Chapter 2 Financial Statements and Measuring Value

1. Chapter 2 Financial Statements and Measuring Value

2. Some Basic Accounting Principles 2-3 • Historical Cost Principle - Assets recorded at their cost • Reliability Principle – FS should be reasonably reliable but cost efficient; materiality • Economic Entity Principle Consolidation • A owns B. A sells widget for $500 and cost is $100. Unconsolidated shows $400 profit for A which is eliminated on consolidation. • Matching Income & Expenses in Accounting Period (Accrual) – This means income is unrelated to having cash.

3. Some Basic Accounting Principles 2-3 • Transparency of Methods – Disclosure and notes • Consistency of Methods – Allows comparison • Going Concern Assumption • Conservatism Principle e.g. lower of cost or market for assets held for sale

4. Accounting Methods Disclosure – Footnote 1 2-4 Revenue Recognition • Scientific_Atlanta's revenue recognition policies are in compliance with Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements" issued by the Securities and Exchange Commission. Revenue is recognized at the time product is shipped or title passes pursuant to the terms of the agreement with the customer which include a standard right of return, the amount due from the customer is fixed and collectibility of the related receivable is reasonably assured. Revenue is recognized only when we have no significant future performance obligation. • Our right of return policy, which is standard for virtually all sales, allows a customer the right to return product for refund only if the product does not conform to product specifications; the non-conforming product is identified by the customer; and the customer rejects the non-conforming product and notifies us within ten days of receipt. • Revenues from progress-billed contracts are primarily recorded using the percentage-of-completion method based on contract costs incurred to date. Losses, if any, are recorded when determinable. Costs incurred and accrued profits not billed on these contracts are included in receivables. Unbilled receivables, which consist of retainage, were $443 at June 29, 2001 and $1,269 at June 30, 2000. It is anticipated that substantially all such amounts will be collected within one year.

5. Quick Check Question 2.1 2- 5 • Your client informs you that he has just bought a $100,000 dog. You ask him how and what he paid for it. He responds that he exchanged his two $50,000 cats for it. How should he book the transaction, if it is part of a business (perhaps dog-breeding)? What accounting principles are applicable?

6. Quick Check Question 2.1 2- 6 • What if he paid $100,000 cash then you would book dog at cost - $100,000

7. Quick Check Question 2.1 2- 7 • What if he paid $100,000 cash then you would book dog at cost (historical cost convention)- $100,000 • BUT if dog held for sale you would book at lower of cost or market value (Conservatism Principle)

8. Quick Check Question 2.1 2- 8 • But he did not pay cash; he swapped two $50,000 cats. Where does this $50,000 value come from? Current value or is it what he paid for the cats? • If he paid $20,000 for each cat then their carrying value is $40,000 and unless another rule allows recognition of built in gain he only can record lower of historical cost of $40,000 or market value of dog

9. Format of Balance Sheets 2- 9 • Balance Sheet • John Lawyer • December 31, 2003 • Assets Liabilities • Current Assets xx Current Liabilities xx • Long-Term Assets xx Long-Term Liabilities xx • Owners’ Equity • Total Assets xxx Total liabilities & Equity xxx

10. Scientific-Atlanta –Current Assets 2-10 • In Thousands Assets 2001 2000 Current assets Cash and cash equivalents $ 563,322 $ 462,496 Short_term investments 191,001 61,481 Receivables, less allowance for doubtful accounts of $5,982,000 in 2001 and $4,134,000 in 2000 502,289 333,242 Inventories 201,762 209,916 Deferred income taxes 57,195 49,681 Other current assets 33,165 33,818 Total current assets 1,548,734 1,150,634

11. Scientific-Atlanta Long-Term Assets 2-11 • In Thousands 2001 2000 Property, plant and equipment, at cost Land and improvements 22,218 20,248 Buildings and improvements 67,946 40,915 Machinery and equipment 246,385 214,295 336,549 275,458 Less - accumulated depreciation and amortization 108,934 96,209 227,615 179,249 Goodwill and other intangible assets, net 81,491 7,475 Non-current marketable securities 17,159 381,983 Deferred income taxes 26,732 __ Other assets 101,097 60,119 Total Assets $2,002,828 $1,779,460

12. Scientific-Atlanta Liabilities2-12 • In Thousands 2001 2000 Liabilities and Stockholders' Equity Current liabilities Current maturities of long-term debt $ 91 $ 386 Accounts payable 223,990 212,111 Accrued liabilities 164,991 149,402 Income taxes currently payable 5,051 18,264 Total current liabilities 394,123 380,163 Long term debt, less current maturities __ 102 Deferred income taxes __ 114,428 Other liabilities 99,76669,807 [Total Liabilities 493,889 564,500]

13. Owens-Illinois Note on Contingent Liabilities– slide 12-10 The following table shows the approximate number of plaintiffs and claimants involved in asbestos claims pending at the beginning of, disposed of and filed during, and pending at the end of, each of the years listed (eliminating duplicate filings): 2001 20001999 • Pending at beginning of year... 20,000 17,000 15,000 • Disposed.............................…..24,000 17,000 10,000 • Filed......................................... 31,00020,00012,000 • Pending at end of year............ 27,000 20,000 17,000 * * * • The Company believes thatits ultimate asbestos-related contingent liability(i.e., its indemnity or other claim disposition costs plus related legal fees)cannot be estimated with certainty.In 1993, the Company established a liability of $975 million to cover indemnity payments and legal fees associated with the resolution of outstanding and expected future asbestos lawsuits and claims. In 1998, an additional liability of $250 million was established. During the third quarter of 2000, the Company established an additional liability of $550 million ….

14. Owens- Illinois Note on Contingent Liabilities – slide 2 2-14 • The Company's ability to reasonably estimate its liability has been significantly affected by the volatility of asbestos-related litigation in the United States, the expanding list of non-traditional defendants that have been sued in this litigation and found liable for substantial damage awards, the continued use of litigation screenings to generate new lawsuits, the large number of claims asserted or filed by parties who claim prior exposure to asbestos materials but have no present physical impairment as a result of such exposure, and the growing number of co-defendants that have filed for bankruptcy. • Since the beginning of 2000, A. P. Green Industries, Inc., Armstrong World Industries, Babcock & Wilcox, Federal-Mogul Corporation, Fibreboard Corporation, G-I Holdings (GAF), Harbison-Walker Refractories Group, Kaiser Aluminum Corporation, North American Refractories Co., Owens Corning, Pittsburgh-Corning, Plibrico Company, Porter Hayden Company, USG Corporation, W. R. Grace & Co. and several other smaller companies have sought protection under Chapter 11 of the Bankruptcy Code.

15. General Motors Note on Defined Benefit Plans – Slide 1 2-15 • GM has a number of defined benefit pension plans covering substantially all employees. Plans covering U.S. and Canadian represented employees generallyprovide benefits of negotiated, stated amounts for each year of serviceas well as significant supplemental benefits for employees who retire with 30 years of service before normal retirement age. The benefits provided by the plans covering . . . employees . . . are generally based on years of service and salary history. * * * Pension plan assets are primarily invested in U.S. Government obligations, equity and fixed income securities, commingled pension trust funds, insurance contracts, GM $1-2/3 common stock (valued at December 31, 2001 at $50 million), and GM Class H common stock (valued at December 31, 2001 at $2.3 billion). GM's funding policy with respect to its qualified pension plans is to contribute annually not less than the minimum required by applicable law and regulations. GM made no pension contributions to the U.S. hourly and salary plans in 2001 and made contributions of $5.0 billion in 2000(consisting entirely of GM Class H common stock contributed during the second quarter of 2000), and $794 million in 1999. In addition, GM made pension contributions to all other U.S. plans of $99 million, $69 million, and $67 million in 2001, 2000, and 1999, respectively.

16. G. M. Note on Defined Benefit Plans – Slide 22-13 • “The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $59.3 billion, $58.8 billion, and $48.2 billion, respectively, as of December 31, 2001, and $4.0 billion, $3.4 billion, and $0, respectively, as of December 31, 2000.”

17. G. M. Note– Questions2-13 • What is a “defined benefit” pension plan? • How large is the deficit in GM’s funding for its pension obligations at the close of 2002?

18. G. M. Note– Questions2-13 • What is a “defined benefit” pension plan? • How large is the deficit in GM’s funding for its pension obligations at the close of 2002? $23 B

19. Analysis of GM’s Pension Benefit Deficit2-19 • (in billions) • 2002 2001 • Projected Benefit Obligation $92 $59 • Accumulated Benefit Obligations 89 59 • Fair value of plan assets 6648 • Funding Deficit based on accumulated benefit obligations $23 $11

20. G. M. Note– Questions2-13 • What is a “defined benefit” pension plan? • How large is the deficit in GM’s funding for its pension obligations at the close of 2002? $23 B • How does this compare to its 2002 net income of $1.736 billion?

21. G. M. Note– Questions2-13 • What is a “defined benefit” pension plan? • How large is the deficit in GM’s funding for its pension obligations at the close of 2002? $23 B • How does this compare to its 2002 net income of $1.736 billion? • It would take over 13 years of profits at this level to cover the deficit. ($23/1.736 billion)

22. G. M. Note– Questions2-13 4. GM’s Balance Sheet reveals a deduction from shareholders’ equity of $22.762 billion, leaving a net equity of $6.814 billion. Note that in calculating this deficit, GM has shown over $17.954 billion in intangible assets, including goodwill of $6.992 billion, . Goodwill is the cost of acquired businesses in excess of the fair value of their identifiable net assets. What does this tell you about the tangible net worth of GM?

23. Excerpts from GM’s 12/31/02 Balance Sheet2-23 • December 31, • GENERAL MOTORS CORPORATION AND SUBSIDIARIES 2002 2001 ASSETS * * * Total cash & marketable securities 38,274 30,624 Finance Receivables (less allowances) 134,647 109,211 Deferred Income Taxes 41,649 28,239 Equipment on operating leases 34,811 36,087 Equity in net assets of nonconsolidated associates 5,044 4,950 Property - net (Note 9) 37,973 36,440 Intangible assets - net (Notes 1 and 10) 17,954 16,967 * * * Total assets $370,782 $322,412 • LIABILITIES AND STOCKHOLDERS' EQUITY * * * • Postretirement benefits other than pensions (Note 14) 38,187 38,393 Pensions (Note 14) 22,762 10,389 * * * Total liabilities 363,134 301,959 • * * * Stockholders' equity (Note 17) * * * • Minimum pension liability adjustment (23,215)(9,581 ) • Accumulated other comprehensive loss (25,832)(12,295 ) • Total stockholders' equity 6,814 19,707 • Total liabilities and stockholders' equity $370,782 $322,412

24. G. M. Note– Questions2-13 5. What are Post-retirement benefits other than pensions? Note that GM’s balance sheet shows a deduction from shareholders’ equity of $38.197 billion. Note that footnote 14 the total benefit obligation is $57.229 billion.

25. G. M. Note– Questions2-13 “Additionally, GM maintains hourly and salary benefit plans that provide postretirement medical, dental, vision and life insurance to most U.S. retirees and eligible dependents.”

26. G. M. Note– Questions2-13 6. In calculating the funding of its pension plans, GM assumes a certain rate of return on a portfolio consisting of “U.S. Government obligations, equity and fixed income securities, commingled pension trust funds, insurance contracts, GM $1-2/3 common stock..., and GM Class H common stock ....” In its 2001 annual report GM stated that returns on this portfolio are “below GM's long-term asset return assumption, in any 10-year period over the last 15 years, GM has achieved pension asset returns of 10% per annum or greater.”

27. G. M. Note Questions2-13 6. Keep in mind that some of the highest returns in history were earned in the period 1985-2000, when the Dow rose from less than 1,500 to over 11,000. Further, long-term returns to broad stock market averages have been between 10 - 11% over the past seventy years or more. Returns on corporate bonds have averaged 5.7% and long-term Treasury Bonds have averaged 5.2%. Would it make sense to use an assumed return of 10% on a portfolio of government and corporate bonds, stocks and GM stock? If so, why did GM reduce its assumed rate of return to 9% in its 2002 report?

28. G. M. Note Questions2-13 Anyone remember what happened to the stock market after 2000????? Do you think GM could see this by the end of 2001?

29. G. M. Note– Questions2-13 7. In an announcement in December, 2003, GM stated that it intended “to reduce the GM pension funds’ exposure to stocks in both U.S. and international markets, and increase investments in global bonds and other alternatives to stocks.” “GM Says It Closed Gap in Pension Fund; 9% Return is Needed,” Wall Street Journal, Dec. 15, 2003, C1. What do you think the shift from stocks to bonds is likely to do to expected returns on the portfolio?

30. Table 3-6. Returns to Asset Classes, 1926-1997 2-30 • Table 3-6 • Returns to Asset Classes Std. Deviation Risk Premium • Nominal Real of over • Asset Class Return Return Annual Returns T- Bills • Short-term Treasury Bills 3.8% 0.7% 3.2% 0% • Intermediate-Term T- Bonds 5.3% 2.2% 5.7% 1.5% • Long-Term Treasury Bonds 5.2% 2.1% 9.2% 1.4% • Corporate Bonds 5.7% 2.6% 8.7% 1.9% • Large-Company Stocks 11% 7.9% 20.3% 7.2% • Small-Company Stocks 12.7% 9.6% 33.9% 8.9%

31. Table 3-6. Analysis 2-31 • Dropping from stocks to bonds reduces returns from 11% to 5.7%. • A 50-50 portfolio would yield 8.85% if stock yields were expected to remain at 11%. • If you assume a 10% return on stocks, the yield on a 50-50 portfolio would be 7.85%. • Their Assumption is “Troubling”

32. Table 3-6. Analysis 2-32 8. Much of GM’s non-pension benefit obligations are for health care for retirees. GM makes certain assumptions about rates of increase in health-care benefit costs through 2009. If GM’s estimates are on the low side by one percent, what would this do to GM’s currently estimated $38.187 obligation?

33. Table 3-6. Analysis 2-33 • This is the “Accumulated Post-Retirement Benefit Obligation” or “APBO.” • GM’s assumptions about health care cost increases on page 58: • 7.2% for 2003, decreasing on a linear basis to 5% to 5% in 2009. • Note that Medicare projects per capita health care costs will increase at annual rates of 7 - 7.5% through 2011. (National Health Care Expenditures Projections: 2004-2014), at http://www.cms.hhs.gov/statistics/nhe/projections-2004/proj2004.pdf

34. Table 3-6. Analysis 2-34 9. From Dec. 31, 2002 until Dec. 15, 2003, the Dow Jones Industrial Average rose from 8,341 to approximately 10,040, or approximately 20%. The GM press release quoted above stated that “Thanks to a $13.5 billion debt offering, improving stock-market conditions, and an expected $4.1 billion the company plans to contribute to the fund after selling its Hughes Electronics Co. subsidiary within the next few weeks, GM expects its pension obligations to be nearly fully funded by the end of this year. The forecast is based on an expected 18% annual return on assets at the end of the calendar year, at a discount rate of 6.25%.” What does this say about the dependence of GM’s pension funds on equity investments?

35. Table 3-6. Analysis 2-35 As we will see later, discount rates are related to the riskiness of activities. Risk correlates with standard deviations, which are shown in Table 3-6 for various asset classes.

36. Table 3-6. Returns to Asset Classes, 1926-1997 2-36 • Table 3-6 • Returns to Asset Classes Std. Deviation Risk Premium • Nominal Real of over • Asset Class Return Return Annual Returns T- Bills • Short-term Treasury Bills 3.8% 0.7% 3.2% 0% • Intermediate-Term T- Bonds 5.3% 2.2% 5.7% 1.5% • Long-Term Treasury Bonds 5.2% 2.1% 9.2% 1.4% • Corporate Bonds 5.7% 2.6% 8.7% 1.9% • Large-Company Stocks 11% 7.9% 20.3% 7.2% • Small-Company Stocks 12.7% 9.6% 33.9% 8.9%

37. Table 3-6. Analysis 2-37 • Assumptions of 18% annual returns are totally unreasonable for any asset class.

38. Scientific-Atlanta Shareholders’ Equity2-38 • In Thousands 2001 2000 • Stockholders' equity • Preferred stock, authorized 50,000,000 shares; no shares issued • Common stock, $0.50 par value, authorized 350,000,000 shares, issued 164,899,158 shares in 2001 and 159,971,077 shares in 2000 82,450 79,986 Additional paid-in capital 545,602 339,649 • Retained earnings 935,038 607,822 Accumulated other comprehensive income (loss), net of taxes of $3,723,000 in 2001 and $135,538,000 in 2000 (6,075) 221,141 • 1,557,015 1,248,598 Less - Treasury stock, at cost (859,339 shares in 2001 and 651,805 shares in 2000) 48,076 33,638 [Stockholders’ Equity] 1,508,939 1,214,960 Total Liabilities and Stockholders' Equity $2,002,828 $1,779,460

39. 2-39

40. 2-40

41. 2-41

42. Scientific-Atlanta Income Statement2-42 • (In Thousands, Except Per Share Data)       2001       2000      1999 Sales                                   $2,512,016   $1,715,410   $1,243,473 Costs and expenses Cost of sales  1,718,1601,212,655888,162 [Gross margin on sales 793,856 502,755 355,311] sales and administrative                 222,027     177,588     162,017 Research and development            154,346     122,403     117,261 Stock compensation                       10,778   __         –___ [Operating Profit 406,705 202,764 76,033] Interest expense                                 411         564        635 Interest income                           (36,879)    (19,636)    (8,526) Other (income) expense, net                 (67,229)        (747)     (62,281) Total costs and expenses                   2,001,614    1,492,827   1,097,268 Earnings before income taxes              510,402    222,583     146,205 Provision for income taxes                 176,728     66,775      43,862 • Net earnings                             $  333,674  $  155,808   $ 102,343 Earnings per common share Basic                                   $     2.06    $    0.99    $     0.67 Diluted                                 $     1.99    $    0.94    $     0.65 Weighted avge. no. common shs. out Basic                                      161,601     157,807     153,630 Diluted                                    167,688     164,895      157,130

43. Scientific-Atlanta Income Statement2-43 • (In Thousands, Except Per Share Data)       2001       2000      1999 Sales                                   $2,512,016   $1,715,410   $1,243,473 Costs and expenses Cost of sales  1,718,1601,212,655888,162 [Gross margin on sales 793,856 502,755 355,311] sales and administrative                 222,027     177,588     162,017 Research and development            154,346     122,403     117,261 Stock compensation                       10,778   __         –___ [Operating Profit 406,705 202,764 76,033] Interest expense                                 411         564        635 Interest income                           (36,879)    (19,636)    (8,526) Other (income) expense, net                 (67,229)        (747)     (62,281) Total costs and expenses                   2,001,614    1,492,827   1,097,268 Earnings before income taxes              510,402    222,583     146,205 Provision for income taxes                 176,728     66,775      43,862 • Net earnings                             $  333,674  $  155,808   $ 102,343 Earnings per common share Basic                                   $     2.06    $    0.99    $     0.67 Diluted                                 $     1.99    $    0.94    $     0.65 Weighted avge. no. common shs. out Basic                                      161,601     157,807     153,630 Diluted                                    167,688     164,895      157,130

44. Securities Litigation and Income Statements 2-44 In re Software Toolworks, Inc. • 50 F.3d 615 (9th Cir. 1994)

45. Securities Litigation and Income Statements 2-45 • July, 1990 registered secondary offering at $18.50. • Stock ultimately fell to $2.375 by Oct. 11, 1990. • Complaint alleges that Toolworks falsely fabricated 1990 income by reporting as revenue sales to original equipment manufacturer (“OEMs”) (Hyosung) with whom Toolworks had no binding agreement. • Complaint also alleges that Toolworks fabricated large consignment sales in order to meet first quarter 1991 financial projections. • And alleges that Toolworks lied to SEC in response to questions before the registration statement became effective.

46. Securities Act of 1933, §112-46 • (a) In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact . . ., any person acquiring such security . . . may, either at law or in equity, in any court of competent jurisdiction, sue – (1) every person who signed the registration statement; * * * • (5) every underwriter with respect to such security. * * * • (b) Notwithstanding the provisions of subsection (a) no person, other than the issuer, shall be liable as provided therein who shall sustain the burden of proof -- * * * • (3) that (A) as regards any part of the registration statement not purporting to be made on the authority of an expert, . . . he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true . . . (C) as regards any part of the registration statement purporting to be made on the authority of an expert . . . , he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . .

47. In Re Software Toolworks2-47 • Underwriters reasonably relied on the financial statements and did not ignore red flags 2. Underwriters were not entitled to summary judgment on questions arising from press criticism of Toolworks’ accounting, an SEC investigation, and a surprise booking of sales at the last minute before going effective?

48. In Re Software ToolworksQuestions 2-48 1. What legal doctrine would prevent the Hyosung contract from being a binding agreement in March, 1990?

49. In Re Software ToolworksQuestions 2-49 2. If underwriters’ counsel rather than the underwriters had conducted the due diligence, would the court have attached more weight to the argument that they were charged with knowledge of the non-binding nature of the Hyosung contract?

50. In Re Software ToolworksQuestions 2-50 3. Would the officers & directors of Toolworks (who are also liable under §11(a) of the Securities Act) be able to rely on the same defense as the underwriters with respect to the Hyosung contract? Suppose that Toolworks’ lawyer is also a director?