of gains and losses must be shown as a part of income. If the instrument is available for
sale, only realized gains and losses are shown in income. Financial instruments that are
potentially available for sale are valued at fair values. Unrealized gains or losses are re-
corded as a part of the comprehensive income and are not included in the income state-
ment.15 Finally, instruments expected to be held to maturity are valued at historical cost,
and only realized gains and losses are reported in the income statement. However, as
noted earlier, these distinctions based on managementÔÇ™s intentions are not relevant from
an economic perspective. Analysts should, therefore, regard both realized and unrealized
gains as relevant for evaluating managementÔÇ™s performance.
Firms with ´¬ünancial instruments that are held for hedging purposes are also required
to record the instruments at fair values (see Chapter 4). The income effect of marking
these types of instruments to market depends on the purpose of ownership. If the purpose
is to hedge changes in the fair value of another item, fair value gains and losses on both
the hedge item and the ´¬ünancial instrument are included in income. However, if the in-
strument is held to hedge ´¬‚uctuations in expected future cash in´¬‚ows or out´¬‚ows, fair
value gains and losses on the effective portion of the hedge are deferred and included in
income only when the cash ´¬‚ows are reported. Fair value gains and losses on the inef-
fective portion of the hedge are included in income immediately.
Key Analysis Questions
The management judgment involved in estimating impairments of operating as-
sets and changes in values of ´¬ünancial instruments raises a number of questions
for ´¬ünancial analysts. They include the following:
ÔÇó For operating assets, is the timing and amount of any asset impairment charge
taken by management consistent with changes in the firmÔÇ™s operating perfor-
mance and the performance of other firms in the same industry? Does man-
agement appear to have delayed recording a loss from asset impairment?
ÔÇó Does management appear to have over- or understated prior impairment loss-
es on operating assets, thereby making it difficult to evaluate future perfor-
mance? Has the firm consistently reported impairment losses, indicating an
unwillingness to appreciate the full extent of the impairment?
ÔÇó What is the basis for the estimation of the fair value of the impaired operating
resource? For example, is the valuation based on an independent appraisal, or
is it a management estimate?
264 Expense Analysis
ÔÇó For financial instruments, what is managementÔÇ™s purpose for owning the fi-
nancial instruments? Is that purpose consistent with shareholdersÔÇ™ interests?
For example, is the firm hedging risks for shareholdersÔÇ™ benefits or for man-
ÔÇó What is the extent of unrealized gains and losses on holding financial instru-
ments, regardless of whether they are reported in the income statement? What
factors explain any significant gains or losses? For example, does manage-
ment appear to be using financial instruments to hedge risks or to take on
additional risk? Is this decision consistent with shareholdersÔÇ™ interests? Are
there appropriate controls in place to avoid excessive risks being taken?
The recording of a ´¬ürmÔÇ™s expenses is determined primarily by the matching and conser-
vatism principles. Under these principles, three classes of expenses arise:
1. Costs of consumed resources that have a cause-and-effect relation with revenues
and are matched with revenues;
2. Costs of resources that have no clear cause-and-effect relation to revenues and are
recorded as expenses during the period they are consumed; and
3. Costs from declines in the future benefits expected to be generated by resources,
which are recorded when the decline in value occurs.
For certain types of transactions, implementing these principles can be challenging.
For example, it can be dif´¬ücult to assess whether to record expenses if:
1. Resources acquired by a firm provide benefits over multiple years, such as for
fixed assets, goodwill, research and development outlays, and advertising.
2. Firms make uncertain long-term commitments for resources that have no long-
term benefits to the firm. This arises for pension and other post-retirement benefits
and for environmental liabilities.
3. Resources used to generate revenues are difficult to value, as in the cost of sales
and executive stock options.
4. Unused resources have declined in value over time, such as for operating and fi-
nancial asset impairments.
In general, corporate managers are likely to have the best information to estimate ex-
penses for the period. However, their incentives to report favorable information on their
stewardship of the ´¬ürm raise questions for users of ´¬ünancial information about the reli-
ability of managementÔÇ™s estimates. In addition, accounting standards require all ´¬ürms to
expense certain types of outlays, such as R&D, even though they generate future bene´¬üts
7-17 Part 2 Business Analysis and Valuation Tools
for successful ´¬ürms. This creates another role for ´¬ünancial analysis: to understand how
accounting standards affect reported performance for different ´¬ürms.
1. A firm purchases an asset for $10,000,000. Management forecasts that the asset will
have an expected life of ten years and a salvage value of 5 percent. What are the fi-
nancial statement effects from recording depreciation for this asset in the first two
years of its life if financial reporting depreciation is recorded under (a) the straight-
line method, and (b) the double-declining balance method? As a financial analyst,
what questions would you raise with the firmÔÇ™s CFO about its depreciation policy?
2. On February 9, 1996, Walt Disney Co. acquired Capital Cities/ABC Inc. for $10.1 bil-
lion 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. Disney estimated that goodwill
under the acquisitions would amount to $19 billion. What forecasts does DisneyÔÇ™s
management have to make to record amortization of this goodwill? What factors
would underlie these forecasts? As a financial analyst, what questions would you
raise with the firmÔÇ™s CFO about the amortization of goodwill?
3. In 1997 Peoplesoft, a software company, presented the following footnote informa-
tion in its annual report:
The Company capitalizes software purchased from third parties if the related soft-
ware product under development has reached technological feasibility or if there are
alternative future uses for the purchased software, provided that capitalized amounts
will be realized over a period not exceeding five years. In addition, the Company cap-
italizes certain internally incurred costs, consisting of salaries, related payroll taxes
and benefits, and an allocation of indirect costs related to developing computer soft-
ware products. Costs incurred prior to the establishment of technological feasibility
are charged to product development expense. The establishment of technological
feasibility and the ongoing assessment of recoverability of capitalized software de-
velopment costs require considerable judgment by management with respect to cer-
tain external factors, including, but not limited to, anticipated future revenues,
estimated economic life and changes in software and hardware technologies. Upon
the general release of the software product to customers, capitalization ceases and
such costs are amortized (using the straight-line method) on a product by product ba-
sis over the estimated life, which is generally three years. All other research and de-
velopment expenditures are charged to research and development expense in the
Capitalized software costs and accumulated amortization at December 31, 1995,
1996 and 1997 were as follows (in thousands):
266 Expense Analysis
1995 1996 1997
Internal development costs $7,016 $10,737 $13,232
Purchased from third parties 5,137 6,832 6,832
12,153 17,569 20,064
Accumulated amortization (4,811) (6,396) (10,358)
$7,342 $11,173 $9,706
How much did Peoplesoft capitalize for software costs in 1996? How much was cap-
italized in 1997? How much did Peoplesoft record as amortization expense for soft-
ware costs in 1997? What was the amortization expense in 1996? If Peoplesoft had
never capitalized any software research and development outlays, how would its
earnings before taxes have been affected in 1997? What would have been the effect
for 1996? Why is the earnings effect of expensing versus capitalizing different in
1996 versus 1997? Microsoft does not capitalize any software costs. Why might Peo-
plesoft choose to capitalize some of its software costs and Microsoft expense all its
costs? As a financial analyst, what questions would you raise with PeoplesoftÔÇ™s CFO
about the firmÔÇ™s policy for amortizing software development costs?
4. Procter and Gamble is a consumer products firm that owns such brands as Pampers
diapers, Crisco vegetable shortening, Tide laundry detergent, and Crest toothpaste.
In its 1998 annual report, the company reported: ÔÇťWorldwide marketing, research
and administrative expenses were $10.04 billion compared to $9.77 billion in the pri-
or year. This equates to 27.0 percent of sales, compared with 27.3 percent in the prior
year.ÔÇŁ As a financial analyst, what questions would you raise with the firmÔÇ™s CFO
about the advertising and research and administrative costs for 1998? As the CFO of
Procter and Gamble, what other information would you recommend the firm include
in its annual report on these outlays?
5. A firm hires a 27-year-old MBA at a salary of $85,000 for the first year. It also agrees
to provide a pension upon retirement at age sixty-five and estimates that the present
value of that pension is $150,000. What forecasts did management have to make to
estimate this value? What factors determine how much of the pension cost is recog-
nized as an expense at the end of the employeeÔÇ™s first year of service? As a financial
analyst, what questions would you raise with the firmÔÇ™s CFO about its pension costs?
6. In the contingent liability section of its 1998 annual report, Dow Chemical Company
reported the following:
Accruals for environmental matters are recorded when it is probable that a liability
has been incurred and the amount of the liability can be reasonably estimated, based
on current law and existing technologies. The Company had accrued $364 million at
December 31, 1998, for environmental matters, including $9 million for the remedi-
ation of Superfund sites. This is managementÔÇ™s best estimate of the costs for remedi-
ation and restoration with respect to environmental matters for which the Company
has accrued liabilities, although the ultimate cost with respect to these particular
7-19 Part 2 Business Analysis and Valuation Tools
matters could range up to twice that amount. Inherent uncertainties exist in these es-
timates primarily due to unknown conditions, changing governmental regulations
and legal standards regarding liability, and evolving technologies for handling site
remediation and restoration. It is the opinion of the CompanyÔÇ™s management that the
possibility is remote that costs in excess of those accrued or disclosed will have a ma-
terial adverse impact on the CompanyÔÇ™s consolidated financial statements.
As a financial analyst, what questions would you raise with the firmÔÇ™s CFO about the
firmÔÇ™s environmental disclosures?
7. Eastman Kodak reported the following information on inventory valuation in its
1998 annual report:
(In millions) 1998 1997
At FIFO or average cost (approximates current cost) $ 907 $ 788
Work in process 569 538
Raw materials and supplies 439 460
LIFO reserve (491) (534)
Total $1,424 $1,252
Kodak reported that its cost of sales was $72.93 million for 1998. What would the
firmÔÇ™s cost of sales have been if it had valued inventory exclusively under the FIFO
method? What factors are likely to be relevant to Kodak in setting its inventory val-
uation policies? As a financial analyst, what questions would you raise with the
firmÔÇ™s CFO about the firmÔÇ™s inventory valuation and cost of sales?
8. In its 1998 annual report, Eastman Kodak reported the following information on its
stock option program:
Pro forma net earnings and earnings per share information, as required by SFAS No.
123, ÔÇťAccounting for Stock-Based Compensation,ÔÇŁ has been determined as if the
Company had accounted for employee stock options under SFAS No. 123ÔÇ™s fair value
method. The fair value of these options was estimated at grant date using a Black-
Scholes option pricing model.
For purposes of pro forma disclosures, the estimated fair value of the options is am-
ortized to expense over the optionsÔÇ™ vesting period (2ÔÇ“3 years). The CompanyÔÇ™s pro
forma information follows:
Year Ended December 31 (In millions, except per share data)
1998 1997 1996
Net earnings (loss):
As reported $1,390 $ 5) $1,288
Pro forma 1,272 (52) 1,262
Basic earnings (loss) per share:
As reported $4.30 $.01) $3.82
Pro forma 3.93 (.16) 3.74
268 Expense Analysis
Is stock option compensation a material item for Kodak? As a financial analyst,
what questions would you raise with the firmÔÇ™s CFO about this disclosure?
9. In a meeting of the Board of Directors over a proposal to restructure, a firmÔÇ™s CEO
states: ÔÇťI recommend we take as large a charge against current earnings as our
auditors will permit, since Wall Street will love us for being tough. Further, in fu-
ture years our earnings will look improved, giving us a long-term boost from the
current hit.ÔÇŁ Do you agree with these comments? Explain why or why not.
10. The CFO of a large bank argues: ÔÇťIt is ridiculous to recognize any fair-value gains
or losses on our debt instruments that we intend holding to maturity. Since we in-
tend holding these securities, we are insulated from the whims of the market.ÔÇŁ Do
you agree? Explain why or why not. Given your answer, what are the implications
for financial analysts following the company?
1. The most common accelerated depreciation method is called double-declining-balance. Un-
der this approach, the depreciation expense in any year is twice the straight-line rate multiplied by