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a liability, to re¬‚ect the ¬nancing of the asset purchase. In subsequent periods, the leased
equipment is depreciated over the life of the lease, and the lease payments are treated as
interest and liability payments. In 1998 American capitalized leases for 187 planes and
recorded a lease liability for these aircraft for $1,671 million.
Lease contracts that do not qualify as an effective purchase for accounting purposes
are termed operating leases. The lessee then reports rental expense throughout the lease
term. American Airlines reported only 86 lease agreements as operating leases in 1998.
Of course, because the criteria for reporting leases are objective, they create opportu-
nities for management to circumvent the spirit of the distinction between capital and op-
erating leases. For example, American Airline™s management can write the lease terms
in such a way that a transaction satis¬es the de¬nition of either an operating lease or a
capital lease. In addition, implementing the lease reporting standards requires manage-
ment to forecast leased planes™ useful lives and their fair values. By comparing the com-
pany™s capital lease liability ($1,671 million) to the payments for all lease obligations
from 1999 to 2003, analysts can see that although it had more capital than operating
leases, American used operating leases for its most expensive equipment. Was this a con-
scious operating strategy, or was the company seeking to keep the effective liability to
¬nance its more expensive aircraft off the balance sheet?

EXAMPLE: HUMAN CAPITAL. Companies spend considerable amounts on profes-
sional development and training for their employees. Formal employee training by U.S.
¬rms is estimated to cost anywhere from $30 to $148 billion per year. If one factors in
informal, on-the-job training these costs increase by a factor of two to three times.1
Training programs range from those that emphasize the enhancement of ¬rm-speci¬c
skills that are unlikely to be transferable to other jobs, to training that upgrades an em-
ployee™s general skills and would be valued by other employers. Firms may be willing
to provide general training only if the employee makes a commitment to remain with the
company for some period after completing the training. This type of commitment is typ-
ical for ¬rms that pay for employees to attend MBA programs.
Firms that spend resources for formal training typically do so in anticipation that they
will have long-term bene¬ts for the ¬rm through increased productivity and/or product
or service quality. How should these expenditures be recorded? Should they be viewed
as an asset and amortized over the employees™ expected life with the ¬rm? Or should
they be expensed immediately?
Accountants argue that skills created through training are not owned by the ¬rm but
by the employee. Thus, employees can leave one ¬rm and take a position with another
without the current employer™s approval. It is also dif¬cult to calibrate the effect of train-
ing on future performance. As a result, accounting standards in the U.S. and elsewhere
require that training costs be written off immediately.
Given the accounting treatment of training costs, ¬nancial analysis can add value by
distinguishing between ¬rms that succeed and those that fail to create value through em-
ployee training. This can be critical for ¬rms where human capital is a key resource.
Such is the case for professional ¬rms. Training can also create a valuable asset for ¬rms
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4-5 Part 2 Business Analysis and Valuation Tools

that rely on sales staffs with specialized knowledge of the technical details of their ¬rms™
products. Training for these types of ¬rms may be critical to the creation of customer
value and to the ¬rms™ reputations in their product markets.

Key Analysis Questions
The above discussion implies that when ownership is dif¬cult to de¬ne, manage-
ment sometimes has the opportunity to use judgment to decide whether to record
the acquisition of a resource as an asset. In other cases management may not have
any judgment because accounting standards do not permit any ¬rms to record the
acquisition of resources as assets. Both situations create opportunities for ¬nancial
analysis. The ¬rst creates an opportunity to evaluate the assumptions that underlie
the method of reporting used by management. The second creates an opportunity
to distinguish ¬rms that are likely to retain the bene¬ts of resource outlays, even
when ownership is vague, from those that cannot. As a result, the following ques-
tions are likely to be useful for analysts:
• What resources for a firm are excluded from its balance sheet because own-
ership of resulting benefits is uncertain? If these resources are critical to its
strategy and value creation, what alternative metrics are available for evalu-
ating how well these resources have been managed? For example, if human
capital is a key asset, how much does the firm spend on training? What is the
rate of employee turnover? What metrics does the firm use to evaluate the ef-
fectiveness of its training programs?
• Does management appear to be deliberately writing contracts to avoid full
ownership of key resources? If so, what factors explain this behavior? For ex-
ample, what types of leasing arrangement does the firm have? Are leases
used to manage technology risks that are outside management™s control or to
report key assets (and liabilities) off the balance sheet?
• If leases are used to avoid reporting key assets and liabilities, what is the ef-
fect of recording these items on the financial statements?
• Has the firm changed its method of reporting for resource outlays where there
are ownership questions? For example, has it changed its method of amortiz-
ing capital lease assets? What factors explain these decisions? Has it changed
its business or operating model?

Challenge Two: Economic Benefits Are
Uncertain or Are Difficult to Measure
A second challenge in determining whether an outlay quali¬es as an asset arises when
the future economic bene¬ts attributable to the outlay are dif¬cult to measure or highly
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Asset Analysis

uncertain. It is almost always dif¬cult to accurately forecast any future bene¬ts associ-
ated with capital outlays because the world is uncertain. A company does not know
whether a competitor will offer a new product or service that makes its own obsolete. It
does not know whether the products manufactured at a new plant will be the type that
customers want to buy. It does not know whether changes in the price of oil make its oil
drilling equipment less valuable. When do accountants view these uncertainties and
measurement problems to be suf¬ciently severe that they require outlays with multi-
period bene¬ts to be expensed? When can such expenditures be capitalized?
The economic values of most resources are based on estimates of uncertain future
economic bene¬ts. For example, receivables values are net of uncollectibles, leased and
owned assets have future residual values, and marketing and R&D outlays create brand
values. Below we discuss reporting for three types of outlays to illustrate how accoun-
tants view uncertainty in recording assets: goodwill, brands, and deferred tax assets.

EXAMPLE: GOODWILL. On February 9, 1996, Walt Disney Co. acquired Capital
Cities/ABC Inc. for $10.1 billion in cash and 155 million shares of Disney valued at $8.8
billion based on the stock price at the date the transaction was announced. Cap Cities
owned and operated the ABC Television Network, eight television stations, the ABC
Radio Networks and 21 radio stations, and 80 percent of ESPN, Inc., and it provided pro-
gramming for cable television. It also published daily and weekly newspapers, shopping
guides, various specialized and business periodicals, and books. The bulk of these assets
were intangible. In 1994, immediately prior to the acquisition, Cap Cities estimated that
approximately 85 percent of its $5.3 billion of broadcasting revenues and 70 percent of
its $1.1 billion publishing revenues came from the sale of advertising, rather than any
tangible product or service.
Disney estimated the fair value of ABC™s tangible assets at $4.0 billion ($1.5 billion
in cash) and its liabilities at $4.3 billion. How should the acquisition be recorded on Dis-
ney™s books? Should the difference between the $18.9 billion purchase price and the
$0.3 billion of net liabilities be recorded as an intangible asset on Disney™s books? If so,
what are the bene¬ts Disney expects to realize from the acquisition? Alternatively,
should the $19.2 billion difference be written off?
Prior to Disney™s offer, the market valued ABC™s equity at approximately $9 billion.
This implies that Disney paid more than a 100 percent premium for ABC™s intangible as-
sets. Here is where the accounting issues become tricky. If the full acquisition price is to
be shown as an asset, Disney™s management and auditors have to be con¬dent that this
outlay is recoverable. But what makes ABC™s intangibles worth twice as much to Disney
as they were to the company™s prior owners? Or did Disney simply overpay for Cap Cit-
ies/ABC, implying that it is unlikely to recover the $19 billion in goodwill?
Accountants in most countries now require companies like Disney to record the value
of acquired tangible assets and liabilities at their fair values and to show the full $19 bil-
lion of goodwill as an asset. The justi¬cation for this approach is that there has been an
arm™s-length transaction between the buyer and seller. There is a presumption that Dis-
ney™s management has made an acquisition that does not destroy value for its own stock-
Asset Analysis

4-7 Part 2 Business Analysis and Valuation Tools

holders, and that it has the best information on the value created as a result of its plans
for the new ¬rm. These presumptions underlie the valuation of goodwill, unless there is
evidence to the contrary. After the acquisition, Disney is required under U.S. accounting
to amortize the goodwill over a maximum of forty years (see Chapter 7).
Two challenges arise from this form of accounting. First, since it is dif¬cult to assess
whether the merger is achieving the expected bene¬ts, it is dif¬cult to estimate whether
goodwill has become “badwill.” This is complicated by management™s incentives. If the
merger does not work out as planned, management is unlikely to want to own up to mak-
ing a mistake. Second, the creation of an arbitrary period for amortizing goodwill makes
it dif¬cult for ¬rms that make successful acquisitions to distinguish themselves from
those that make neutral ones. If both use a forty-year amortization period, the ¬rm that
has enhanced shareholder value reports the acquisition in exactly the same manner as the
¬rm that created no new value.

EXAMPLE: BRANDS. Coca-Cola Inc. reports a book value of equity of $8.4 billion
and has a market value of $165 billion. Much of this difference is attributable to the value
of Coke™s brand. Coke created the brand through years of investment in advertising, pro-
motion, and packaging. Other well-known brands include Marlborough, Nescafe,
Kodak, Microsoft, Budweiser, Kellogg™s, Gillette, McDonald™s, Gucci, Mercedes, and
Baccardi. Brand-name products can create value for their owners by (a) permitting lower
levels of marketing than the competition, due to high market awareness, (b) creating
leverage with distributors and retailers, since customers expect them to carry the brand,
and (c) enabling higher prices than the competition, due to higher customer perception
of value. Unlike patents or copyrights, brands have no limit in terms of how long they
can apply. If they are well managed, they can be enduring assets.
As noted in Chapter 7, the advertising, promotion, and packaging activities that give
rise to brands are typically expensed. This convention was adopted because of the dif¬-
culty in linking advertising outlays with brand creation. Given the dif¬culty in valuing
brands in the ¬rst place, and given the challenge in assessing when and how much adver-
tising enhances brand values and affects only the current period™s sales, accountants have
traditionally avoided showing brand capital as an asset. In the U.S., even brands that have
been acquired are not reported separately and are included as part of intangible assets.
In Australia and the U.K., however, ¬rms have been permitted to report brand assets
on their books. The driving force behind this phenomenon has been mergers and acqui-
sitions. Target ¬rms have valued and revalued brands on their books. For example, in
1989, following an increased acquisition interest from General Cinema, Cadbury
Schweppes valued brands acquired since 1985. These assets were not amortized but re-
viewed annually for any diminution in value. In 1997 Cadbury reported brand intangi-
bles on its balance sheet at £1.575 billion, representing one-third of its total assets.
Showing brands on the books as assets provides management with a way of commu-
nicating their value to investors. It also signals that managers are aware of the impor-
tance of these assets and provides an annual indication of how well they have been
134 Asset Analysis

Asset Analysis

managed. Brands that have been managed well are likely to retain their value, whereas
mismanaged brands will have to be written down. However, including brands on the bal-
ance sheet also raises opportunities for misuse of management judgment. Given the dif-
¬culty in estimating brand values, investors are likely to be concerned that management
overstates the value of brands and fails to recognize any declines in value on a timely
basis. Management may be able to mitigate these concerns by using independent valua-
tion experts to value brand assets and by having auditors sign off on the valuations. How-
ever, even these forms of veri¬cation are unlikely to completely eliminate investors™
For ¬rms where brands are not reported as assets (i.e., most ¬rms), the challenge for
management is to provide other ways to convince investors of the value of brands. For
example, in its 1998 annual report, Coca-Cola provided the following performance data
for its key brands in North America:

Population 305 million
Per Capita 377
High Per Capita Rome, Georgia, at 821
1 Year Low Per Capita Quebec, Canada, at 142
Coca-Cola USA
Coca-Cola Classic 3%
Rest of Industry*
Diet Coke 4%
1998 vs. 1997 Sprite 9%
Unit Case
5 Years Also Notable:
Sales Growth
Coca-Cola USA Fruitopia 105%
6% POWERaDE 33%
Rest of Industry* Minute Maid soft drinks 29%
2% Nestea 20%
Barq™s 18%
*Rest of industry includes soft drinks only.

Source: Coca-Cola Annual Report, 1998

Coca-Cola also outlined its initiatives to support its brands. In North America these
included sponsorship of NASCAR and the distribution of 50 million Coca-Cola cards of-
fering discounts at more than 10,000 retailers across the United States. In addition, the
company announced 1999 plans for extensions of its brands by adding two new POW-
ERaDE ¬‚avors (Arctic Shatter and Dark Downburst), a new ¬‚avor for Fruitopia (Kiwi-
berry Ruckus), and the launch of Dasani, a puri¬ed water with added minerals. Similar
details were provided for Coke™s other markets. For example, in Argentina a new mar-
keting campaign was initiated to encourage use of Coke products at meal times. In Asia


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