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CHAPTER TEN
The Analysis of the Balance Sheet and Income Statement
Stephen H. Penman
The web page for Chapter Ten runs under the following headings:
Reformulated Balance Sheets and Income Statements for a Firm with Net
Financial Assets: Microsoft Corporation
Getting the Tax Rate for Tax Allocation in the Income Statement
Readers Corner
Chapter 10 applies the template laid out in Chapter 8 to reformulate balance sheets and
income statements in a way that clearly distinguishes operations from the financing of
operations. Firms add value from operations trading with customers and suppliers not
from financing activities that involve raising cash and from claimants and returning cash
to them. GAAP financial statements, unfortunately, do not make a clear distinction. They
have to be cleaned up.
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
You may not see the payoff to the reformulation exercise at this stage, so the material
may seem a bit mechanical. But you will strike pay dirt as you proceed to the analysis of
profitability and growth (Chapters 12 and 13) and, particularly, as you carry out
valuations based on the reformulated statements in Part Three of the book.
One must reformulate the income statement to differentiate income derived from
sales from other operating income.
The Separation of Operating Activities and Financing Activities: the Key Question
What is an operating item and what is a financing item? This is the question you will find
yourself asking as you reformulate financial statements. An operating item is one that is
involved in selling goods and services to customers or in trading with suppliers to
develop the products for customers. Or, another way to see it is to ask: How does the firm
make money and is the item involved in this activity? (The firm makes money by selling
products to customers, of course.) So, a note payable written to a supplier (a trade note) is
an operating liability, but a note written to raise cash for operations is a financing item.
Borrowings by a bank from which they lend at a higher rate than their borrowing rate are
operating liabilities, even though they look like a financing item.
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
VF Corporation
GAAP Balance Sheets
________________________________________________________________________
JANUARY 2 JANUARY 2
1999 1998
ASSETS
CURRENT ASSETS
Cash and equivalents $ 63,208 $ 124,094
Accounts receivable, less allowances of
$52,011 in 1998 and $39,576 in 1997 705,734 587,934
Inventories 954,007 774,755
Deferred income taxes 99,608 94,750
Other current assets 25,595 19,933
Total current assets 1,848,152 1,601,466
PROPERTY, PLANT AND EQUIPTMENT 776,091 705,990
INTANGIBLE ASSETS 951,562 814,332
OTHER ASSETS 260,861 200,994
$ 3,836,666 $ 3,322,782
LIABILITIES AND SHAREHOLDERS EQUITY
CURRENT LIABILITIES
Short-term borrowings $ 244,910 $ 24,191
Current portion of long-term debt 969 450
Accounts payable 341,126 301,103
Accrued liabilities 446,001 440,164
Total current liabilities 1,033,006 765,908
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
1998 1997
Operating Assets
Cash $ 15,000 $ 12,000 (4)
Accounts receivable $ 757,745 $ 627,510
less allowances for doubtful accounts ( 52,011) 705,734 (39,576) 587,934
Inventories - Finished goods 552,729 434,000
- Work in process 185,929 166,947
- Materials 215,349 954,007 173,808 774,755 (6)
Other current assets 25,595 19,933
Property, plant and equipment - Land 45,296 44,786
- Buildings 443,619 437,903
- Machinery 1,222,216 1,086,263
1,711,131 1,568,952
less accumulated depreciation (935,040) 776,091 (862,962) 705,990 (6)
Goodwill 1,195,062 1,022,632
less accumulated amortization (243,500) 951,562 (208,300) 814,332 (6)
Deferred income tax asset 235,044 212,975
less valuation allowance (34,249) 200,795 (32,506) 180,469 (6)
Pension asset 35,164 27,713 (6)
Other assets 124,510 87,562
Deferred ESOP contributions 20,399 26,275 (7)
Operating Liabilities
Accounts Payable 341,126 301,103
Accrued liabilities - Taxes payable 70,112 86,244 (6)
- Compensation payable 103,769 84,425
- Insurance payable 18,605 62,153
- Other 253,515 207,342
Other liabilities - Deferred compensation 151,436 113,727 (6)
- Deferred income taxes 11,512 -----
- Other 18,802 968,877 30,086 885,080
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
Notice several things about the reformulated statement (numbers refer to the numbers
flagging items in the exhibit):
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
Reformulated Balance Sheets and Income Statements for a Firm with Net
Financial Assets: Microsoft Corporation
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
Getting the Tax Rate for Tax Allocation in the Income Statement
The reformulation of the income statement requires allocation of taxes to the operating
activities and the financing activities. The allocation uses the marginal tax rate. In almost
all cases, except where the firm cannot get the tax benefit of debt because it has operating
losses that cannot be utilized in its tax return, the marginal rate is the statutory rate. In the
US, the statutory rate is the federal rate (currently 35%) plus the rate for any state taxes.
As state taxes are deductible on firms federal tax return, the state rate is the nominal rate
multiplied by (1 0.35). So for a state tax rate of 3%, the rate to use in the allocation is:
= 36.95%
Tax rates can be obtained from the tax footnote. Here is the tax footnote from the 2002
10-K for Dell Computer.
Income before income taxes and cumulative effect of change in accounting principle included
approximately $302 million, $491 million, and $449 million related to foreign operations in fiscal 2002,
2001, and 2000, respectively.
The Company has not recorded a deferred income tax liability of approximately $711 million for additional
taxes that would result from the distribution of certain earnings of its foreign subsidiaries if they were
repatriated. The Company currently intends to reinvest indefinitely these undistributed earnings of its
foreign subsidiaries.
The components of the Company s net deferred tax asset are as follows:
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
Tax credit carryforwards will generally expire between 2003 and 2023.
The effective tax rate differed from statutory U.S. federal income tax rate as follows:
The tax rates are given at the end of the note. Dell in a Texas company where there are no
state taxes, so the statutory rate is the federal rate of 35%. Note that the benefits of lower
taxes in foreign companies do not affect the rate used for the tax allocation: these are
benefits that go to the operations, not the financing activities.
Here is the relevant tax rates from IBMs 2002 10-K. You see the state tax rates there.
(From IBM 2002 10-K)
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
Some firms do not report taxes rates, only dollar amounts of federal and state taxes. The
federal rate is always 35%, and the state rate (in this case) has to be interpolated from the
dollar numbers.
This chapter described how taxes are allocated between components of the income
statement (see particularly Box 10.3). This is the allocation that the analyst does.
However, GAAP has also carried some tax allocation, for example always allocating
taxes to items below the tax line in the income statement and to other comprehensive
income items. The diagram below describes:
(1) How recorded taxes differ from taxes paid (by recognition of deferred tax assets
and liabilities)
(2) How GAAP then allocates the accrued taxes to items in the financial statements
(3) How the analyst then extends the allocation (as in this chapter)
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
(next page)
Tax Allocation
Deferred Taxes
(Interperiod Allocation)
Intraperiod Allocation
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
There are a number of reasons (see also Box 10.2 in Chapter 10):
1. To grease the working of the operations. This is typically a very small amount of
cash, called working cash. This is sometimes called the transactions demand for
cash.
2. For ultimate payout to shareholders
3. To settle debt in the future
4. For making future investmentscapital expenditures or acquisitions. Firms might
hold more cash for acquisitions when their stock price is low, for then they would
prefer to use cash rather than stock in the acquisition.
5. As a precaution against a rainy day. This is sometime called the precautionary
demand for cash. See the discussion in Chapter 10.
6. For tax reasons: U.S. corporations incur taxes when they repatriate cash back to
the U.S. from overseas subsidiaries. So they hold the cash overseas.
7. To waste it: management holds cash for suboptimal investments the corporate
jet rather than paying it out to shareholders. Entrenched managers build excess
cash balances (it is said) to spend on empire building and pet projects.
The last point is sometimes referred to as the free cash flow hypothesis---too much free
cash results in waste.
After accumulating nearly $100 billion in cash (financial assets), Apple Inc. announced
in early 2012 that it would start to pay a dividend. A newspaper article that followed up
on the announcement claimed that this would do nothing for shareholders, invoking the
Miller and Modigliani principle that paying dividend does not increase value. Rather,
claimed the article, Apple should be scouring the globe to find companies to buy up
with the cash, perhaps a cable company, or telecoms with bandwidth.
Is the article correct? Well, they are correct on the M&M point: dividends will not add
value. But on the point that the cash should be kept for investment, it is incorrect. First,
making poor investments does not add value. But, second, if good investments could be
found that mesh with Apples business model, the firm can also borrow to fund the
investment (or to pay out dividends). Indeed, that is what the M&M principle says: firms
can pay out dividends (and not affect their investment opportunities) because they can
also borrow. The firm cannot be capital constrained, of course, but Apple would have
little problem borrowing to make an acquisition. Indeed, for an acquisition, it can issue
stock rather than pay cash.
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
To reformulate financial statements, one needs to refer to the footnotes to get more detail
first, to identify items as operating or financing and, second, to bring more detail up
onto the face of the statement. Here are some of the frustrations you might run into:
Other income from operations is lumped together with interest income (from
financing activities)
There is not a lot of detail given for SG&A expense, even though this is often a
large percentage of sales. Advertising costs are usually identified, but little else. It
is not clear whether SG& A contains expenses not related to sales (that should be
part of other operating income not from sales). Firms have been known to credit
gains on asset sales to SG&A (IBM, in 1999, for example).
Other Assets and Other Liabilities are not detailed
The following web site prepared by Deloitte Touche Tohmatsu, the accounting firm, gives
the layout of financial statements prepared under international accounting standards:
http://www.iasplus.com/fs/fs.htm
The Chapter 9 web supplement gave the equity statement for Siemens, the large German
electronic and engineering firm. Here are the accompanying balance sheet and income
statement for 2011. Notice the two-statement format for reporting comprehensive
income.
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
As indicated above, U.S. GAAP required expenses to be classified by function rather than
nature. An exception is airlines. Here is the income statement Delta Airlines, classified by
nature:
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Chapter 10 - The Analysis of the Balance Sheet and Income Statement
Readers Corner
A paper that shows how the separation of operating and financing activities relates to
valuation:
J. Feltham, and J. Ohlson., Valuation and clean surplus accounting for operating
and financing activities, Contemporary Accounting Research 11 (1995): 689
731.
T. Bates, K. Kahle, and R. Stulz, Why Do U.S. Firms Hold So Much Cash than
They Used To? Journal of Finance LXIV (October 2009): 1985-2101.
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