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Agenda. Earnings Components Organic vs. acquired Debt retirement gains (losses) Hidden gains (losses) Accruals Write-offs and contingencies Restructuring expenses Income statement analysis Core/transitory Operating/nonoperating Recasting Financial Statements S&P Core Earnings
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Agenda • Earnings • Components • Organic vs. acquired • Debt retirement gains (losses) • Hidden gains (losses) • Accruals • Write-offs and contingencies • Restructuring expenses • Income statement analysis • Core/transitory • Operating/nonoperating • Recasting Financial Statements • S&P Core Earnings • Foreign Currency Translation
Organic vs. acquired Earnings - Target CAPEX =$2.2b ($3b x 74%) in 2003, or approximately $22 million ($2.2b/ 101 new stores) per new store. Projections of continued sales growth at the 2003 level will, therefore, entail similar expenditures unless we expect retail markets to improve.
Debt Retirement Gains (Losses) • Bond and note liabilities are carried on the balance sheet at historical cost (original issue price plus or minus any unamortized premium or discount). • When such debt is repurchased in the open market or acquired via a call provision, the difference between the purchase price and the book value of the debt is recorded as a gain or loss in the income statement. • Classification of these gains and losses as ordinary or extraordinary items depends on whether they meet the test for extraordinary items of being unusual and infrequent. • Although such gains and losses on debt repurchases are reported in income, no gain or loss occurs in an economic sense. Thus, such gains and losses are irrelevant for income analysis. As a result, we must adjust income to eliminate the effect of these gains and losses as part of our prospective analysis.
Write-offs and contingencies • Write-offs: • Compare undiscounted cash flows with book value of asset • If less, write down to present value of cash flows Loss on W/D of assets xxx (I/S) Asset xxx (B/S) • Contingent liabilities: • Record if probable and can be estimated Expense xxx (I/S) Liability xxx (B/S) Restructuring Expenses
Kellogg mini-case • How much expense did Kellogg Company report in each of the last 3 years relating to restructuring activities? • How much of this expense in each year was paid in cash? • What are the principle areas of cost encompassed under the general term of restructuring expense? • Do you feel that the character of these expenses is the same? That is, as a financial analyst, how do you interpret the different types of restructuring expenses? • Should restructuring expenses be ignored in interpreting financial results? That is, should analysts look at income before restructuring expense? • What effect does the write-off of an asset have on current income? On future income? • Assuming that you choose not to ignore them, does the character of the restructuring cost suggest possible ways to treat them in your analysis of the company’s profitability?
P&G Restructuring Charges • But even as P&G excludes the restructuring charges from what it calls its "core net earnings," it includes gains from selling brands, sales that some analysts and investors believe should be treated as one-time events. • Depending on investors' views of the charges and gains, P&G earnings are either rising or falling. • If you back out the gain, as does Tim Drake, a senior equity analyst at Banc One Investment Advisors, in Columbus, Ohio, P&G's core earnings actually dropped 7%, to $1.16 billion. "Their business isn't manufacturing brands and companies to sell. Their business is manufacturing products to sell.“ • “You can chastise the company for the way it puts a [news] release out, but it is still the analysts' job to put some thought into this issue and decide what should or shouldn't be included."
Recasting – a preview • Income Statement Adjustments • Removing transitory items such as: • Gains and losses on sales of assets (long-term and investments) • Transitory items below income from continued operations (discontinued operations, extraordinary items, and changes in accounting principles) • Restructuring expenses • Gains on stock issuances by subsidiaries • Losses on write-downs of assets (long-term and inventories) • Merger costs • LIFO liquidation gains • Gains and losses on debt retirement • Liability accruals deemed excessive • Gains from reductions of deferred tax valuation allowance • Separating operating and non-operating items • Treating pension service cost as operating • Treating pension interest costs and expected returns as non-operating • Treating debt retirement gains and losses as non-operating • Treating short-term fluctuations in tax expense as non-operating • Treating income from equity method investments as non-operating • Adding expenses not reflected in income • Employee stock option expense • Inadequate reserves for bad debts • Reductions of R&D, advertising, etc., to achieve short-term income targets
Recasting – a preview • Balance Sheet Adjustments • Capitalization of operating leases • Consolidation of equity method investments • Consolidation of variable interest entities (VIEs) • Elimination of discontinued segments • Write-down of impaired goodwill • Statement of Cash Flows Adjustments • Recast cash inflows from asset securitization, from operating cash flows to financing • Eliminate operating cash flows that relate to tax benefits from exercise of employee stock options • Eliminate operating cash flow gains from excessive increases in accounts payable • Recast operating cash flows from discontinued operations to non-operating section
S&P’s Core Earnings Definition(e.g., Operating, not Persistent)
Foreign Currency Translation • Relates to translation of I/S and B/S into $US • Choice of Functional Currency dictates translation method (Current or Temporal) • Translation method dictates whether FX gains (losses) are run though I/S or in OCI.
Translation methods • Current rate method • balance sheet items (except capital accounts) are translated at current exchange rates. • Income statement accounts are translated at average exchange rates. Net unrealized gains (losses) are accumulated in other comprehensive income and do not affect current profitability until the subsidiary is sold. • Temporal method • monetary assets (liabilities) are remeasured at current exchange rates, non-monetary assets (liabilities) at historical exchange rates. • Income statements are translated at average exchange rates except for expenses relating to non-monetary assets (COGS and depreciation, for example), which are remeasured at historical exchange rates. Unrealized gains (losses) affect current profitability under this method.
Current Rate Example Assume that a company begins operations with an infusion of €1,350,000 in cash and uses €1 million to purchase PP&E. The opening balance sheet is, therefore, (in €) Cash 350,000 L-T debt 550,000 PP&E 1,000,000 Equity 800,000 Total assets 1,350,000 Tot Liabs & Equity 1,350,000 At the end of the year, the company’s equity has increased to €1,300,000. Assume that the exchange rates of the dollar and euro (€ ) are as follows: January 1 €1.05 = $1.00 Average €1.02 = $1.00 December 31 €0.95 = $1.00 The translation gain (loss) can be computed as follows: Gain on beginning net assets €800,000 x [(1/1.05 – 1/0.95)] = 80,200 Gain on increase in net assets €500,000 x [1/1.02 – 1/0.95)] = 36,120 Total translation gain 116,320 Reported in OCI, not reported in current income
Temporal Method Example Assume that a company begins operations with an infusion of €1,350,000 in cash and uses €1 million to purchase PP&E. The opening balance sheet is, therefore, (in €) Cash 350,000 L-T debt 550,000 PP&E 1,000,000 Equity 800,000 Total assets 1,350,000 Tot Liabs & Equity 1,350,000 The net monetary position at the beginning of the year is a net monetary liability of €200,000 (cash of €350,000 less L-T debt of €550,000). Assume that the net monetary position of the company at the end of the year is a net monetary liability of €500,000 for an increase of €300,000. Assume that the exchange rates of the dollar and euro are as follows: January 1 €1.05 = $1.00 Average €1.02 = $1.00 December 31 €0.95 = $1.00 The remeasurement gain (loss) can be computed as follows: Loss on beginning net monetary liability €200,000 x [(1/1.05 – 1/0.95)] = $(20,050) Loss on increase in the liability €300,000 x [1/1.02 – 1/0.95)] = $(21,672) Total remeasurement loss $(41,722) Reduces Current period profit
