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"true" amount that a company needs to allocate annually in order to maintain and
replace its fixed asset base. In theory, economic depreciation corrects for errors in
both directions. Consider the depreciation of real estate, which is usually an over-
charge, reducing the real estate's book value--calculated by the original investment
minus accumulated depreciation--to something far below its fair market value. On
the other hand, consider a key piece of equipment that is subject to rapid inflation.
Its eventual replacement will cost more than the original, in which case depreciation
actually under-charges the expense. If depreciation expense is large relative to other
expenses, it often helps to ask whether the charge approximates the replacement
value of the assets. Determining this can be difficult, but sometimes the footnotes in
a company's financial documents give explicit clues about future expenditures.

It is also helpful to look at the underlying trend in the fixed asset base. This will tell
you whether the company is increasing or decreasing its investment in its fixed asset
base. An interesting side effect of decreasing investments in the fixed asset is that it
can temporarily boost reported profits. Consider the non-current portion of
Motorola's balance sheet:




You can see that the book value of Motorola's plant, property, and equipment (PP&E)
fell roughly a billion dollars to $5.164 billion in 2003. We can understand this better
by examining two footnotes, which are collected below:




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The book value is the gross investment (that is, the original or historical purchase
price) minus the accumulated depreciation expense. Book value is also called net
value, meaning 'net of depreciation'. In Motorola's case, the gross asset value is
dropping (which indicates asset dispositions) and so is the book value. Motorola has
disposed of assets without a commensurate investment in new assets. Put another
way, Motorola's asset base is aging.

Notice the effect on depreciation expense: it drops significantly, from $2 billion to
$1.5 billion in 2003. In Motorola's case, depreciation is buried in cost of goods sold
(COGS), but the temporary impact is a direct boost in pre-tax profits of half a billion
dollars. To summarize, an aging asset base--the result of the company disposing of
some old assets but not buying new ones--can temporarily boost profits. When
assets are aged to inflate reported profits, it is sometimes called "harvesting the
assets."

We can directly estimate the age of the fixed asset base with two measures: average
age in percentage terms and average age in years. Average age in percentage
equals accumulated depreciation divided by the gross investment. It represents the
proportion of the assets that have been depreciated: the closer to 100%, the older
the asset base. Average age in years equals accumulated depreciation divided by the
annual depreciation expense. It is a rough estimate of the age of the in-place asset
base. Below, we calculated each for Motorola. As you can see, these measures show
that the asset base is aging.




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Investments
There are various methods to account for corporate investments, and often
management has some discretion in selecting a method. When one company (a
parent company) controls more than 50% of the shares of another company (a
subsidiary), the subsidiary's accounts are consolidated into the parent's. When the
control is less than 50%, there are three basic methods for carrying the value of an
investment: these are the cost, market, and equity methods. We show each method
below. But first, keep in mind there are three sorts of investment returns:

1. The investment can appreciate (or depreciate) in market value: we call these
holding gains or losses.

2. The investment can generate earnings that are not currently distributed to
the parent (they are instead retained): we call this investment income.

3. The investment can distribute some of its income as cash dividends to the
parent.

The table below explains the three methods of accounting for corporate investments
that are less than 50% owned by the parent:




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When an investment pays cash dividends, the rules are straightforward: they will be
recognized on the parent company's income statement. But the rules are not
straightforward for (i) undistributed earnings and (ii) gains/losses in the investment's
holding value. In both cases, the parent may or may not recognize the
earnings/gains/losses.

We have at least three goals when examining the investment accounts. First, we
want to see if the accounting treatment has hidden some underlying economic gain
or loss. For example, if a company uses the cost method on a superior investment
that doesn't pay dividends, the investment gains will eventually pay off in a future
period. Our second goal is to ask whether investment gains/losses are recurring.
Because they are usually not operating assets of the business, we may want to
consider them separately from a valuation of the business. The third goal is to gain
valuable clues about the company's business strategy by looking at its investments.
More often than not, such investments are not solely motivated by financial returns.
They are often strategic investments made in current/future business partners.
Interesting examples include investments essentially made to outsource research
and development or to tap into different markets.

Let's consider a specific example with the recent long-lived accounts for Texas
Instruments:


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What immediately stands out is that equity investments dropped from $800 million
to $265 million in 2003. This should encourage us to examine the footnotes to
understand why.

The footnotes in the same annual report include the following:

During the third and fourth quarters of 2003, TI sold its remaining 57 million shares
of Micron common stock, which were received in connection with TI's sale of its
memory business unit to Micron in 1998. TI recognized pretax gains of $203 million
from these sales, which were recorded in other income (expense) net¦.The
combined effect of the after-tax gains and the tax benefit was an increase of $355
million to TI's 2003 net income.

We learn two things from this footnote: 1) TI sold its significant stake in Micron, and
2) that sale created a one-time (nonrecurring) boost in current profits of $355
million.

Goodwill
Goodwill is created when one company (the "buyer") purchases another company
(the "target"). At the time of purchase, all of the assets and liabilities of the target
company are re-appraised to their estimated fair value. This includes even intangible
assets that were not formerly carried on the target's balance sheet, such as
trademarks, licenses, in-process research & development, and maybe even key
relationships. Basically, accountants try to estimate the value of the entire target
company, including both tangible and intangible assets. If the buyer happens to pay
more than this amount, every extra dollar falls into goodwill. Goodwill is a catch-all
account, because there is nowhere else to put it. From the accountant's perspective,
it is the amount the buyer "overpays" for the target.




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To illustrate, we show a target company below that carries $100 of assets when it is
purchased. The assets are marked-to-market (that is, appraised to their fair market
value) and they include $40 in intangibles. Further, the target has $20 in liabilities,
so the equity is worth $80 ($100 “ $20). But the buyer pays $110, which results in a
purchase premium of $30. Since we do not know where to assign this excess, a
goodwill account of $30 is created. The bottom exhibit shows the target company's
accounts, but they will be consolidated into the buyer's accounts so that the buyer
carries the goodwill.




At one time, goodwill was amortized like depreciation. But as of 2002, goodwill
amortization is no longer permitted. Now, companies must perform an annual test of
their goodwill. If the test reveals that the acquisition's value has decreased, then the
company must impair, or write-down, the value of the goodwill. This will create an
expense (which is often buried in a one-time restructuring cost) and an equivalent
decrease in the goodwill account.

The idea behind this change was the assumption that goodwill--being an unidentified
(unassigned) intangible--does not necessarily depreciate automatically like plants or
machinery. This is arguably an improvement in accounting methods, because we can
watch for goodwill impairments, which are sometimes significant red flags. Because
the value of the acquisition is typically based on a discounted cash flow analysis, the
company is basically telling you "we took another look at the projections for the
acquired business, and they are not as good as we thought last year."




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Consider Novell's latest balance sheet:




We see that intangible assets decreased from $36.351 million to $10.8 million.
Because purchases and dispositions impact the accounts, it is not enough to check
increases or decreases. For example, Novell's goodwill increased, but that could be
due to a purchase. Similarly, it is possible that the decrease in intangible assets
could be the result of a disposition, but this is unlikely as it is difficult to sell an
intangible by itself.

A careful look at the footnote explains that most of this intangible asset decline was
due to impairment. That is, a previously acquired technology has not generated the
revenues that were originally expected:

During the third quarter of fiscal 2003, we determined that impairment indicators
existed related to the developed technology and trade names we acquired from
SilverStream as a result of unexpected revenue declines and the evident failure to
achieve revenue growth targets for the exteNd products. Based on an independent
valuation of these assets, we recorded a $23.6 million charge to cost of revenue to
write down these assets to estimated fair value, which was determined by the net
present value of future estimated revenue streams attributed to these assets.

Summary
You have to be careful when you examine the long-lived assets. It is hard to make
isolated judgments about the quality of investments solely by looking at measures
such as R&D as a percentage or capital expenditures as a percentage of sales. Even
useful ratios such as ROE and ROA are highly dependent on the particular accounting
methods employed. For example, both of these ratios count assets at book value, so
they depend on the depreciation method.

You can, however, look for trends and clues such as the following:

• The method of depreciation and the pattern of investment - Is the company
maintaining investment(s)? If investments are declining and assets are aging,
are profits distorted?




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• The specific nature and performance of investments - Have investment sales
created one-time gains?

• Goodwill impairments - Has goodwill been impaired, and what is the business
implication going forward?



Long-Term Liabilities

Long-term liabilities are company obligations that extend beyond the current year, or
alternately, beyond the current operating cycle. Most commonly, these include long-
term debt such as company-issued bonds. Here we look at how debt compares to
equity as a part of a company's capital structure, and how to examine the way in
which a company uses debt.

The following long-term liabilities are typically found on the balance sheet:




You can see that we describe long-term liabilities as either operating or financing.
Operating liabilities are obligations created in the course of ordinary business
operations, but they are not created by the company raising cash from investors.
Financing liabilities are debt instruments that are the result of the company raising
cash. In other words, the company--often in a prior period--issued debt in exchange
for cash and must repay the principal plus interest.

Operating and financing liabilities are similar in that they both will require future
cash outlays by the company. It is useful to keep them separate in your mind,
however, because financing liabilities are triggered by a company's deliberate



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funding decisions, and therefore will often offer clues about a company's future
prospects.

Debt is Cheaper than Equity--to a Point
Capital structure refers to the relative proportions of a company's different funding
sources, which include debt, equity, and hybrid instruments such as convertible
bonds (discussed below). A simple measure of capital structure is the ratio of long-
term debt to total capital.

Because the cost of equity is not explicitly displayed on the income statement--
whereas the cost of debt (interest expense) is itemized--it is easy to forget that debt
is a cheaper source of funding for the company than equity. Debt is cheaper for two
reasons. First, because debtors have a prior claim if the company goes bankrupt,
debt is safer than equity and therefore warrants investors a lower return; for the
company, this translates into an interest rate that is lower than the expected total
shareholder return (TSR) on equity. Second, interest paid is tax deductible to the
company; and a lower tax bill effectively creates cash.

To illustrate this idea, let's consider a company that generates $200 of earnings
before interest and taxes (EBIT). If the company carries no debt, owes tax at a rate
of 50%, and has issued 100 common shares, the company will produce earnings per
share (EPS) of $1.00 (see left-hand column below).




Say on the right-hand side we perform a simple debt-for-equity swap. In other
words, say we introduce modest leverage into the capital structure, increasing the
debt-to-total capital ratio from 0 to 0.2. In order to do this, we must have the


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company issue (borrow) $200 of debt and use the cash to repurchase 20 shares
($200/$10 per share = 20 shares). What changes for shareholders? The number of
shares drops to 80 and now the company must pay interest annually ($20 per year if
10% is charged on the borrowed $200). Here is the point of the illustration: after-tax
earnings decrease, but so does the number of shares. Our debt-for-equity swap
actually causes EPS to increase!

What Is the Optimal Capital Structure?
The example above shows why some debt is often better than no debt--in technical
terms, it lowers the weighted average cost of capital. Of course, at some point,
additional debt becomes too risky. The optimal capital structure--that is, the ideal
ratio of long-term debt to total capital--is hard to estimate. It depends on at least
two factors, but keep in mind that the following are general principles:

• First, optimal capital structure varies by industry, mainly because some
industries are more asset-intensive than others. In very general terms, the
greater the investment in fixed assets (plant, property, & equipment), the
greater the average use of debt. This is because banks prefer to make loans
against fixed assets rather than intangibles. Industries that require a great
deal of plant investment, such as telecommunications, generally utilize more
long-term debt.

• Second, capital structure tends to track with the company's growth cycle.
Rapidly growing startups and early stage companies, for instance, often favor
equity over debt because their shareholders will forgo dividend payments--as
these companies are growth stocks--in favor of future price returns. High-
growth companies do not need to give these shareholders "cash today",
whereas lenders would expect semi-annual or quarterly interest payments.




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Examining Long-Term Liability
Below, we look at some important areas investors should focus on when analyzing a
company's long-term liability accounts.

Ask Why the Company Issued New Debt
When a company issues new long-term debt, it's important for investors to
understand the reason. Companies should give explanations of new debt's specific
purpose rather than vague boilerplate such as "it will be used to fund general
business needs." The most common purposes of new debt include the following:

1. To fund growth: The cash raised by the debt issuance is used for specific
investment(s)--this is normally a good sign.

2. To refinance "old" debt: Old debt is retired and new debt is issued,
presumably at a lower interest rate--this is also a good sign, but it often
changes the company's interest rate exposure.

3. To change the capital structure: Cash raised by the debt issuance is used to
repurchase stock, issue a dividend, or buyout a big equity investor--
depending on the specifics, this may be a positive indicator.

4. To fund operating needs: Debt is issued to pay operating expenses because
operating cash flow is negative. Depending on certain factors, this motive
may be a red flag. Below, we look at how you can determine whether a
company is issuing new debt to fund operating needs.

Be Careful of Debt that Funds Operating Needs
Unless the company is in the early growth stage, new debt that funds investment is
preferable to debt that funds operating needs. To understand this thoroughly, recall
from the cash flow installment that changes in operating accounts (that is, current
assets and current liabilities) either provide or consume cash. Increases in current
assets--except for cash--are "uses of cash" and increases in current liabilities are
"sources of cash." Consider an abridged version of RealNetworks' balance sheet for
the year ending December 31, 2003:




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From December 2002 to December 2003, accounts receivable (a current asset)
increased dramatically and accounts payable (a current liability) decreased. Both
occurrences are uses of cash. In other words, RealNetworks consumed working
capital in 2003. At the same time, the company issued a $100 million convertible
bond. The company's consumption of operating cash and its issue of new debt to
fund that need is not a good sign. Using debt to fund operating cash may be okay in
the short run but, since this is an action undertaken as a result of negative operating
cash flow, it cannot be sustained forever.

Examine Convertible Debt
You should take a look at the conversion features attached to convertible bonds
(a.k.a. "convertibles"), which the company will detail in a footnote to its financial
statements. Companies issue convertibles in order to pay a lower interest rate;
investors purchase convertibles because they receive an option to participate in
upside stock gains.

Usually, convertibles are perfectly sensible instruments, but the conversion feature
(or attached warrants) introduces potential dilution for shareholders. If convertibles
are a large part of the debt, be sure to estimate the number of common shares that
could be issued on conversion. Be alert for convertibles that have the potential to
trigger the issuance of a massive number of common shares (as a percentage of the
common outstanding), and thereby could excessively dilute existing shareholders.

An extreme example of this is the so-called "death spiral PIPE," a dangerous flavor of
the 'private investment, public equity' (PIPE) instrument. Companies in distress issue
PIPES, which are usually convertible bonds with a generous number of warrants
attached (for more info, see "What Are Warrants?"). If company performance


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deteriorates, the warrants are exercised and the PIPE holders end up with so many
new shares that they effectively own the company. And existing shareholders get hit
with a double-whammy of bad performance and dilution. A PIPE has preferred claims
over common shareholders, and it's advisable not to invest in the common stock of a
company with PIPE holders unless you have carefully examined the company and the
PIPE.

Look at the Covenants
Covenants are provisions banks attach to long-term debt that trigger technical
default when violated by the borrowing company. Such a default will lower the credit
rating, increase the interest (cost of borrowing), and often send the stock lower.
Bond covenants include but are not limited to the following:

• Limits on further issuance of new debt.

• Limits, restrictions, or conditions on new capital investments or acquisitions.

• Limits on payment of dividends. For example, it is common for a bond
covenant to require that no dividends are paid.

• Maintenance of certain ratios. For example, the most common bond covenant
is probably a requirement that the company maintain a minimum 'fixed
charge coverage ratio'. This ratio is some measure of operating (or free) cash
flow divided by the recurring interest charges

Assess Interest Rate Exposure
Two things complicate the attempt to estimate a company's interest rate exposure.
One, companies are increasingly using hedge instruments, which are difficult to
analyze.

Second, many companies are operationally sensitive to interest rates. In other
words, their operating profits may be indirectly sensitive to interest rate changes.
Obvious sectors here include housing and banks. But consider an oil/energy company
that carries a lot of variable-rate debt. Financially, this kind of company is exposed
to higher interest rates. But at the same time, the company may tend to outperform
in higher-rate environments by benefiting from the inflation and economic strength
that tends to accompany higher rates. In this case, the variable-rate exposure is
effectively hedged by the operational exposure. Unless interest rate exposure is
deliberately sought, such natural hedges are beneficial because they reduce risk.

Despite these complications, it helps to know how to get a rough idea of a company's
interest rate exposure. Consider a footnote from the 2003 annual report of Mandalay
Resort Group, a casino operator in Las Vegas, Nevada:




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Fixed-rate debt is typically presented separately from variable-rate debt. In the prior
year (2002), less than 20% of the company's long-term debt was held in variable-
rate bonds. In the current year, Mandalay carried almost $1.5 billion of variable-rate
debt ($995 million of variable-rate long-term debt and $500 million of a "pay
floating" interest rate swap) out of $3.5 billion in total (leaving $2 billion in fixed-rate
debt).

Don't be confused by the interest rate swap: it simply means that the company has a
fixed-rate bond and "swaps" it for a variable-rate bond with a third party by means
of an agreement. The term 'pay floating' means the company ends up paying a
variable rate; a 'pay fixed interest rate' swap is one in which the company trades a
variable-rate bond for a fixed-rate bond.

Therefore, in 2003, the proportion of Mandalay's debt that was exposed to interest
rate hikes increased from 18% to more than 40%.

Operating Versus Capital Lease
It is important to be aware of operating lease agreements because economically they
are long-term liabilities. Whereas capital leases create liabilities on the balance
sheet, operating leases are a type of "off-balance sheet financing." Many companies
tweak their lease terms precisely to make these terms meet the definition of an
operating lease so that leases can be kept off the balance sheet (improving certain
ratios like long term debt-to-total capital).

Most analysts consider operating leases as debt, and therefore manually add
operating leases back onto the balance sheet. Pier 1 Imports is an operator of retail
furniture stores. Here is the long-term liability section of its balance sheet:




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Long-term debt is a very tiny 2% of total assets ($19 million out of $1 billion).
However, as described by a footnote, most of the company's stores utilize operating
leases rather than capital leases:




The present value of the combined lease commitments is almost $1 billion. If these
operating leases are recognized as obligations and therefore manually put back onto
the balance sheet, both an asset and a liability of $1 billion would be created, and
the effective long term debt-to-total capital ratio would go from 2% to about 50%
($1 billion in "capitalized" leases divided by $2 billion).

Summary
It has become more difficult to analyze long-term liabilities because innovative
financing instruments are blurring the line between debt and equity. Some
companies employ such complicated capital structures that investors must simply
add "lack of transparency" to the list of its risk factors. Here is a summary of what to
keep in mind:

• Debt is not bad. Some companies with no debt are actually running a sub-
optimal capital structure.



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• If a company raises a significant issue of new debt, the company should
specifically explain the purpose. Be skeptical of boilerplate explanations--if
the bond issuance is going to cover operating cash shortfalls, you have a red
flag.

• If debt is a large portion of the capital structure, take the time to look at
conversion features and bond covenants.

• Try to get a rough gauge of the company's exposure to interest rate changes.

• Consider treating operating leases as balance sheet liabilities.



Pension Plans

Following from the preceding section focusing on long-term liabilities, this section
focuses on a special long-term liability, the pension fund. For many companies, this
is a very large liability and, for the most part, it is not captured on the balance sheet.
We could say that pensions are a type of off-balance-sheet financing. Pension fund
accounting is complicated and the footnotes are often torturous in length, but the
good news is that you need to understand only a few basics in order to know the
most important questions to ask about a company with a large pension fund.

There are various sorts of pension plans, but here we review only a certain type: the
defined benefit pension plan. With a defined benefit plan, an employee knows the
terms of the benefit that he or she will receive upon retirement. The company is
responsible for investing in a fund in order to meet its obligations to the employee,
and so, the company bears the investment risk. On the other hand, in a defined
contribution plan (e.g. 401k), the company probably makes contributions--or
matching contributions--but does not promise the future benefit to the employee. As
such, the employee bears the investment risk.

Among defined benefit plans, the most popular type bears a promise to pay retirees
based on two factors: 1. the length of their service and 2. their salary history at the
time of retirement. This is called a "career average" or "final pay" pension plan. Such
a plan might pay retirees, say, 1.5% of their "final pay," their average pay during
the last five years of employment, for each year of service (up to a maximum
number of years). Under this plan, an employee with 20 years of service would
receive a retirement benefit equal to 30% (20 years x 1.5%) of their final average
pay. But formulas and provisions vary widely; for example, some will reduce or
"offset" the benefit by the amount of social security the retiree receives.

Funded Status = Plan Assets - Projected Benefit Obligation (PBO)
A pension plan has two primary elements:

• The future liabilities--or benefit obligations--created by employee service.

• The pension fund--or plan assets--that are used to pay for retiree benefits.




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At this primary level, a pension plan is simple: the company (called the "plan
sponsor" in this context) contributes to its pension fund; the pension fund is invested
into bonds, equities, and other asset classes in order to meet its long-term
obligations; and retirees are then eventually paid their benefits from the fund.

Three things make pension fund accounting complicated. First, the benefit obligation
is a series of payments that must be made to retirees far into the future. Actuaries
do their best to make estimates about the retiree population, salary increases, and
other factors in order to discount the future stream of estimated payments into a
single present value. This first complication is unavoidable.

Second, the application of accrual accounting means that actual cash flows are not
counted each year. Rather, the computation of the annual pension expense is based
on rules that attempt to capture changing assumptions about the future.

Third, the rules require companies to "smooth" the year-to-year fluctuations in
investment returns and actuarial assumptions so that pension fund accounts are not
dramatically over- (or under-) stated when their investments produce a single year
of above- (or below-) average performance. Although well-intentioned, smoothing
makes it even harder for us to see the true economic position of a pension fund at
any given point in time.

Let's take a closer look at the two basic elements of a pension fund:




On the left, we show the fair value of the plan assets. This is the investment fund.
During the year, wise investments will hopefully increase the size of the fund. This is
the "return on plan assets." Also, employer contributions, cash the company simply
gives from its own bank account, will increase the fund. Finally, benefits paid (or
disbursements) to current retirees will reduce the plan assets.



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On the right, we show the basic calculation of the projected benefit obligation (PBO),
which is an estimate of the future stream of benefit obligations discounted to the
present value into a single number. For clarity's sake, we omitted a few items.

In the annual report, you will see two other measures of estimated future
obligations: the vested benefit obligation (VBO) and the accumulated benefit
obligation (ABO). You do not need either of these for the purposes we discuss here,
but ABO is less than PBO because it assumes that salaries will not rise into the
future, while PBO assumes salary increases. VBO is less than ABO because it counts
only service already performed, but PBO counts the future service (minus turnover
assumptions). PBO is the number that matters because it's the best guess as to the
present value of the discounted liabilities assuming the employees keep working and
salaries keep rising.

By subtracting the PBO from the fair value of the plan assets, you get the funded
status of the plan. This is an important number that will be buried somewhere in the
footnotes, but it must be disclosed.

Breaking Down the Funded Status of the Plan
Let's look at an actual example. We will use data from the annual report 10-K for
PepsiCo (ticker: PEP) for the year ended December 31, 2003. Although its pension
plan happened to be under-funded at that time, it can be considered relatively
healthy--especially compared to other companies. We picked PepsiCo because the
company's plan is well-disclosed and its 10-K contains helpful commentary.

Below is the part of the footnote that calculates the fair value of the plan assets. You
can see that the pension fund produced an actual return of 7.9% in the year 2003
($281 / $3,537). Other than the investment returns, the largest changes are due to
employer contributions and benefit payouts:




Now take a look at the calculation of the PBO (see below). Whereas the fair value of


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plan assets (how much the fund was worth) is a somewhat objective measure, the
PBO requires several assumptions which make it more subjective:




You can see that PepsiCo started 2003 with an estimated liability of $4,324, but the
liability is increased by service and interest cost. Service cost is the additional
liability created because another year has elapsed, for which all current employees
get another year's credit for their service. Interest cost is the additional liability
created because these employees are one year nearer to their benefit payouts.

The reason for and effect of the additional interest cost is easier to understand with
an example. Let's assume that today is 2005 and the company owes $100 in five
years, in the year 2010. If the discount rate is 10%, then the present value of this
obligation is $62 ($100 · 1.1^5 = $62). (For a review of this calculation, see
"Understanding the Time Value of Money.") Now let one year elapse. Because at the
start of 2006 the funds now have four years instead of five years to earn interest
before 2010, the present value of the obligation as of 2006 increases to $68.3 ($100



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· 1.1^4 = $68.3). You can see how interest cost depends on the discount rate
assumption.

Now, let's continue with PepsiCo's footnote above. Plan amendments refer to
changes to the pension plan, and they could have a positive or negative impact on
cost. "Experience loss" is more commonly labeled "actuarial loss/gain," and it too can
be positive or negative. It refers to additional costs created because of the actuarial
estimates changes made during the year. For example, we don't know exactly the
cause in PepsiCo's case, but perhaps it increased its estimate of the average rate of
future salary increases or the average age of retirement. Either of these changes
would increase the PBO and the additional cost would show up as an "actuarial loss."

We see that PepsiCo's liability at the end of the year 2003 was $5,214. That is the
PBO. We also see a lesser amount "for service to date." That is the VBO and we can
ignore it.

The fair value of the plan assets ($4,245) subtracted by the PBO ($5,214) results in
the funded status at the end of 2003 of -$969 million. The bottom line: PespiCo's
pension plan at that time was under-funded by almost one billion dollars.

Pension Plans and the Balance Sheet
Now remember we said that pension plans are off-balance-sheet financing, and in
PepsiCo's case, the $4.245 billion in assets and $5.214 billion in liabilities are not
recognized on the balance sheet. Therefore, typical debt ratios like long-term debt to
equity probably do not count the pension liability of $5+ billion. But it's even worse
than that. You might think the net "deficit" of -$969 million would be carried as a
liability, but it is not. Again, from the footnotes:




Due to the smoothing rules of pension plan accounting, PepsiCo carried $1,288 in
pension plan assets on the balance sheet, at the end of 2003. You can see how the


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two "unrecognized" lines on the footnote above boost the negative into a positive:
the losses for the current year--and prior years, for that matter--are not recognized
in full; they are amortized or deferred into the future. Although the current position
is negative almost one billion, smoothing captures only part of the loss in the current
year--it's not hard to see why smoothing is controversial.

Cash Contributed to the Pension Is Not Pension Cost
Now we have enough understanding to take a look at why cash contributed to the
pension plan bears little--if any--resemblance to the pension expense (also known as
"pension cost") that is reported on the income statement and reduces reported
earnings. We can find actual cash contributed in the statement of cash flows:




Now compare these cash contributions to the pension expense. In each of the three
years reported, cash spent was significantly higher than pension expense:




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The first two components of pension expense--service and interest cost--are identical
to those found in the calculation of PBO. The next component is "expected return on
plan assets." Recall that the "fair value of plan assets" includes actual return on plan
assets. Expected return on plan assets is similar, except the company gets to
substitute an estimate of the future return on plan assets. It is important to keep in
mind that this estimate is an assumption the company can tweak to change the
pension expense. Finally, the two "amortization" items are again due to the effects of
smoothing. Some people have gone so far as to say the pension expense is a bogus
number due to the assumptions and smoothing.

Critical Questions
We have just scratched the surface of pension plan accounting, but we have
reviewed enough to identify the four or five critical questions you need to ask when
evaluating a company's pension fund.

We have two primary concerns in regard to analysis of the pension fund:

• What is the economic status of the liability? A dramatically under-funded plan
will require increased cash contributions in the future and foreshadows future
increases in income statement expenses.

• How aggressive/conservative is the pension expense? An aggressive
accounting policy is a "red flag" because it will usually have to be unraveled
by the company in future periods. Conservative policies contribute to earnings
that are higher in quality.




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Take a look at key assumptions disclosed by PepsiCo:




In regard to our first concern--the economic status of the liability--we want to look at
the funded status that equals the fair value of plan assets minus the PBO. The two
key assumptions that impact the PBO are the discount rate and projected rate of
salary increases. A company can decrease its PBO (and therefore, increase its funded
status) by either increasing the discount rate or lowering the projected rate of salary
increases. You can see that PepsiCo's rate of salary increase is fairly stable at 4.4%
but the discount rate dropped to 6.1%. This steady drop in the discount rate
contributes significantly to the increased PBO and the resultant under-funded status.




In regard to our second concern--the quality of the pension expense--there are three
key assumptions:




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The discount rate is a little bit mixed because it has opposite effects on the service
and interest cost, but in most cases, it behaves as before: a lower discount rate
implies a decrease in pension expense. Regarding expected return on plan assets,
notice that PepsiCo's assumption here has steadily decreased over the two years to
finish at 8.2%. Soft equity markets are a double-whammy for pension funds: they
not only lower the discount rate (which increases the PBO) but they lower the
expected return on the plan assets!

So we can now summarize the effect of accounting practices:

• Aggressive (dubious) accounting includes one or more of the following: a high
discount rate, an expected return on plan assets that is overly optimistic by
being quite higher than the discount rate, and a low rate of salary increase.

• Conservative (good) accounting includes all of the following: low discount
rate, an expected return on plan assets that is near the discount rate, and a
high rate of salary increase

Finally, companies are now required to disclose how the pension plan is invested. For
example, PepsiCo's footnote explains the target asset allocation of its pension (60%
stock and 40% bonds) and then breaks down its actual allocation. Furthermore, you
can check to see how much of the pension fund is invested in the company stock.

You should definitely look at these allocations if you have a view about the equity or
bond markets. There has been much academic discussion about companies'
allocation mismatching: the argument goes that they are funding liabilities with too




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much equity when liabilities should be funded with bonds (of course, companies fund
with equities to boost their actual and expected returns).

Conclusion
For evaluating stocks that have a pension plan, you can do the following:

1. Locate the funded status (fair value of plan assets minus projected benefit
obligation).

2. Check the trend and level of the following key assumptions:

• Discount rate: make sure it is conservative (low) enough. If it's going up,
ask why.
• Expected return on plan assets: is it conservative (low) enough? If it's
significantly higher than the discount rate, be skeptical of the pension
expense.
• Rate of salary increase: is it high enough?

3. Check the target and actual allocation of the pension plan. Is the company
making sufficient use of bonds to fund the pension liability (conversely, are
they overly exposed to equities)?



Conclusion and Resources

Let's summarize the ideas discussed throughout this tutorial according to a few
major themes:

Let the Business Model Shape Your Focus Areas
The average 10-K annual report is stuffed with dozens of dense footnotes and
adjusted numbers offered as alternatives to the "recognized" numbers contained in
the body of the income statement and balance sheet. For example, companies often
disclose six or eight versions of earnings per share, such as the "as reported,"
"adjusted," and "pro forma" versions for both basic and diluted EPS. But the average
individual investor probably does not have the time to fully assimilate these
documents.

Therefore, it may be wise to first look at industry dynamics and the corresponding
company business model and let these guide your investigation. While all investors
care about generic figures, such as revenue and EPS, each industry tends to
emphasize certain metrics. And these metrics often "lead" or foreshadow the generic
performance results.

The table below illustrates this idea by showing some of the focus areas of a few
specific industries. For each industry, please keep in mind that the list of focus areas
is only a "starter set"--it is hardly exhaustive. Also, in a few cases, the table gives
key factors not found in the financial statements in order to highlight their
shortcomings:



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Selected Industries: Nature of Business Model: Selected Focus Areas:
• •
Business Services (for People are key Revenue
example, temporary help, assets. recognition.
• •
advertising, and consulting.) Much of the Recurring sources
company value is of revenue (for
likely to be example, long-term
intangible (not on contracts).

the balance sheet). Gross margin (1 “
cost of goods as %
of revenue) since it
tells you about
"pricing power" with
customers.


• •
Computer Hardware Rapid price Revenue
deflation (decrease breakdown into no.
in price-to- of units x avg. price
performance). per unit (how many
• units are selling?).
Rapid inventory

turnover. Cash conversion
• cycle (days
Rapid innovation
inventory + days
and product
receivable “ days
obsolescence.
payable).
• Quality of research
and development
(R&D) spending
and joint ventures.


• •
Consumer Goods Brand value is Cash conversion
critical. cycle and inventory
• turnover.
Companies require
• Gross margin.
efficient inventory

because it is often Operating margin
perishable. (for example, EBIT
• Industry sees or EBITDA margin).

relatively low Key factors not in
margins. statements: new
product
development and
investment in the
brand.


• •
Industrial Goods (materials, Cyclical. Long-term assets

heavy equipment) and depreciation
If commodities, then
methods.
market sets price.

• Asset turnover
Heavy investment in
(sales/assets) and
long-term assets.
• asset utilization (for
High fixed costs.
example, return on



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capital).
• Key factors not in
financial
statements: market
pricing trends and
point in business
cycle.


• •
Media Economies of scale Revenue
are typically recognition,
important. especially for
• subscriptions and
Requires significant
advertising.
investment.

• Free cash flow,
Convergence is
especially for cable
"blurring the line"
and publishing.
between industries.
• Pension plans as
many companies
are "old economy."
• Key factors not in
financial
statements:
regulatory
environment and
joint/ventures
alliances.


• •
Retail (for example, apparel Intense competition Revenue
or footwear) against fickle breakdown in
fashion trends. product lines and
• trends--one product
Inventory
can "make or
management, which
break."
is critical.

• Cash conversion
Low margins.
cycle.
• Gross margin.
• Operating margin--
low employee
turnover will keep
this down.


• •
Software High "up front" Revenue
investment but high recognition, which is
margins and high absolutely essential
cash flow. in software industry.
• •
Complicated selling Gross margin
schemes (channels, trends.

product bundling, Stock option
license cost/dilution
arrangements). because, of all
industries, software


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grants the most
options.


• •
Telecommunications High fixed Long-term assets
investment (capital and depreciation.

intensive). Long-term debt (for
• Changing regulatory instance, many
environment. companies are
highly leveraged).



Cash Flows Help to Determine the Quality of Earnings
While some academic theories say that cash flows set stock prices, and some
investors appear to be shifting their attention toward cash flows, can anyone deny
that earnings (and EPS) move stocks? Some have cleverly resolved the cash flow-
versus-earnings debate with the following argument: in the short run, earnings move
stocks because they modify expectations about the long-term cash flows.
Nevertheless, as long as other investors buy and sell stocks based on earnings, you
should care about earnings. To put it another way, even if they are not a
fundamental factor that determines the intrinsic value of a stock, earnings matter as
a behavioral or phenomenal factor in impacting supply and demand.

Thoughout this tutorial, we explore several examples of how current cash flows can
say something about future earnings. These examples include the following:

Cash Flows That May Impact Future Earnings Why the Cash Flows May Be
Predictive
Changes in operating accounts, which are found
in the statement of cash flows, sometimes hint at
future operational deterioration:
• •
Increase in inventory as percentage of Unless company is stocking
COGS/sales (or decrease in inventory up ahead of anticipated
turnover). demand, the increase in
inventory could indicate a
slackening demand.


• •
Increase in receivables as percentage of Customers may be taking
sales (or decrease in receivables longer to pay; there may be
turnover). an increase in collection
problems.



• •
Decrease in payables as percentage of Company may be losing
COGS/sales (or decrease in payables leverage with vendors.
turnover).

If "cash collected from customers" grows less Reported revenue may be getting a
than revenues, there may be future revenue temporary (current) boost by end-of-


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problems. year incentives.
If free cash flow to equity (FCFE) (which equals In the long-run, it is unlikely that
cash flow from operations minus cash flow from divergence between the two can be
investments) is growing more than earnings, it sustained--eventually, earnings will
may be a good sign. (Conversely, a FCFE that probably converge with the cash flow
grows less than earnings may be a bad sign.) trend.
The funded status of a pension plan, which Unless trends reverse, under-funded
equals the fair value of plan assets minus the (over-funded) pension plans will
projected benefit obligation (PBO), tends to require greater (fewer) contributions
impact future earnings. in the future.

Red Flags Theme
The red flags emphasized in this tutorial stem from this single principle: the aim in
analyzing financial statements is to isolate the fundamental operating performance of
the business. In order to do this, you must remove two types of gains that may not
be sustainable:

1. Non-recurring gains - These include gains due to the sale of a business, one-
time gains due to acquisitions, gains due to liquidation of older inventory
(that is, liquidation of the LIFO layer), and temporary gains due to harvesting
old fixed assets (where lack of new investment saves depreciation expense).

2. Gains due to financing - These are important because, while they are real
gains, they are often random variables that depend on market conditions and
they may be reversed in future years.

The sources of financing gains include special one-time dividends or returns on
investments, early retirement of debt, hedge or derivative investments, abnormally
high pension plan returns (including an upward revision to expected return on plan
assets, which automatically reduces pension cost), and increases to earnings or EPS
simply due to a change in the capital structure (for example, an increase in EPS due
to an equity-for-debt swap).

Green Flags Theme
In regard to green flags, the key principle--as far as financial statements are
concerned--is that it is important to see conservative reporting practices. In regard
to the two most popular financial statements, conservatism is implied by the
following:

1. In the income statement: Conservative revenue recognition is shown by
things like no barter arrangements, no front-loaded recognition for long-term
contracts, a sufficient allowance for doubtful accounts (that is, it is growing
with sales), the choice of LIFO rather than FIFO inventory costing method,
and the expensing of rather than capitalizing of R&D expenditures.

2. In the balance sheet: Conservative reporting practices include sufficient cash
balances; modest use of derivative instruments that are deployed only to
hedge specific risks such as interest rate or foreign currency exchange; a
capital structure that is clean and understandable so those analyzing the


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statements don't have to sort through multiple layers of common stock,
preferred stock, and several complex debt instruments; and a debt burden
that is manageable in size, not overly exposed to interest rate changes, and
not overly burdened with covenants that jeopardize the common
shareholders.

Final Note
This series is designed to help you spot red and green flags in your potential stock
investments. Keep in mind the limitations of financial statements: they are
backward-looking by definition, and you almost never want to dwell on a single
statistic or metric.

Finally, U.S. accounting rules are always in flux. At any given time, the Financial
Accounting Standards Board (FASB) is working on several accounting projects. You
can see the status of the projects at their website. But even as rules change and
tighten in their application, companies will continue to have plenty of choices in their
accounting. So, if there is a single point to this tutorial, it is that you should not
accept a single number, such as basic or diluted earnings per share (EPS), without
looking "under the hood" at its constituent elements.

Related Tutorials:


Accounting and Valuing ESOs - Learn the different accounting and valuation
treatments of ESOs, and discover the best ways to incorporate these techniques into
your analysis of stock.


Introduction to Fundamental Analysis - Here's an easy-to-understand
tutorial on the techniques of analyzing a company's financial statements, including
the annual and quarterly reports, the auditor's report, and much more.


Guide to Stock Picking Strategies - Every stock investor needs a strategy that
fits his or her outlook and style. Here you will learn abut the most popular stock
picking strategies, including their philosophies, methods, and tools.


Advanced Bond Concepts - This detailed tutorial explains some of the more
complex concepts and calculations you need to know for trading bonds, including
bond pricing, yield, term structure of interest rates, duration, and much more.




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Economic Value Added - EVA




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