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category. Of course, if these costs are large and unlikely to be ongoing, analysts may
want to consider them separately from operating income in order to improve the fore-
casts of future operating earnings.

Key Analysis Questions
Considerable management judgment is involved in estimating the costs for future
obligations that are uncertain in timing and amount. In addition, for some of these
costs, accounting standards do not require an expense to be recorded because the
amount is too uncertain, making it dif¬cult to assess which ¬rms™ costs are likely
to be understated. As a result, the following questions are likely to be useful for
¬nancial analysts:
• What assumptions are made by management to recognize the cost of uncer-
tain future obligations? Have these assumptions changed in relation to prior
years? If so, what factors explain this change? For example, has the firm al-
tered its benefit plans or its business operations? If management changed the
discount rate used to compute the present value of pension obligations, has
there been a comparable change in interest rates?
• Are there any differences in the firm™s assumptions for estimating the costs
of uncertain future obligations in relation to other firms in the same industry?
If so, what factors can explain these differences? Does the firm have a differ-
ent relationship with the suppliers of these resources?
• Is there any evidence that the firm™s managers have a record of systematically
over- or underestimating costs for long-term obligations?
• How seriously are a firm™s expenses likely to be affected by accounting stan-
dards that delay recording costs for future obligations because of uncertainty
in estimating the future outlays, such as the cost of environmental liabilities?
How does the firm manage these risks? Are there indicator variables that can
be used to help identify firms with high and low risks?

Challenge Three: It Is Difficult to Define
the Value of Resources Consumed
Some types of resources used to generate revenues are dif¬cult to value. For example,
inventory is purchased or manufactured at different prices and then has to be matched to
revenues. Which inventory units should be reported as a cost of sales and which should
be reported as inventory? Executive stock options also raise questions about the value of
the resources consumed in return for the options, and the timing of when these costs
should be treated as an expense. We discuss how these types of resources are recorded
and the challenges involved.
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7-11 Part 2 Business Analysis and Valuation Tools

EXAMPLE: COST OF SALES. If a ¬rm purchases or manufactures products at differ-
ent costs and then sells some of those units, it faces a question of determining the cost
of the units that were sold and the cost of units remaining in inventory. Costs of mer-
chandise purchased or produced can differ over time if there is in¬‚ation in the economy
or if there is a demand or supply shock for the ¬rm™s merchandise or inputs. Manufac-
turing costs can also vary over time if the ¬rm changes the number of units it produces.
Since capacity costs of production are ¬xed in the short run, these costs will be allocated
over more or less units, affecting unit costs.
For some types of products, the valuation of the cost of sales and inventory can be
easily resolved, since the speci¬c units that are purchased and sold are identi¬able. Such
is the case for auto dealerships. New and used cars are identi¬able by make, model,
color, year, accessories, and if necessary by vehicle identi¬cation number. Conse-
quently, when a vehicle is sold, management can identify its speci¬c cost to match
against the sales revenue.
However, for most businesses it is not feasible to speci¬cally identify each unit pur-
chased and sold. For example, a large automobile manufacturer that purchases thou-
sands of inputs to make a new automobile would ¬nd it inef¬cient to keep track of the
cost of each speci¬c part. Consequently, some other form of accounting is required to
estimate the cost of sales.
The approach taken by accountants is to make an assumption about how products
¬‚ow from inventory to cost of sales. Three major methods are permitted. The ¬rst, called
the last-in-¬rst-out method (or LIFO), assumes that the last units purchased or manufac-
tured are the ¬rst units to be sold. This method therefore matches recent costs with rev-
enues, leading some to argue that it gives a better indication of the ¬rm™s future pro¬t
margins than do the other methods.8 However, it can also lead to inventory valuations
that are long out of date, and it provides the potential for management to temporarily
boost pro¬ts by reducing inventory levels, thereby selling merchandise carried at old
The second method is the ¬rst-in-¬rst-out (or FIFO) method. This approach assumes
that the ¬rst units purchased or manufactured are the ¬rst to be sold. The advantage to
this approach is that it ensures that inventories are valued at recent costs. However, it
makes it more dif¬cult to interpret pro¬t margins, since margins include holding gains
on units purchased at old cost levels.
The third approach, the average cost method, is a compromise between LIFO and
FIFO. It values the cost of sales and inventory at the average cost of units purchased or
Several points are worth noting about inventory valuation. First, the particular
method followed does not have to represent the actual physical ¬‚ow of merchandise
from the warehouse. Thus, a company that bakes bread can report under the LIFO
method, but it would not follow such an approach for managing its physical inventory.
Second, the LIFO method cannot be used in some countries. For example, it is not per-
mitted under U.K., French, or Canadian accounting. Third, in the U.S., tax factors are a
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Expense Analysis

consideration for managers deciding which method to use for ¬nancial reporting. Tax
rules require that the method used for ¬nancial reporting must also be used for tax re-
porting. Consequently, ¬rms in industries with increasing factor or merchandise costs
have tax incentives to select the LIFO method, since it lowers the present value of their
tax obligations. For ¬rms in industries with declining factor or merchandise costs, there
are tax advantages from using FIFO.
In summary, the valuation of the cost of sales provides several opportunities for man-
agers to exercise judgment in ¬nancial reporting. Managers can select the inventory ¬‚ow
method, increase or reduce production to allocate capacity costs over more or less units,
or, if the ¬rm uses LIFO, deplete inventory to match old costs against revenues.9

lic companies provide stock option remuneration to top executives. A stock option permits
an executive to purchase stock at a given price, known as the exercise or strike price, at
some point in the future, known as the exercise or expiration date. For example, Walt
Disney Company™s 1999 proxy statement disclosed that on September 30, 1996, the
Compensation Committee granted the ¬rm™s CEO, Michael Eisner, the option to pur-
chase 15,000,000 Disney shares at an exercise price of $21.10, the stock price when the
option was granted. The option expires on September 30, 2008. At ¬scal year-end on
September 30, 1998, Disney™s stock price was $25.375.
Stock option compensation, like that reported for Michael Eisner, is intended to pro-
vide top management with a powerful incentive to maximize shareholder value, since
managers get to share in any upside in the stock price. For several reasons, options are a
more popular form of compensation than straight stock awards. They protect manage-
ment against downside risk from holding the stock. Compensation that imposes down-
side risk on risk-averse managers can induce them to be more cautious in their decisions
than owners would like. Also, stock option compensation is often tax advantageous
relative to stock awards.10
The challenging question for ¬nancial reporting is how to record these forms of com-
pensation. Should an expense be recorded for these types of compensation awards, or is
it too dif¬cult to estimate their value? If an expense is to be recorded, when should it be
shown and at what value? Should the value of the compensation be recognized when the
award is granted? If so, what is its value? Should the compensation cost be shown
throughout the option exercise period? Again, what is the value of the compensation pro-
vided? Should compensation be recorded when the options are exercised and the value
of shares awarded is known? Should the compensation expense be recognized when
management actually sells the shares awarded under option grants?
Prior to 1995, U.S. ¬rms were required under APB Opinion 25 to use the “intrinsic
value” method of reporting for option grants. Under this approach, a compensation ex-
pense was recorded for the difference between the market price of the stock at the date
the option was granted and its exercise price. However, since most options had an exer-
cise price equal to the stock price at the grant date, no compensation expense was
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7-13 Part 2 Business Analysis and Valuation Tools

reported. In 1995 the FASB released an Exposure Draft on stock option compensation,
recommending the “fair value” method to value options. This involved creating at the
grant date a deferred compensation expense for the market value of options awarded, es-
timated using Black-Scholes or binomial option-valuation models.11 The compensation
expense, re¬‚ecting compensation effectively earned by managers from option awards, is
then recorded by amortizing the deferred compensation expense over the option™s vest-
ing period.
Considerable controversy surrounded the stock option exposure draft, and the FASB
decided to tone down its recommendation. The ¬nal standard, SFAS 123, permitted man-
agers to decide whether to report under APB 25 or SFAS 123. However, if a ¬rm elects
to use APB 25, it is also required to disclose the fair value of options awarded in its foot-

Key Analysis Questions
When it is dif¬cult to de¬ne the value of resources consumed, accounting rules
have to either suggest de¬nitive methods that can be used to estimate resource
consumption, or permit management to exercise judgment in recording their con-
sumption. Both outcomes create an opportunity for ¬nancial analysis of expenses.
Some questions that are likely to arise for ¬nancial analysts include the following:
• What method does management use to account for and value the cost of sales,
stock option compensation, and other expenses for resources whose use is
difficult to value? Has this method changed over time? Does the firm use the
same method as other firms in the industry? If the method used differs over
time or across firms in the industry, what factors are likely to explain this dif-
ference? Has the firm changed its business strategy or is it following a differ-
ent model for value creation than its competitors that could explain any
method differences? Has it changed its tax status or tax management strate-
gy? Or does it appear to be trying to report positive performance to the capital
• What earnings effects, if any, arise from the accounting methods used to val-
ue the cost of sales, stock options, and other expenses for resources that are
difficult to value? For example, are there any one-time effects on the cost of
sales from LIFO inventory liquidations? How do changes in production ca-
pacity utilization affect the cost of sales? If firms use FIFO or average cost
methods to record the cost of sales, how are future margins likely to be af-
fected by any recent increases in input prices? If the firm uses the “intrinsic
value” method to record option expenses, what would have been the effect of
using the “fair value” approach? Is management being compensated appro-
priately, given the firm™s performance?
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Expense Analysis

Challenge Four: Unused Resources Decline in Value
The ¬nal challenge in recording expenses arises for unused resources whose values
change over time. In most cases the ¬nancial reporting implications of these value
changes are based on the application of the conservatism principle. This principle holds
that permanent declines in resource values should be recorded as a loss, but if values
have increased, no gain should be recognized until the resource is sold. The issues are
the same as those discussed for asset impairments in Chapter 4. Below we discuss the
expense reporting challenges for changes in values of operating assets and ¬nancial in-

EXAMPLE: OPERATING ASSET IMPAIRMENTS. As discussed in Chapter 4, the
conservatism principle requires that an asset whose value is impaired should be written
down to its market value, below cost. For example, in December 1997, following a dis-
appointing performance in its core business, Eastman Kodak recorded a $1.5 billion
restructuring charge. Of this amount, $428 million was for asset impairments (7 percent
of pre-written-down ¬xed assets), and $165 million was for inventory write-downs
(12 percent of pre-written-down inventory). The remainder was primarily to re¬‚ect the
severance costs for 16,100 personnel to be laid off.
The challenge in recognizing losses from asset impairments is that it is often dif¬cult
to assess whether an asset has been impaired and, if so, the amount of the loss. Account-
ing for asset impairments in the U.S. is regulated by SFAS 121. Under this standard,
¬rms are required to review assets for impairment whenever there is a change in the
¬rm™s circumstances or an indication that the book value cannot be recovered. Changes
in circumstances can arise if the asset is used less extensively or in a different manner,
if legal or regulatory changes affect the asset™s value, or if the ¬rm has a history of cash-
¬‚ow losses. If management™s forecast of the undiscounted future cash ¬‚ows associated
with an asset is less than its book value, the asset is required to be written down to fair
value and a loss recognized.
The decision to recognize an impairment loss and the estimation of the value of the
loss under SFAS 121 involves considerable management judgment. Management must
decide what level of asset grouping is appropriate for evaluating asset impairments.13 It
must also forecast and value the expected future cash ¬‚ows from these assets.
In late 1998 the SEC expressed concern about management abuse of its reporting
judgment for asset impairments. Arthur Levitt, Chairman of the SEC, articulated this
concern as follows: “When earnings take a major hit, the theory goes that Wall Street
will look beyond a one-time loss and focus only on future earnings. And if these charges
are conservatively estimated with a little extra cushioning, that so-called estimate is mi-
raculously reborn as income when estimates change or future earnings fall short.”14

in Chapter 4, ¬rms are required to record at fair values their ¬nancial instruments that
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7-15 Part 2 Business Analysis and Valuation Tools

are held as investments and are intended to be sold or are available for sale. A key ques-
tion is whether gains and losses on these types of investment should be re¬‚ected in the
income statement or charged directly to owners™ equity. Current rules require that if a


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