite lives and
any large allocations thereto should be viewed skeptically.

There is no average period or benchmark against which to compare company amortization

periods. However, we believe assigning a useful life amortization period to a finite life
intangible asset exceeding 20 years is presumptuous. Amor period over 10 years for
customers lists and other intangible may elicit a SEC comment letter.
Tax deductible goodwill and intangibles
For example, a company and their investment banker will value the tax shield from tax
deductible intangible assets/goodwill when considering an acquisition price
Did the company prepay for any costs at the mergers closing?
Analysts should review disclosures for the existence of any prepayments at the mergers
closing
date. Prepaying certain expenses at the closing date boosts future operating cash flow of the
combined company.requires companies to value the amount paid for the target company
based on the value exchanged on the acquisition date. Previously, transactions were valued
based on consideration exchanged on the announcement date.
Under the rules, IPR&D is capitalized at the acquisition date as an intangible asset (valued
by third parties) and amortized as a non-cash expense in earnings over its useful life once
the project has been completed. In the interim, any additional costs incurred on the project
will follow existing accounting guidance (i.e., expensed as costs incurred) and the capitalized
IPR&D asset is subject to at least an annual impairment test under FAS 142, Goodwill and
Other Intangible Assets. It is hoped that this accounting change better matches revenues
with costs incurred to generate those revenues
If a company deems foreign earnings permanently reinvested
abroad, GAAP does not require companies to record U.S. income taxes on foreign earnings in
the income statement. The permanently reinvested assertion is made by most companies.
Since most foreign income tax rates are lower than the U.S. 35% tax rate, companies
consequently report a lower effective income tax rate. If the permanently reinvested
assertion is not made for foreign earnings, the effective income tax rate would approximate
the 35%-40% U.S. corporat
and state blended income rate.
In effect, there is an off-balance sheet deferred tax
but not U.S. taxes. Generally, when a foreign subsidiary earns income overseas, it is not
included on the U.S. corporations income tax return until the earnings are repatriated (a
dividend or deemed distribution) to the U.S. company. At that point, the parent pays U.S.
taxes on the pre-foreign earnings, but it will receive a foreign tax credit for foreign taxes
paid. Since GAAP does not require companies to record U.S. taxes on unrepatriated foreign
earnings, most companies
report lower effective income tax rates. liability for any foreign taxes that would be owed
upon the repatriation of foreign earnings.
A low cash tax rate may suggest aggressive tax planning or aggressive GAAP reporting.
Compare this to other like companies. Check for special circumstances.
Goodwill Impairment
In our view, a companys goodwill-to-market capitalization ratio is an indicator of whether
agoodwill impairment charge may be forthcoming. That is, the higher the level of goodwill as
a previously described, goodwill is recorded and analyzed for impairment at the reporting
unit level.percentage of market capitalization, the greater the probability the implied fair

value of goodwill will be less than its recorded value. We use this ratio as a screen for
goodwill impairments at the
aggregate company level since we dont have enough detail to calculate the goodwill
amounts at the reporting unit level. We reviewed goodwill impairment charges over recent
history (2000 present). Historically, the average goodwill-to-market capitalization ratio in
the quarter before a goodwill impairment occurs is 39% (median = 22%).