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book value, and with a P/E ratio of 4, its earnings yield is 25% per year. GI is a likely candi-
date for a takeover by another firm that might replace GI™s management and build shareholder
value through a radical change in policy.

4. You have the following information for IBX Corporation for the years 2001 and Concept
2004 (all figures are in $millions):
2004 2001
Net income $ 253.7 $ 239.0
Pretax income 411.9 375.6
EBIT 517.6 403.1
Average assets 4,857.9 3,459.7
Sales 6,679.3 4,537.0
Shareholders™ equity 2,233.3 2,347.3

What is the trend in IBX™s ROE, and how can you account for it in terms of tax
burden, margin, turnover, and financial leverage?
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

470 Part FOUR Security Analysis

Financial statement analysis gives us a good amount of ammunition for evaluating a com-
pany™s performance and future prospects. But comparing financial results of different compa-
nies is not so simple. There is more than one acceptable way to represent various items of
revenue and expense according to generally accepted accounting principles (GAAP). This
means two firms may have exactly the same economic income yet very different accounting
Furthermore, interpreting a single firm™s performance over time is complicated when in-
flation distorts the dollar measuring rod. Comparability problems are especially acute in this
case because the impact of inflation on reported results often depends on the particular method
the firm adopts to account for inventories and depreciation. The security analyst must adjust
the earnings and the financial ratio figures to a uniform standard before attempting to compare
financial results across firms and over time.
Comparability problems can arise out of the flexibility of GAAP guidelines in accounting
for inventories and depreciation and in adjusting for the effects of inflation. Other important
potential sources of noncomparability include the capitalization of leases and other expenses,
the treatment of pension costs, and allowances for reserves, but they are beyond the scope of
this book.

Inventory Valuation
There are two commonly used ways to value inventories: LIFO (last-in, first-out) and FIFO
(first-in, first-out). We can explain the difference using a numerical example.
The last-in first-out
Suppose Generic Products, Inc. (GPI), has a constant inventory of 1 million units of
accounting method
generic goods. The inventory turns over once per year, meaning the ratio of cost of goods sold
of valuing inventories.
to inventory is 1.
The LIFO system calls for valuing the million units used up during the year at the current
cost of production, so that the last goods produced are considered the first ones to be sold.
The first-in first-out
They are valued at today™s cost. The FIFO system assumes that the units used up or sold are
accounting method
the ones that were added to inventory first, and goods sold should be valued at original cost.
of valuing inventories.
If the price of generic goods were constant, at the level of $1, say, the book value of in-
ventory and the cost of goods sold would be the same, $1 million under both systems. But sup-
pose the price of generic goods rises by 10 cents per unit during the year as a result of
LIFO accounting would result in a cost of goods sold of $1.1 million, while the end-of-year
balance sheet value of the 1 million units in inventory remains $1 million. The balance sheet
value of inventories is given as the cost of the goods still in inventory. Under LIFO, the last
goods produced are assumed to be sold at the current cost of $1.10; the goods remaining are
the previously produced goods, at a cost of only $1. You can see that, although LIFO ac-
counting accurately measures the cost of goods sold today, it understates the current value of
the remaining inventory in an inflationary environment.
In contrast, under FIFO accounting, the cost of goods sold would be $1 million, and the
end-of-year balance sheet value of the inventory is $1.1 million. The result is that the LIFO
firm has both a lower reported profit and a lower balance sheet value of inventories than the
FIFO firm.
LIFO is preferred over FIFO in computing economics earnings (that is, real sustainable
cash flow), because it uses up-to-date prices to evaluate the cost of goods sold. A disadvan-
tage is that LIFO accounting induces balance sheet distortions when it values investment in
inventories at original cost. This practice results in an upward bias in ROE because the in-
vestment base on which return is earned is undervalued.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

13 Financial Statement Analysis

In computing the gross national product, the U.S. Department of Commerce has to make
an inventory valuation adjustment (IVA) to eliminate the effects of FIFO accounting on the
cost of goods sold. In effect, it puts all firms in the aggregate onto a LIFO basis.

Another source of problems is the measurement of depreciation, which is a key factor in com-
puting true earnings. The accounting and economic measures of depreciation can differ
markedly. According to the economic definition, depreciation is the amount of a firm™s oper-
ating cash flow that must be reinvested in the firm to sustain its real cash flow at the cur-
rent level.
The accounting measurement is quite different. Accounting depreciation is the amount of
the original acquisition cost of an asset that is allocated to each accounting period over an
arbitrarily specified life of the asset. This is the figure reported in financial statements.
Assume, for example, that a firm buys machines with a useful economic life of 20 years at
$100,000 apiece. In its financial statements, however, the firm can depreciate the machines
over 10 years using the straight-line method, for $10,000 per year in depreciation. Thus, after
10 years, a machine will be fully depreciated on the books, even though it remains a produc-
tive asset that will not need replacement for another 10 years.
In computing accounting earnings, this firm will overestimate depreciation in the first
10 years of the machine™s economic life and underestimate it in the last 10 years. This will
cause reported earnings to be understated compared with economic earnings in the first
10 years and overstated in the last 10 years.
Depreciation comparability problems add one more wrinkle. A firm can use different de-
preciation methods for tax purposes than for other reporting purposes. Most firms use accel-
erated depreciation methods for tax purposes and straight-line depreciation in published
financial statements. There also are differences across firms in their estimates of the deprecia-
ble life of plant, equipment, and other depreciable assets.
The major problem related to depreciation, however, is caused by inflation. Because con-
ventional depreciation is based on historical costs rather than on the current replacement cost
of assets, measured depreciation in periods of inflation is understated relative to replacement
cost, and real economic income (sustainable cash flow) is correspondingly overstated.
The situation is similar to what happens in FIFO inventory accounting. Conventional de-
preciation and FIFO both result in an inflation-induced overstatement of real income because
both use original cost instead of current cost to calculate net income.
For example, suppose Generic Products, Inc., has a machine with a three-year useful life
that originally cost $3 million. Annual straight-line depreciation is $1 million, regardless of
what happens to the replacement cost of the machine. Suppose inflation in the first year turns
out to be 10%. Then the true annual depreciation expense is $1.1 million in current terms,
while conventionally measured depreciation remains fixed at $1 million per year. Accounting
income therefore overstates real economic income.

Inflation and Interest Expense
While inflation can cause distortions in the measurement of a firm™s inventory and deprecia-
tion costs, it has perhaps an even greater effect on the calculation of real interest expense.
Nominal interest rates include an inflation premium that compensates the lender for inflation-
induced erosion in the real value of principal. From the perspective of both lender and
borrower, therefore, part of what is conventionally measured as interest expense should be
treated more properly as repayment of principal.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

472 Part FOUR Security Analysis

For example, suppose Generic Products has debt outstanding with a face value of $10 mil-
lion at an interest rate of 10% per year. Interest expense as conventionally measured is $1 mil-
lion per year. However, suppose inflation during the year is 6%, so that the real interest rate is
4%. Then $0.6 million of what appears as interest expense on the income statement is really
an inflation premium, or compensation for the anticipated reduction in the real value of the
$10 million principal; only $0.4 million is real interest expense. The $0.6 million reduction in
the purchasing power of the outstanding principal may be thought of as repayment of princi-
pal, rather than as an interest expense. Real income of the firm is, therefore, understated by
$0.6 million.
This mismeasurement of real interest means that inflation results in an underestimate of
real income. The effects of inflation on the reported values of inventories and depreciation that
we have discussed work in the opposite direction.

5. In a period of rapid inflation, companies ABC and XYZ have the same reported
earnings. ABC uses LIFO inventory accounting, has relatively fewer depreciable as-
CHECK sets, and has more debt than XYZ. XYZ uses FIFO inventory accounting. Which
company has the higher real income and why?

Quality of Earnings and Accounting Practices
Many firms make accounting choices that present their financial statements in the best pos-
sible light. The different choices that firms can make give rise to the comparability problems
we have discussed. As a result, earnings statements for different companies may be more or
less rosy presentations of true “economic earnings””sustainable cash flow that can be paid to
shareholders without impairing the firm™s productive capacity. Analysts commonly evaluate
the quality of earnings reported by a firm. This concept refers to the realism and conser-
quality of
vatism of the earnings number, in other words, the extent to which we might expect the re-
ported level of earnings to be sustained.
The realism and
Examples of the accounting choices that influence quality of earnings are:
sustainability of
reported earnings.
• Allowance for bad debt. Most firms sell goods using trade credit and must make an
allowance for bad debt. An unrealistically low allowance reduces the quality of reported
earnings. Look for a rising average collection period on accounts receivable as evidence of
potential problems with future collections.
• Nonrecurring items. Some items that affect earnings should not be expected to recur
regularly. These include asset sales, effects of accounting changes, effects of exchange rate
movements, or unusual investment income. For example, in 1999, which was a banner
year for equity returns, some firms enjoyed large investment returns on securities held.
These contributed to that year™s earnings, but should not be expected to repeat regularly.
They would be considered a “low-quality” component of earnings. Similarly gains in
corporate pension plans can generate large, but one-time, contributions to reported
earnings. For example, IBM increased its year 2000 pretax income by nearly $200 million
by changing the assumed rate of return on its pension fund assets by 0.5%.
• Reserves management. In the 1990s, W. R. Grace reduced its earnings by offsetting high
earnings in one of its subsidiaries with extra reserves against unspecified future liabilities.
Why would it do this? Because later, it could “release” those reserves if and when
earnings were lower, thereby creating the appearance of steady earnings growth. Wall
Street likes strong, steady earnings growth, but Grace planned to provide such growth
through earnings management.
• Stock options. Many firms, particularly start-ups, compensate employees in large part with
stock options. To the extent that these options replace cash salary that otherwise would
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

13 Financial Statement Analysis

need to be paid, the value of the options should be considered as one component of
the firm™s labor expense. But GAAP accounting rules do not require such treatment.
Therefore, all else equal, earnings of firms with large employee stock option programs
should be considered of lower quality.
• Revenue recognition. Under GAAP accounting, a firm is allowed to recognize a sale
before it is paid. This is why firms have accounts receivable. But sometimes it can be hard
to know when to recognize sales. For example, suppose a computer firm signs a contract
to provide products and services over a five-year period. Should the revenue be booked
immediately or spread out over five years? A more extreme version of this problem is
called “channel stuffing,” in which firms “sell” large quantities of goods to customers, but
give them the right to later either refuse delivery or return the product. The revenue from
the “sale” is booked now, but the likely returns are not recognized until they occur (in a
future accounting period). According to the SEC, Sunbeam, which filed for bankruptcy in
2001, generated $60 million in fraudulent profits in 1999 using this technique. If you see
accounts receivable increasing far faster than sales, or becoming a larger percentage of
total assets, beware of these practices. Global Crossing, which filed for bankruptcy in
2002, illustrates a similar problem in revenue recognition. It swapped capacity on its
network for capacity of other companies for periods of up to 20 years. But while it seems
to have booked the sale of its capacity as immediate revenue, it treated the acquired
capacity as capital assets that could be expensed over time. Given the wide latitude firms
have to manipulate revenue, many analysts choose instead to concentrate on cash flow,
which is far harder for a company to manipulate.
• Off-balance-sheet assets and liabilities. Suppose that one firm guarantees the outstanding
debt of another firm, perhaps a firm in which it has an ownership stake. That obligation
ought to be disclosed as a contingent liability, since it may require payments down the
road. But these obligations may not be reported as part of the firm™s outstanding debt.
Similarly, leasing may be used to manage off-balance-sheet assets and liabilities. Airlines,
for example, may show no aircraft on their balance sheets but have long-term leases that
are virtually equivalent to debt-financed ownership. However, if the leases are treated as
operating rather than capital leases, they may appear only as footnotes to the financial

Enron Corporation, which filed for bankruptcy protection in December 2001, presents an
extreme case of “management” of financial statements. The firm seems to have used several
partnerships in which it was engaged to hide debt and overstate earnings. When disclosures
about these partnerships came to light at the end of 2001, the company was forced to restate
earnings amounting to almost $600 million dating back to 1997. Enron raises the question of
where to draw the line that separates creative, but legal, interpretation of financial reporting
rules from fraudulent reporting. It also raises questions about the proper relationship between
a firm and its auditor, which is supposed to certify that the firm™s financial statements are pre-
pared properly. Enron™s auditor, Arthur Andersen LLP, actually earned more money in 2000
doing nonauditing work for Enron than it did for its external audit. The dual role of the audit-
ing firm creates a potential conflict of interest, since the auditor may be lenient in the audit to
preserve its consulting business with the client. Andersen™s dual role has become common in


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