10-K Navigation Guide

ACCOUNTING&TAXPOLICY
February28,2012
10KNAVIGATIONGUIDE
A Primer on Reading Annual Reports
This report is our annual guide to understanding and interpreting annual 10-K disclosures. We
believe a thorough reading and understanding of a companys annual report assists in identifying
overlooked investment opportunities and potential risk exposures. 10-Ks provide a once-a-year
comprehensive view of a companys business and detailed financial statement footnotes. As many
10-Ks now exceed 200 pages, to assist investors, we explain and interpret over 40 commonly found
disclosures as applied in analyzing debt and equity investments.
Annual Reports are Due on February 29th for Most U.S. Publicly Traded Companies. For
smaller companies with market capitalizations below $700 million (but above $75 million), annual
10-K reports are due on March 15, 2012.
Important Disclosures to Review Include: Cost capitalization, equity investments, depreciation,

derivatives/foreign currency, foreign cash, inventory, M&A accounting, operating leases, offbalance sheet entities, pensions, reserves, segment disclosures, and taxes.
Earnings Quality and Cash Flow Analysis. We highlight ways in which companies may
manage earnings and cash flows and how to spot such practices when reading through 10-K
filings. For our detailed earnings quality framework initiation report, please see our December
2011 report: Earnings Quality: Ideas and a Guide to Avoid Accounting Pitfalls.
U.S. and IFRS Key Differences Examined. Today, the investment landscape is global and,
accordingly, knowledge of more than one accounting language is necessary to compare
companies across the globe. We highlight the key differences between U.S. GAAP and
International Financial Reporting Standards (IFRS).
Chris Senyek, CFA, CPA

(646) 845-0759
csenyek@WolfeTrahan.com
Adam Calingasan, CFA, CPA

(646) 845-0757
acalingasan@WolfeTrahan.com
Clinton Chang, CFA, CPA

(646) 845-0756
cchang@WolfeTrahan.com
ThisreportislimitedsolelyfortheuseofclientsofWolfeTrahan&Co.PleaserefertotheDISCLOSURESlocatedattheend ofthis
reportforapplicabledisclosures.
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Accounting&TaxPolicy
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TABLEOFCONTENTS
Introduction .................................................................................................................................................................................4
Filing Deadlines ..........................................................................................................................................................................4
Annual Report Sections .............................................................................................................................................................5
Recent Accounting Pronouncements and Changes ...............................................................................................................6
Review 10-K for Unresolved SEC Staff Comments .................................................................................................................9
Properties Section: Leased or Owned? ...................................................................................................................................9
Managements Discussion and Analysis ...............................................................................................................................10
Critical Accounting Policies ....................................................................................................................................................15
Quality of Cash and Investments ............................................................................................................................................17
Accounting for Inventory .........................................................................................................................................................18
Property, Plant, and Equipment: Check Asset Lives and For Changes in Policies ..........................................................22
Implications of Accelerated Depreciation ..............................................................................................................................25
Bonus Depreciation ..................................................................................................................................................................26
Hidden Asset Value ..................................................................................................................................................................29
Accounting for Equity Investments: < 20% Ownership ........................................................................................................32
Accounting for Equity Investments: 20% to 50% Ownership ..............................................................................................33
Mergers & Acquisitions............................................................................................................................................................34
Acquisition Accounting Antics: The Perfect Storm ..............................................................................................................40
Goodwill Impairments (FAS 141R, 142, and 144) ..................................................................................................................42
Look for Related Party Transactions ......................................................................................................................................45
When Are Segment Disclosures Required? ..........................................................................................................................46
Excessive Cost Capitalization on the Balance Sheet? .........................................................................................................50
Loss Reserves...........................................................................................................................................................................54
Other Than Temporary Impairments ......................................................................................................................................55
Watch for Large Reserves and Reserve Reversals ...............................................................................................................59
Warranty Reserves May be a Source of Earnings Growth ...................................................................................................61
Are There Underreported Accrued Expenses / Accounts Payable .....................................................................................62
Accounting for Leases .............................................................................................................................................................63
Convertible Debt .......................................................................................................................................................................69
Debt and Debt Covenants ........................................................................................................................................................74
Other Assets and Liabilities ....................................................................................................................................................75
Accumulated Other Comprehensive Income .........................................................................................................................76
Fair Value Measurements ........................................................................................................................................................79
Balance Sheet Relationships...................................................................................................................................................82
Revenue Recognition ...............................................................................................................................................................84
Non-Recurring Items? ..............................................................................................................................................................87
Comparability of Margins.........................................................................................................................................................89
Changes in Estimate Driven Expenses ..................................................................................................................................90
Restructuring Costs .................................................................................................................................................................94
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Reserve Reversal Gains included in Earnings - Do Not Overlook the Schedule II ........................................................95
Stock Based Compensation ....................................................................................................................................................97
Economic Cost of Stock Based Compensation ..................................................................................................................105
Incorporating Stock Based Compensation In Cash Flows and Valuation ........................................................................107
Modifications to Options and Vesting Periods ....................................................................................................................108
Income Taxes ..........................................................................................................................................................................109
Share Repurchases ................................................................................................................................................................119
Earnings Per Share & Diluted Share Count .........................................................................................................................120
Statement of Cash Flows .......................................................................................................................................................122
Material Non-Cash Activities / Supplemental Cash Flow Information .............................................................................. 126
Pension and Postretirement Plan Disclosures ....................................................................................................................128
Key Pension Items: Funded Status = Pension Plan Assets Pension Liability ..............................................................129
Key Pension Assumptions ....................................................................................................................................................130
Pension Cost ...........................................................................................................................................................................133
Pension Footnote Example 3M Company .........................................................................................................................135
Mark to Market Pension Accounting ....................................................................................................................................142
Unfunded Multi-Employer Pension Plans ............................................................................................................................143
Pension Q&A ...........................................................................................................................................................................145
Market Risk Disclosures ........................................................................................................................................................151
Hedging and Derivative Disclosures ....................................................................................................................................154
Derivatives: An 8 Point Checklist To Analyze Disclosures ................................................................................................156
Analyzing Derivative Disclosures: Becton Dickinson Illustration .....................................................................................158
Subsequent Event Disclosures .............................................................................................................................................164
Dated Financial Statements ...................................................................................................................................................166
Internal Controls .....................................................................................................................................................................167
Auditors Opinion ...................................................................................................................................................................169
Differences Between U.S. GAAP and IFRS GAAP ...............................................................................................................172
Appendix: Accounting Case Studies ....................................................................................................................................187
Accounting & Tax Policy Research Library .........................................................................................................................202
Disclosures..............................................................................................................................................................................203
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INTRODUCTION
Graham and Dodds seminal book, Security Analysis, popularized financial statement analysis as a
critical component of investing. It fostered the notion that a thorough reading and understanding of a
companys annual report would lead to identifying overlooked investment opportunities and potential risk
exposures. In short, reading an annual report increased the odds of producing alpha. We still believe the
same holds true today, but 10-Ks are larger than ever before with complicated accounting principles
underlying the figures and footnotes.
To assist investors in navigating through these lengthy documents, this report explains and interprets
essential financial statement disclosures and sections. Weve arranged this report by key sections,
following the typical 10-K progression, and wrote each section in such a way that each topic may be
read individually.
FILINGDEADLINES
For 10-K and 10-Q (quarterly reports) filing deadlines, the U.S. Securities and Exchange Commission
(SEC) rules classify companies as large accelerated filers, accelerated filers, or non-accelerated filers.
Companies that are classified as large accelerated filers have a worldwide common public equity float of
at least $700 million and have filed reports with the SEC for at least 12 months. Worldwide common
public equity float is measured on the last day of the most recently completed fiscal second quarter. The
10-K filing deadline for large accelerated filers is 60 days after year-end.
Accelerated filers are defined as companies with a common public equity market float of $75 million to
$700 million. The 10-K filing deadline for these companies is 75 days after year-end.
Non-accelerated filers is the third category of companies and is defined as a company with a public
common equity float of less than $75 million or a company completing an initial public offering (IPO)
during the year. Non-accelerated filers 10-K deadline is 90 days after year-end.
Sometimes a companys filing deadline falls on a Saturday or Sunday in which case the company has
until the following Monday to file its 10-K. For a recent IPO, once a company has been subject to the
Securities Exchange Acts reporting requirements for at least 12 calendar months and has filed at least
one annual report, the company is eligible for either large accelerated or accelerated filing status.
If a company cant file its annual report without unreasonable effort or expense, it may seek temporary
relief under SEC rule 12b-25. In these circumstances, the SEC allows a 15-calendar-day extension to
the companys 10-K filing deadline. When this happens, the company files a Form 8-K or NT-10-K,
explaining the reason for delay.
SEC Annual Report Filing Deadlines
SECClassification
LargeAcceleratedFilers
AcceleratedFilers
OtherFilers
(1)
Definition
Publicfloatofatleast$700million
Publicfloatbetween$75and$700million
Publicfloatlessthan$75million;recentIPOs
Form10KFilingDeadline
60daysafteryearend(Feb.29,2012forcalendaryearendcompanies)
75daysafteryearend(March15,2012forcalendaryearendcompanies)
90daysafteryearend(March30,2012forcalendaryearendcompanies)
(1)Marketvaluefloatisbasedonthedateofthemostrecentsecondquarter(June30,2011forcalendaryearendcompanies).Onceacompany
becomesaLargeAcceleratedFiler,publicfloatmustfallbelow$500milliontoreturntoAcceleratedFilerstatus.ToexitAcceleratedFilerstatus,
thepublicfloatmustdropbelow$50million.
Source: Wolfe Trahan Accounting & Tax Policy Research; SEC.
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ANNUALREPORTSECTIONS
The 10-K is divided into four main parts, of which we focus on interpreting and reviewing the footnotes
and related disclosures. We also delve into other specific sections of the 10-K if they are applicable to
investment analysis.
Part I
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
Business
Risk Factors
Unresolved SEC Comments
Properties
Legal Proceedings
Submission of Matters to Vote of Security Holders
Part II
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
Market for Registrants Common Equity and Related Stockholder Matters

Selected Financial Data
Managements Discussion and Analysis of Financial Condition and Results
Quantitative and Qualitative Disclosures About Market Risk
Financial Statements and Supplementary Data
Change in and Disagreements with Accountants on Accounting and Financial
Disclosure
Controls and Procedures
Other Information
Part III (This section is usually included in a proxy statement and referenced in the Form 10-K)
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
Directors and Executive Officers of the Registrant

Executive Compensation
Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
Certain Relationships and Related Transactions
Principal Accountant Fees and Services
Part IV
Item 15.
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Exhibits and Financial Statement Schedules
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RECENTACCOUNTINGPRONOUNCEMENTSANDCHANGES
Disclosure of the financial impact of newly issued accounting standards (those that have not yet been
adopted) is required under SEC Staff Accounting Bulletin No. 74 (SAB 74). This information is typically
located following the summary of significant accounting policies section. Under this SEC guidance,
companies are required to describe the new accounting rule, adoption date, method of adoption (e.g.
prospective/retrospective), known estimated financial statement impact, and related potential impact on
other significant matters (e.g., debt covenants). We note that some companies voluntarily choose to list
all recently issued accounting standards not yet adopted even if they do not expect a material impact.
Many times, this disclosure may simply be boilerplate language that contains only general information
about the pending change. However, as the effective date draws closer, analysts may find that the
financial impact of adopting of adopting the new rule is disclosed.
Below are recent and upcoming accounting rule changes that may impact companies.
Recent FASB / SEC Accounting Pronouncements and Changes
New / Pending Change
ASU No. 2010-26, Financial ServicesInsurance (Topic 944): Accounting for
Costs Associated with Acquiring or
Renewing Insurance Contracts (EITF
Consensus)
Description
Immediate changes to GAAP on costs that qualify as deferred acquisition costs.
The changes tighten the rules on allowable capitalized costs since there is
concern that companies are inappropriately and inconsistently capitalizing
indirect and other marketing costs on balance sheet. DAC would only include
costs that are directly related to the acquisition or renewal of an insurance
contract. Only incremental direct costs of contract acquisition are allowed.
Requires additional disclosures of derivative assets and liabilities that are offset
for balance sheet purposes or are subject to master netting agreements.
Additional information must be described pertaining to the gross amounts of
assets / liabilities, the amounts offset within the balance sheet, and the amounts
subject to master netting agreements (whether offset or not).
Effective Date / Status

Effective Q1 2012 with a prospective
transition (retrospective election would be
allowed). Early adoption was allowed.
ASU No. 2011-09, Compensation Retirement Benefits - Multiemployer

Plans (Subtopic 715-80): Disclosures
about an Employer's Participation in a
Multiemployer Plan
Requires additional disclosures in tabular formats for each significant

multiemployer pension plan: 1) Name and identifying EIN number;
2) Level of employers participation (whether the employers contribution
represents >5% of total contributions to the plan);
3) Financial health of the plan based on the risk zone as indicated by the
Pension Protection Act; any funding improvement plans pending or implemented;
any surcharges imposed; and
4) Expiration date and information about the collective bargaining agreements
underlying the required contributions to the plans.
Importantly, certain information about plan withdrawal liabilities will still NOT be
required.
Effective for 2011 10-Ks for calendar year

companies.
ASU No. 2011-08, IntangiblesGoodwill and Other (Topic 350):

Testing Goodwill for Impairment
Adds a preliminary qualitative assessment to the testing for goodwill impairment.

Instead of proceeding directly to step 1 of the quantitative 2 part goodwill
impairment test (determiing whether the carrying value of the reporting unit
exceeds its fair value), a company may use a qualitative events or circumstances
test to assess whether it's more likely than not (50% or greater) that the fair value
of the reporting unit is less than the carrying value. These events and
circumstances include macroeconomic conditions, industry & market
considerations, input cost factors, financial performance, entity specific events
such changes in management, customers, strategy, etc., or a sustained
decrease in share price.
Effective 'Q1 2012.
ASU No. 2011-05, Comprehensive

Income (Topic 220): Presentation of
Comprehensive Income
Clarifies the presentation of items recognized in Other Comprehensive Income.

Other Comprehensive Income and its components must either be presented as
part of the income statement or in a immediately subsequent separate statement
of comprehensive income. The option to present the components of
comprehensive income in the statements of changes in shareholder's equity is
no longer available. More closely aligns the US GAAP presentation to IFRS
(differences still remaining in the measurement of comprehensive income).
Effective 'Q1 2012.
ASU No. 2011-11, Balance Sheet

(Topic 210): Disclosures about
Offsetting Assets and Liabilties
Effective 'Q1 2013 with retrospective

comparison.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FASB.
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FASB Proposals
Topic
Revenue Recognition
Description
Joint FASB/IASB project. Intends to improve existing revenue recognition
standard, which contain inconsistencies and weaknesses. While direct impact
will be to difficult to quantify, the new standard is likely to materially affect a
number of industries.

Exposure draft document issued November
2011. FASB will receive comment letters
through March 2012 and then begin redeliberations. Effective date not before
2015.
Lease Accounting
Joint FASB/IASB project. Will result in complete overhaul of current lease

accounting policies. Operating lease commitments that are currently will be
capitalized on the balance sheet as intangible right to use asset and related debt
obligation. Will impact debt ratios, earnings and reported operating cash flow.
Largest impact on retail, restaurants, airlines, air freight, and certain industrials.
The decision whether to include option renewals and contingent rent continues to
be a controversial topic that Board members cannot reconcile.
Significant changes have been made since

the original exposure draft issued August
2010. New exposure draft will be issued in
'H2 2012. Any final standard will not likely
be effective before 2015.
Financial Instruments Accounting
Joint FASB/IASB project. Will result in overhaul of accounting for financial

instruments (loans, securities etc.). FASB and IASB taking two different
approaches to standard setting process . More items expected to be recorded at
fair value on balance sheet as opposed to amortized cost (some items may be
marked to market through earnings and some may be marked through OCI).
Loans held for investment likley to retain amortized cost accounting model.
Impairment (loan reserves) will be on a more expected basis vs. the current
incurred basis model. Hedge accounting will be simplified and clarified.
There have been significant changes since

FASB's exposure draft was issued in May
2010. Re-deliberations continue. A joint
supplementary exposure draft on
impairment was issued In January 2011.
The FASB may re-expose in 'H2 2012.
IASB has broken the project into 3 phases.
Phase 1 (Measurement) has been
completed but has delayed the effective
date to 2015. Phase 2 (Impairment) ED
released 'Q4 2009 but significant changes
have been made since then. Initial Phase 3
(Hedging) ED was released 'Q2 2010. Any
final standards will not likely be effective
before 2014/2015.
Insurance Accounting
Joint FASB/IASB project. Will overhaul and clarify the insurance contract
accounting. Deferred acquisition costs (DAC) likely to continue to receive similar
accounting treatment as is currently provided (e.g. capitalized, not immediately
expensed).
Re-deliberations are ongoing based on

FASB's informal discussion paper and IASB
exposure draft (June 2010). FASB is
targeting to release an exposure document
"H2 2012 . We do not expect any changes
to be effective before 2014.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FASB.
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Tax Policy Changes

Topic
Corporate Tax Reform
Description
"Presidents Framework for Business Tax Reform" includes proposals to reduce
the corporate tax rate to 28%, reform the US international tax system in an
attempt to tax more foreign source income of US corporations pertaining to
deferral, foreign tax credits and intangible property profits shifting. Other
corporate tax reforms proposed in the budget include LIFO repeal, insurance
industry taxation, oil & gas industry taxation, and taxation of carried interests
(hedge funds and PE firms). The tax-advantaged status of many pass-through
entities may also be at risk under any reform. Outlook for passing any major
reform before this year's election remains unlikely in our opinion given
Washington gridlock.

Under consideration
Bonus Depreciation
100% bonus depreciation expired at the end of 2011 and is 50% for 2012. All
bonus depreciation provisions will expire and revert to standard MACRS
beginning 2013.
Under consideration
Individual Tax Increases
Expiration of lower individual Pre-Bush tax cut rates resulting in increased

personal income tax rates (top bracket from 35 % to 39.6%). Dividend tax rate
will revert to ordinary income tax rate (currently at lower capital gains rate).
Capital gains tax rate to revert to 20%. Obama's budget retains the lower Bush
tax rates for those not considered "high-earners" (<$250k joint). Proposed capital
gains and dividend tax rates to remain at 15% for this same group and increase
to 20% for "high-earners". Personal exemption phaseouts will be reinstated as
well as the Pease maximum 28% tax rate for itemeized deductions. Healthcare
bill will impose a 3.8% tax surcharge on investment income for high-earners.
Under review.
Source: Wolfe Trahan Accounting & Tax Policy Research.
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REVIEW10KFORUNRESOLVEDSECSTAFFCOMMENTS
Analysts should review Item 1B, unresolved SEC staff comments, of the 10-K. Under the SarbanesOxley Act of 2002, the SEC must review every public companys financial disclosures at least once
every three years. The SEC will send companies comment letters based on these reviews, requesting
additional disclosures or asking why certain disclosures were not included in 10-Ks or 10-Qs.
SEC comment letters may also lead to a deeper SEC investigation into a companys accounting
practices if questionable or non-Generally Accepted Accounting Principles (GAAP) are discovered.
Unresolved SEC comments must be disclosed under the following circumstances:
The SECs written comment remains unresolved at the10-K filing date;

The SEC written comments are material; and
The SEC comments were issued more than 180 days before the end of the fiscal year to which
the annual report relates.
At least 45 days after the SEC review is finished, comment letters are publicly available on the SEC
website and other data provides such as Edgar. The filing type appears as CORRESP (the companys
response to the SEC) or UPLOAD (the SECs letter to the company).
PROPERTIESSECTION:LEASEDOROWNED?
Item 2 of the 10-K requires a description of the companys major properties and facilities, noting if they
are leased or owned. This footnote will aid investors in understanding a companys mix of owned versus
leased real estate and its physical location. It may also assist in identifying hidden asset values in land
or other properties. There is no required standardized format and, therefore, disclosures do vary by
company as some are several pages in length while others are one or two paragraphs.
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MANAGEMENTSDISCUSSIONANDANALYSIS
SEC Regulation S-K requires a managements discussion and analysis (MD&A) section. The MD&A
section, among other items, is a narrative on a companys financial condition, results of operations,
liquidity, and capital resources. Since reading the MD&A for the results of operations is as much an art
as it is a science, we discuss other important MD&A disclosures related to off-balance sheet entities,
liquidity, and contractual obligations in the sections that follow.
OFF-BALANCE SHEET EXPOSURES

Off-balance sheet entities and disclosures are particularly important to review for many reasons. They
may require cash funding, consolidation, and/or some type of subordinated support and this might
impact debt covenants, balance sheet liquidity, and capital ratios (and in turn credit ratings). Although
uncommon, off-balance sheet entities may also be used to hide losses and manage earnings.
Companies must disclose detail and terms of significant off-balance sheet arrangements in a separate
section of MD&A. This section of the MD&A includes a discussion on joint ventures (JVs), debt
guarantees, certain contract guarantees, retained interests, derivatives classified as equity, and variable
interests (VIEs) in unconsolidated entities (e.g., CDOs, SIVs, and commercial paper conduits). Offbalance sheet arrangements may also be disclosed in the debt footnote.
The accounting rules impart considerable subjectivity in assessing whether an entity should be
consolidated and, therefore, allow flexibility in structuring entities for the desired off-balance sheet
treatment. By finessing these complicated accounting rules, a company technically may not be required
to consolidate an entity even though it retains a significant amount of risk. In 2010, companies adopted
the Financial Accounting Standards Boards (FASB) new Financial Accounting Standards (FAS) 166
and FAS 167 rules. These stringent rules required consolidation of more off-balance sheet entities.
The most important disclosures, in our view, evaluate the loss probabilities of off-balance sheet entities
and guarantees, the underlying credit quality of the off-balance sheet arrangement, and the probability of
liquidity support for either contractual or reputational reasons. Investors should also review any yearover-year language changes in the disclosures. Below are a few key questions and items that we
believe investors should consider when analyzing off-balance sheet entities:
1. Contingent events: What circumstances must occur for the contingent obligations to become a
liability of the parent company? Would any cash funding be required?
2. Potential losses: What is the off-balance sheet entitys maximum exposure to loss? What events
would need to occur to trigger the maximum losses?
Companies may disclose expected losses from off-balance sheet entities, but we dont give
much weight to these amounts since they are full of management assumptions, generally only
reflect current market conditions, and are not sensitivities to specific events. Also, note that the
disclosure of maximum losses may not reflect losses currently deemed to be remote.
3. Liquidity: Reviewing the disclosure for liquidity triggers is important. We suggest reviewing the
disclosures to see if there is a liquidity support agreement to the off-balance entity and if there are
specific asset value triggers to fund it (asset values declining below a certain amount may require
liquidity support). We also seek to identify if there are any additional cash funding requirements
and, if available, review the credit quality of the underlying assets in the VIE.
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4. Consolidation: Its important to review the off-balance sheet disclosures and/or use them as a
basis in asking management for under what circumstances would the company be required to
consolidate the off-balance sheet entity. Under the relatively new FASB consolidation rules,
companies must evaluate off-balance sheet entities (e.g., variable interest entities) every quarter
to assess whether they should be consolidated. When thinking about consolidation, we assess
the following:
o How would consolidation impact the financial ratios and position of the company?
o Would consolidation violate debt covenants?
o How would consolidation impact capital? (Under GAAP, if a reconsideration event occurs, a
company may be required to consolidate an off-balance sheet entity.)
5. Voluntary Rescue: Even if a company is not legally obligated to provide financial or other support
to an off-balance sheet entity, there may be circumstance under which the company would
voluntarily choose to provide it. This would occur if the entitys failure would hurt the parent
companys reputation or limit its access to an important input to its business. As an example, a
parent company may choose to guarantee JV debt that wasnt legally guaranteed previously to
keep the entity afloat if it was a key source of raw material inputs.
The disclosures should be also viewed with some caution since they dont take into account any
offsetting financial instruments used to hedge these risks. These may be noted in a table footnote, but
weve found disclosures to be spotty in this area.
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As an off-balance sheet disclosure example, weve reproduced a portion of Wells Fargos 2010 10-K,
discussing the banks maximum loss exposure in unconsolidated VIEs.
Wells Fargos MD&A Off-Balance Sheet Entities Disclosures
Note 8: Securitizations and Variable Interest Entities
transfer assets to a VIE and account for the transfer as a sale, we are considered the transferor. We consider investments in securities held outside of
trading, loans, guarantees, liquidity agreements, written options and servicing of collateral to be other forms of involvement that may be significant. We
have excluded certain transactions with unconsolidated VIEs from the December 31, 2010, balances presented in the table below where
we have determined that our continuing involvement is not significant due to the temporary nature and size of our variable interests, because we were not
the transferor or because we were not involved in the design or operations of the unconsolidated VIEs.
(in millions)
December 31, 2010
Total
VIE
assets
Debt and
equity
interests (1)
Servicing
assets
Derivatives
Other
commitments
and
guarantees
Net
assets
Carrying value asset (liability)

Residential mortgage loan securitizations:
Conforming
Other/nonconforming
Commercial mortgage securitizations
Collateralized debt obligations:
Debt securities
Loans (2)
Asset-based finance structures
Tax credit structures
Collateralized loan obligations
Investment funds
Other (3)
Total
$1,068,737
76,304
190,377
5,527
2,997
5,506
12,115
495
608
6
261
20,046
9,970
12,055
20,981
13,196
10,522
20,031
$1,442,219
1,436
9,689
6,556
3,614
2,804
1,416
3,221
42,766
43
13,261
844
(118)
56
377
1,426
(928)
(107)
16,714
3,391
6,375
(1,129)
(6)
(2,170)
2,280
9,689
6,438
2,485
2,860
1,416
3,635
55,283
Maximum exposure to loss

Residential mortgage loan securitizations:
Conforming
Other/nonconforming
Commercial mortgage securitizations
Collateralized debt obligations:
Debt securities
Loans (2)
Asset-based finance structures
Tax credit structures
Collateralized loan obligations
Investment funds
Other (3)
Total
5,527
2,997
5,506
12,115
495
608
6
488
4,248
233
21,890
3,731
6,602
1,436
9,689
6,556
3,614
2,804
1,416
3,221
42,766
43
13,261
2,850
118
56
916
4,434
2,175
1
519
87
162
7,432
4,293
9,689
8,849
3,615
3,379
1,503
4,342
67,893
(1) Excludes certain debt securities held related to loans serviced for FNMA, FHLMC and GNMA.
(2) Represents senior loans to trusts that are collateralized by asset-backed securities. The trusts invest primarily in senior tranches from a diversified pool of
primarily U.S. asset securitizations, of which all are current, and over 91% were rated as investment grade by the primary rating agencies at December 31,
2010. These senior loans were acquired in the Wachovia business combination and are accounted for at amortized cost as initially determined under
purchase accounting and are subject to the Companys allowance and credit charge-off policies.
(3) Includes student loan securitizations, auto loan securitizations and credit-linked note structures. Also contains investments in auction rate securities
(ARS) issued by VIEs that we do not sponsor and, accordingly, are unable to obtain the total assets of the entity.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings.
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USING OFF-BALANCE SHEET VEHICLES TO HIDE DEBT, INVENTORY, AND/OR EXPENSES

To boost earnings or improve reported financial ratios, a company may choose to move inventory and
debt into a joint venture or other off-balance sheet entity. A careful reading and analysis of joint venture
disclosures will help identify whether a significant increase in inventory might have been shifted offbalance sheet. For example, a joint venture may produce and sell inventory to the parent company. The
parent company may control the purchases of inventory from this entity. Therefore, financial analysis of
the parent companys inventory balance may be obfuscated by inventory increasing on the balance
sheet of the joint venture partner.
A company may also finance a joint venture with debt or with a parent company guarantee for all or a
portion of the joint venture debt. This debt amount or debt guarantee would not appear on the parent
companys balance sheet, but may be a real obligation and very similar in substance to debt. An analyst
would find these type of debt arrangements or guarantees typically in the MD&A section listed as an offbalance arrangement.
Furthermore, JV arrangements typically mask underlying leverage levels at the parent company due to
the equity method of accounting. In a JV arrangement, both companies usually account for an
investment under the equity method of accounting instead of consolidating the JV entity. Under the
equity method of accounting, the balance sheet contains a single line item, typically called investments
or equity method investments, classified under other long-term assets. On the liability side of the
balance sheet, the JVs debt is not reported under the equity method of accounting. On the income
statement, the companys proportion of the JVs income is recorded as equity income/loss and usually
reported in other income. For financial analysis and ratios, we suggest analysts consolidate the
companys attributable portion (e.g., 50%) of the joint ventures off-balance sheet debt amount as well as
their percentage of any JV debt guarantees.
The creation of new JVs or off-balance sheet entities is another way to improve reported margins. If the
business contributed to the new entity has lower overall margins, the remaining parent company will
report higher margins since the business will be deconsolidated and be reported under the equity
method of accounting. On the income statement, only one line equity income/loss is reported and
typically shown separate from gross and operating income.
CONTRACTUAL OBLIGATIONS AND FIXED CASH FLOW COMMITMENTS

Within the MD&A section, SEC rules require a table of contractual obligations. This table summarizes
information usually contained in other sections of the 10-K and lists fixed debt and debt like
commitments, such as long-term debt repayments, capital and operating lease payments, purchase
obligations, and other long-term contractual liabilities. It should (but does not always) include material
cash funding requirements for pension and OPEB plans, probable FIN 48 tax cash contingency
payments, and cash interest expense. We find the disclosure to be a great summary of a companys
future contractual cash outflows and a tool in evaluating a companys future liquidity needs.
Analysts should be mindful that not all contractual-type fixed payment arrangements are included in the
table of contractual obligations. If a contractual arrangement may be cancelled without any material
penalties, it may be excluded. Furthermore, the table does not include such items as salaries to
employees or dividend payments. The next exhibit is an example of a contractual obligations table.
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Delta Air Lines (2011 Form 10-K): Contractual Obligations Table
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CRITICALACCOUNTINGPOLICIES
For financial reporting purposes, a critical accounting policy is one that requires significant and/or
subjective management judgment. The summary of significant accounting policies section is a similar
disclosure that overlaps with the critical accounting estimates section, typically located in the first or
second 10-K footnote.
The summary of significant accounting policies includes both critical accounting policies and other
material accounting policies. Both of these sections are important to uncover any year-over-year
changes in accounting policies that impact earnings or signal possible other business issues. A reading
of this section may help identify companies under/over earning relative to other companies. For
example, the section may describe a very conservative accounting policy that is reducing current period
earnings.
One of the first signs of a more aggressive accounting policy change may be a new one or two sentence
disclosure in this section. Additionally, a companys accounting policies should be reviewed and
compared against competitors policies since differences may impact reported earnings and
comparability. Below is an example of the critical accounting policies for USG.
USGs Critical Accounting Policies Excerpt (2011 Form 10-K)
PROPERTY,PLANTANDEQUIPMENT
We assess our property, plant and equipment for possible impairment whenever events or changes in circumstances indicate that the
carrying values of the assets may not be recoverable or a revision of remaining useful lives is necessary. Such indicators may include
economicandcompetitiveconditions,changesinourbusinessplansormanagementsintentionsregardingfutureutilizationoftheassets
orchangesinourcommodityprices.Anassetimpairmentwouldbeindicatedifthesumoftheexpectedfuturenetpretaxcashflowsfrom
theuseofanasset(undiscountedandwithoutinterestcharges)islessthanthecarryingamountoftheasset.Animpairmentlosswouldbe
measuredbasedonthedifferencebetweenthefairvalueoftheassetanditscarryingvalue.Thedeterminationoffairvalueisbasedonan
expectedpresentvaluetechnique,inwhichmultiplecashflowscenariosthatreflectarangeofpossibleoutcomesandariskfreerateof
interestareusedtoestimatefairvalue,oronamarketappraisal.
INTANGIBLEASSETS
We have indefinite and definite lived intangible assets withnet values of $30 million and $40 million, respectively, as of December 31,
2011. Intangible assets determined to have indefinite useful lives, primarily comprised of trade names, are not amortized. We perform
impairment tests for intangible assets with indefinite useful lives annually, or more frequently if events or circumstances indicate they
mightbeimpaired.Theimpairmenttestsconsistofacomparisonofthefairvalueofanintangibleassetwithitscarryingamount.Ifthe
carrying amount of an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. An
income approach is used for valuing trade names. Assumptions used in the income approach include projected revenues and assumed
royalty,longtermgrowthanddiscountrates.
EMPLOYEERETIREMENTPLANS
Wemaintaindefinedbenefitpensionplansformostofouremployees.Mostoftheseplansrequireemployeecontributionsinorderto
accruebenefits.Wealsomaintainplansthatprovidepostretirementbenefits(retireehealthcareandlifeinsurance)foreligibleexisting
retirees and for eligible active employees who may qualify for coverage in the future. For accounting purposes, these plans depend on
assumptions made by management, which are used by actuaries we engage to calculate the projected and accumulated benefit
obligations and the annual expense recognized for these plans. The assumptions used in developing the required estimates primarily
includediscountrates,expectedreturnonplanassetsforthefundedplans,compensationincreaserates,retirementrates,mortalityrates
and,forpostretirementbenefits,healthcarecosttrendrates.
INCOMETAXES
We record income taxes (benefit) under the asset and liability method. Under this method, deferred tax assets and liabilities are
recognizedbasedonthefuturetaxconsequencestotemporarydifferencesbetweenthefinancialstatementcarryingamountsofexisting
assetsandliabilitiesandtheirrespectivetaxbasesandattributabletooperatinglossandtaxcreditcarryforwards.Deferredtaxassetsand
liabilities are measured using enacted tax rates expected to apply in the years in which the temporary differences are expected to be
recoveredorpaid.Theeffectondeferredtaxassetsandliabilitiesofachangeintaxratesisrecognizedinearningsintheperiodwhenthe
changeisenacted.
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BalanceSheet
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QUALITYOFCASHANDINVESTMENTS
The composition and location of cash and investments are often overlooked by analysts. To be
classified as cash under GAAP, the instrument must have a maturity date of 90 days or less.
Investments are classified as short-term or long-term depending on their maturity date. Historically,
auction rate securities (ARS) also met the GAAP definition of cash and equivalents since their interest
rate was reset every 7, 21, or 28 days and there was an auction into which to sell the securities.
CASH BALANCES ARE OFTEN OVERSTATED IN VALUATION

A significant portion of some multinational companies cash balances may be domiciled overseas and
not accessible for distribution to shareholders or other payments. Therefore, its important to ascertain
where the cash is located and if any additional taxes would be owed to access the cash. One common
mistake we observe in valuations is valuing cash at 100% of its balance sheet value. To calculate
distributable cash, the gross cash amount reported on companies balance sheets needs to be adjusted
downward for any U.S. taxes expected to be owed upon cash repatriation. Unfortunately, not all
companies disclose the percentage of cash residing overseas, but we have seen more companies begin
to disclose this item after a higher level of SEC scrutiny.
Current U.S. corporate tax law incentivizes companies to keep cash overseas as companies only pay
foreign taxes on the foreign earnings in the current period insofar as the earnings are not repatriated to
the U.S. This is often termed foreign deferral. To access overseas cash, a company would typically be
required to pay incremental U.S. taxes on cash amounts repatriated, reaching as high as the 35%
current U.S. corporate tax rate.
To illustrate the repatriation and cash issue, assume Chris Corp. operates a foreign subsidiary in Ireland
and earns $500 of foreign income that is taxed at 20%. In the current year, Chris Corp. would owe
Ireland taxes of $100. This generates a $100 U.S. foreign tax credit and the remaining reported cash
balance after foreign taxes would be $400. The earnings remain in Ireland and are neither distributed to
the U.S. parent company nor included as income in Chris Corp.s consolidated U.S. income tax return.
Additionally, under U.S. GAAP, it is very common for companies to deem their foreign earnings as
permanently reinvested overseas, removing additional U.S. GAAP income taxes from earnings.
Therefore, the company would report a 20% GAAP effective income tax rate ($100 income tax expense
/ $500 income).
Assume that the company decides to repatriate and distribute the foreign cash domiciled in Ireland to
the U.S. entity. To calculate U.S. taxable income on Chris Corp.s U.S. tax return, the companys foreign
earnings are grossed-up to their pre-tax foreign amount ($500). Then U.S. corporate taxes are
calculated at the current 35% corporate tax rate ($500 x 35% = $175). The foreign tax credit of $100 is
applied to the U.S. corporate tax of $175, leaving $75 of incremental taxes due. As a result of these
taxes, the companys cash balance available for U.S. activities is reduced from $400 to $325 ($400 less
$75 in U.S. taxes).
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ACCOUNTINGFORINVENTORY
The inventory 10-K footnote should be reviewed for: (i) changes in inventory accounting policies, (ii)
inventory reserve changes, (iii) last-in, first-out (LIFO) liquidations, and (iv) inventory charges from
reduced production levels. Two important disclosures in this footnote are details of the inventory
balances (i.e., raw materials, work in progress and finished goods) and reserves.
LARGE INVENTORY RESERVE CHANGES MAY INFLATE PROSPECTIVE GROSS MARGINS

An analyst should review inventory for write downs to the lower of cost or market because in a quarter of
poor results or at year-end, a company might excessively write-down its inventory as a one-time charge
owing to a decrease in the inventorys selling prices. The inventory write-down is recorded in an
inventory reserve account until the inventory is sold or scrapped (inventory reserves are required to be
disclosed if material). If the sales price of inventory previously written-down recovers in value, and the
product sells at the higher price, a company would record an inflated gross margin since it wrote-down
the inventory in a prior quarter. The increase in gross margin is unsustainable since there is only a
limited amount of inventory on the balance sheet at the lower value. The production of new inventory at
its normal or higher cost will result in the company recording a lower, but normal gross margin in the
income statement in the subsequent period. Inventory write-downs and subsequent recoveries in value
are common after recessions and this is why we feel this issue has been more common in 2010 and
2011. Below is an illustration of an inventory write down and subsequent sale for CF Industries.
Inventory Write-Downs Followed by Subsequent Sale
AtDecember31,2008,werecordeda$57.0millionnoncashchargetowritedownourphosphateandpotashinventoriesby$30.3million
and$26.7million,respectively,asthecarryingcostoftheinventoriesexceededtheestimatednetrealizablevalues.Netrealizablevalues
for our phosphate and potash inventories are determined considering the fertilizer pricing environment at the time, as well as our
expectations of future price realizations. The inventory that was held at December 31, 2008 included inventory that was produced or
purchased earlier when input costs and fertilizer prices were higher. During the first quarter of 2009, we sold all of the higher cost
phosphateinventorythatexistedatDecember31,2008.AtSeptember30,2009,wereassessedthenetrealizablevaluesoftheinventory
held.Basedonthisanalysis,noadditionalinventoryvaluationreserveswerenecessaryforthephosphatefertilizerinventory.However,
duringthefirstandsecondquartersof2009,additionalinventoryvaluationreservesof$24.3millionand$5.0million,respectively,were
recognizedrelatedtothepotashinventory.Duringthethirdquarter,wesoldallremainingpotashinventory.
ANY LARGE CHANGES IN THE MIX OF INVENTORY RELATIVE TO TOTAL INVENTORIES?

A calculation of the percentage of each inventory category (raw materials, work in progress and finished
goods) to total inventory will highlight any differences in the mix of inventory. While there are normal
reasons for mix shifts, any large changes may suggest changes in the business. For example, if the
finished goods balance materially increased relative to total inventory, it may presage slowing end
demand for the companys product. At the same time, the total inventory balance may not have
materially changed if the company decreased raw material purchases to offset slowing demand (finished
goods increased and raw materials decreased).
HAVE THERE BEEN MATERIAL REDUCTIONS IN THE LIFO INVENTORY RESERVE?

Inventory is accounted for using one of several methods including first-in, first-out, average cost, last-in,
first-out or specific identification. By far, the FIFO accounting costing method is the most common.
However, to appease companies concerns over paying higher taxes on inflationary profits, LIFO
accounting was created in a 1970s tax code change that allowed it to be used as an accounting cost
flow assumption. Under the tax codes LIFO conformity rule, companies are required to use LIFO
accounting for GAAP purposes if they use it for tax purposes. LIFO is not allowed under International
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Accounting Standards and is one of the major differences between U.S GAAP and IFRS. In a period of
rising prices, LIFO accounting generally results higher costs and, therefore, lower earnings. However,
the reported earnings under LIFO are closest to economic reality and reflective of the current business
conditions than a company using FIFO accounting, where their cost of sales could reflect the cost of
inventory purchased many years ago.
Analysts may adjust a company from LIFO accounting to FIFO to compare like kind margins. To adjust a
company to FIFO, the LIFO companys cost of sales is decreased/(increased) by the
increase/(decrease) in year-over-year (or quarter-over-quarter) LIFO inventory reserve balance. For
balance sheet purposes, the FIFO inventory balance is an approximation of replacement cost and
should be used for balance sheet ratios/analysis. The LIFO inventory balance is often outdated and may
reflect prices paid for inventory many years ago.
The LIFO reserve and material amounts of LIFO liquidations are required 10-K disclosures. The LIFO
reserve is the difference between the FIFO inventory balance and the LIFO inventory balance. It
represents the cumulative difference between FIFO and LIFO inventory. Put another way, if the reserve
is multiplied by the U.S. 35% corporate tax rate, it is the amount of cash taxes cumulatively saved by the
company.
The LIFO disclosures should be reviewed for items that may unsustainably increase gross margin: (i)
LIFO liquidations/LIFO income and (ii) large changes in the LIFO reserve. The reason for a decrease in
LIFO reserves should be closely examined. LIFO reserves will decline due to (1) a price decline or (2)
inventory quantity reduction. A decline in the LIFO reserve reduces cost of sales and increases gross
margins. As we discuss below, if a LIFO reserve decline is due to the quantity of goods sold, it is
unsustainable and, therefore, lowers the quality of gross margins and earnings.
Companies often refer to increases in the LIFO inventory reserve as a charge since recently
purchased inventory items are placed into the inventory balance at a higher cost than inventory
purchased in a prior period. We dont view these as necessarily one-time charges since they are the
normal cost of doing business the company experienced higher costs in the current period and this
reduced margins. A company with volatile raw material and/or other input costs using LIFO inventory will
experience more volatile and immediate gross margins changes than a company using FIFO.
Below we present an example of a LIFO liquidation using Deere as an example.
Deeres LIFO Liquidation (2011 Form 10-K)
MostinventoriesownedbyDeere&CompanyanditsU.S.equipmentsubsidiariesarevaluedatcost,onthelastin,firstout(LIFO)basis.
Remaining inventories are generally valued at the lower of cost, on the firstin, firstout (FIFO) basis, or market. The value of gross
inventories on the LIFO basis represented 59 percent of worldwide gross inventories at FIFO value at October 31, 2011 and 2010. The
pretaxfavorableincomeeffectfromtheliquidationofLIFOinventoryduring2009wasapproximately$37million.
If a reduction in inventory quantity is the cause of the LIFO reserve decline, similar to any reserve
reduction, there is a positive impact on earnings (in this case gross margins) LIFO income or a gain.
This gain is unsustainable since inventory quantities cannot be realistically reduced to zero. To
normalize margins, we suggest removing the LIFO income effect by increasing reported cost of goods
sold by the LIFO income amount.
Conversely, if the decrease in the LIFO reserve is due to price changes, we dont advise in making any
adjustments to normalize gross margins since input price changes are a normal part of the business.
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However, we do believe margins should be adjusted if current input prices are viewed as unsustainable
or short-term aberrations.
INVENTORY ACCOUNTING POLICY CHANGES (E.G. LIFO TO FIFO)?

A change in an inventory costing method accounting policy is rare and, therefore, we view them with a
high level of skepticism. To boost earnings, a company may choose to change from LIFO to FIFO
inventory and weve observed this as most common (but still uncommon) accounting policy change.
Weve seen it among companies encountering rising raw material costs since earnings are higher under
FIFO. A change in an inventory accounting policy is not generally allowed without good reason and
requires a preferability letter from the companys auditor. Therefore, it piques our interest when we find
them.
As an example, in the next exhibit, Kodak changed their inventory method policy from LIFO to average
cost at the beginning of 2006.
Change of Inventory Method Eastman Kodak
On January 1, 2006, the Company elected to change its method of costing its U.S. inventories to the
average cost method, which approximates FIFO, whereas in all prior years most of the Companys
inventory in the U.S. was costed using the LIFO method. As a result of this change, the cost of all of the
Companys inventories is determined by either the FIFO or average cost method. The new method of
accounting for inventory in the U.S. is deemed preferable as the average cost method provides better
matching of revenue and expenses given the rapid technological change in the Companys products. The
average cost method also better reflects more current costs of inventory on the Companys Statement of
Financial Position. As prescribed in SFAS No. 154, Accounting Changes and Error Corrections,
retrospective application of the change in accounting method is disclosed below.
The effects of the change in methodology of costing U.S. inventories from LIFO to average cost on
inventory and cost of goods sold for prior periods presented are as follows (in millions):
As of and for the Year
Ended
December 31, 2005
As of and for the Year

Ended
December 31, 2004
LIFO
Method
LIFO
Method
Average
Cost Method
Average
Cost Method
Inventory
$ 1,140
1,455
$ 1,158
1,506
Cost of goods sold
$ 10,617
$ 10,650
$ 9,582
9,601
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filing.
ARE INVENTORY RESERVES BOOSTING MARGINS?

Large reductions in inventory reserves may boost gross margins. Inventory reserves are recorded on
obsolete, excessive, or returned inventory. As an example, selling previously written down inventory at
a higher expected margin (than at the time of write-down) boosts margins. It is unsustainable as the cost
of producing new inventory is higher than the previously written down amount. Another way margins
may temporarily benefit is by deferring an inventory write-down into a future period.
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IS LOWER PRODUCTION DEPRESSING MARGINS FROM EXCESS OVERHEAD?

FAS 151, Inventory Costs, clarified that abnormal amounts of idle facility expense, handling cost,
freight, and spoilage must be expensed rather than capitalized as part of inventory on the balance sheet.
One large fixed cost included in inventory is fixed overhead costs, namely facility depreciation expense.
Allocation of fixed production overhead is calculated using the normal capacity of the plant or facility,
where normal capacity is defined as the typical production expected over a number of periods or
seasons. Prior to this guidance, companies accounted for these costs in different ways when there were
low capacity levels. In a period of low or idled production, margins may receive a boost when production
levels normalize as these currently expensed costs will be absorbed into inventory.
IS HIGHER PRODUCTION BOOSTING MARGINS?

Companies can overproduce inventory to increase gross margins by spreading the fixed overhead
expenses across more units, thereby lowering the inventorys average cost per unit. Therefore, a
company may boost margins simply by overproducing inventory for which there may not be enough endmarket demand. Weve observed this particularly in high fixed cost businesses. Both rising gross
margins and inventory balances (days of inventory or DOI, calculated as [inventory / annualized cost of
sales x 365]) are suggestive of lower earnings quality. We'd prefer to see rising margins and a stable (or
lower) DOI number.
ARE OTHER COSTS CAPITALIZED INTO INVENTORY?

A careful reading of the inventory footnote may identify other costs currently capitalized into inventory
balances. Two examples of costs that are typically capitalized into inventory are pension and stock
option expense. A portion of both expenses would be capitalized into inventory if its a labor cost of
producing inventory. Separately, inventory is an area where companies in the same industry group may
capitalize different costs into the inventory balance.
INVENTORY: EARNINGS QUALITY

Below we summarize a number of inventory maneuvers used to improve a companys reported gross
margins:
Change in inventory accounting methods;

Gains from reversing inventory reserves;
Delaying inventory write-downs by under-reserving for obsolete or old items;
LIFO liquidations;
Overproducing to lower average cost; and
Large inventory write-downs in the current period followed by a recovery in the selling price in a
subsequent period.
HOW TO SPOT INVENTORY ISSUES

We've found that the trend in, and peer company comparison of, DOI is the most predictive variable at
identifying inventory related issues. A rise in DOI may presage slowing end demand and be an early
warning signal. Changes in inventory reserves should also be reviewed for draw-downs or the lack of
sufficient reserves.
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PROPERTY,PLANT,ANDEQUIPMENT:CHECKASSETLIVESANDFORCHANGESINPOLICIES
Companies may boost future earnings by changing PP&E depreciable lives, residual values, and/or
depreciation methods. Over the years, weve found that these types of changes often signal trouble
around the corner. Companies must disclose the depreciation period and method for each material
asset group.
GAAP requires that PP&Es cost to be allocated as depreciation expense in earnings over the assets
estimated useful life in a systematic and rational manner. There are several allowable methods of
depreciation including straight-line (most common) and other various forms of accelerated depreciation,
such as sum of the years digits and double declining balance. Below are the formulas used to calculate
depreciation expense under each method.
Straight line = (Original cost residual value) / depreciable life
Double declining balance = Depreciation in Year X = 2 / depreciable life x (asset book value at the
beginning of Year X)
Sum of the years digits = Depreciation in Year X = (original cost salvage value) x (n X + 1) /
sum of years digits
Another rarely used depreciation method is units of production (UOP). We highlight it in this section
since Whirlpool switched to it in 2009. Under this method, an asset is depreciated based on the
assumed total production units over the assets entire estimated life. Using this method will increase
depreciation expense during periods of high production levels and reduce depreciation expense during
low levels of production. In effect, it turns a fixed depreciation cost into a variable cost, reducing the
volatility of gross margins and earnings. However, this method is likely to understate economic
depreciation expense for a company in a mature industry or with a declining business as lower current
year production defers depreciation expense into a future period. If product obsolescence or other items
ultimately reduces the assets estimated production units, it will necessitate a PP&E write-down and
indicate that prior periods earnings were overstated (too low depreciation expense).
We suggest reviewing the 10-Ks accounting policy section for any changes or unusual depreciation
policies. Over the years, weve observed that a change in an assets depreciable life has sometimes
been a precursor to deterioration in the companys business fundamentals. GAAP also requires
disclosure of any material changes in depreciable lives, residual values, or depreciation methods. Oddly,
PP&Es residual value amounts are not required disclosures. Next, we highlight the disclosures of some
companies with recent depreciation method changes.
Examples of Depreciation Methodology Change: International Rectifier
Effective December 27, 2010, the Company changed its depreciation method for certain fabrication equipment from the unitsof
production method to the straightline method. The Company considers this change of depreciation method a change in accounting
estimateaffectedbyachangeinaccountingprinciple.Thischangeinestimateisaccountedforprospectivelyasofthebeginningofthe
thirdquarteroffiscalyear2011.WhiletheCompanybelievestheunitsofproductionmethod,asafunctionofusage,reasonablyreflects
the matching of costs and revenues, it requires considerable effort to monitor and track the usage of certain fabrication equipment
consistentlyacrossallfabricationfacilities.TheCompanybelievesthestraightlinemethodofdepreciationrepresentsabetterestimateof
the use of the equipment over its productive life and better reflects the pattern of economic consumption. Additionally, the Company
believestherevisedpracticeisconsistentwiththepredominantindustrypractice.
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DEPRECIATION CHANGES: TWO WAYS TO USE PP&E TO BOOST EARNINGS

Changing assumptions used to calculate depreciation expense is one method used to increase earnings
and has been the underlying reason for numerous historical accounting restatements. Two ways to
lower annual depreciation expense are to extend an assets depreciation period or increase its residual
value. Either of these changes should be viewed with a lot of skepticism.
To calculate depreciation expense, there are three primary inputs: depreciation method (straight line,
accelerated depreciation, etc.), assets residual value, and depreciable life. To lower annual depreciation
expense and boost earnings, a company might change its assumptions by increasing residual values,
extending depreciable lives or changing the depreciation method. Any such changes are red flags in our
view. To identify these changes, we suggest reading through the financial filings as material changes in
these items are required disclosures. The average depreciable life ratio is also helpful in spotting
changes in assumptions (gross PP&E divided by LTM depreciation expense). Within a sector or industry
group, comparing depreciation expense to sales assists in identifying companies with more lenient
depreciation expense policies.
Under GAAP, residual value or depreciable life changes are accounted for prospectively. Increasing an
assets depreciable life does not change the total depreciation expense amount recognized. Instead, it
defers a portion of current depreciation expense into future periods as a smaller annual amount of the
asset is expensed over a longer time period. Similarly, an increase in an assets residual value will
reduce the depreciable amount of the asset and, therefore, lower depreciation expense.
The following exhibit is an illustration of a company increasing the salvage value of its equipment from
$1,000 to $3,000 after owning it for two years. By changing the salvage value, annual depreciation
expense declines from $1,800 to $1,133.
Example: Decreasing Depreciation Expense by Altering Salvage Values
NewlyAcquiredAssetwithanEstimated$1,000
TwoYearsLater:NewSalvageValueEstimateof
$3,000(StraightLineDepr.)
SalvageValue(StraightLineDepr.)
Originalcost
Salvagevalue
Asset'sdepreciableamount
Depreciationperiod(years)
Annualdepreciation(a)
ChangeinDepr.Expense
Originaldepr.Schedule(a)
Newlyadjusteddepr.Expense(b)
Lowerdepr.expense
10,000
1,000
9,000
5
1,800
Year1
1,800
n/a
n/a
Originalcost
Amountalreadydepreciated
Newsalvagevalue
Asset'sdepreciableamount
Remainingdepr.period(years)
Newannualdepreciation(b)
Year2
1,800
n/a
n/a
Year3
1,800
1,133
(667)
Year4
1,800
1,133
(667)
10,000
3,600
3,000
3,400
3
1,133
Year5
1,800
1,133
(667)
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Example of Depreciation Changes in Estimated Lives Archer Daniels Midland
During the second quarter of fiscal year 2011, the Company updated its estimates for service lives of certain of its machinery and
equipmentassetsinordertobettermatchtheCompanysdepreciationexpensewiththeperiodstheseassetsareexpectedtogenerate
revenue based on planned and historical service periods. The new estimated service lives were established based on manufacturing
engineering data, external benchmark data and on new information obtained as a result of the Companys recent major construction
projects. These new estimated service lives are also supported by biofuels legislation and mandates in many countries that are driving
requirementsovertimeforgreaterfutureusageandhigherblendratesofbiofuels.
The Company accounted for this service life update as a change in accounting estimate as of October 1, 2010 in accordance with the
guidanceofASCTopic250,AccountingChangesandErrorCorrections,therebyimpactingthequarterinwhichthechangeoccurredand
futurequarters.Theeffectofthischangeonaftertaxearningsanddilutedearningspersharewasanincreaseof$83millionand$0.13,
respectively,fortheyearendedJune30,2011.
Here are a few financial ratios that detect changing depreciation policies and residual values.
Detecting Changes in Depreciation Methods and/or PP&E Residual Values
Gross PP&E

Accumulated Depreciation
Accumulated Depreciation

Gross PP&E
Gross PP&E

Depreciation Expense
Net PP&E

Depreciation Expense
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IMPLICATIONSOFACCELERATEDDEPRECIATION
A reading of a companys PP&E footnote and accounting policy section may identify a company with a
variant depreciation policy. One example of this is a company using accelerated depreciation for GAAP.
If a company depreciates PP&E on an accelerated basis, uses low residual values, or uses short
depreciable lives, the companys true earnings power may be understated (accounting depreciation
might exceed the assets true economic decline in value). In our review of 10-K disclosures over the
years, we find this uncommon. However, other countries often use accelerated depreciation for GAAP
(for tax reasons). The next exhibit is Northrop Grummans 2011 10-K disclosure of its accelerated
depreciation policy for fixed assets.
Northrop Grumman (2011 Form 10-K): Accelerated Deprecation
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BONUSDEPRECIATION
In recent years, in an effort to stimulate capital investment and growth, Congress has enacted bonus
depreciation. Under bonus depreciation, companies may elect an additional first year tax depreciation
deduction (usually 50%), thereby reducing the companys cash taxes. Bonus depreciation was originally
enacted in 2008 and passed again through a series of extensions. In 2010, the 50% bonus depreciation
was extended by the Small Business Jobs Act. The Tax Relief, Unemployment Insurance
Reauthorization and Job Creation Act of 2010 allowed 100% bonus depreciation for equipment placed in
service after September 8, 2010 through December 31, 2011 and 50% bonus depreciation for
equipment placed in service after December 31, 2011 through December 31, 2012. It was
unprecedented when Congress allowed 100% immediate expensing of most U.S. capital expenditures in
2011. Below we summarize bonus depreciation permitted in each year.
Recent Periods of Bonus / Accelerated Deprecation
Bonus Depreciation Allowed Under U.S. Tax Law for Corporations
2000
0%
2001
0%
2002
30%
2003
50%
2004
50%
2005
0%
2006
0%
2007
0%
2008
50%
2009
50%
2010
50%
2011
100%
2012
50%
2013
0%
Source: Wolfe Trahan Accounting & Tax Policy Research; IRS.
Based on the guidance in the most recent bonus depreciation legislation, in order to qualify for the initial
bonus depreciation, companies must purchase and place the capital assets in use. A number of points
to keep in mind when thinking about bonus depreciation:
1. The asset must be subject to Modified Accelerated Cost Recovery System (MACRS) tax
depreciation with a maximum recovery period of 20 years. It also includes 25-year asset life water
utility properties, software, and qualified leasehold improvement property. This qualifies most
assets except real property/buildings.
2. Bonus depreciation typically only applies to capital expenditures by corporations in the U.S. and
tax consolidated foreign corporations, excluding most non-U.S. capital expenditures. Bonus
depreciation is also generally available for a foreign corporations U.S. capital expenditures, if it
files a U.S. corporate tax return.
3. Some smaller capital expenditures may already be immediately expensed for tax purposes under
the de minimis rule and, therefore, not subject to bonus depreciation as described next:
A. IRS De Minimis Rule: The tax code does not require the capitalization of all incidental costs as
long as the following requirements are met:
i. The company immediately expenses the costs in its GAAP financial statements.
ii. The company has written accounting procedures in place at the beginning of the year
mandating the expensing of property with a purchase price below a certain amount.
iii. The total aggregate amounts paid for property and not capitalized are not distortive to the
taxpayers income for the year (IRS safe harbor: amounts expensed are the lesser of 0.1%
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of a companys gross receipts or 2% of a companys total depreciation and amortization

expense).
B. Materials and supplies: if materials and supplies cost $100 or less, they may be expensed
immediately (subject to the IRS safe harbor rule mentioned herein).
4. Used equipment doesnt qualify. Per the legislation: original use of the property must commence
with the taxpayer. Original use is the first use of the asset whether or not used by the taxpayer
(e.g., purchasing new equipment with the intent of leasing would qualify as long as the company
is the legal owner).
5. The asset must be purchased and placed into service during the relevant taxable year. Certain
time extensions are available for assets with long production periods. For the 100% bonus
depreciation, a one-year extension to January 1, 2013 (asset must be put into use by) is available
for:
A. Property with a production period in excess of one year,
B. An asset life of at least 10 years (also includes transportation property which has a different
asset life); and,
C. Purchase cost of at least $1 million.
The extension period also includes qualifying aircraft purchases. Aircraft purchases not
considered transportation property (commercial airlines dont qualify for the extended place in
service rules) qualify for the extension period if they have an estimated production period
exceeding 4 months, a cost greater than $200,000 and, at the time of contract for purchase, the
purchaser made a nonrefundable deposit of the lesser of 10% of cost or $100,000. For 50%
bonus depreciation (allowed for companies in 2012) there is a one-year extension to January 1,
2014 for assets with long production periods.
BONUS DEPRECIATION: FINANCIAL STATEMENTS IMPACT

Depreciation deductions are just timing differences as the same total amount of the asset is depreciated
over its life under GAAP and tax. Bonus depreciation pulls forward the depreciation tax shield to earlier
periods than normally allowed under the tax code and as compared to GAAP depreciation (typically
straight line). The real benefit to companies electing accelerated depreciation is the time value of money
from cash tax savings in the current year. If an extension of 100% depreciation is not passed by
Congress in 2012, companies will encountered higher cash taxes beginning in 2012 and continuing into
2013/2014 as the benefits of more immediate capital expenditure tax deductions reverse and companies
use regular tax MACRS depreciation schedules. This will be a cash flow headwind for companies with
material U.S. capital expenditures. Since bonus depreciation has occurred with increasing frequency
over the past few years, historical cash tax rates (and cash flow) are distorted by this benefit and
analysts should use caution when using historical cash tax rates to project future cash taxes.
All else being equal, bonus depreciations impact on the financial statements are lower cash tax
payments in the current period (e.g., 2011) and, therefore, higher operating and free cash flow.
Accelerated bonus depreciation does not generally have an impact on a companys GAAP tax rate or
EPS. The balance sheet impact of bonus depreciation is an increase in a deferred tax liability
representing the tax effected difference between the current year tax depreciation (higher) and the
current year GAAP depreciation (lower and typically straight line). A review of the companys table of
deferred tax assets/liabilities in the tax footnote should reveal an increasing deferred tax liability for
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property, plant and equipment depreciation at 2011 year-end. Technically speaking, a larger deferred
tax liability has built-up on companies balance sheets in 2008 through 2011 that will begin to unwind
(decrease) in 2012 (assuming Congress does not extend 100% bonus depreciation in 2012).
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HIDDENASSETVALUE?
Companies may hold significant investments in other assets. Depending on ownership levels and
whether the assets are publicly traded, these investments often are not reported on the balance sheet at
fair market value. Therefore, investors may find hidden balance sheet value by reviewing the 10-K for
these types of inter-corporate investments.
Yahoo, Inc. is an example of a company with material equity investments accounted for using the equity
method. The companys balance sheet does not reflect these investments at fair value. Below is
Yahoos disclosure of its significant investments accounted for under the equity method.
Yahoo (2010 Form 10-K): Investments in Equity Interests
AsofDecember31,investmentsinequityinterestsconsistedofthefollowing(dollarsinthousands):
EquityInvestmentinAlibabaGroup.OnOctober23,2005,theCompanyacquiredapproximately46percentoftheoutstandingcommon
stock of Alibaba Group, which represented approximately 40 percent on a fully diluted basis, in exchange for $1.0 billion in cash, the
contributionoftheCompanysChinabasedbusinesses,including3721NetworkSoftwareCompanyLimited(Yahoo!China),anddirect
transactioncostsof$8million.AnotherinvestorinAlibabaGroupisSOFTBANK.AlibabaGroupisaprivatelyheldcompany.Throughits
investment in Alibaba Group, the Company has combined its search capabilities with Alibaba Groups leading online marketplace and
onlinepaymentsystemandAlibabaGroupsstronglocalpresence,expertise,andvisionintheChinamarket.Thesefactorscontributedto
apurchasepriceinexcessoftheCompanysshareofthefairvalueofAlibabaGroupsnettangibleandintangibleassetsacquiredresulting
ingoodwill.
TheinvestmentinAlibabaGroupisbeingaccountedforusingtheequitymethod,andthetotalinvestment,includingnettangibleassets,
identifiableintangibleassetsandgoodwill,isclassifiedaspartofinvestmentsinequityinterestsontheCompanysconsolidatedbalance
sheets.TheCompanyrecordsitsshareoftheresultsofAlibabaGroupandanyrelatedamortizationexpense,onequarterinarrears,within
earningsinequityinterestsintheconsolidatedstatementsofincome.
The Companys initial purchase price was based on acquiring a 40 percent equity interest in Alibaba Group on a fully diluted basis;
however,theCompanyacquireda46percentinterestbasedonoutstandingshares.Inallocatingtheinitialexcessofthecarryingvalueof
theinvestmentinAlibabaGroupoveritsproportionateshareofthenetassetsofAlibabaGroup,theCompanyallocatedaportionofthe
excess to goodwill to account for the estimated reductions in the carrying value of the investment in Alibaba that may occur as the
Companys equity interest is diluted to 40 percent. As of December 31, 2009 and 2010, the Companys ownership interest in Alibaba
Groupwasapproximately44percentand43percent,respectively.
In the initial public offering (IPO) of Alibaba.com on November 6, 2007, Alibaba Group sold an approximate 27 percent interest in
Alibaba.com through the issuance of new Alibaba.com shares, the sale of previously held shares in Alibaba.com, and the exchange of
certain Alibaba Group shares previously held by Alibaba Group employees for shares in Alibaba.com, resulting in a gain on disposal of
interestsinAlibaba.com.Accordingly,inthefirstquarterof2008,theCompanyrecordedanoncashgainof$401million,netoftax,within
earningsinequityinterestsrepresentingtheCompanysshareofAlibabaGroupsgain,andtheCompanysownershipinterestinAlibaba
Groupincreasedapproximately1percentfrom43percentto44percent.
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Accounting for an investment in another company is based on the parent companys level of influence or
control. GAAP measures this influence and control using voting equity stock ownership. Below we
summarize the different ways of accounting for inter-corporate investments.
Accounting for Corporate Investments
AccountingMethod
Ownership%
Threshold
AccountingStandard
CostorMarket
<20%
Passive;noinfluenceorcontrol
FASNo.115
EquityMethod
2050%
Significantinfluence,butnocontrol
APBNo.18
Consolidation
>50%
Control
FASNo.141(R)/FINNo.46(R)
(1)
(1) FIN No. 46(R) superseded by FAS No. 167 effective Jan. 1, 2010 for calendar year-end companies.
The above ownership percentages are guidelines and where influence and/or control isnt equivalent to
the equity voting ownership percentages, a company may use a different method in accounting for the
investment (still very uncommon). To be sure, significant management judgment is required in
evaluating whether a company exerts significant influence over the investee. To illustrate, a company
may conclude that a 19% equity ownership interest constitutes significant influence if it had four out of
seven seats on the board of directors.
SEC and GAAP rules require specific disclosures for equity method investments. SEC Regulation S-X
requires separate financial statements for equity method investments when they are deemed individually
significant at a 20% level if either the investment or income test is met (as described below). In addition,
summary information is required when equity method companies in the aggregate exceed 10%
significance based on any of the three tests of significance.
The following summarized financial information is required (no explanatory notes are required) if any of
the three significance tests are met at the 10% level individually or in the aggregate:
Current assets
Noncurrent assets
Current liabilities
Noncurrent liabilities
Redeemable preferred stock
Non-controlling interest
Net sales
Gross profit
Income or loss from continuing operations
Net income or loss
The three tests of significance are:

1. Assets - Total parent companys proportionate share of the total assets in investee(s) (after
intercompany eliminations) compared to the total consolidated assets of the company.
2. Investment - The parent companys equity investment in the investee(s) (of which it owns 20% to
50%) compared to the total consolidated assets of the company.
3. Income - The parent companys equity income from the investee(s) [before income taxes,
extraordinary items, and cumulative effect of accounting changes] compared to consolidated
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income from continuing operations before taxes, extraordinary items and cumulative effect of
accounting changes. There are also several items to keep in mind when using net income for
purposes of this test.
a. Impairment charges at the investee level are excluded from the income calculations.
b. If the parent companys current year consolidated income (or absolute value of its loss) from
continuing operations is at least 10% less than the average of the last five years, a five year
historical average of income should be used in the denominator for the parents consolidated
income from continuing operations.
c. When testing whether entities are in the aggregate significant, no netting is allowed and,
therefore, the income test should be separately calculated for investees with income and
losses (aggregate all the entities with income and compare to consolidated income to
determine if at least the 10% threshold is met for increased disclosures; similarly, aggregate all
the entities with losses and compare the absolute value of this amount to consolidated
income).
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ACCOUNTINGFOREQUITYINVESTMENTS:<20%OWNERSHIP
GAAP requires less than 20% equity ownership interests to be accounted for either under the cost or fair
value market value method. The latter method is required when there is an active market for the
investment (e.g., publicly traded). If the investment is privately held, it is almost always reported at
historical cost on balance sheet. In either case, the investment amount is categorized as a one-line item
on the balance sheet typically under long-term investments in the other assets category.
If there is an active market for the equity security, it is accounted for under FAS No. 115 and classified
as either: (1) trading or (2) available-for-sale. Trading securities are recorded at fair value on the balance
sheet based on the valuation at each period end. Both realized and unrealized gains and losses from
marking the security to market are recognized in earnings each period. Available-for-sale securities are
also marked to fair value on the balance sheet at each period end, too. However, only realized gains
and losses are recorded in earnings; unrealized gains or losses are recorded directly in shareholders
equity as part of accumulated other comprehensive income. Any dividends or interest income received
from both types of securities are recognized in earnings (e.g., other income) in the period in which it is
earned.
If there is not a public market for the security, the cost method is used to account for the investment.
Under this method, the investment is recorded on the balance sheet as an asset at its initial cost. It is
not marked to fair value on the balance sheet in each period but the amount is tested for permanent
impairment at least annually. Similar to a trading/available-for-sale security, dividend and interest
income is recorded in earnings each period as it is earned.
Circumstances change and there may be a public market valuation available for a less than 20% owned
equity investment. In this scenario, a company would change from cost to market value accounting for
the investment. Mechanically, in the first period in which the investee company goes public, the
investment on the balance sheet (heretofore at amortized cost) is marked to fair value. Assuming there
are no shares sold by the investee in the initial public offering, the resulting unrealized gain or loss is
recorded directly in equity in the period in which the market value became available (other
comprehensive income (net of a deferred tax liability)).
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ACCOUNTINGFOREQUITYINVESTMENTS:20%TO50%OWNERSHIP
Ownership interests in investees of between 20% and 50% are accounted for under the equity method
of accounting unless specific circumstances dictate otherwise. The equity method is typically used to
account for 50%/50% joint ventures (as mentioned later in this report, one of the material differences
between U.S. GAAP and IFRS is the latters use of proportionate method accounting for 50% JVs).
Below we explain the equity method of accounting.
On the balance sheet under the equity method, a long-term asset is recorded at the amount paid for the
initial investment in the equity of the entity. In each period after that, the investment account is increased
(decreased) by the parents percentage ownership of the investee net income (loss). Notably, dividends
received from the investee are not recorded in earnings of the parent company, but rather reduce its
balance sheet equity investment account as they are viewed as a return of capital under GAAP. On the
consolidated income statement, the parent company records a line item often entitled equity income.
This amount is equal to its percentage ownership in the income of the investee (e.g., 25% of the
investees net income).
It isnt well known that this equity income amount is adjusted for elimination of inter-company profits and
depreciation/amortization due to the hypothetical step-up of the investees net assets to fair market
value on the date of the initial investment. In effect, on date the equity investment occurs, a company will
fair value all of the assets and liabilities of the investee and any intangible amortization or
increased/decreased depreciation is recorded as an adjustment to the equity income amount that is
recorded by the parent company. This is often why the equity income amount reported by a parent
company does not equal the parent companys percentage ownership interest multiplied by the
investees net income that may be separately reported to the investees shareholders. Inter-company
profits arising from sales between the parent and subsidiary are eliminated based on the parent
companys ownership percentage. Further, as a matter of convenience, GAAP and SEC rules allow
companies to record the equity method investees reported results of operations in the arrears by up to 3
months.
The cash flow statement reports the equity income (loss) amount as a non-cash item that is subtracted
(added) to operating cash flow unless this equity amount was distributed as a dividend to the parent
company. In the latter situation, there is no subtraction or, only a partial subtraction, reflecting the
amount of equity income not received as dividends.
In certain extreme scenarios, significant losses at the investee level may reduce the parent companys
equity investment to zero on the balance sheet. In this scenario, the parent company ceases recording
equity investment losses in their income statement unless there are additional debt guarantees and/or
other commitments for additional financial support or profitability was expected to re-occur soon. The
parent company would begin recording equity income again once it reached the watermark on its
investment (i.e., the unrealized losses were recouped).
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MERGERS&ACQUISITIONS
The M&A purchase accounting disclosure is typically found in one of first few financial statement
footnotes. We always find it useful to review a companys purchase accounting disclosures. GAAP and
SEC rules require a company to disclose the amount of the purchase price allocated to the specific
assets and liabilities of the target company.
In 2001, pooling of interests merger accounting was disallowed upon the issuance of FAS No. 141(R)
Business Combinations. Now U.S. and IFRS GAAP allow only purchase accounting for M&A
transactions. The overall concept of FAS No. 141(R) is to mark all of the acquired companys assets and
liabilities to fair market value on the acquisition date. Commonly, a target company is purchased at an
equity value exceeding the fair market value of its net tangible assets. In this scenario, intangible assets
and goodwill are recorded on the balance sheet. The day 2 accounting for intangible assets depends
on if they are finite or indefinite life intangible assets. If intangible assets have a finite life they are
expensed as amortization over each assets expected life. Examples of such assets include customer
lists, contract backlog, trademarks, and patents. By contrast, intangible assets with indefinite lives and
goodwill are not expensed in earnings. Rather these amounts are tested for impairment at least
annually. Prior to the issuance of FAS 141(R), both goodwill and all intangibles assets were amortized
as expenses in earnings.
Below are several things to focus on when reviewing the purchase accounting disclosures:
ARE INTANGIBLE ASSETS AND GOODWILL TAX-DEDUCTIBLE?

There may be different accounting for goodwill and intangibles under GAAP and the Internal Revenue
Code (IRC). GAAP requires companies to disclose whether acquisition related goodwill and/or intangible
assets are tax deductible under the tax code. Specifically, for asset acquisitions, IRC Section 197 allows
goodwill and intangible assets to be deducted (amortized) as expenses ratably over a 15 year period
even if such amounts are not expensed under GAAP. This has implications for a companys prospective
cash tax rate and the tax shield is a hidden asset that may not be fully reflected in the share price of the
company. To be sure, our experience is that companies and their bankers incorporate such assets into
the valuation of the target company. This often manifests itself when investors are comparing the prices
paid for acquisitions as a buyer would be in a position to pay more in a transaction structured as a
taxable purchase of assets (goodwill and intangible assets are tax deductible). To compare the
purchase price multiples across companies, we suggest separately valuing this tax shield (similar to a
NOL valuation) on a net present value basis and reducing the targets enterprise value by this amount.
HAVE THERE BEEN MATERIAL CHANGES IN PURCHASE PRICE ALLOCATIONS?

GAAP allows companies up to one year after the acquisition date to adjust the recorded fair market
valuations of the target companys balance sheet. We suggest reviewing the business combinations
footnote for any large changes in the fair market value amounts allocated to the acquired net assets
since the initial purchase price allocation. To be sure, initial estimates may be tentative as asset
valuations may take many months to complete and yet quarterly and annual financial statements must
be filed. GAAP requires amounts to be trued-up in the following quarter(s) as valuations are finalized.
Review large changes in purchase price allocations for reasonableness and the possible underlying
cause(s). Large purchase price accounting adjustments are rare and we view them as a red flag,
particularly if they benefit future earnings. Mechanically, when a subsequent purchase price accounting
adjustment is recorded, the other entry of the adjustment is to increase or decrease goodwill (assuming
goodwill was recorded).
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WHAT PERCENTAGE OF THE PURCHASE PRICE WAS ALLOCATED TO GOODWILL?

Since both U.S. and IFRS GAAP no longer require goodwill to be amortized, companies have an
incentive to allocate a large portion of the acquisition price to goodwill on the balance sheet. If the
acquisition doesnt pan out, goodwill is written off as a one-time impairment charge to earnings and
typically excluded from analysts net income calculations. Under GAAP, goodwill is in effect a plug
number recorded after the fair market value of net assets acquired are recorded. We do believe that it
contains informational content, however. First, a high level of goodwill as a percentage of the total
purchase price amount indicates that the company is assigning a large amount to synergy value and a
signal of overpayment. Second, since goodwill is not amortized, the company may be under allocating
the purchase price to tangible and intangible assets to increase earnings from avoiding higher postacquisition depreciation / amortization expense. As a rule of thumb, we become concerned when a
company allocates more than 70% of the purchase price to goodwill. It suggests the company may have
overpaid or is under allocating expenses, neither of which are positive signals.
WAS A HIGH PERCENTAGE OF THE PURCHASE PRICE ALLOCATED TO INDEFINITE LIVED INTANGIBLE
ASSETS?
GAAP identifies two types of intangible assets: finite and indefinite life. An indefinite life intangible asset
is defined as one extending beyond the foreseeable horizon and used as a default if a company cannot
ascertain an intangible assets useful life. Such assets are not amortized as a periodic expense, but
instead tested at least annually for impairment. Similar to goodwill, since indefinite life intangible assets
are not amortized as an expense, there is an incentive for management to allocate a substantial portion
of the intangible purchase price allocation to these assets. Therefore, we suggest analysts closely
review the M&A disclosures for large and unreasonable purchase price allocations to indefinite life
intangible assets. As an example, we would review and determine if a company allocated a portion of
the purchase price to a brand indefinite life intangible asset that one does not expect to have longevity.
Additionally, when material, GAAP requires a separate footnote disclosure for expected intangible asset
amortization amounts and asset lives for both indefinite and finite intangible assets.
WHAT IS THE AMORTIZATION PERIOD FOR INTANGIBLE ASSETS?

Finite life intangible assets are required to be expensed over their useful life and, as such, we suggest
carefully reviewing their assigned amortization life for reasonableness. To reduce the annual
amortization expense charged against earnings, a company might use a very short period (1-2 years
and try and classify the expense as non-recurring) or a very long period (more than 20 years).
Unfortunately, we have found no average period or benchmark against which to compare company
amortization periods since they vary by industry group. However, assigning a useful life amortization
period to a finite life intangible asset exceeding 20 years is aggressive, in our view. Amortization periods
for customer lists has been a SEC hot button in recent years as there is a view that companies should
be expensing customer list intangible assets over an accelerated time period rather than using a straight
line amortization period. We view customer list amortization periods exceeding 5-10 years as
aggressive.
WERE COSTS PREPAID AT THE TIME OF THE MERGER?

The M&A footnote disclosures should be reviewed to see if the target company prepaid costs prior to
acquisitions closing date. Such a maneuver may provide an unsustainable increase to operating cash
flow. Mechanically, if a cost is prepaid prior to the merger, it appears on the target companys balance
sheet as a prepaid asset and there is a cash outflow in the period in which the cost is prepaid. When the
merger closes, the prepaid asset carries over to the acquired companys balance sheet. In turn, as the
prepaid asset is recorded as an expense in earnings, the reduction in the prepaid asset increases
operating cash flow. However, if the prepaid costs at closing are recurring costs of the company, in a
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subsequent period after the prepaid asset is drawn down, there will need to be a replenishment of the
asset. This will necessitate a cash outflow as the cost is paid again in cash.
HOW MUCH WAS PP&E UNDERVALUED ON THE TARGET COMPANYS BALANCE SHEET?
The amount of the purchase price allocated to PP&E and operating leases may provide detail into the
amount by which they were undervalued. One quick way to analyze the undervaluation would be to
compare the amount allocated to PP&E from the purchase accounting disclosure to the standalone
target companies PP&E amount. Its also not well understood that operating leases are marked to fair
value in purchase accounting, so rent expense reflects current market rents existing at the acquisitions
closing date. Under purchase accounting, if the lease is undervalued, an operating lease intangible
asset (favorable lease) is recorded. Conversely, if the lease is overvalued, an accrued lease liability is
recorded. In turn, after the acquisition closes, the operating lease asset or (liability) recorded in purchase
accounting increases or (decreases) future GAAP rent expense. This non-cash item is added back to
operating cash flow, so the cash rental expense amount is unchanged.
PURCHASE ACCOUNTING DISCLOSURES: EXAMPLES

As an example of M&A disclosures, the next exhibit is the purchase accounting disclosure of the
Qualcomm-Atheros acquisition. Among other items, Qualcomm recorded a $692 million technology
based intangible asset, a $150 million IPR&D intangible asset, and $1.8 billion of goodwill in purchase
accounting. Following this example, we also show the purchase accounting disclosure for Texas
Instruments purchase of National Semiconductor.
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Qualcomm (2011 Form 10-K): Purchase Accounting Disclosure Under FAS No. 141(R)
OnMay24,2011,theCompanyacquiredAtherosCommunications,Inc.,whichwasrenamedQualcommAtheros,Inc.(Atheros),fortotal
cash consideration of $3.1 billion (net of $233 million of cash acquired) and the exchange of vested and earned unvested sharebased
payment awards with an estimated fair value of $106 million. Atheros sells communication chipsets to manufacturers of networking,
computing and consumer electronics products. The primary objective of the acquisition is to help accelerate the expansion of the
Company'stechnologiesandplatformstonewbusinessesbeyondcellular,includinghome,enterpriseandcarriernetworking.Atheroswas
integratedintotheQCTsegment.
Theallocationofthepurchasepricetotheassetsacquiredandliabilitiesassumedbasedontheirfairvalueswasasfollows(inmillions):
GoodwillrecognizedinthistransactionisnotdeductiblefortaxpurposesandwasallocatedtotheQCTsegmentforannualimpairment
testing purposes. Goodwill largely consists of expected revenue synergies resulting from the combination of product portfolios, cost
synergiesrelatedtoreductioninheadcountgrowthandlowermanufacturingcosts,assembledworkforceandaccesstoadditionalsales
anddistributionchannels.Theintangibleassetsacquiredwillbeamortizedonastraightlinebasisoverweightedaverageusefullivesof
four years, six years and three years for technologybased, marketingrelated and customerrelated intangible assets, respectively. The
estimatedfairvaluesoftheintangibleassetsacquiredwereprimarilydeterminedusingtheincomeapproachbasedonsignificantinputs
thatwerenotobservable.Ontheacquisitiondate,IPR&Dconsistedof26 projects,primarilyrelatedtowirelesslocalareanetworkand
powerlinecommunicationstechnologies.Theprojectsareexpectedtobecompletedoverthenextthreeyears.Theestimatedremaining
costs to complete the IPR&D projects were $36 million as of the acquisition date. The acquired IPR&D will not be amortized until
completionoftherelatedproductsasitwasdeterminedthattheunderlyingprojectshadnotreachedtechnologicalfeasibilityatthedate
ofacquisition. Uponcompletion,eachIPR&Dprojectwillbeamortizedoveritsusefullife;useful lives forIPR&Dareexpectedto range
between two to six years. Acquisition costs related to the merger of $23 million were recognized as selling, general and administrative
expensesasincurredinfiscal2011.TheCompanysresultsofoperationsforfiscal2011includedtheoperatingresultsofAtherossincethe
dateofacquisition,theamountsofwhichwerenotmaterial.
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Texas Instruments Purchase of National Semiconductor: Purchase Accounting Disclosure

The acquisition-date fair value of the consideration transferred is as follows:
Cash payments
6,535
Fair value of vested share-based awards assumed by TI
22
Total consideration transferred to National shareholders
6,557
At September 23, 2011

Cash and cash equivalents
1,145
Current assets
451
Inventory
225
Property, plant and equipment
865
Other assets
138
Acquired intangible assets (see details below)
2,956
Goodwill
Assumed current liabilities
Assumed long-term debt
Deferred taxes and other assumed non-current liabilities
3,528
(191 )
(1,105 )
(1,455 )
Total consideration transferred
6,557
Identifiable intangible assets acquired and their estimated useful lives as of the acquisition date are as follows:
Asset Amount
Developed technology
Customer relationships
Other
Identified intangible assets subject to amortization
In-process R&D
Weighted Average
Useful Life (Years)
2,025
10
810
16
2,851
105
(a)
Total identified intangible assets

$
2,956
(a) In-process R&D is not amortized until the associated project has been completed. Alternatively, if the associated project is
determined not to be viable, it will be expensed.
remaining consideration, after adjusting for identified intangible assets and the net assets and liabilities recorded at fair value, was
$3.528 billion and was applied to goodwill. Goodwill is attributed to Nationals product portfolio and workforce expertise. None of
the goodwill related to the National acquisition is deductible for tax purposes.
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As an illustration of the purchase accounting disclosures within the financials sector, we present 1st
United Bancorps acquisition of Old Harbor Bank of Florida.
1st United Bancorp (2011 Form 10-K): Acquisition of Old Harbor Bank of Florida ($ in thousands)
TheCompanyaccountedforthetransactionundertheacquisitionmethodofaccountingwhichrequirespurchasedassetsandassumed
liabilities to be recorded at their respective acquisition date fair values. The estimated fair values are considered preliminary and are
subjecttorefinementasadditionalinformationrelativetotheclosingdatefairvaluesbecomesavailableduringthemeasurementperiod,
nottoexceedoneyear.Specifically,additionalinformationrelatedtothefairvalueoverloans,otherrealestateandtheFDIClossshare
receivable are preliminary and may change as new information becomes available. Preliminary valuation and purchase price allocation
adjustmentsarereflectedinthetablebelow.
The acquisition of Old Harbor is consistent with the Companys plan to enhance both its footprint and competitive position. This
acquisitionprovidedfortheinitialexpansionintotheWestCoastofFloridamarketsspecificallyPascoandPinellascounties.TheCompany
believesitiswellpositionedtodeliversuperiorcustomerservice,achievestrongerfinancialperformanceandenhanceshareholdervalue
throughthesynergiesofcombinedoperations,allofwhichcontributedtotheresultinggoodwillassociatedwiththetransactions.
On the date of acquisition, the Company did not immediately acquire the furniture or equipment or any of the owned facilities of Old
Harbor.Managementassessedeachbankinglocationanddeterminednot toassumethreebankingfacilities,twoofwhichwereleased
andonewasowned.TheCompanyhaspurchasedtwobankingfacilitiesandrelatedfurnitureandequipmentfor$2,200andassumedtwo
leasedbankingfacilities.
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ACQUISITIONACCOUNTINGANTICS:THEPERFECTSTORM
Acquisitions create the pressure for management teams to show pro forma earnings accretion of the
combined company and justify the financial terms of the transaction. This creates the perfect storm for
earnings management and low earnings quality. Under the GAAP purchase accounting rules,
companies are required to mark the entire balance of the target company (not parent) to fair value on
the acquisition date. Intangible assets are also typically created as part of this process. The amount paid
for the target company in excess of the net assets fair value (including intangibles) is recorded as
goodwill and there is no amortization of goodwill for GAAP purposes. This amount remains on the
balance sheet and is tested at least annually for impairment. There are several other items to watch in
acquisitions and each is discussed in turn:
Excess write-down of the targets property, plant and equipment = lower future depreciation;
Big bath restructuring charges taken by the target company prior to acquisition;
Movement to pro forma earnings reporting for acquisition related items;
Disguising future compensation as earn-outs or other one-time payments;
Cherry picking accounting policies: choosing the more favorable accounting method of the two
companies; and
Managing the target companys working capital levels prior to the acquisition.
A few acquisition accounting antics center on lowering post-acquisition costs by incurring them prior to
the closing date of the acquisition or by recording big bath accounting write-downs when valuing the
target companys net assets. One way of increasing a companys post-acquisition earnings is by
excessively writing down the target companys property, plant and equipment in purchase accounting. In
so doing, annual depreciation expense is lowered since the PP&E balance, subject to annual
depreciation, is lower. One way of spotting this is to review the companys purchase price allocations
financial statement footnote. Another related way of lowering post acquisition depreciation expense is to
simply change the depreciation method or life in purchase accounting. Still another way of lowering the
annual expense is recording significant pre-acquisition restructuring costs by the target company. These
expenses would be accrued as a liability on the balance sheet of the target company prior to the
acquisition and, therefore, treated as an assumed liability in purchase accounting.
Switching to the use of pro forma earnings after the acquisition is another way to boost earnings. There
may be justifiable reasons for reporting under an earnings measure that excludes certain non-recurring
costs, such as restructuring. For example, beginning in 2009, GAAP now requires the expensing of all
restructuring costs post-acquisition during the period in which they are incurred. If a company is
expected to report only several quarters of restructuring costs, viewing an earnings metric excluding
such costs is most appropriate, in our view. However, since the costs chosen to be excluded are subject
to significant management judgment and there is pressure to show post-acquisition earnings accretion,
earnings quality deteriorates as the frequency and amount of such excluded items increases.
Some acquisition structures include future earn-out payments to prior shareholders or employees
based on targets of future sales, earnings or other operating performance metrics. This structure tends
to be used in the acquisition of a private company in which there are only a few shareholders. Often, the
senior management of the acquired company will move to the acquired firm and assume similar roles.
One way of reducing subsequent compensation cost of these employees is to try and structure their
future compensation in the form of an earn-out since these payment amounts are not expensed through
earnings (some are marked up or down through earnings if their initial value changes).
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Last, acquisitions provide the opportunity for companies to change to more favorable accounting
policies. Under the ruse of harmonizing different policies, there may be a switch (benign or otherwise)
in depreciation policies, classification of expenses, taxes, revenue recognition and cost capitalization,
among other items. Any changes may fall under the radar given the acquisition.
Given the aforementioned numerous ways to manage post acquisition earnings, its logical to conclude
that highly acquisitive companies should be analyzed based on cash flow. However, cash flow isnt a
great measure either as companies may materially alter working capital. A simple illustration is to push
off collecting receivables until after the transaction closes (high days sales outstanding DSOs when
transaction closes) and then decrease to a normal level. Alternatively, on the liability side of the
balance sheet, a company might choose to reduce accounts payables (lows days payable ratio) prior to
an acquisition (a cash outflow) and then rebuild accounts payable amounts (a cash inflow) after the
acquisition closes.
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GOODWILLIMPAIRMENTS(FAS141R,142,AND144)
THE MECHANICS
GAAP requires goodwill to be recorded at the reporting unit level. GAAP defines a reporting unit as an
operating segment or one level below an operating segment. This leaves management discretion in
assigning goodwill to a reporting unit since one company might assign goodwill at the higher segment
level while another company might assign goodwill to a lower business unit level. Assigning goodwill to a
higher segment level leaves more room for a buffer in avoiding a potential future write-down as an
increase in a business value in one area of an operating segment might offset weakness in another.
After goodwill is recorded, it is required to be tested at least annually for impairment or if circumstances
warrant, more frequently (should be tested at the same time each year).
There are two steps in GAAPs goodwill impairment test:
1. Compare the reporting units fair market value to its carrying amount (book value). If the fair
market value of the reporting unit is greater than its book value, the impairment test is finished
and there is no goodwill impairment.
To complete Step 1 of the test of goodwill impairment, a company must calculate the fair market
value of the reporting unit using fair value accounting guidance contained in FAS No. 157, Fair
Value Measurement. Theres usually no readily available market value for a reporting unit. As a
result, management will hire an external valuation firm to calculate fair value and/or use an
internal valuation model based on DCF or multiplies of comparable companies, if available.
2. In Step 2, if the fair value of the reporting unit is less than its book value, a company must
estimate the new fair market value of goodwill or what is known as the implied goodwill amount.
To calculate this amount, the company completes a hypothetical purchase accounting allocation
under which the newly calculated reporting units fair market value is allocated to the individual
tangible and intangible assets (excluding goodwill). The amount by which the reporting units fair
market value amount exceeds the fair market value of its net assets is goodwills implied fair
market value. In the last calculation, the calculated implied goodwill amount is compared to the
goodwill amount recorded on the balance sheet at that same unit level. The resulting goodwill
impairment charge is the reporting units existing goodwill amount less its newly calculated
implied fair market value.
In the following exhibit, we walk through the mechanics of a goodwill impairment test. In this example,
we assume book value of assets of $350, goodwill of $450, liabilities of $275, and equity of $525.
Step 1 of a goodwill impairment test compares the fair market value of a reporting unit to its carrying
value. The fair market value is determined using various valuation methodologies such as discounted
cash flow analysis, market multiples, or the cost approach. The assumed $450 fair value of the reporting
unit is less than its $525 carrying value, indicating that an impairment exists. Since the reporting units
fair value is less than its carrying value, proceed to Step 2.
In Step 2 of a goodwill impairment test, the fair market value of tangible and intangible assets is
calculated and the implied fair value of goodwill becomes apparent. Goodwills implied fair market value
of $375 is calculated based on an assumption of $475 of assets (the sum of all tangible and identifiable
intangible assets) and $325 of liabilities. A $75 goodwill impairment charge (fair market value of $375
less book value of $450), runs through the income statement as a loss.
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Goodwill Impairment Testing Example

Assets
Goodwill
Totalassets
350
450
800
Liabilities
Bookvalueofequity
Totalliabilities+equity
275
525
800
Step1:Comparethefairvalueofreportingunittothecarryingamount
(1)
Fairvalueofreportingunit
Bookvalueofreportingunit
Excesscarryingvalue
450
525
(75)
Sincethereportingunit'sfairvalueislessthanitsbookvalue,proceedtoStep2.
Step2:Comparetheimpliedvalueofgoodwilltothecarryingamountofgoodwill
Bookvalueofreportingunit
Less:fairvalueoftangibleandidentifiable
intangibleassets
Less:fairvalueofliabilities
525
475
(325)
150
150
Impliedvalueofgoodwill(a)
Carryingvalueofgoodwill(b)
Goodwillimpairment(a)(b)
375
450
(75)
(1) Fair value based on a reasonable valuation methodology such as DCF analysis, market multiples, cost to recreate, etc.
GOODWILL IMPAIRMENT CHARGE INDICATOR: GOODWILL / MARKET CAPITALIZATION

We have found that a high ratio of goodwill to a companys market capitalization is a leading indicator of
a future goodwill impairment charge. That is, the higher the level of goodwill as a percentage of market
capitalization, the greater the probability that the implied fair value calculation of goodwill will be less
than its current balance sheet amount. This is a useful ratio to screen for goodwill impairments at the
aggregate company level since we dont have enough detail to calculate the goodwill amounts at the
reporting unit level. Historically, weve found that the goodwill-to-market capitalization ratio in the
quarter before a goodwill impairment charge occurred averaged 39% with a median ratio of 22%.
HOW TO ESTIMATE POSSIBLE GOODWILL IMPAIRMENT CHARGES

GAAP requires goodwill to be recorded and analyzed for impairment at the reporting unit level. However,
there is often limited disclosure on a reporting unit level available in public filings. As a result, in order to
assess the possibility and size of a potential goodwill impairment charge, we must make a number of
assumptions.
In the first step of the goodwill impairment test, the fair value of the reporting unit is compared to its book
value. If the fair value is greater than the book value, the impairment testing ceases. If it is not, the test
proceeds to Step 2. As a substitute for the reporting unit value, we use the fair value of the companys
market capitalization to the companys shareholders equity balance.
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In Step 2, the fair value of all tangible and identifiable intangible assets and liabilities are allocated to the
fair value of the reporting unit. In this part of the analysis, we assume the asset and liability amounts
recorded on the GAAP balance sheet are equal to their fair values. The book value of the non-goodwill
assets (net identifiable assets) is calculated by subtracting goodwill from shareholders equity. The
implied fair value of goodwill is, in turn, calculated by comparing the companys market capitalization
(our proxy for fair value of the reporting unit) to the book value of the net identifiable assets (our estimate
of net identifiable assets fair value). Next, the implied goodwill fair value amount is compared to the
amount of goodwill on the companys balance sheet. If the implied fair value of goodwill is less than the
balance sheet amount, there company is at high risk of an impairment charge. An impairment charge
would be recorded in earnings as a noncash charge, reducing equity at its tax-effected amount.
LONG LIVED ASSET IMPAIRMENT TESTING: THE RULES AND MANAGEMENTS SUBJECTIVITY
FAS 144, Accounting for the Impairment of Disposal of Long-Lived Assets, requires companies to test
long lived assets, such as PP&E for impairment when indicators exist. Under the accounting guidance in
FAS 144, the impairment test is performed when events or changes in circumstances indicate that its
carrying amount may not be recoverable. Indicators would include items, such as significant decreases
in the assets market price, adverse changes in the extent or manner that the assets are being used, a
change in legal factors or the business climate that may impact assets value, or recent cash flow and/or
operating losses.
A two-step test is performed if an impairment test is necessary. In Step 1, the company compares the
total undiscounted estimated future cash flows of the asset to its carrying value. If the assets carrying
value exceeds the undiscounted cash flows, there is an impairment loss. This loss is measured as the
difference between the assets carrying value and fair value (where fair value would be measured on a
discounted cash flow basis or through other fair value measurements). Readers will recognize that in
light of the inherent management subjectivity in this impairment test, companies have lots of flexibility in
the amount and timing of long-lived asset write-downs.
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LOOKFORRELATEDPARTYTRANSACTIONS
Related party transactions are a required GAAP disclosure. The accounting literature broadly defines a
related party as including:
1.
2.
3.
4.
5.
A parent company and its subsidiaries;

Subsidiaries of a common parent company;
Affiliates;
An enterprise and trust for the benefit of employees;
An enterprise and its principal owners (owners or beneficial owners of at least 10% of voting
interest), management (Board of Directors, CEO, COO, SVPs, or immediate family members);
6. Other parties if one party controls or can significantly influence management or operating policies
of the other inasmuch as one of the transacting parties might be prevented from fully pursuing its
own separate interests.
In assessing the disclosure requirements, there is not a dollar amount materiality threshold per se and
companies must also evaluate qualitative factors. Related party transactions are not required
disclosures in situations where the transactions are eliminated in the consolidated financial statements.
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WHENARESEGMENTDISCLOSURESREQUIRED?
GAAP requires disclosure of operating segment information under FAS No. 131, Disclosures about
Segments of an Enterprise and Related Information. The framework for identifying segments under FAS
No. 131 is a management approach based on the way management organizes the company in making
operating decisions and evaluating operating results. Segments may be organized by line of business,
division, geography, end markets, customer, etc. As a result, this information is often disparate across
companies since its disclosed based on how management organizes the company for decision making.
Under GAAP, an operating segment is a component of a business when:
1. It engages in business activities from which it may earn revenues and incur expenses;
2. Its operating results are regularly reviewed by the enterprises chief operating decision maker to
make decisions about resources to be allocated to the segment and assess its performance; and
3. For which discrete financial information is available.
GAAP further classifies a segment as a reportable segment (that must be disclosed) if it meets the
aforementioned operating segment definition and at least one of the three following quantitative
thresholds.
a. Its assets are 10% or more of the combined assets of all operating segments.
b. Its reported revenue, including both sales to external customers and intersegment
transfers, is 10% or more of the combined revenue (internal and external) of all
operating segments; and/or
c. The absolute amount of its reported income or loss is 10% or more of the greater, in
amount, of (1) the combined reported profit of all operating segments that did not report
(2) the combined reported loss of all operating segments that did report a loss.
sales or
reported
absolute
a loss or
If a segment is a reportable segment, GAAP requires certain disclosures. First, a measure of income or
loss and total assets is a required disclosure for each reportable segment. Second, disclosure of the
following items is required if it is included in the companys measure of segment profit or loss reviewed
by the companys chief operating decision maker:
1. Revenue from external customers;
2. Revenue from transactions with other operating segments of the same company;
3. Interest revenue;
4. Interest expense;
5. Depreciation, depletion, and amortization expense;
6. Equity income/loss;
7. Income tax expense/benefit;
8. Impact of items in earnings that are unusual in nature or occur infrequently but not both;
9. Extraordinary items;
10. Significant non-cash items other than depreciation, depletion, and amortization expense;
11. Type of product or service from which each reportable segment derives its revenues; and
12. Factors used to identify the enterprises reportable segments, including the basis for organization
(products, services, geographic).
Additionally, GAAP requires several reconciliations in the segment disclosures:
1. The total of the reportable segments net revenues to the companys consolidated net revenues;
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2. A reconciliation of the total of the reportable segments measures of profit or loss to the
companys consolidated income from continuing operations;
3. The total of the reportable segments assets to the enterprises consolidated assets; and
4. The total of the reportable segments amounts for every other significant item of information
disclosed to the corresponding consolidated amount.
Besides segment disclosures, geographical disclosures are required for the following items:
1.
2.
3.
4.
Total domestic revenues;

Total revenues from all other foreign countries;
Revenues from individual countries, if material (materiality not defined in FAS No. 131); and
Long-lived assets (i.e., PP&E) in the companys home country, in all other foreign countries, and
in individual countries, if material.
GAAP also requires disclosure of large customers if a customer is 10% or more of the companys
revenues. The customers percentage of the firms total revenues and the identity of the segment or
segments reporting the revenues must be disclosed. Notably, the specific customer is not required to be
disclosed, so sometimes companies will list the disclosure as Customer A, B, C, etc. along with the
customers specific percentage of the total firms revenues. The customer percentage of a certain
segments revenue is not required to be disclosed.
Unfortunately, FAS No. 131 does not define the profit or loss measure required to be disclosed (e.g.,
operating income, EBIT, EBT, net income, etc.). Therefore, any measure is allowed to be used as the
segment measurement of profit or loss insofar as its used by management for internal decision making.
GAAP also allows segment information to be reported under different accounting methods than is used
in the consolidated GAAP financial statements (e.g., LIFO vs. FIFO). However, the amount reported for
each segment item must be the same amount reported to the chief operating decision maker used to
allocate resources and measure the segments financial performance.
Any adjustments, eliminations and allocations of revenues, expenses, gains and/or losses are included
in the segments earnings only if they are included in the earnings measure used by the chief operating
decision maker. These items could vary. For example, a company reports LIFO inventory for external
reporting purposes and uses the FIFO inventory costing method for internal performance measurement
purposes. If amounts such as corporate overhead and other costs are allocated to reported segments,
GAAP requires such items to be allocated to segments on a reasonable basis. To be sure, this is open
for managements interpretation and, thus, we often find different cost allocations across companies. We
are also cautious in how allocations are calculated across companies since the information is used by
the chief decision maker internally and is a likely input into evaluating the performance and
compensation of company management. This creates a large financial incentive among internal
managers to report high segment profits.
If segments change, GAAP requires restatement of prior-period comparative information for the new
segments unless it is impracticable. If segment information for earlier periods is not restated, companies
are required to disclose the segment information in the current year on both its current year segment
basis and its old segment basis unless it is impracticable. Notwithstanding comparable restated segment
information, the newly reorganized segment disclosures may still be used to mask slowing growth.
ARE THERE CHANGES TO SEGMENTS?

Management has discretion in choosing if, or when, they change their internal organizational structure
and how the chief operating decision maker analyzes the segments operating performance. While
changing segments is often undertaken for a specific business purpose, such as a change in customer
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patterns or recent acquisitions, it still may be used as an artifice to mask slowing growth. As an example,
a highly acquisitive company acquires another business and consolidates the acquired business into an
existing operating segment. Fortunately, GAAP requires companies to disclose if they change segments
and we view this alone as a yellow flag. To provide an example of the different types of GAAP segment
disclosures, in the next exhibit, we present McGraw-Hill's operating segment and geographical
disclosures.
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The McGraw-Hill Companies (2011 Form 10-K): Segment and Geographic Information
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EXCESSIVECOSTCAPITALIZATIONONTHEBALANCESHEET?
A careful reading of the 10-K footnotes is important in searching for signs of improper cost capitalization
and accounting policy choices that may impact earnings comparability across companies. Improperly
capitalizing normal operating costs on the balance sheet has been one of the most common areas of
accounting fraud. The incentives are large. By capitalizing costs and expensing them over time in
earnings, a company reports higher earnings in the short-term. One of the classic illustrations of
improper cost capitalization was WorldCom. The company improperly capitalized line costs as capital
expenditures in PP&E on the balance sheet instead of expensing them as operating costs. In turn, the
line costs were depreciated as an expense over a longer period of time. On the cash flow statement,
these line costs were shown as capital expenditures and other amounts within the investing section
of the cash flow statement. This resulted in permanently overstated operating cash flow since the capital
expenditures are expensed as depreciation and the latter is added back to operating cash flow when it
occurs.
COST CAPITALIZATION: COMPARABILITY

Expenditures for long-lived assets are typically capitalized into the assets cost on the balance sheet if
they are expected to provide future benefits more than one year. The accounting theory behind this
concept is the matching principle, which attempts to match revenues with costs incurred to generate the
revenues. Cost capitalization does not need to be improper to impact comparability and GAAP actually
requires cost capitalization in certain situations. However, there are grey areas where companies may
have a choice of cost capitalization.
Mechanically, capitalizing a (accumulating) cost on the balance sheet increases an asset account, such
as PP&E or other current/non-current assets. By capitalizing costs, the companys reported earnings are
higher since all these costs are not expensed through earnings in the current period. The cash outflow
associated with the asset increase is reported on the cash flow statement as a cash outflow either in the
operating, investing, or financing section. If the cash outflow for the capitalized cost is classified in
operating cash flow, cost capitalization does not distort operating cash flow (another reason to analyze
cash flow rather than earnings). On the other hand, if the cash flow effect of the asset increase is shown
as an investing cash outflow on the cash flow statement, this classification permanently overstates
operating cash flow.
Subsequently, when capitalized costs are expensed (as depreciation or other costs), this lowers
earnings but the expense is non-cash in the current period and is added back to operating cash flow.
Therefore, operating cash flow remains unchanged. This is one of the shortcomings with alternative
measures of cash flow, such as EBITDA or even operating cash flow. Free cash flow is the only
measure correcting for different cost capitalization practices across companies. Even with free cash flow
measures, analysts need to be careful in deducting other investing cash outflows that may be cap-ex
substitutes or other recurring investing cash outflows (e.g., software capitalization).
COST CAPITALIZATION: EXAMPLE

The next exhibit is an illustration of the financial statement impact of improperly capitalizing costs in
PP&E instead of expensing them. We illustrate this with the scenario of a $500 expense capitalized as a
5-year asset, assuming straight line depreciation.
In Year 1, expense capitalization increases earnings and operating cash flow compared to the company
immediate expensing costs. However, free cash flow is the same under either scenario.
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In Year 2, under the cost capitalization scenario, earnings are lower from $100 of non-cash depreciation
expense compared with $0 of depreciation expense under the immediate expensing scenario (the entire
amount was expensed in Year 1). Both operating cash flow and free cash flow are the same in Year 2
under both scenarios. The same dynamic will occur through Years 3 through 5 (not shown).
Example: Cost Capitalization vs. Immediate Expensing
CAPITALIZE
Year1
Year2
EXPENSE
Year1
Year2
IncomeStatement
Revenue
Expenses
Depreciation
Netincome
$1,000
0
100
900
$1,000
0
100
900
$1,000
500
0
500
$1,000
0
0
1,000
StatementofCashFlow
Depreciation
Cashflowfromoperations
100
$1,000
100
$1,000
0
$500
0
$1,000
(500)
($500)
0
$0
0
$0
0
$0
Freecashflow
$500
$1,000
$500
$1,000
BalanceSheet
Retainedearnings
$900
$1,800
$500
$1,500
PP&E
Cashflowfrominvesting
COST CAPITALIZATION DISCRETION FOR CERTAIN EXPENSES: WATCH OUT!

In the next several sections, we discuss situations in which GAAP requires cost capitalization and where
management has flexibility in capitalizing costs:
INTEREST COST
GAAP (FAS No. 34, Capitalization of Interest), requires interest from debt used to finance long-term
assets to be capitalized into the assets cost on the balance sheet (e.g., PP&E). Since cash is fungible,
there is subjectivity is specifically assigning debt to long-term projects and, thus, its capitalization.
Further, some companies may choose to fund projects with internally generated cash flow or finance the
assets differently. This impairs comparability across companies.
There are several financial statement impacts from capitalizing interest. First, capitalized interest
expense is never recognized under the interest expense caption on the income statement. Since the
interest expense amount is included in the assets cost, it is subsequently expensed as depreciation
expense over the life of the long-term asset. On the cash flow statement, the initial cash interest
expense outflow is shown in the section of the related assets cash cost outflow. Since capitalized
interest usually relates to PP&E assets, it is included as part of capital expenditures in investing cash
flow. This is why creditors also focus on cash interest expense in calculating debt coverage ratios since
reported interest expense in the income statement is understated if interest cost is capitalized. When
using operating cash flow or net income metrics, there will also be non-comparability across companies
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when one company chooses to finance long-term assets with debt while another company finances
assets with equity or cash. Using Verizons 2010 10-K disclosure, in the next exhibit, we illustrate
capitalized interest expense.
Verizon (2010 Form 10-K): Interest Expense / Capitalized Interest
Interest Expense
Years Ended December 31,

Total interest costs on debt balances
Less capitalized interest costs
Total
Average debt outstanding
Effective interest rate
2009
2008
2010
$ 4,029
$ 2,566
$ 3,487
927
747
964
$ 3,102
$ 1,819
$ 2,523
$64,039
$41,064
$57,278
6.3%
6.2%
6.1%
(dollars in millions)
Increase/(Decrease)
2009 vs.
2008
2010 vs. 2009
$(542) (13.5)% $1,463 57.0%
180 24.1
37
4.0
$1,283 70.5
$(579) (18.7)
SOFTWARE DEVELOPMENT FOR EXTERNAL SALE

GAAP requires capitalization of internal software development once so-called technological feasibility is
reached (FAS No. 86, Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed).
While this may sound simple, there is considerable discretion in identifying the point at which
technological feasibility is reached.
We find this dynamic currently among the video game companies. Electronic Arts (EA) expenses all
software development costs and discloses that technological feasibility occurs very late in the software
development process. Other competitors maintain that they reach technological feasibility earlier in the
video game development phase and capitalize a larger amount of software development costs. This
impacts the comparability of earnings across the industry group. Since the changes in software
development assets are shown in operating cash flow, cash flow is comparable across the companies.
However, not all companies classify changes in the software development cost asset in operating cash
flow. In the next exhibit, we show how Synopsys capitalized software development costs are classified
in investing cash flow. We believe such costs should be reclassified as a cash operating cost in
operating cash flow.
Synopsys (2011 Form 10-K): Statement of Cash Flows Investing Section
2011
Cash flows from investing activities:

Proceeds from sales and maturities of short-term investments
Purchases of short-term investments
Proceeds from sales of long-term investments
Purchases of long-term investments
Purchases of property and equipment
Cash paid for acquisitions and intangible assets, net of cash acquired
Capitalization of software development costs
Net cash used in investing activities
Year Ended October 31,

2010
2009
136,983
(127,385)
2,828
(57,345)
(41,015)
(2,885)
547,686
(243,515)
(39,223)
(500,829)
(2,852)
290,709
(386,431)
(771)
(39,199)
(53,358)
(2,852)
(88,819)
(238,733)
(191,902)
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INTERNAL USE SOFTWARE

GAAP requires internal use software costs to be capitalized as an asset and amortized over their useful
life typically 3 to 5 years (Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use). Training costs are always immediately expensed.
SOP 98-1 classifies internal use software development costs into three separate stages:
(1) Preliminary Project Stage: The first stage includes the conceptual formulation and evaluation of
alternatives leading up to the determination that the development of the software will begin. Costs
incurred during this stage are expensed immediately.
(2) Application Development Stage: Once the second stage begins, costs are capitalized on balance
sheet. Such costs/activities include but are not limited to design, coding, hardware installation, and
testing. Once the software is ready for its intended use and substantial testing is completed,
companies move to the Post-Implemental Operating Stage.
(3) Post-Implementation Operation Stage: When the Post-Implementation/Operation Stage begins,
maintenance costs are expensed while upgrades that add functionality are capitalized into the asset
account.
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LOSSRESERVES
A company may encounter an uncertain loss or other potential liability and, therefore, a careful reading
of the 10-Ks loss contingency footnote disclosures may highlight potential future legal and other losses.
This footnote is typically qualitative and vague. Under GAAP, the loss is recorded as an accrued liability
(reserve) if it is both probable (generally interpreted to mean at least a 70% chance of occurring) and
reasonably estimable (FAS No. 5, Accounting for Contingencies). We find that unexpected negative
surprises occur more often when a loss reserve isnt recorded because it is not probable and estimable.
In this scenario, GAAP requires the following:
If a loss is only reasonably possible, GAAP requires a qualitative disclosure of the loss and an
estimate or range of the potential loss. No loss reserve is recorded on the balance sheet.
If a range of possible losses exists, the most probable loss is recorded as an expense and
accrued liability.
In a scenario when losses are not estimable with any certainty or contain an equal probability of
occurring, GAAP requires an accrued liability to be recorded for the lowest contingency amount
within the range of possible outcomes.
If amounts are not estimable, a company must disclose this fact.
Management teams try to shift blame and dont often record losses until a lawsuit is resolved. Therefore,
this section should be reviewed for unexpected, large cash outflows associated with unfavorable lawsuit
outcomes.
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OTHERTHANTEMPORARYIMPAIRMENTS
In this next section, we review the accounting rules for other than temporary impairments of underwater
marketable debt securities. First, we review the accounting rules for marketable securities. FAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities categorizes investments in debt and
equity securities into: (1) trading, (2) available-for-sale (AFS), and (3) held-to-maturity (HTM). AFS is
the largest category on corporate balance sheets. Under GAAP, trading and AFS securities are
recorded at fair value on the balance sheet. Conversely, HTM securities are recorded on the balance
sheet at amortized cost. GAAP requires an additional stipulation for a security to be classified as HTM
as a company must have both the intent and ability to hold the security until maturity. Equity securities
by their very nature cannot be classified as HTM. Since trading and AFS securities are marked to
market each period even though they may not have been sold, GAAP requires different classification of
unrealized gains and losses. Trading securities unrealized gains and losses are recorded in earnings
each period. Available-for-sale securities unrealized gains or losses are not recorded through earnings,
but instead recorded in shareholders equity in the other comprehensive income (OCI) account. Heldto-maturity securities unrealized gains or losses are not recorded on the balance sheet since they are
not marked to fair value.
GAAP requires companies to assess AFS and HTM investments for other-than-temporary impairments
(OTTI) each period. This also includes any cost and equity method investments. While many
companies hold debt securities, this issue is most germane to financial institutions holding large
securities portfolio. The rules governing GAAP OTTI rules changed in April 2009 when FASB issued
new accounting guidance on determining if an underwater debt security should be impaired as a loss
through earnings (FSP FAS No. 115-2 and FAS No. 124-1). The OTTI rules require an unrealized loss
to be recognized as a permanent write-down through earnings if any of the following conditions are met:
(a) The company has the intent to sell the debt security;
(b) There is a greater than 50% chance that the company will be required to sell the debt security
before its anticipated recovery in value; or
(c) The company does not expect to recover the securitys entire amortized cost basis.
Under the OTTI impairment model, a company will always record an impairment loss related to the
credit component of the marketable debt securitys unrealized loss in earnings. The other portion of the
unrealized market security loss (that is due to non-credit, such as liquidity) is recorded in earnings only if
any of the three aforementioned criteria are met. Otherwise, the unrealized loss stays in equity in other
comprehensive income until the security is sold or otherwise disposed of.
The GAAP test for ascertaining if there is a credit loss is expected cash flow. Under this test, FASB rules
require the company compare the present value of the cash flows that are expected to be collected from
the security to its amortized cost basis. The expected cash flows are discounted at the effective interest
rate implicit in the security at acquisition date. Under GAAP (FSP FAS No. 115-2), the difference
between the present value of cash flows expected to be collected and the securitys amortized cost
basis is recorded as the credit loss. This test is highly subjective and difficult for auditors to assess since
its based on managements expectations of future cash flow. Consequently, this allows companies wide
latitude in pushing out impairment losses into future periods.
To assist companies in evaluating possible OTTI losses, GAAP includes guidance on factors companies
should use in assessing whether a credit loss exists:
The length of time and extent to which fair value of the investment has been below its cost basis.
Adverse conditions specifically related to the security, a geographic area or an industry.
Historical and implied volatility of the securitys fair value.
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The debt securitys payment structure.

Any changes in the securitys credit rating.
Failure of the issuer of the security to make scheduled interest or principal payments.
Recoveries or additional declines in the securitys fair value after the most recent balance sheet
date.
If a company determines that an OTTI has occurred, the security is written down to fair value and a loss
is recognized in earnings. If events change and the security later recovers in value, GAAP does not
allow it to be written-up to its new fair market value. Instead, the loss is recycled through income as the
written down amount is accreted up to its par value amount through higher (non-cash) interest income.
As an example of other than temporary impairment losses and related disclosures for marketable debt
securities, the next exhibit is First Financials 2011 OTTI disclosure. There were $879k of OTTI charges
in 2011, all of which were recorded in earnings.
First Financial Holdings (2011 Form 10-K): Other-Than-Temporary Impairment Disclosure
OtherThanTemporaryImpairment
Management evaluates securities for OTTI on at least a quarterly basis. In determining OTTI, investment securities are evaluated
accordingtoASC320InvestmentsDebtandEquitySecuritiesandmanagementconsidersmanyfactorsincluding:(1)thelengthoftime
andextenttowhichthefairvaluehasbeenlessthancost;(2)thefinancialconditionandneartermprospectsoftheissuer;(3)whether
themarketdeclinewasaffectedbymacroeconomicconditions;and(4)whetherFirstFinancialhastheintenttosellthedebtsecurityor
more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists
involves a high degree of subjectivity and is based on information available to management on the assessment date. In assessing the
recoveryofvalue,thekeyfactorsreviewedincludethelengthoftimeandtheextentthefairvaluehasbeenlessthanthecarryingcost,
adverseconditions,ifany,specificallyrelatedtothesecurity,industryorgeographicarea,historicalandimpliedvolatilityofthefairvalue
ofthesecurity,creditqualityfactorsaffectingtheissuerortheunderlyingcollateral,paymentstructureofthesecurity,paymenthistoryof
thesecurity,changestothecreditratingofthesecurity,recoveriesordeclinesinvaluesubsequenttothebalancesheetdateoranyother
relevantfactors.Evaluationsareperformedonamorefrequentbasisasthedegreetowhichfairvalueisbelowcarryingcostorthelength
oftimethatthefairvaluehasbeencontinuouslybelowcarryingcostincreases.
AtSeptember30,2011,themajorityofunrealizedlosseswererelatedtotrustpreferredcollateralizeddebtobligations(CDOs)and,to
alesserdegree,privatelabelcollateralizedmortgageobligations(CMOs)asdiscussedbelow.FortheyearendedSeptember30,2011,
creditrelated OTTI of $879 thousand was recorded in net impairment losses recognized in earnings in the Consolidated Statements of
Operations.ThecomponentsoftheOTTIwere:$623thousandonCDOsand$256thousandonCMOs.Thetotalcarryingvalueofsecurities
affectedbycreditrelatedOTTIrepresent1.9%ofthecarryingvalueofFirstFinancialsinvestmentportfolioatSeptember30,2011,and
thereforehavenegligibleimpactonFirstFinancialsliquidityandcapitalpositions.
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First Financial Holdings (2011 Form 10-K): Other-Than-Temporary Impairment Disclosure (Continued(
ThefollowingtableprovidesinformationregardingtheCDOportfoliocharacteristicsandfiscal2011OTTIlosses.
ThefollowingtablepresentstheinvestmentgradesassignedbytheratingagenciesforCMOsecuritieswhichwereinalosspositionat
September30,2011alongwithOTTIlossesrecordedduringtheyearendedSeptember30,2011.
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MARKETABLE SECURITIES: REVIEW UNDERWATER AMOUNTS TO AVOID SURPRISES

A quick review of a companys underwater marketable security disclosure is helpful in avoiding any
unexpected future security write-downs. GAAP requires at least annual tabular disclosure of investments
that have been in a continuous unrealized loss position for less than 12 months and investments in a
continuous unrealized loss position greater than 12 months. The schedule is usually classified by the
type of security, such as treasury bonds, corporate bonds, MBS, municipal bonds, etc. Companies are
further required to provide commentary on why they view these losses as only temporary and do not
necessitate an OTTI.
In the next exhibit, we illustrate Googles 2011 disclosure of marketable securities unrealized losses.
Based on an analysis of this disclosure, Google had $111 million of continuous unrealized losses on
marketable securities less than 12 months old and $3 million in continuous unrealized losses of 12
months or longer.
Google (2011 Form 10-K): Unrealized Losses on Marketable Securities
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WATCHFORLARGERESERVESANDRESERVEREVERSALS
10-K footnotes provide detail on the composition and changes in reserve accounts. A careful review of
these disclosures is warranted as companies have been known to use reserves to manage earnings in
what is known as cookie jar accounting. This occurs when a company reverses an accrued liability or
contra asset account (bad debt reserve which is netted against accounts receivable) as a gain in
earnings. Another variation of this is big bath accounting in which a company records a very large
charge in earnings by writing down assets and recording various reserves. If the charge is excessive, in
a subsequent period, GAAP requires the reserve to be reduced / eliminated and companies have
discretion in choosing when to reverse it as a gain in earnings. Common reserves include bad debts,
restructuring, warranty, sales discounts, workers compensation, taxes, and legal. Mechanically, GAAPs
matching principal requires an expense to be recorded in the same period in which revenue is
recognized and a loss recorded when both probable and estimable even though there is still uncertainty
over the exact timing and amount of the loss.
We suggest reviewing the reserve accounts footnote disclosure for:
(1) Reserve Reversal Gains: Check to make sure a material amount of excess reserves were not
reversed as a gain in earnings. The SEC now requires quarterly and annual detailed activity of
restructuring reserves, frequently presented in a reconciliation table as we illustrate in the next
exhibit.
(2) Under Reserving To Boost Earnings in the Current Period: A company might choose to under
expense recurring costs such as warranty or sales returns to boost current period earnings. Since
this account will need to be replenished in a future period, the company may encounter higher
costs in future years. We suggest reviewing the current period expense amount and comparing it
to historical trends. This analysis isnt as applicable to restructuring accruals since, by definition,
they should be episodic.
One specific disclosure is the restructuring reserve table. We suggest reviewing it for material reserve
reversals into earnings. While GAAP technically requires excess reserves to be recorded as a gain in
earnings, they are low quality. Therefore, we suggest excluding them from normalized earnings. We also
find this specific disclosure useful in assessing future cash restructuring costs for severance, closing
facilities, etc. As an example of the restructuring 10-K disclosure, we reproduced Monsantos in the next
exhibit.
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Monsanto (2011 Form 10-K): Restructuring Disclosure
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WARRANTYRESERVESMAYBEASOURCEOFEARNINGSGROWTH
Accounting for warranty reserves is an area of significant management judgment. A company might
choose to under-accrue warranty expense in the current period to increase earnings. However, if
warranty costs havent economically changed, the company will need to replenish the reserve and face
higher costs in future periods. Since this account is very subjective, we find it to be a relatively easy area
with which for management to make changes.
GAAP requires companies to disclose a roll forward of the warranty balance, if material. The disclosure
should be analyzed in a similar way as any other reserve account. To that end, we compare the ending
warranty reserve balance to revenues and would expect a fairly constant ratio unless something
significant has changed in the business. We also look for any warranty reserve gains (reversals) that
would have increased EPS (changes in estimates and other). Further, we compare the accruals for
product warranties (the amount expensed in earnings) to the payments on a current year basis and with
a one year lag (current year expense to prior year payments). If a company has been consistently
expensing higher warranty cost than payments, it may reflect a management tone of conservatism. As
an example of the warranty reserve disclosure, below is Meritors.
Meritor (2011 Form 10-K): Other Current Liabilities
Thecompanyrecordsestimatedproductwarrantycostsatthetimeofshipmentofproductstocustomers.Warrantyreservesareprimarily
based on factors that include past claims experience, sales history, product manufacturing and engineering changes and industry
developments.Liabilitiesforproductrecallcampaignsarerecordedatthetimethecompanysobligationisknownandcanbereasonably
estimated.Productwarranties,includingrecallcampaigns,notexpectedtobepaidwithinoneyeararerecordedasanoncurrentliability.
Asummaryofthechangesinproductwarrantiesisasfollows(inmillions):
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ARETHEREUNDERREPORTEDACCRUEDEXPENSES/ACCOUNTSPAYABLE
Are part of a 10-K footnote review and balance sheet analysis, we think its important to analyze accrued
expenses and payables for possible signs of business issues. Below is a summary checklist of items.
Read the MD&A section of the 10-K for changes in accrued expense policies.
Calculate the change in accrued expenses to the change in revenue. Detail of accrued expenses
is typically disclosed annually, or more frequently, if the account is large and there have been
large changes. The best method is to compare the most granular account changes year-overyear or period-over-period (salary accrual, marketing accrual, warranty, accrual, etc.). We
suggest comparing each detailed accrued expense item, if available, to its underlying driver (e.g.,
bonus accrual to sales).
Calculate and analyze the days payable ratio (payables / cost of goods sold x 365 days). This
ratio calculates the number of days required to pay vendors based on cost of goods sold.
Compare the percentage change in inventory to the percentage change in accounts payable.
Over the long-term, the two accounts should move in tandem since the growth in payables should
match the growth in inventory. Any large differences in this relationship may signal issues. The
relationship of inventory growing and payables declining is most concerning to us as it may signal
finished goods have been piling up while the company has reduced the purchase of new raw
material inputs (the latter of which would drive the decrease in accounts payable).
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ACCOUNTINGFORLEASES
The economics of operating and capital leases are similar, but the accounting for each type of lease
differs under GAAP accounting. FAS No. 13, Accounting for Leases, outlines four bright line rules to
determine whether a lease should be classified as a capital lease or not. If a lease meets at least one of
the following four tests, then it should be classified as a capital lease:
1.
2.
3.
4.
The lease conveys ownership to the lessee at the end of the lease term;
The lessee has the option to purchase the asset at a bargain price at the end of the lease term;
The term of the lease is 75% or more of the assets economic life; and
The present value of the minimum lease payments is 90% or more of the assets fair market
value.
Due to operating and capital lease accounting differences, most management teams decide to structure
leases as off-balance sheet operating leases (weve estimated that <10% of all leases are classified as
capital leases), resulting in lower leverage ratios for the company.
With regard to going concern companies, we treat leases as debt-like given their contractual nature. The
rating agencies also consider and treat leases as debt. The future minimum lease payments for noncancelable operating leases must be disclosed by companies at least annually. There are two methods
to approximate lease payments as debt:
1. Calculate the NPV of the leases future minimum payments, discounted at the companys
marginal borrowing rate; or
2. Multiply the total lease payment by 7 or 8 to approximate the debt and asset amounts, which was
developed by the rating agencies in the 1980s.
Below, weve reproduced Discovers lease commitments footnote disclosure.
Discover Financial Services (2011 Form 10-K): Commitments, Contingencies, and Guarantees
Lease commitments. The Company leases various office space and equipment under capital and noncancelable operating leases which
expireatvariousdatesthrough2022.AtNovember30,2011,futureminimumpaymentsonleaseswithoriginaltermsinexcessofone
yearconsistofthefollowing(dollarsinthousands):
Occupancy lease agreements, in addition to base rentals, generally provide for rent and operating expense escalations resulting from
increased assessments for real estate taxes and other charges. Total rent expense under operating lease agreements, which considers
contractual escalations, was $16.2 million, $14.2 million and $15.0 million for the years ended November 30, 2011, 2010 and 2009,
respectively.
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Future minimum lease payments, which are often based on revenue, do not include cancelable leases
or contingent rentals, and therefore, will be understated if a company uses renewable short-term leases
or contingent rentals based on future revenue. These nuances make minimum lease payment
comparability an issue; different companies with different types of leases may report vastly different
minimum lease payment numbers in their footnotes. Since future minimum lease payment disclosures
exclude contingent rentals and dont assume lease renewal options, we usually use the second method
of capitalizing leases (7-8x total rent expense) on the balance sheet as debt.
CAPITAL LEASES UNDERSTATE CAPITAL EXPENDITURES

Under capital lease accounting, the lease obligation and related asset are recorded at inception, but
there is no cash flow / cash flow statement impact. The capital leased asset is depreciated over its
useful life as a non-cash depreciation expense. There is a corresponding obligation payment each
period consisting of interest expense and reduction in lease obligation principal (similar to a typical
amortizing loan payment). The principal portion of the lease obligation is recorded as a cash outflow
from financing, while the interest expense lowers a companys earnings and cash flow from operations.
Compared to companies traditionally buying assets as capital expenditures, capital leases skew
reported EBITDA and free cash flow metrics because interest and depreciation are added back to
EBITDA. Capital leases are more similar to an asset purchase financed with debt, resulting in a
financing cash inflow.
Since GAAP understates capital expenditures (no cash outflow shown on the cash flow statement) for
companies using capital leases, we suggest adding new capital leases to capital expenditures. In doing
this, we believe that the cash flows will be more comparable, irrespective of a companys financing
policy, and that you arrive at a better free cash flow number.
Next we compare Amazon.com's new capital leases versus the companys capital expenditures and
calculate the adjusted cap-ex numbers over the past six years.
Amazon.com (2011 Form 10-K): Capital Leases vs. Capital Expenditures from the Cash Flow Statement ($ in millions)
Capitalexpenditures
Newcapitalleases
Adjustedcapitalexpenditures
Newcapitalleases/capex
2006
$216
69
285
2007
$224
89
313
2008
$333
220
553
2009
$373
335
708
2010
$979
577
1,556
2011
$1,811
1,012
2,823
32%
40%
66%
90%
59%
56%
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To further demonstrate the effects of including capital leases as capital expenditures, we adjust
Amazon.coms free cash flow to the firm (FCFF) by deducting new capital leases signed over the same
six year time period.
Amazon.com (2011 Form 10-K): Adjusted Free Cash Flow to the Firm Calculations ($ in millions)
Amazon.com
Operatingcashflow
Less:capex
Reportedfreecashflow
2006
$702
216
486
2007
$1,405
224
1,181
2008
$1,697
333
1,364
2009
$3,293
373
2,920
2010
$3,495
979
2,516
2011
$3,903
1,811
2,092
Add:aftertaxinterestexpense
Reportedfreecashflowtothefirm
51
537
50
1,231
46
1,410
22
2,942
24
2,540
42
2,134
Less:newcapitalleases
Adjustedfreecashflowtothefirm
Adj.FCFF/ReportedFCFF
69
468
87%
89
1,142
93%
220
1,190
84%
335
2,607
89%
577
1,963
77%
1,012
1,122
53%
CAPITAL LEASES BOOST CASH FLOWS AND REDUCE CAP-EX

Given the four bright line tests for lease accounting, it is fairly simple for companies to structure new
leases as either capital or operating without altering the economics of the lease much. Therefore, some
management teams may choose to increase cash flow from operations and free cash flow by using
capital leases instead of operating leases. We believe that analysts should be wary of companies that
switch operating leases to capital leases given the resulting higher on-balance sheet leverage reported
from capital leases.
Assuming that one companys operating lease payments (sometimes referred to as rent expense)
approximate another companys capital lease payments, their operating cash flows are not comparable
since a different amount of expense is recorded under each scenario. Only the interest portion of a
capital lease payment reduces operating cash flow, whereas, under an operating lease, operating cash
flow is reduced by the entire lease payment.
NEW FASB AND IASB LEASE ACCOUNTING PROPOSALS

In August 2010, the FASB and IASB jointly issued an Exposure Draft proposal to overhaul lease
accounting, which we believe will capitalize most leases on balance sheet as an intangible asset (right to
use property) and debt and eliminate off-balance sheet operating lease accounting. The FASB and IASB
were hoping to issue a final standard in 2011; however, they did not do so and are currently in redeliberations. We believe that a final standard wont be effective any time before 2014, at the earliest.
Under this proposal, a lessee who enters into a lease agreement would record a right of use lease
asset and a corresponding lease obligation on the balance sheet. These journal entries would occur
upon inception of the lease. The asset amount would be calculated as the present value of the future
lease payments plus any initial direct costs incurred by the lessee. The discount rate used to calculate
the leases present value would be based on the companys incremental borrowing rate on the date of
the lease or the rate the lessor charges the lessee, if it can be readily determinable.
Incremental borrowing rate is defined as the interest rate that, on the day of inception, the lessee would
pay to borrow the funds necessary to purchase a similar underlying asset, over a similar time period.
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Under the proposals, if the discount rate changes in a subsequent period, no remarking of the
asset/liability would occur. The right of use asset would be classified as if it were a tangible asset within
PP&E and evaluated for impairment at least annually. The liability to make lease payments would be
presented as a liability on the balance sheet.
LEASE ACCOUNTING PROPOSALS: FINANCIAL STATEMENT IMPACT

The financial statement impact of the proposed accounting changes for leases is summarized below.
Operating Leases Under Current and Proposed Accounting Rules
FinancialStatement
CurrentAccounting
ProposedAccounting
BalanceSheet
Assets
Liabilities
DeferredTaxes
Nothingrecorded
Nothingrecorded
Nodeferredtaxes
Rightofuseleaseassetrecorded
Leaseobligationrecorded
Deferredtaxassetrecorded(ingeneral)
IncomeStatement
Rentexpense
Amortization/depreciationexpense
Interestexpense
StatementofCashFlows
Alloperatingoutflows
Amortizationexpenseoperatingoutflow
Interestexpenseoperatingoutflow
Declineinleaseobligationfinancingoutflow
Totalchangeincash
Minimumleasepayment(rentexp.)
Minimumleasepayment(principal+int.)
LEASE ACCOUNTING PROPOSALS: KEY FINANCIAL RATIO IMPACTS

Under current lease accounting, companies that use operating leases appear less levered than in reality
since their contractual lease payments are not captured as liabilities on the balance sheet. Not only do
companies using operating leases appear less levered, they also typically report better profitability ratios
(ROA, asset turnover ratio, etc.).
Operating cash flow, EBITDA, and EBIT would all most likely be higher under the new proposals than
currently reported numbers because rental expense would become separated into amortization and
interest expense.
The proposed lease accounting changes would impact financial ratios, measures of earnings, and cash
flow in the following manner:
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Financial Ratio Impacts Under Current and Proposed Accounting Rules

FinancialStatement
CurrentAccounting
ProposedAccounting
Enterprisevalue
Lower
Higher
ROA
ROE
Assetturnover
Higher
Typicallyhigher
Higher
Lower
Typicallylower
Lower
EBITDA
EBIT
Netincome
Lower
Lower
Typicallyhigher
Higher
Higher
Typicallylower
Debt/Equity
Interestcoverage
Lower
Higher
Higher
Lower
Cashfromoperations
Capitalexpenditures
Unleveredfreecashflow
Lower
Understated
Lower
Higher
Understated
Higher
LEASE ACCOUNTING PROPOSALS: LOWER EARNINGS

Under the current treatment for operating leases, total lease expense includes the current periods
minimum rental expense plus any amount of contingent rental expenses. The proposal suggests that the
total rental expense should instead be composed of interest expense on the lease obligation and the
amortization expense (similar to depreciation) on the right of use asset.
The total aggregate lease expenses recognized over the lease term would be the same as a current
operating lease. However, due to higher interest expense in the early years of a purchased asset, net
income would be lower in the earlier years under the proposal, reversing to a higher net income number
in later years.
LEASE ACCOUNTING PROPOSALS: MATERIAL IMPACT ON GROWTH COMPANIES EARNINGS

For most companies, the net income difference of a single operating lease based on current operating
lease accounting and the proposal reverses over time, usually a very long time (many years). This is
especially the case for growth companies adding new leases every year or companies that frequently
renew expiring leases.
Its extremely difficult to generalize any possible earnings impact since it truly depends on what point
along the following graph a company is at. But due to the proposals, we believe that growth companies
earnings could be 10-25% lower. The net income effect is smaller for mature companies or companies
with slowing growth and might actually be higher for companies that are shrinking. In the next exhibit, we
compare lease expense under the proposal and current accounting, using straight-line rent expense /
amortization.
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Recorded Expenses Under Current and Proposed Accounting Rules

150
Proposedaccounting:
InterestExp.+Amortization
100
InterestExpense
50
0
2000.05
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Currentaccounting:
lease~rentalexpense
50
100
150
Time
Source: Wolfe Trahan Accounting & Tax Policy Research; FASB; IASB.
LEASE ACCOUNTING PROPOSALS: SUBSEQUENT ACCOUNTING FOR RENTAL EXPENSE

Operating lease rental payments are recorded as rent expense on a pay-as-you-go basis under current
accounting rules, whereas rent expense will become amortization and interest under the proposal. The
amortization will be calculated on the right of use asset and interest will be calculated on the lease debt
obligation.
The right of use asset will be amortized, straight-line, as an expense over the leases term and the
lease obligation will be reduced each period using the effective interest method, similar to a typical
mortgage amortization schedule.
Besides this change, companies will continue paying their rental lease expenses under the lease
agreements with no changes to the leases economics.
LEASE ACCOUNTING PROPOSALS: SIMPLIFIED RETROSPECTIVE TRANSITION

Prior period financial statements would not be restated, but upon the new accounting standards initial
adoption date, the right of use asset and related lease liability would be measured as the present value
of remaining lease payments. These remaining lease payments would be discounted using the lessees
incremental borrowing rate on the adoption date.
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CONVERTIBLEDEBT
Convertible bond accounting has become complicated in recent years due to increasingly complex
instruments and a desire to massage the terms of the instruments to achieve a favorable accounting
result (i.e., avoid including shares in EPS calculations). Two economically similar instruments may be
accounted for in different ways across companies depending on how the convertible debt is settled upon
conversion. Convertible bonds are now accounted for in one of two ways depending on their terms,
specifically how the convertible bond is settled upon conversion:
1. Plain vanilla straight convertible bonds. Bonds that are solely convertible into stock or may be
converted into stock and/or cash at the companys option are accounted for still under the if
converted method for diluted EPS calculations. We discuss the EPS treatment for convertible
bonds later in this section. For balance sheet purposes, the convertible debt is recorded on the
balance sheet at its issuance price (generally par) and interest expense is recorded in earnings at
the convertible bonds coupon rate. This was fairly simple accounting until a new innovation
appeared in the convertible bond market in 2005 as discussed next.
2. Cash settled (net-share settled) principal convertible bonds. In 2005, a new innovation
appeared in the convertible bond market as companies began issuing cash-settled principal
convertible bonds (also referred to as treasury stock bonds or net share settled bonds). Cash
settled principal convertible bonds indenture require that, upon conversion or at maturity, the
bonds principal amount must be settled in cash and the excess amount of the conversion value
(stock price x # shares convertible into) over the bonds principal amount may be settled in either
stock or cash at the companys option. One of the reasons for their increased usage was the
favorable accounting EPS benefits afford to them as the more favorable treasury stock method
is used to calculated diluted EPS rather than the if-converted method.
Over concerns that companies were issuing these instruments at low interest rates due to the
conversion feature and including no shares in diluted EPS until the bond was converted, FASB changed
the accounting rules for cash settled principal convertible bonds at the beginning of 2009. The rules did
not change for convertible bonds that are solely convertible into stock. New FSP APB 14-1 changed the
accounting treatment for cash-settled principal convertible debt by requiring bifurcation accounting.
The new rules require GAAP interest expense to be calculated based on a companys non-convertible
debt interest rate (straight rate). The old GAAP and plain vanilla convertible bond accounting records
interest expense at the cash (effective) interest rate. The rules did not change the diluted share count
treatment for convertible bonds or change the accounting for convertible preferred stock. Also, the
change more closely aligns with International Financial Reporting Standards (IFRS), which already
require convertible debt to be bifurcated and accounted for as debt and equity on the balance sheet.
The mechanics of bifurcation accounting for cash-settled principal convertible bonds are as follows:
1. A convertible bonds value is calculated excluding its equity conversion feature (considering all
other embedded features, such as other calls and puts by the company). Simplistically, the value
of debt is calculated based on the companys non-convertible debt borrowing rate on the date
upon which the convertible bond is issued. Since a companys straight debt rate is invariably
higher, the net present value of the bonds cash flows and other conversion features results in a
value lower than the convertible bonds principal amount. This amount is recorded as discounted
debt on the companys balance sheet.
2. In the next step, the company must calculate its prospective interest expense, which will include
both non-cash accretion and cash interest. The debt discount amount is accreted up to the bonds
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par amount over the expected life of the bond as additional non-cash interest expense. Interest
expense is calculated using the effective yield method. (Multiply the beginning of the period debt
balance by the bonds effective yield that was calculated on the issuance date. The non-cash
accretion increases the debt amount. In the next period, this higher debt amount is multiplied by
the same effective interest rate and so forth.). By using the effective yield method, interest
expense is recorded in earnings at the companys straight date rate. In the event that the bond is
redeemed early, the un-accreted bond discount is accounted for as a loss on debt
extinguishment.
3. The equity conversion option is calculated as the difference between the bonds issuance price
(e.g., par) and the calculated straight debt value (step 1 value). This equity amount is recorded in
additional paid-in-capital in shareholders equity and is not changed until the bond matures or is
redeemed.
The next exhibit illustrates and compares the plain vanilla convertible bond and cash settled principal
convertible bond accounting. Assume a company issues a $1,000 convertible bond for cash and the
equity conversion option is $226 (pre-tax). Under cash settled principal bond accounting, on the balance
sheet, there is a $136 ($226 x 40% tax rate) increase in shareholders equity, $226 lower total debt and
a $90 deferred tax liability. On the income statement, the company reports reports $27 higher interest
expense. Cash flow from operations is the same under both methods of accounting since the non-cash
portion of interest expense is added back to operating cash flow.
Example: Issuing $1,000 in Convertible Debt for Cash
Balance Sheet: Convertible Bond Issuance Date
Plain Vanilla
Debit: Cash
Credit: Convertible debt
Cash Settled
1,000
1,000
Debit: Cash
Credit: Convertible debt
1,000
774
(1)
Credit: Deferred tax liability
90
(2)
Credit: Equity conversion feature (net of taxes)
136
Income Statement: Year 1

Cash Settled
Plain Vanilla
Operating income (assumption)
150
Operating income (assumption)
150
Interest expense
20
Interest expense
47
Taxes
Net income
52
78
Taxes
Net income
41
62
Statement of Cash Flows - Cash from Operations: Year 1

Cash Settled
Plain Vanilla
Net income
Interest expense
Deferred taxes
Cash from operations
78
0
0
78
Net income
Interest expense
Deferred taxes
Cash from operations
62
27
(11)
78
(1) The tax effected amount of $226 allocated to equity at 40%.

(2) $226 allocated to equity less deferred taxes of $90.
Note: Assumed the deduction of interest expense on the tax return at the cash coupon rate.
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In the next exhibit, we illustrate a typical convertible bond disclosure for cash settled principal bonds
using Intels 10-K. Both the coupon and effective interest rate are disclosed. The latter of which is used
to calculate interest expense in earnings (i.e., the straight debt rate). Recall that the effective interest
rate is based on the date on which the bond is issued and does not change each period.
Intel (2010 Form 10-K): Long-Term Debt Excerpt
ConvertibleDebentures
In2009,weissued$2.0billionofjuniorsubordinatedconvertibledebentures(the2009debentures)duein2039.In2005,weissued$1.6
billionofjuniorsubordinatedconvertibledebentures(the2005debentures)duein2035.Boththe2009and2005debenturespayafixed
rateofinterestsemiannually.Wecapitalizedallinterestassociatedwiththesedebenturesduringtheperiodspresented.
Theeffectiveinterestrateisbasedontherateforasimilarinstrumentthatdoesnothaveaconversionfeature.
CONVERTIBLE DEBT AMOUNT ON BALANCE SHEET OFTEN NOT THE TRUE LIABILITY
In light of newer accounting for cash settled principal convertible bonds, the liability reported on the
balance sheet for convertible debt will not be the true liability due at redemption. The next exhibit is a
continuation of Intels long-term debt footnote wherein they disclose the outstanding principal, equity
component, and net debt carrying amounts. The balance sheet amount for their 2009 convertible debt
was $1 billion at 12/25/10 compared to $2 billion of principal amount outstanding and the conversion
feature of $613 million was recorded in equity. For valuation and financial analysis, we believe the
outstanding principal amount should be used as debt rather than the balance sheet value.
Intel (2010 Form 10-K): Long-Term Debt Excerpt
Boththe2009and2005debenturesareconvertible,subjecttocertainconditions,intosharesofourcommonstock.Holderscansurrender
the2009debenturesforconversioniftheclosingpriceofIntelcommonstockhasbeenatleast130%oftheconversionpricethenineffect
foratleast20tradingdaysduringthe30consecutivetradingdayperiodendingonthelasttradingdayoftheprecedingfiscalquarter.
Holders can surrender the 2005 debentures for conversion at any time. We will settle any conversion or repurchase of the 2009
debenturesincashuptothefacevalue,andanyamountinexcessoffacevaluewillbesettledincashorstockatouroption.However,we
cansettleanyconversionorrepurchaseofthe2005debenturesincashorstockatouroption.OnorafterAugust5,2019,wecanredeem,
for cash, all or part of the 2009 debentures for the principal amount, plus any accrued and unpaid interest, if the closing price of Intel
commonstockhasbeenatleast150%oftheconversionpricethenineffectforatleast20tradingdaysduringany30consecutivetrading
dayperiodpriortothedateonwhichweprovidenoticeofredemption.OnorafterDecember15,2012,wecanredeem,forcash,allor
partofthe2005debenturesfortheprincipalamount,plusanyaccruedandunpaidinterest,iftheclosingpriceofIntelcommonstockhas
beenatleast130%oftheconversionpricethenineffectforatleast20tradingdaysduringany30consecutivetradingdayperiodpriorto
thedateonwhichweprovidenoticeofredemption.
In the preceding table, the remaining amortization periods for the unamortized discounts for the 2009 and 2005 debentures are
approximately29and25years,respectively,asofDecember25,2010.
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CONVERTIBLEDEBT:DILUTEDEPSCALCULATIONSAREFARFROMSIMPLE
Below we discuss the EPS accounting treatment for convertible bonds. The EPS accounting is
predicated on how the convertible bonds principal amount is required to be settled and, accordingly, is
calculated under one of two methods:
1. If-Converted Method: Used when the convertible bonds principal amount is not required to be
settled in cash.
Mechanics:
Under the if-converted method, the bond is assumed to have been converted at the beginning of
the quarter, year, or, if later, the issuance date. Since it is assumed to be converted into shares,
there is both a numerator and denominator adjustment in the diluted EPS calculation (note that
this diluted EPS calculation is disclosed in the financial statement footnotes). First, the total
number of shares underlying the convertible bond is added to the diluted share count. Second,
there is also an adjustment to net income since if the bond converted, the company would not be
paying interest expense. Accordingly, net income is adjusted higher by the after-tax interest
expense on the convertible bond. In some extreme scenarios, doing the aforementioned
adjustment actually increases EPS and the convertible bond is not dilutive if converted. If this
occurs, GAAP requires the company to exclude the shares and not make the related after-tax
interest expense adjustment.
One common belief is that a convertible bond needs to be in the money to be included in the
diluted share count. This is simply not true as the calculation is mechanical. If the above
calculation results in a dilutive EPS effect, the adjustments are made.
2. Treasury stock method: This method is used when the convertible bonds principal amount
must be cash-settled at the companys option (note that the terms may be such that amounts
above the bonds principal amount may be settled in cash or shares at the companys option).
Mechanics
Under the treasury stock method, there is only EPS dilution from the convertible bond when its
in-the-money since the principal amount must be cash-settled. The number of shares included in
the companys share count is the number of shares of stock required to settle the in-the-money
amount of the convertible bonds conversion spread (convertible bond par value). There are no
shares included in the share count if the bond is not in the money.
To illustrate this method, assume a share price of $10 and that a $1,000 convertible bond is convertible
into 200 shares of stock. The current conversion value of the bond is equal to the $10 current share
price multiplied by 200 shares or $2,000.
Under the treasury stock method, diluted EPS is calculated as follows:
Conversion value amount:
Less: bonds par value:
Excess
Divided by average share price
Equals:
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$2,000 ($10 x 200 shares)

1,000 (assumed)
1,000
$10 (assumed)
100 shares included in diluted EPS share count
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CONVERTIBLEDEBT:INCORPORATINGINTOVALUATION
Accounting for convertible debt is far from perfect and, therefore, analysts should consider several
adjustments for financial analysis and valuation.
For a plain vanilla convertible bond, if the current stock price or the analysts target share price is greater
than the convertible bonds exercise (strike) price, we believe the underlying shares into which the bond
may be converted should be included in the diluted share count. Conversely, if the convertible bond is
currently out-of-the-money and the analyst believes that it is unlikely to become in-the-money (a true
busted convertible), we suggest that the convertible bond be treated similar to straight debt and,
accordingly, do not include any shares (underlying the convertible) in the diluted share count. If a bond
is out of the money and is never likely to be in the money again, we believe that current GAAP does not
reflect the real economics of the transaction. This is a situation where the if converted method of
accounting is overly conservative and arrives at the wrong economic answer.
Analysts should also remember to not double count items in valuation. That is, be careful to not treat the
convertible as 100% debt while at the same time including all the shares in the share count. The
companys share count may not include the economically correct number of shares, but a quick review
of the diluted share count 10-K disclosure will assist in making sure the correct number of shares is
included.
For cash-settled principal convertible bonds, we advise classifying the principal amount as debt and the
amount in excess of the principal, if any, as equity. If the bond is out-of-the-money and the analyst does
not expect the bond to increase in price to be in-the-money, we suggest treating the convertible debts
par amount as debt. This reflects the companys obligation to pay the debt off at par value or, if its
higher, we use the put value (e.g., bonds may be puttable at 102%, etc.).
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DEBTANDDEBTCOVENANTS
After reading through a companys 10-K debt disclosures for customary items such as debt covenants,
debt terms, and debt maturities we suggest reviewing it for the following items:
.
Does the company account for its debt under fair value accounting? GAAP requires the revaluing
the target companys debt to fair value at the acquisition date. As part of this process, a new
effective interest rate on the debt is calculated on which interest expense is calculated. This
creates a scenario where the cash interest expense on the debt may be materially different than
the GAAP interest expense. Separately, companies have the option to account for their debt at
fair value under GAAP with changes in fair value reported in earnings each period. We find this
more common in financial institutions than in other industries.
Does the debt contain a cross payment default provision? Under this provision, creditors of a
material amount of debt may elect to declare that a default has occurred under their debt
indenture and, therefore, accelerate the principal amounts due to creditors.
Does the debt contain a cross accelerated provision? This provision permits a bondholder to
declare default on a second debt instrument only if a default on the first debt instrument occurs
and the first debt instrument is, in fact, accelerated.
Does the debt have a subjective acceleration clause? This debt term allows bondholders to
accelerate the maturity of debt if certain events occur that are not objectively determinable (or
defined).
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OTHERASSETSANDLIABILITIES
SEC rules require additional disclosure of certain balance sheet accounts if materiality thresholds are
met. We suggest reviewing these disclosures for large or unusual increases and/or decreases. In
particular, a careful review of the other current or noncurrent assets is warranted as a company might
capitalize costs into a non-current asset account rather than expensing such amounts. Annual
disclosure of the following is required:
Any other current assets greater than 5% of total current assets;
Any other noncurrent assets greater than 5% of total assets;
Deferred costs greater than 5% of total assets;
Any other current liabilities greater than 5% of total current liabilities; and
Any other noncurrent liabilities greater than 5% of total liabilities.
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ACCUMULATEDOTHERCOMPREHENSIVEINCOME
The FASB decided to exclude certain items from current period earnings to avoid unnecessary earnings
volatility. To that end, accumulated other comprehensive income (AOCI) was created to hold certain
gains or losses within shareholders equity. AOCI has no other conceptual basis or theoretical
justification except to smooth earnings.
Analysts should review AOCI activity in the current period for large and unusual changes. Given the
nature of the items accounted for in AOCI, we expect to see volatile year-over-year changes. The four
items included in AOCI include (1) pensions, (2) unrealized gains/losses on marketable securities, (3)
unrecognized gains/losses on cash flow hedges, and (4) foreign currency translation effects. Below we
discuss each of these AOCI items and how it relates to Honeywells 2011 Form 10-K disclosure.
1. Pensions and OPEB: Under FAS No. 158, Employers Accounting for Defined Benefit Pension
and Other Postretirement Plans, companies must record the economic funded status of pension
and other post-retirement plans (OPEB) as either an asset (if overfunded) or liability (if
underfunded). Since GAAP allows (and most companies choose to) smooth investment
gains/losses on pension plans over a period of up to five years, the change in a companys
unfunded pension amount is recorded as an decrease/increase to AOCI.
Most pension plans are underfunded due to significant losses incurred during 2008. Companies
with defined benefit plans usually have large unrecognized balances in AOCI (the balance sheet
impact is to reduce equity, net of a deferred tax asset, while increasing the pension liability).
Since pension plans are generally only marked-to-market once a year, this section of AOCI
should not change on a quarterly basis.
The pension impact in 2011 on AOCI was $209 million as shown in Honeywells disclosure. The
unrecognized pension amount in the companys AOCI balance at 2011 year-end was $1.65
billion. Note that Honeywell adopted a form a pension mark to market accounting in 2010 that
will limit the AOCI pension amounts compared to historical amounts.
2. Unrealized gains/losses on available-for-sale marketable securities: Under FAS No. 115,
Accounting for Certain Investments in Debt and Equity Securities, unrealized gains/losses on a
companys marketable security portfolio are recorded in AOCI. In 2009, all else being equal,
unrealized gains on company portfolios increased the AOCI balance. If management decides to
sell all or a portion of its marketable securities, the unrealized gain/loss is removed from this
account and recognized as income/expense in earnings.
As shown in Honeywells 2011 Form 10-K AOCI disclosure, the marketable securities current
year unrealized gain was approximately $12 million, resulting in a net cumulative $163 million in
unrecognized gains held in the companys securities portfolio.
3. Unrecognized gains/losses from cash flow hedges of forecasted transactions: Under FAS No.
133, Accounting for Derivative and Hedging Instruments, all derivatives are recorded at fair
market value on the balance sheet. The two typical types of derivative transactions temporarily
recorded in AOCI include (1) unrealized gains/losses on cash flow hedges of forecasted
transactions and (2) hedging cash flows of a recorded balance sheet asset or liability (e.g.,
derivative to hedge floating rate debt that is swapped into a fixed rate). Gains or losses on these
hedging transactions are temporarily held in AOCI until the hedged transaction is recorded into
earnings. Hedge ineffectiveness is recognized immediately in earnings.
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This portion of AOCI should be reviewed any large unrealized or unsettled derivative losses or for
large year-over-year changes, suggesting new hedging policies and/or risk management
practices. But be aware that companies may close out hedges at quarter-end or year-end to
minimize the amount of unrealized gains or losses at period-end.
Honeywells 2011 Form 10-K AOCI disclosure shows that the company had a $31 million loss on
its derivatives and hedging at year-end (due to a net $34 million unrealized loss in 2011).
4. Impact of foreign currency translation of foreign subsidiaries balance sheet under the current rate
method of foreign currency accounting (currency translation adjustment): Under FAS No. 52,
Foreign Currency Translation, companies may translate their balance sheet under the (1) current
rate method (majority of companies use) or (2) temporal method.
The current rate method translates all foreign subsidiary balance sheet assets and liabilities at the
end of period exchange rate. The cumulative impact of translating foreign subsidiaries balance
sheets from a foreign currency into U.S. dollars under the current rate method is recorded directly
into AOCI. Under the temporal method, the impact of translating foreign balance sheets is
recorded in earnings.
In a period of substantial exchange rate volatility, this account may experience a material yearover-year change. The amount of the gain/loss from currency translation depends on the
companys net exposure (i.e., equity balances) and the change in exchange rates. The translation
gain/loss is calculated as the foreign subsidiarys equity balance multiplied by the change in
exchange rate, and the current year change represents the net gain or loss.
As shown in Honeywells AOCI disclosure, the impact of translating foreign subsidiaries in 2011
was approximately ($146) million, resulting in a cumulative unrecognized translation gain at yearend of $74 million.
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Honeywell (2011 Form 10-K): AOCI Disclosure ($ in millions)

Note19.AccumulatedOtherComprehensiveIncome(Loss)
Total accumulated other comprehensive income (loss) is included in the Consolidated Statement of Shareowners Equity.
ComprehensiveIncome(Loss)attributabletononcontrollinginterestconsistedpredominantlyofnetincome.ThechangesinAccumulated
OtherComprehensiveIncome(Loss)areasfollows:
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FAIRVALUEMEASUREMENTS
FAS No. 157, Fair Value Measurements, provides a fair value framework to record the fair market
values of financial assets and liabilities. This is the mark-to-market standard of accounting that created
much controversy recently.
Central to this framework is the fair value hierarchy, commonly referred to as the Level 1, 2, and 3
assets and liabilities. The type of inputs used to determine the fair values of a companys financial
instrument determine which level the asset (or liability) should be disclosed under. According to FAS No.
157, below is the basis for fair value hierarchy classification:
Level 1: Inputs based on quoted prices in active markets for identical assets or liabilities are
Level 1 assets. The most common example would be determining a fair value based on an
exchange traded stock price.
Level 2: Observable inputs other than quoted prices for identical instruments are Level 2 assets.
Observable inputs include items such as quoted prices for similar assets or pricing formulas
based on commonly quoted inputs (e.g. interest rates).
Level 3: Unobservable factors in the market are Level 3 assets, the most subjective of the three
categories. Fair values of these assets consist primarily of management assumptions and can
take the form of DCF models or comparable company analyses (i.e., mark to model).
Companies must provide a disclosure that shows the amount of their assets and liabilities within each of
these levels. In the following exhibit, we present State Streets disclosure of its Level 1, 2, and 3 assets.
At December 31, 2011, $5.8 billion of the companys assets held at fair value (~7% of total) were valued
based on Level 3 inputs.
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State Street (2010 Form 10-K): Fair Value Measurement Disclosure
Companies are required to disclose a summary of Level 3 asset changes over the year. This disclosure
is interesting and important to analyze because the determination of fair value is dynamic and the inputs
used to determine the fair value may have changed year-over-year. Since Level 3 asset fair values are
the most open to management subjectivity, investors should watch out for large transfers from Level 1 or
2 into Level 3. It is also important to inquire about any large increases into the Level 2 category as there
is relatively more subjectivity in valuing these types of assets than Level 1 assets.
Analysts should inquire with management about the type of valuation techniques and methods used to
determine their assets fair values. The next step would be determining the viability and applicability of
managements valuation assumptions.
It is important to note that being classified as a Level 3 (or 2) asset doesnt necessarily mean that the
asset is more or less risky than another. The key difference is the type of inputs used to arrive at the
recorded fair value. The following exhibit is State Streets disclosure of Level 3 assets and liabilities
activities.
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State Street (2010 Form 10-K): Fair Value Measurement Disclosure
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BALANCESHEETRELATIONSHIPS
When a company chooses to overstate reported earnings, a corresponding overstatement of an asset
account (or understatement of a liability account) is also created. The following relationships are critical
in analyzing a companys 10-K and detecting potential earnings management tactics.
Inventory:
To lower cost of goods (and increase earnings), management might choose to understate inventory
purchases or the companys ending inventory balance.
Beginning Inventory
+ Purchases
- Ending Inventory
= Cost of Goods Sold
Companies can increase inventory, and thereby reduce COGS, by:
o Failing to write-down inventory;
o Overstating inventory quantities;
o Adding amounts and overstating to the inventory account; and/or
o Overproducing inventory to absorb fixed overhead costs.
Best detection metric: Days of Inventory (Inventory / COGS x 365 days) analyzed over time.
Accounts Payable:
Inventory and accounts payable are inter-connected (accounts payable is generally linked to
inventory purchases) and changes to these balance sheet accounts should be reviewed together.
Movement in these two accounts should, more or less, happen in tandem.
To increase current reported earnings, management may under-report accounts payable and
inventory purchases at the same time, resulting in a low cost of goods sold number and higher
reported earnings.
Accrued Expenses (unpaid expenses):
Accrued liabilities are balance sheet amounts related to expenses already recognized on the income
statement1. To increase current earnings, a company may understate accrued expenses on the
balance sheet, tempting management to draw-down and reduce existing accrued liability accounts
instead of recording an expense through earnings and increasing the accrued liabilities further.
Although management may temporarily increase earnings, the benefit is transitory if the expenses
are actually recurring costs since the one-time earnings benefit will reverse as higher costs in the
future as the account is replenished.
Two examples:
o Reducing accrued warranty liabilities. If warranty costs are recurring in nature, the company
will be recording a higher expense through earnings in the following period.
o Requiring employees to use their accrued vacation at year-end. Instead of recording a
compensation expense in the current period, the accrued liability is decreased along with a
corresponding cash outflow.
1
Exception:AsPP&Eispurchasedandrecordedonthebalancesheet,anaccruedliabilityexistsforanyunpaidamounts.
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IncomeStatement
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REVENUERECOGNITION
Historically, the largest number of financial restatements has resulted from improper revenue
recognition. Disclosures about revenue recognition in the 10-K can glean information about potential
risks due to aggressive accounting policies. Some business models lend themselves to more flexibility in
recognizing revenue. For example, consider a sell-in versus sell-through business model where there is
a distributor or other vendor as the middle man. In a sell-in revenue recognition practice, revenue is
recognized when shipped to the distributor and, from the companys perspective, there is clearly more
discretion in the timing and amount of inventory shipped and, therefore, recognized. This is often known
as stuffing the channel.
Conversely, in a sell-through model, revenue is recognized upon final shipment to the end customer
(distributor to the customer). There is less (but still some) flexibility to stuff the channel in this scenario
as revenue is recognized based on end demand from the customer. Improper revenue recognition under
a sell-through model may still occur if a company is using bill and hold type sales or shipping inventory
to a related party or vendor with close ties.
Below is an example of the revenue recognition policy for Snap-On from the Critical Accounting section
of the MD&A.
Snap-On (2011 Form 10-K): Critical Accounting Policies Revenue Recognition
RevenueRecognition:Snaponrecognizesrevenuefromthesaleoftools,diagnosticsandequipmentsolutionswhencontracttermsare
met, the price is fixed or determinable, collectability is reasonably assured and a product is shipped or risk of ownership has been
transferredtoandacceptedbythecustomer.Forsalescontingentuponcustomeracceptance,revenuerecognitionisdeferreduntilsuch
obligations are fulfilled. Estimated product returns are recorded as a reduction in reported revenues at the time of sale based upon
historicalproductreturnexperienceandgrossprofitmarginadjustedforknowntrends.Provisionsforcustomervolumerebates,discounts
andallowancesarealsorecordedasareductionofreportedrevenuesatthetimeofsalebasedonhistoricalexperienceandknowntrends.
Revenuerelatedtomaintenanceandsubscriptionagreementsisrecognizedoverthetermsoftherespectiveagreements.
Snaponalsorecognizesrevenuerelatedtomultipleelementarrangements,includingsalesofhardware,softwareandsoftwarerelated
services.Whenasalesarrangementcontainsmultipleelements,suchashardwareandsoftwareproductsand/orservices,Snaponuses
the relative selling price method for hardware and related software elements that are essential to the hardwares functionality. For
software elements that are not essential to the hardwares functionality and related software postcontract customer support, vendor
specificobjectiveevidence(VSOE)offairvalueisusedtoallocaterevenuetoeachelementbasedonitsrelativefairvalueand,when
necessary,usestheresidualmethodtoassignvaluetothedeliveredelementswhenVSOEonlyexistsfortheundeliveredelements.The
amount assigned to future delivery of products or services is recognized when the product is delivered and/or when the services are
performed. In instances where the product and/or services are performed over an extended period, as is the case with subscription
agreementsortheprovidingofongoingsupport,revenueisgenerallyrecognizedonastraightlinebasisoverthetermoftheagreement,
whichgenerallyrangesfrom12to60months.
Franchisefeerevenue,includingnominal,nonrefundableinitialandongoingmonthlyfees(primarilyforsalesandbusinesstrainingand
marketingandproductpromotionprograms),isrecognizedasthefeesareearned.
Below we discuss the primary ways in which revenues may be managed.

1. Bill and hold sales. The existence of bill and hold type sales are a red flag, in our view. Sunbeam
and Diebold are two examples of large historical accounting restatements due in part to improper
bill and hold accounting. Bill and hold sales are where a company sells a product to its
customer, title is transferred, collectability of payment is reasonably assured, but the product
hasnt shipped. Certainly, there may be legitimate means for such sales. However, since the
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product hasnt shipped and isnt consuming space on the customers premises, there is incentive
for companies to use it as a means to pull forward sales into a current quarter. A discount may
even be offered as terms for its use. The way to spot this artifice is through a careful 10-K/10-Q
reading and comparison of the companys accounting policy section and/or the questioning of
company management.
2. Extended payment terms. In a like vein to bill and hold sales, a company might grant extended
payment terms to customers as an inducement for sales, in effect, financing the purchase with a
longer-term receivable.
3. Sales return / discounts reserves. Revenues are recorded in earnings net of estimated sales
return and discount reserves. Since these amounts are estimated, a company may use a
reduction (drawdown) of these reserves as a gain to boost revenues. An alternative means to
boost current period revenues is to under reserve for sales returns and discounts. In this
scenario, since a lower amount is deducted from gross sales, earnings improve. However, this is
unsustainable if returns/discounts turn out to be higher as the company will need to replenish the
reserve in a future period (reducing earnings). Furthermore, if a product experiences a changing
pattern of returns or discounts, there may be a surprise increase in this reserve and a
corresponding reduction in net revenues. Further, a new policy of sales right of returns may
suggest sales returns/reserves could be understated. As we discuss elsewhere in this report, the
10-K Schedule II is an important item to review for the existence and amount of any sales return
and discount reserves. In the past, retailers and some drug companies have experienced issues
with sales returns/discount reserves. One example of a company restating earnings as a result of
this process is Medicis Pharmaceutical Corporation.
4. One-time gains recorded as revenue. Although not common, a company may choose to record a
gain on the sale of a business in revenue. Earlier this decade, GM recorded a gain on the sale of
their defense business in revenues.
5. Contract accounting/percentage of completion accounting. Some business models lend
themselves to more revenue recognition flexibility. For complex and multi-period/year projects,
revenue is often recognized under the percentage of completion (POC) accounting method. The
POC method records revenues based on the percentage of costs incurred in the current period
relative to total estimated costs or based upon certain project milestones. At the onset of the
project, revenues, expenses and a related project margin are estimated. In turn, revenue is
recognized each period based on these assumptions. If a companies estimate of costs and
related revenues are inaccurate, there may be a one-time charge to write-off accumulated costs.
Even if costs are not written off, there is still significant flexibility to manage reported revenues
and margins under this type of accounting.
We view changes to this form of accounting very skeptically. As an example, before the housing
bust, WCI Communities and Toll Brothers began using percentage of completion accounting for
condo development sales based on a cost incurred to total cost method.
6. Material decreases/changes in deferred revenue. GAAP requires a deferred revenue liability to be
recorded in situations where cash is received prior to when revenue is allowed to be recognized.
A simple example is a 2 year newspaper subscription. On the balance sheet, there is an increase
in cash and an increase in the short and/or long term deferred revenue liability. Assuming no new
subscriptions, the deferred revenue liability decreases each period as papers are delivered and
revenue is recognized in earnings. For an ongoing business growing sales, the deferred revenue
liability should grow each period and be a source of cash in operating cash flow. Since deferred
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revenue represents a pool of future revenue, a company may change how deferred revenue is
recognized or improperly draw down from this account. Therefore, we review this account for
material year-over-year and sequential declines. The ProQuest case study later in this report is
an illustration of improper use of deferred revenue accounting. A deferred revenue decrease or a
deceleration in this account is a possible warning sign of a deteriorating underlying business
since it represents revenue to be recognized in future periods.
FINANCIAL RATIO WARNING SIGNS

Apart from reviewing the financial footnote for changes in revenue recognition policies, existence of sellin revenue recognition and bill and hold practices, weve found a few simple ratios to be the best at
signaling aggressive revenue recognition:
I.
Days Sales Outstanding (DSOs). We calculate this ratio as ending accounts receivable divided by
sales (annualized if quarterly) multiplied by 365 days. Average accounts receivable may also be
used, but we prefer to use ending as average smooths out the possible effects of such practices
as stuffing the channel at quarter-end. We also recommend reviewing the debt footnote to ensure
there is no securitization of accounts receivable. Selling receivables would artificially lower this
ratio and, therefore, decrease its efficacy in detecting aggressive revenue recognition.
II.
Days Deferred Revenue (DDR). If a companys business model uses deferred revenue, we
calculate a days deferred revenue metric similar to a days sales outstanding metric. It is
calculated as the total deferred revenue divided by sales (annualized if quarterly) multiplied by
365 days. A declining ratio may suggest a move to a more aggressive revenue recognition policy,
a slowing overall business, or a change in policies.
III.
Sales Return Reserves / Discounts. If disclosures exist, we calculate the sales return/discounts
reserve to sales and review for material decreases in this ratio. A company may dip into these
reserves as a means to boost earnings and this is unsustainable if the sales return/discount
reserves are actually higher. We also compare the sales return/discount provision to current
period revenues.
IV.
Large Increases in Other Receivables or Other Assets. As an enticement to boost current period
sales, long-term financing may be used. An increase in balance sheet accounts such as other
receivables, financing receivables or other assets are areas in which long term receivables may
be recorded. In this scenario, days sales outstanding would not necessarily be a reliable red flag
indicator.
V.
Related Party Sales or Sales to Off-Balance Sheet Joint Ventures. Review financial statement
footnotes for the existence of these items.
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NONRECURRINGITEMS?
Analysts should pay particular attention to any accounting changes or non-recurring items reported, no
matter how innocuous they may appear on the surface. Below we discuss the GAAP treatment for
certain one-time items:
Extraordinary items. Extraordinary items are defined by GAAP as infrequent in occurrence and
unusual in nature. There is a very high threshold for classification as extraordinary. If a company
has an extraordinary gain or loss, it will be shown discretely on the income statement, net of tax,
and below discontinued items. Given the very high threshold to be classified as extraordinary,
these items may generally be treated as true one-time items.
Unusual or infrequent items. GAAP requires unusual or infrequent items that are not
extraordinary to be classified within continuing operations. Restructuring and impairment charges
are common examples. As we explain later in this section, our historical tests have found that
companies that consistently report these special items tend to underperform.
Accounting changes. A company may choose to change their accounting policy or method for
certain items. Reasons for the change may vary, primarily being the FASB changing the rules or
a company voluntarily choosing to change its accounting policy. Unless it is impractical to do so,
the change in accounting will generally be applied retrospectively, meaning that all prior periods
reflected in the current statements will be changed as if the new accounting was always in place.
The scenario when a company voluntarily makes a change in accounting policy should be viewed
cautiously, as it may be used as a mechanism to improve earnings optically. One recent popular
change is companies changing the method of actuarial loss recognition for their pension plans.
Notably, companies will obtain a preferability letter from their auditors to change from one
permissible accounting standard to another (e.g., moving from LIFO to FIFO inventory method).
Generally, these letters are difficult to obtain from auditors.
Changes in estimates. Another type of change is an accounting estimate change changes in

estimates are accounted for only prospectively. One such example is changing the depreciable
life of PP&E. These changes should be viewed skeptically, particularly if a company increases the
useful life estimate, which would have the impact of increasing earnings through lower
depreciation expense.
Companies Reporting Consistent Special Charges Underperform

In our December 6, 2011 report Earnings Quality, we performed a share price return analysis of
companies reporting special items - include restructuring charges, impairments, settlements, inventory
write-downs, etc. These special items are generally deemed to be non-recurring. We found that
companies consistently reported these special items underperformed.
When companies continually report non-recurring items, we believe that the market at some point will
begin to view the charges as recurring. These charges may be symptomatic of underlying business
issues, therefore impacting growth prospects, multiples and company valuation.
We assessed the frequency of charges on a four quarterly trailing basis based on how many quarters
out of the previous four quarters a special charge occurred, using two different thresholds to assess the
charges materiality: 0.25% and 1% of revenue.
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Companies that reported special charges at least 1% of revenue in 4 out of the last 4 quarters
underperformed the index by 300 basis points on average with 67% of the companies failing to match
the performance of the index (the inverse of a 33% hit ratio). Using a lower 0.25% of revenue
threshold, there was 198 basis points of underperformance with 67% of the companies failing to match
the performance of the index (the inverse of a 33% hit ratio).
Special Charges: Historical Returns (# of Quarters out of Trailing Four)
RelativeReturnofCompaniesReportingSpecialItems
>.25%ofRevenues
RelativeReturn
%HitRatio
70
50
40
1
30
HitRatio%
RelativeReturn%
60
20
10
0
3
0
No.ofQuartersSpecialItemsReported
RelativeReturnofCompaniesReportingSpecialItems
>1%ofRevenues
RelativeReturn
%HitRatio
70
60
50
40
30
HitRatio%
RelativeReturn%
20
3
10
0
0
1
2
3
No.ofQuartersSpecialItemsReported
Note: Number of quarters of special items reported out of the previous four quarters. Hit ratio is the percentage of companies outperforming the index.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poors; FactSet.
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COMPARABILITYOFMARGINS
Analysts should review the MD&A and footnote disclosures to ascertain whether any classification
issues exist that would impact the comparability of one companys margins to its peers. For example,
certain types of income or expenses may be classified in different line items within the financial
statements. For many items, no clear accounting guidance exists on where to classify certain costs on
the income statement. Current practice has been established through SEC guidance and industry
practice.
One common point of non-comparability is the classification of distribution expenses. Items such as
inbound freight charges, inspection costs, warehouse costs, and other distribution network costs may be
in either in cost of sales or SG&A. For a retailer, rent expense and shipping and handling costs could
potentially be included as either cost of sales or SG&A. Depreciation and amortization expense may be
classified in SG&A or alternatively, capitalized into inventory and eventually expensed by way of in cost
of sales. Intangible asset amortization will typically be classified based on the intangible assets function.
Although less common, certain gains may be classified in a manner where an analyst may want to
adjust for multiple, growth or margin purposes. For example, a company might include equity income
from an unconsolidated subsidiary or interest income in revenue. The SEC does require that product
and service revenue that is at least 10% of total revenues to be separately disclosed on the income
statement.
In the next exhibit, we illustrate Whirlpools classification of gains on certain asset dispositions in cost of
sales. While gains and losses have been nominal in recent years, amounts may be included in future
years that would require adjustment.
Whirlpool (2010 Form 10-K): Gain on Asset Sale Classifications
Weclassifygainsandlossesassociatedwithassetdispositionsinthesamelineitemastheunderlyingdepreciationofthedisposedassetin
theConsolidatedStatementsofIncome.Weretiredapproximately$600millionand$80millionofmachineryandequipmentnolongerin
useduring2011and2010.Netgainsandlossesrecognizedincostofproductssoldwerenominalfor2011,2010and2009.
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CHANGESINESTIMATEDRIVENEXPENSES
Recognition of operating expenses in earnings is another area requiring significant management
estimates and assumptions. To boost earnings, a company may defer current period expenses to a
future quarter (cost capitalization), lower (understate) current period expenses, classify normal operating
expenses as non-recurring items or use pro forma earnings.
Changes in estimate driven expenses generally fall into one of six categories:
I.
II.
III.
IV.
V.
VI.
Cost capitalization;
Depreciation changes (discussed earlier in the PP&E section)
Reserves;
Accrued expenses;
Pension Expected Rate of Return (see pensions section)
Recurring costs / pro forma earnings (see Non-recurring items section above)
COST CAPITALIZATION
Improper capitalization of costs on balance sheet has been an area historically rife with aggressive
accounting. Its form varies from a change in an accounting policy, to an outright fraud, or even to a new
business model under which it is permitted since there are no clear accounting rules. Cost capitalization
is required in certain circumstances, but it still may impair comparability across companies. In its true
form, cash is expended in the current period for business items (marketing, contract costs), but
management must reasonably allocate the costs to future period(s) expected to benefit under the
matching principle. Estimating the future benefit period of such costs is rife with assumptions. Whats
more, cost capitalization is relatively easy to do. As an example, to shift current period expenses out of
earnings to the balance sheet, a company might adopt a voluntary change in their cost capitalization
policy.
Expenses related to long life assets (e.g., PP&E) are capitalized on the balance sheet as an asset if they
are expected to provide future benefits typically greater than 1 year. This allows the matching of costs
incurred with related revenues. By capitalizing costs, earnings are higher since the costs are deferred to
an expense in a future quarter. On the cash flow statement, the increase in the asset is reported as a
cash outflow in operating, investing or financing cash flow. If the cost capitalization is reported in
operating cash flow, it will be comparable to other companies. Conversely, if the capitalization of asset is
reported in investing or financing, operating cash flow will be permanently overstated. Over time, as the
capitalized costs are expensed, earnings are lower, but operating cash flow is unchanged since the
expense is non-cash and added back to operating cash flow. As an example, WorldCom improperly
capitalized normal recurring costs as property, plant and equipment and reported the cash outflow in
investing cash flow.
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Classifying Costs as Investing Cash Outflows WorldCom
WorldCom
($inmillions)
YearendedDecember31,
2000Reported 2000Restated
2001Reported 2001Restated
$7,666
$4,227
$7,994
$2,845
Cashflowsfrominvestingactivities
Capitalexpenditures
Acquisitionsandrelatedcosts
Increaseinintangibleassets
Decreaseinotherliabilities
Allotherinvestingactivites
Cashusedbyinvestingactivies
(11,484)
(14)
(938)
(839)
(1,110)
(11,668)
0
0
0
505
(7,886)
(206)
(694)
(480)
(424)
(6,465)
(171)
0
0
514
($14,385)
($11,163)
($9,690)
($6,122)
As two examples of where cost capitalization is required consider interest cost and software
development. Under FAS 34, interest cost on borrowings used to construct long term assets is
capitalized as part of the assets cost. Since the interest cost is included in PP&E, it never appears as
interest expense on the income statement. Rather, it is included as part of the asset and, therefore,
depreciation expense over time. It also never appears as a cost in operating cash flow as the interest
paid is encapsulated in the cash outflow shown for capital expenditures in investing cash flow.
Therefore, this is why credit rating agencies calculate cash interest paid to measure debt servicing
capabilities. Reported interest expense may be artificially low.
Software development cost is another area where capitalization is allowed. FAS No. 86 requires
capitalization of internal software development costs once technological feasibility is reached and then
such costs are amortized over their expected benefit period. There is inherent subjectivity in the
estimated cost amortization period and the determination of when technological feasibility is reached.
This illustrates how even if an accounting principle requires a certain practice, different management
assumptions may lead to different reported expense amounts, all else being equal. For internal use
software, capitalization is required once the application development stage begins and this is defined
as the stage in which the design, coding, hardware installation and testing occur.
HOW TO SPOT COST CAPITALIZATION

Insofar as there is not fraud involved, aggressive cost capitalization may come to light by reading the
company's accounting policies section and reviewing several balance sheet accounts. First, if costs are
capitalized, what is the period of time over which such costs are expensed and is it reasonable? It may
appear that a company has calculated a proper amortization period with precision; nevertheless, it is
highly subjective and variable. Therefore, we prefer to find short amortization periods for capitalized
costs (<3 years) as technological obsolescence or product displacement may occur over longer periods
of time. It is also useful to review changes in other current assets and other assets as these accounts
may be the repository for a company capitalizing costs. In more aggressive accounting historical cases,
routine costs were placed in property, plant and equipment. Therefore, its useful to review the historical
progression of a few ratios within the same sector or industry group: revenue to PP&E and depreciable
life (gross PP&E / depreciation expense).
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We also recommend a quick review of large changes in other balance sheet accounts for possible
excessive cost capitalization (avoiding expensing through earnings). Companies are required to
annually disclose:
Any other current assets greater than 5% of total current assets;

Any other noncurrent assets greater than 5% of total assets;
Any deferred costs greater than 5% of total assets;
Any other current liabilities greater than 5% of total current liabilities; and
Any other noncurrent liabilities greater than 5% of total liabilities.
ACCRUED EXPENSES: UNDERREPORTING / DRAW DOWNS

Understating accrued expenses on the balance sheet is one less known tactic to increase current period
earnings. An accrued expense liability is an unpaid expense for which there has already been a GAAP
expense recognized. As an example, consider an employee vacation accrual. During the year in which
the employee earns vacation, an expense is recorded along with a vacation accrued liability as the
employee works during the year. When the employee takes vacation, the accrued liability is reduced but
there is no income statement impact. To boost current period earnings, a company may draw down the
accrued expense liability and avoid a current period expense in earnings. Continuing the vacation
accrual example, an employer could institute a policy of requiring employees to take two weeks of
vacation at the end of December. During those two weeks in which the employee is off, the accrued
liability is drawn down instead of recording employee compensation cost in earnings since vacation days
are drawn down. This benefit is temporary if the accrued expenses are recurring as the accrued
compensation cost will increase in the following period.
The best ways we've found to detect these items are by comparing the ratio of the change in accrued
expenses to the change in revenue and by reading through Management's Discussion and Analysis
section (MD&A) for any changes in accrual accounting policies. Changes (decrease) in the accrued
liability balance at year-end are also red flags.
RESERVES
Balance sheet reserve liabilities are another category of accrued expenses that may be drawn down to
lower current period expenses. Examples of balance sheet reserves include warranty, restructuring, bad
debts, taxes and litigation. Reserve accounts should be reviewed for gains from excess reserve
reversals (i.e., the cookie jar) and under-reserving (expensing) in the current period. Since reserves are
management estimates, GAAP provides significant flexibility in the timing and amount expensed in
earnings or reversed as a gain in earnings. A common abuse over the years is to incur a large one-time
excessive restructuring charge (shown as an accrued liability on the balance sheet) and then slowly
reverse this as a gain into earnings. The large restructuring charge itself may improve future earnings as
assets are written down (lower depreciation expense) and future operating expenses are pulled forward
into a charge in earnings. Abuse in the 1990's caught the attention of the SEC and now companies are
required to include a quarterly restructuring reserve roll forward. This has improved the transparency of
spotting restructuring reserve reversals. However, quarterly (or even annual) roll forward tables are not
required for other reserves. Another reserve reversal is taxes. Companies maintain a material tax
reserve liability for uncertain tax positions. Management may reverse part of the reserve as an offset
against reported income tax expense to lower the current period effective tax rate. This is a typical
reason a company "beats" earnings due to a lower than expected income tax rate.
A less well known tactic used to boost current period earnings is under expensing a recurring cost such
as warranty or bad debts. This will benefit current earnings, but without a sustainable improvement in
quality or collection efforts, the company will need to replenish the reserve through higher warranty/bad
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debt expense in future periods. To match costs in the same periods revenues are recognized, the
company must expense its estimate of the cost of returns, product quality issues, bad debt, etc. in the
period in which the sale occurs. In calculating the current period expense amount, companies generally
use their historical experience and expectations based on current market conditions. This provides the
flexibility to manage the expense amount. To detect possible under accruing of expenses, we compare
the reserve amount to the related cost driver (warranty to sales, bad debt expense to accounts
receivable, inventory reserves to inventory, sales returns to sales and inventory). A low reserve
percentage relative to the historical ratio is one indicator of possible under-expensing current period
costs. As an example, a company begins the quarter with a warranty accrued liability to sales of 3%. To
reduce current period expenses, the company might expense only 1% of sales as warranty expense. As
a result, the ending reserve declines to 2% of sales. If reserves really are 3% of sales, the company will
need to increase warranty expense even higher than 3% of sales in future periods to make up for the
current period shortfall. The next exhibit is an illustration of Ericsson's material reserve reversals. After
the telecom bust, the company recorded substantial "big bath" restructuring and other charges. In
hindsight, the charges were excessive and, therefore, part of this accrued liability was reversed as a
gain in earnings over time. Based on the table below, there was at least a two year pattern of
approximately 4.8 billion SEK reserve reversals into earnings each year.
Illustration of Reserve Reversals: Ericsson
Ericssons 2006 20-F Filing: Provisions (SEK Millions)

Warranty
commitments
2006
Opening balance
4,821
Additions
2,561
Costs incurred
-3,471
Reversal of excess amounts

-1,100
Balances regarding divested/acquired businesses

224
Reclassification
15
Translation difference for the year

-89
Closing balance
2,961
2005
Opening balance
6,424
2,858
Additions
Costs incurred
-3,181
Reversal of excess amounts

-1,390
Balances regarding divested/acquired businesses
6
3
Reclassification
Translation difference for the year

101
Closing balance
4,821
1) Both current and non-current provisions.
2) Off-balance customer financing is included in other provisions.
Restructuring
Other1)2)
Total
provisions
2,314
2,765
-2,308
-416
20
19
-117
2,277
11,533
5,420
-4,561
-3,231
-24
-121
-372
8,644
18,668
10,746
-10,340
-4,747
220
-87
-578
13,882
3,598
1,323
-1,983
-480
-322
178
2,314
14,756
5,564
-6,894
-2,923
224
806
11,533
24,778
9,745
-12,058
-4,793
6
-95
1,085
18,668
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RESTRUCTURINGCOSTS
The accounting rules for recording restructuring charges lay out a framework that attempts to prevent
the abuse of big bath charges or cookie jar reserves. Stemming from perceived abused in the 1990s,
when many companies previously took large charges in advance of actually incurring related
restructuring costs, FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities was
issued. This standard set a higher hurdle to recognize restructuring costs in that a liability must be
incurred in a manner where there is little or no discretion to avoid (a probable future sacrifice of
economic benefits arising from present obligations). No charges can be taken below the line - all costs
must be included as part of operating income. A company simply having a restructuring plan will not be
sufficient to meet the hurdle to recognize the charges additional steps must be taken. The following is
a description of the accounting for several common restructuring items.
One-time Termination Benefits: For one-time benefits provided to terminated employees, the
following must occur in order for the company to record a restructuring expense:
1. Management commits to a termination plan.
2. The plan identifies the number of employees to be terminated, their job classifications or
functions, and the expected completion date.
3. The termination plan includes and establishes specific termination benefits so employees may
ascertain the type and amount of benefits to be received.
4. It is unlikely that significant change will be made to the plan or that the plan will be withdrawn.
5. Communicated to the impacted employees.
The charges are recorded on the date the plan is communicated to the employees when
employees are not required to render service until their termination date or if they will not be
retained beyond a minimum retention period. The charges are recorded over the employees
remaining service period in the scenario that the employee is required to provide service until
their termination date and required to stay beyond the minimum retention period. (Note that the
minimum retention period may not exceed the legal notification period or, if none, 60 days.)
Contract Termination Costs: When a company restructures, certain contracts or operating leases
may be terminated. These terminations will result in a restructuring charge and related accrued
liability to account for contract termination costs on the termination date. Additionally, there may
be other ongoing costs expected to be incurred under terminated contracts when the company
ceases using the rights under the contract (e.g., leased property). These amounts will also be
included in the charge and liability. The charges may be incurred on the same date as the
contract termination date or on a later date.
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RESERVEREVERSALGAINSINCLUDEDINEARNINGSDONOTOVERLOOKTHESCHEDULEII
Due to its location, typically near the end of the 10-K filing, the Schedule II (Valuation and Qualifying
Accounts) of reserve accounts is often overlooked. Although sometimes inconsistent and not
standardized, the schedule provides a very useful summary of a companys critical reserve accounts.
Common items included on the Schedule II include inventory reserves, sales return reserves, deferred
tax valuation allowance, and bad debt reserves.
If a reserve account is disclosed elsewhere in the 10-K, it is not required to be disclosed in the Schedule
II (common with restructuring reserves). A review of the Schedule II is important to determine whether
the company reversed reserves or had another unsustainable benefit to earnings. For example, to boost
earnings in the current period, a company might reduce the expense amount of a recurring reserve,
such as warranties. Unless there is a sustainable trend whereby the lower reserve amount will not need
to be increased in a future period, this will be only a temporary earnings boost. The company will
subsequently record higher warranty expenses in future periods to build the account again. Likewise, the
company may be over-reserving in the current period so that the reserve may be reversed as a gain into
earnings at some future date (cookie jar reserves) when earnings are slowing.
To assess the reasonable of reserves, provisions and reversals, its important to standardize these
amounts. Companies use historical experience to calculate reserve amounts - the reserve amount
should be compared to the driver of the cost (e.g. warranty to revenues, bad debt expense to accounts
receivable, sales returns to sales and inventory) and contrasted with prior years. If the reserve
percentage is low compared to historical periods, this may presage future reserve increases as an
expense to earnings. The additions to the reserve account (the expense/provision) should be compared
with the subtractions from the reserve account. This can be done on a current year basis but we also
suggest a one-year lag (subtractions from the current year vs. the additions from the prior year). This is
due to the fact that the expensing of costs in the current period matches those costs with revenues, but
charge-off amounts and payout amounts will occur in subsequent period(s) as the balance sheet asset
is deemed worthless (receivables / inventory) or actual cash payments are made (warranties).
As an illustration and analysis of Schedule II, in the next exhibit we highlight Cypress Semiconductors
2011 disclosure. The schedule reconciles the beginning and ending reserve balances. The charges
(releases) to expenses / revenues column represents the amount of expense (income) recognized in
the earnings during the respective year and a corresponding allowance account is increased (reduced).
On the balance sheet, the allowance account is generally netted against the related asset account
(accounts receivable, inventory, tax assets, etc.).
Next, the deductions column is the amount written-off or utilized in the current period. As amounts are
written-off, there is generally no earnings impact the accounts are removed from the balance sheet.
For example, if an accounts receivable amount is written-off for which there is a bad debt reserve, both
the accounts receivable account and the bad debt reserve is reduced by the same amount. For sales
returns, this may represent a cash outflow as products previously sold were refunded to customers.
There is generally no income statement impact. Similarly, when inventory is written-off, the inventory
and inventory reserve account are both reduced.
Based on the items included on this schedule, there were not material reserve reversals benefiting
earnings in the current period. Next, we compare the amounts charged to expense in the current period
to the deductions amounts. The charges to expenses for both doubtful accounts receivable and sales
returns have been trending lower over the last several years. We then compare the prior year bad debt
expense to the current year "deductions" since bad debt amounts written off in the current year (called
"deductions" in this situation) would have been expensed to earnings in the prior year. Ideally, we would
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prefer observing charges to earnings slightly higher than deductions. In the case of Cypress, the
amounts charged to expense each year have slightly exceeded the subsequent year's deduction
amount. Due to their nature, they may be more lumpy on a year-over-year basis if there are larger
receivables reserved for and subsequently written-off. We would be skeptical of large decreases in bad
debt reserves relative to receivables or sales from the prior year, depending on the economic
environment.
To assess the reasonableness of the allowance for doubtful accounts, we compare the ending balance
to the receivables balance. Based on accounts receivable of $104 million at 1/1/2012 and $117 million at
1/2/2011, the ending allowance balances seem consistent at around .6-.7% each year. The reserve at
1/3/2010 was likely higher due to the recession at the time. The decline since then is likely due to an
improved economy.
Cypress sales returns reserve account was almost flat year over year. It does not appear that there is as
much lag time for sales returns as the deductions for each year are closely tied to the charges in that
same year.
Cypress Semiconductor Schedule II
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
Balance at
Beginning of
Period
Allowance for doubtful accounts receivable:

Year ended January 1, 2012
Allowance for sales returns:
Charges (Releases)
to Expenses/Revenues
(In thousands)
Deductions
Balance at
End of
Period
$
$
$
803
1,358
777
$
$
$
24
60
1,120
$
$
$
(3)
(615)
(539)
$
$
$
824
803
1,358
$
$
$
3,347
3,151
3,341
$
$
$
2,000
5,541
8,825
$
$
$
(2,262)
(5,345)
(9,015)
$
$
$
3,085
3,347
3,151
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STOCKBASEDCOMPENSATION
Now known as ASC 718, companies have been required to record stock based compensation as an
expense in the earnings since the implementation of FAS No. 123(R), Share Based Repayment, in
2006. The primary forms of stock-based compensation include stock options, restricted stock and stock
appreciation rights, and are each described briefly below.
Types of Stock-Based Compensation
Stock options: Stock options provide the employee with a right to purchase a share of company
stock at a stated exercise price. This right becomes effective upon vesting and has a limited
timeframe until expiration. Common vesting conditions include service time, meeting a
performance condition or being subject to a market condition. The most common vesting
condition is the service period, which is typically 3-4 years of service time. Option expiration is
typically 7-10 years from the date of grant. The exercise price is typically set by the company as
the market price of the stock on the day the option is granted (at the money). When the option is
vested and the option is in the money (market price>exercise price), the employee may exercise
the option resulting in a cash payment from the employee to the company and an issuance of a
share of stock to the employee. Employee stock options may expire worthless to the employee if
the share price declines below the exercise price and remains lower through expiration date. Prior
to the required expensing of stock options in earnings, stock option grants were the preferred
form of stock-based compensation, but have since given way to restricted stock grants.
Restricted shares/stock or restricted stock units (RSUs): A company may also issue shares of
restricted stock to employees as compensation. They are typically subject to similar vesting
conditions to stock options that will be lifted upon meeting the terms. RSUs are promises made
by the company to issue the share of stock upon vesting. Restricted shares and RSUs are
essentially stock options with a $0 exercise price. Both restricted stock and RSUs may or may not
have dividend and voting rights, depending on the company. We have noticed a trend towards
companies moving towards more restricted stock grants (away from options). The advantage to
the employee of a restricted share grant is that some value is realized by the employee upon
vesting, even if the share price has declined since the grant date, due to the $0 exercise price.
Stock Appreciation Rights (SARs): Stock Appreciation Rights are stock based compensation
instruments that are net settled in either cash or stock. Similar to a stock option, employees
participate in any increases in the stock price between the grant date and the exercise date.
However, no actual exercise proceeds will be paid to the company. Instead, the employee is
either directly paid in cash or shares based on the net increase in share price upon exercise.
From a company perspective, less dilution occurs as full shares are not issued. There will be
different accounting treatment based on whether the SARS are cash settled (and, thus, marked to
market through earnings each period based on the change in stock price) or share settled (similar
treatment to stock options and restricted stock).
Expensing of Stock-Based Compensation

Companies must expense the grant date fair value of stock based compensation. This expense is
recognized over the service period, or the period the compensation is being earned by the employee.
The service period is typically the same as the vesting period, which is usually three to four years.
Depending on the actual vesting schedule, the grant date fair value will be recognized either straight line
or under an accelerated amortization method. Regardless of the subsequent changes in stock price and
intrinsic value of the option, the grant date fair value is a fixed compensation amount (no mark to market
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or true-up). As a result, there may be scenarios where the GAAP cost does not reflect the true
economic cost of stock based compensation.
Stock-based compensation expense is not typically a discrete line-item in the income statements.
Instead, its defined as a compensation cost and will be classified where the remainder of that particular
employees compensation cost relates. For example, stock-based compensation for executives will be
recorded in SG&A. For manufacturing companies, a portion of stock-based compensation may be
capitalized into inventory and eventually recognized as cost of goods sold upon sale. As an example,
below we present Ciscos disclosure that shows the allocation of total stock based compensation
expense throughout the income statement line items.
Cisco (2011 Form 10-K): Stock Based Compensation Summary
(c) Summary of Share-Based Compensation Expense
Share-based compensation expense consists primarily of expenses for stock options, stock purchase rights, restricted stock, and restricted stock units granted to
employees. The following table summarizes share-based compensation expense (in millions):
Years Ended
Cost of salesproduct
Cost of salesservice
July 30, 2011
61
177
July 31, 2010
57
164
July 25, 2009
46
128
Share-based compensation expense in cost of sales
238
221
174
Research and development

Sales and marketing
General and administrative
481
651
250
450
602
244
382
482
193
1,382
1,296
1,057
Share-based compensation expense in operating expenses

Total share-based compensation expense
1,620
1,517
1,231
As of July 30, 2011, the total compensation cost related to unvested share-based awards not yet recognized was $2.9 billion, which is expected to be recognized over
approximately 2.2 years on a weighted-average basis. The income tax benefit for share-based compensation expense was $444 million, $415 million, and $317 million
for fiscal 2011, 2010, and 2009, respectively.
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MEASUREMENT OF STOCK-BASED COMPENSATION GRANT DATE FAIR VALUE

The income statement expense amount for the next several years will be driven by the grant date fair
value of the stock based compensation. For restricted shares or RSUs, the fair value is rather
straightforward as it is set as the market price of the stock at that date. (If the employee cannot
participate in dividends before vesting, there may be some discount to the market price for the expected
dividends).
Management will have additional judgment in setting grant date fair value amounts for options and share
settled SARs. Typically, they will use a Black-Scholes, Binominal-Lattice, or some other type of option
pricing model. Companies are required to disclose the material assumptions used in their option pricing
models. It is important to assess these assumptions for reasonableness as well as any year to year
changes. The primary input assumptions for the Black-Scholes model include exercise price, expected
life, volatility, dividend rate, and risk-free rate.
The volatility assumption in an option pricing is the most subjective. Analysts should pay particular
attention to this assumption as management can use it to reduce future earnings impact. Due to SEC
guidance, companies typically use a market based assumption (may come from the implied volatility on
the companys market traded equity options) as opposed to the historical volatility of their stock price.
Analysts should review the disclosure of option assumptions and ascertain whether any changes in the
volatility assumption are reasonable given the underlying volatility of the stock.
FORFEITURES
Due to employee turnover, not all share based compensation that is granted will ultimately vest.
Companies assume a forfeiture rate, or an amount that will not vest, and are only required to record an
expense for the amount expected to vest. This rate is not always disclosed and varies by company. An
annual forfeiture rate in the two to ten percent range is most common. The higher forfeiture rate
assumed, the lower the expense. However, at the end of each vesting period, companies will make a
true-up to include actual vested amounts.
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DISCLOSURES
In the next series of exhibits, we provide examples of what to look for in the common stock-based
compensation related disclosures, using Cisco as an example. Cisco grants both restricted stock units
and stock options to its employees. Note that some companies also offer employee stock purchase
plans, which may be included in the similar exhibits. These plans typically afford employees a
discounted purchase price on company stock (usually 10-20%). While also expensed based on fair
value, the size of these plans is typically small relative to option or RSU programs.
FAIR VALUE ASSUMPTIONS

Below we show Ciscos assumptions for determining the fair value of its stock option grants. Cisco did
not grant any options in 2011 as the company has moved to granting more restricted shares. For their
2009 and 2008 option grants, the company used a lattice binomial model and disclosed that they use
the expected volatility of their stock based on the implied volatility of market traded options of 30.5% and
36% respectively.
Cisco (2011 Form 10-K): Stock Option Valuation Assumptions
The valuation of employee stock options and the underlying assumptions being used are summarized as follows:
EMPLOYEE STOCK OPTIONS
Years Ended
July 31,
2010
Weighted-average assumptions:
Expected volatility
Risk-free interest rate
Expected dividend
Kurtosis
Skewness
Weighted-average expected life (in years)
Weighted-average estimated grant date fair value per option
30.5%
2.3%
0.0%
4.1
0.20
5.1
$ 6.50
July 25,
2009
36.0%
3.0%
0.0%
4.5
(0.19)
5.9
$ 6.60
TheCompanyestimatesonthedateofgrantthevalueofemployeestockpurchaserightsusingtheBlackScholesmodelandthevalueof
employeestockoptionsusingalatticebinomialmodel.Thedeterminationofthefairvalueofemployeestockoptionsandemployeestock
purchase rights is impacted by the Companys stock price on the date of grant as well as assumptions regarding a number of highly
complexandsubjectivevariables.
TheCompanyusedtheimpliedvolatilityfortradedoptions(withcontracttermscorrespondingtotheexpectedlifeoftheemployeestock
purchaserights)ontheCompanysstockastheexpectedvolatilityassumptionrequiredintheBlackScholesmodel.Theimpliedvolatilityis
morerepresentativeoffuturestockpricetrendsthanhistoricalvolatility.Theriskfreeinterestrateassumptionisbaseduponobserved
interestratesappropriateforthetermoftheCompanysemployeestockpurchaserights.Thedividendyieldassumptionisbasedonthe
historyandexpectationofdividendpayoutsatthegrantdate.PriortotheinitialdeclarationofaquarterlycashdividendonMarch17,
2011,thefairvalueofemployeestockpurchaserightsandemployeestockoptionswasmeasuredbasedonanexpecteddividendyieldof
0%astheCompanydidnothistoricallypaycashdividendsonitscommonstock.ForawardsgrantedonorsubsequenttoMarch17,2011,
theCompanyusedanannualizeddividendyieldbasedonthepersharedividenddeclaredbyitsBoardofDirectors.
ThelatticebinomialmodelismorecapableofincorporatingthefeaturesoftheCompanysemployeestockoptions,suchasthevesting
provisionsandvariousrestrictionsincludingrestrictionsontransferandhedging,amongothers,andtheoptionsareoftenexercisedprior
to their contractual maturity. The use of the latticebinomial model requires extensive actual employee exercise behavior data for the
relativeprobabilityestimationpurpose,andanumberofcomplexassumptionsaspresentedintheprecedingtable.TheCompanyused
the implied volatility for twoyear traded options on the Companys stock as the expected volatility assumption required in the lattice
binomialmodel.Theimpliedvolatilityismorerepresentativeoffuturestockpricetrendsthanhistoricalvolatility.Theriskfreeinterest
rateassumptionisbaseduponobservedinterestratesappropriateforthetermoftheCompanysemployeestockoptions.Thedividend
yieldassumptionisbasedonthehistoryandexpectationofdividendpayoutsatthegrantdate.Theestimatedkurtosisandskewnessare
technical measures of the distribution of stock price returns, which affect expected employee stock option exercise behaviors, and are
basedontheCompanysstockpricereturnhistoryaswellasconsiderationofvariousacademicanalyses.Theexpectedlifeofemployee
stock options is a derived output of the latticebinomial model, which represents the weightedaverage period the stock options are
expectedtoremainoutstanding.
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The Company uses thirdparty analyses to assist in developing the assumptions used in, as well as calibrating, its latticebinomial and
BlackScholes models.TheCompanyisresponsiblefordeterminingtheassumptionsused inestimatingthefairvalueofitssharebased
paymentawards.TheCompanysdeterminationofthefairvalueofsharebasedpaymentawardsisaffectedbyassumptionsregardinga
numberofhighlycomplexandsubjectivevariables.Thesevariablesinclude,butarenotlimitedto,theCompanysexpectedstockprice
volatility over the term of the awards and actual and projected employee stock option exercise behaviors. Optionpricing models were
developedforuseinestimatingthevalueoftradedoptionsthathavenovestingorhedgingrestrictionsandarefullytransferable.Because
the Companys employee stock options have certain characteristics that are significantly different from traded options, and because
changesinthesubjectiveassumptionscanmateriallyaffecttheestimatedvalue,inmanagementsopiniontheexistingvaluationmodels
maynotprovideanaccuratemeasureofthefairvalueorbeindicativeofthefairvaluethatwouldbeobservedinawillingbuyer/willing
sellermarketfortheCompanysemployeestockoptions.
The fair value of restricted shares granted is disclosed within the grant and activity schedule discussed
next.
GRANT AND EXERCISE TABLES

Below, we show the tabular format typically used to disclose the activity (number outstanding, number
granted, number exercised, etc.) of stock based compensation grants. Based on the companys
disclosures, Cisco granted 56 million restricted shares/RSUs in 2011 at a weighted average value of
$20.62. As shown in an earlier section, Cisco did not grant any stock options in 2011 but the table is still
disclosed showing that 80 million were exercised and 31 million were canceled/forfeited/expired.
Cisco (2011 Form 10-K): RSU Awards
(e) Restricted Stock and Stock Unit Awards
A summary of the restricted stock and stock unit activity is as follows (in millions, except per-share amounts):
Restricted Stock/
Stock Units
Weighted-Average
Grant Date Fair
Value per Share
BALANCE AT JULY 26, 2008

Granted and assumed
Vested
Canceled/forfeited
10
57
(4)
(1)

Granted and assumed
Vested
Canceled/forfeited
62
54
(16)
(3)
21.25
23.40
21.56
22.40

Granted and assumed
Vested
Canceled/forfeited
97
56
(27)
(10)
22.35
20.62
22.54
22.04
116
24.27
20.90
23.56
22.76
Aggregated Fair
Market Value
69
378
529
21.50
Certain of the restricted stock units awarded in fiscal 2011 were contingent on the future achievement of financial performance metrics.
Prior to the initial declaration of a quarterly cash dividend on March 17, 2011, the fair value of restricted stock units was measured based on the grant date share price
reduced by the present value of the dividend using an expected dividend yield of 0%, as the Company did not historically pay cash dividends on its common stock. For
awards granted on or subsequent to March 17, 2011, the Company used an annualized dividend yield based on the per-share dividends declared by its Board of
Directors.
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Cisco (2011 Form 10-K): Stock Option Awards

(f) Stock Option Awards
A summary of the stock option activity is as follows (in millions, except per-share amounts):
STOCK OPTIONS OUTSTANDING

Number
Outstanding
(1)
Weighted-Average
Exercise Price per Share

Granted and assumed
Exercised (1)
Canceled/forfeited/expired
1,199
14
(33)
(176)

Granted and assumed
Exercised (1)
1,004
15
(158)
(129)
24.29
13.23
17.88
47.31

Exercised (1)
732
(80)
(31)
21.39
16.55
25.91
621
27.83
19.01
14.67
49.79
21.79
The total pretax intrinsic value of stock options exercised during fiscal 2011, 2010, and 2009 was $312 million, $1.0 billion, and $158 million, respectively.
TOTAL STOCK-BASED COMPENSATION GRANTED

Our view is that the economic cost of stock-based compensation is the normalized total fair value that is
granted. This can be attained from the disclosures in the previous two exhibits. Generally, multiply the
number of grants (options/RSUs/restricted shares) by the fair value per item granted. Restricted shares
are straightforward as both items are disclosed in the grant table. For options, it is important to use the
fair value of the options granted (which is disclosed in the table with the model assumptions) as opposed
to the weighted average exercise price that was disclosed in the roll-forward table.
Below we calculate the 2011 fair value of stock based compensation granted using the disclosures
above. There were 56 million shares of restricted stock / RSUs granted at a fair value of $20.62 per
share and no options were granted. The total stock based compensation granted in 2011 was $1.2
billion.
Fair Value Calculation of Ciscos Total Stock-Based Compensation Granted
Restricted shares / RSUs

Stock options
Total Value of 2011 Stock Based Compensation Grants
Amount Granted
(millions)
56
0
Weighted Ave.
Fair Value ($)
$20.62
NA
Compensation
Granted
($ in millions)
$1,155
0
$1,155
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DILUTION OVERHANG & OUTSTANDING OPTION TRANCHE TABLE

To account for the outstanding restricted shares and options (that havent been issued or exercised) in
the diluted share count, the treasury stock method is used. Only options that are in the money are
considered to be included in the diluted share count. For Cisco, in 2011, stock-based compensation
resulted in 34 million additional shares included in the diluted EPS calculation. Although not disclosed by
Cisco, many companies disclose the number of outstanding options that have not been included in the
diluted share count at period end. This is likely the result of options being out of the money, and careful
attention should be paid to such outstanding options for possible future EPS dilution (as discussed in the
following paragraphs).
Cisco (2011 Form 10-K): EPS Calculation
The following table presents the calculation of basic and diluted net income per share (in millions, except per-share amounts):
Years Ended
July 30, 2011
July 31, 2010
July 25, 2009
Net income
6,490
7,767
6,134
Weighted-average sharesbasic
Effect of dilutive potential common shares
5,529
34
5,732
116
5,828
29
Weighted-average sharesdiluted
5,563
5,848
5,857
Net income per sharebasic
1.17
1.36
1.05
Net income per sharediluted
1.17
1.33
1.05
Antidilutive employee share-based awards, excluded
379
344
977
Employee equity share options, unvested shares, and similar equity instruments granted by the Company are treated as potential common shares outstanding in
computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options, unvested restricted stock, and restricted stock
units. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury
stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet
recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are collectively assumed to be used
to repurchase shares.
To be aware of potential large increases in the dilutive impact of stock options, analysts should pay
attention to the tranches of outstanding options. If provided, this table will disclose a breakout of
outstanding options based on ranges of various exercise prices. Both the total options outstanding are
shown as well as the subset of those that are vested (exercisable). Keep in mind that whether the
options are actually vested or exercisable has no bearing on whether the options are included in diluted
EPS under the treasury stock method.
An increase in the market price of a companys stock can cause a large dilution impact if there are a
large number of options with exercise prices at or slightly below the current stock price. This is due to
the mechanics of the treasury stock method. For example, given a stock price in the period of $20, a
tranche of options with a weighted average exercise price of $30 would not be included in calculating
diluted EPS. However, if in the following period, there is a large increase in the stock price to
somewhere above $30, these options will begin to be included in the diluted share count, reducing EPS.
While many companies continue to disclose it, this table is no longer a required GAAP disclosure. Next,
we present the table provided in Ciscos 10-K. The company had 154 million outstanding options (of
which 144 million are vested) with exercise prices between $20.01 and $25.00.
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Cisco (2011 Form 10-K): Outstanding Options by Tranche

The following table summarizes significant ranges of outstanding and exercisable stock options as of July 30, 2011 (in millions, except years and share prices):
STOCK OPTIONS OUTSTANDING
Range of Exercise Prices
$ 0.01 15.00
15.01 18.00
18.01 20.00
20.01 25.00
25.01 35.00
Total
STOCK OPTIONS EXERCISABLE
Number
Outstanding
WeightedAverage
Remaining
Contractual
Life
(in Years)
56
97
167
154
147
1.59
3.03
1.91
3.87
5.08
10.62
17.72
19.29
22.75
30.65
300
2
54
96
166
144
115
10.74
17.72
19.29
22.75
30.62
282
2
621
3.29
21.79
302
575
21.37
284
WeightedAverage
Exercise
Price per
Share
Aggregate
Intrinsic
Value
WeightedAverage
Exercise
Price per
Share
Number
Exercisable
Aggregate
Intrinsic
Value
The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Companys closing stock price of $15.97 as of July 29, 2011,
which would have been received by the option holders had those option holders exercised their stock options as of that date. The total number of in-the-money stock
options exercisable as of July 30, 2011 was 57 million. As of July 31, 2010, 606 million outstanding stock options were exercisable and the weighted-average exercise
price was $20.51.
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ECONOMICCOSTOFSTOCKBASEDCOMPENSATION
The true economic cost of stock based compensation is the transfer of value from the company to
employees. We would calculate this as the difference in the exercise price and the stock price at
exercise date. For restricted stock, the exercise price is $0 and the exercise date is the vesting date.
The net economic cost of stock-based compensation is calculated as follows:
Fair value of stock options exercised and restricted shares/ RSUs vested during the period:
Fair value of options exercised = number of stock options exercised times the average stock value during
the period.
Fair value of restricted shares/ RSUs = number of restricted shares/ RSUs vested times the average stock
value during the period.
Less: Cash received from stock option exercises (calculated as number of stock options exercised times the
weighted average exercise price). No exercise proceeds from restricted stock/ RSUs.
Less: Cash tax benefit of stock options exercised and restricted shares / RSUs vested. For statutory stock
options (most plans) the company does not receive a tax deduction until the option is exercised. The cash tax
benefit should be disclosed by the company, typically in the narrative of the stock compensation footnote.
Equals: Net cash cost of stock options exercised / restricted shares vesting during the period.
In the following exhibit, we calculate Ciscos 2011 net cash cost of stock-based compensation. Cisco
actually provides the intrinsic value of option exercises ($312 million) and fair value of restricted stock
vested ($529 million). These amounts are disclosed in the roll-forward table exhibit previously discussed
and the related narrative. The cash tax benefit is estimated at a 35% tax rate. We estimate the net cash
cost of stock-based compensation in 2011 was $547 million.
Economic Cash Cost of Ciscos Stock-Based Compensation ($ in millions)
Aggregate intrinsic value of options exercised in 2011 (1)
Aggregate fair falue of restricted stock vested in 2011 (2)
Less: Tax benefits from stock option exercises and other awards (3)
Equals: Net cash cost of stock option exercises & restricted stock vesting
312
529
(294)
547
(1) Explicitly disclosed by company. If not disclosed this amount can be estimated as (# of options
exercised X average stock price) less (# of options exercised x average exercise price).
(2) Explicitly disclosed by company. If not disclosed this amount can be estimated as # of restricted
shares vested X average stock price. (27 million shares x $22.54).
(3) Estimated at 35% tax rate.
Note: Excludes employee purchase plans. For fiscal year ending July 31, 2011.
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ARE SHARE REPURCHASE PROGRAMS ACTUALLY A RETURN OF CAPITAL?

To offset the dilution from share based compensation, companies will typically utilize their share
buyback programs. We compare the net cash cost of stock based compensation to the shares
repurchased during the period to determine if the buyback program really is returning capital to
shareholders, or is merely being used as an offset to dilution from stock-based compensation (wealth
transfer to employees). When compared to $6.9 billion of gross share repurchases in 2011 and after
accounting for $547 million of stock repurchased to offset the economic cost of options/shares
exercised/vesting, Cisco repurchased a net $6.4 billion in stock in its fiscal year ending July 31, 2011.
Economic Cash Cost of Ciscos Stock-Based Compensation
Net cash cost of stock option exercises & restricted stock vesting
Offset by: Value of shares repurchased (per Cash Flow Statement)
Equals: Cash cost of stock options exercises - actual shares repurchased
547
(6,896)
(6,349)
Note: Excludes employee purchase plans. For fiscal year ending July 31, 2011.
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INCORPORATINGSTOCKBASEDCOMPENSATIONINTOCASHFLOWSANDVALUATION
GAAP treats stock based compensation cost as a non-cash item that is add-back in the statement of
cash flows in calculating cash flow from operations. Therefore, any free cash flow calculations that use
reported operating cash flow figures do not include stock-based compensation. Relatedly, some
companies view stock based compensation expense as a non-cash item. We disagree.
In our view, stock based compensation costs should be thought of in two distinctive components:
(1) Choosing to compensate the employee in a specific amount (an operating decision); and
(2) The issuance of options or shares directly to the employee instead of cash (a financing decision)
Analytically, we view the amount of compensation paid to the employee as a cash cost and, therefore,
reduce cash flow from operations for this cost. Our view is that this is akin to the company selling the
options or shares to some outside party and paying the employee in cash - an economically identical
transaction with very different accounting impacts.
The cash cost of stock based compensation as an adjustment to operating cash flow may be calculated
in a variety of ways, none of which are perfect. One method is to simply use the reported stock-based
compensation expense that GAAP adds back to net income in calculating cash flow from operations.
This is relatively simple with likely as much accuracy as the methods discussed next.
However, due to changes in compensation policies, sometimes this reported stock-based compensation
amount is not representative of future stock compensation amounts. In this case, we suggest using the
normalized fair value of stock-based compensation grants. This amount is calculated by using the value
granted in the most recent year (or an average of recent years) similar to how we calculated it previously
in the fair value calculation of total stock based compensation granted. In turn, adjustments can be
made for any expected changes in company stock compensation policies.
Another alternative is to use the aforementioned calculated economic cost of stock based
compensation. Again, there may be a historical bias in this amount as it reflects a compensation policy
when the options were issued in the past (sometimes up to ten years ago), and may not be
representative of the current stock-based compensation practices.
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MODIFICATIONSTOOPTIONSANDVESTINGPERIODS
When stock prices declined in 2008 and 2009, many previously granted stock options were left
significantly out of the money. As a response to help employees maintain some of their original value,
some companies have modified underwater stock options and accelerated the vesting of stock options
and restricted stock. These modifications can have an impact on future expense amounts reported in
earnings and EPS. For example, companies may choose to modify/cancel/accelerate awards and
recognize a large expense in bad quarters. This is a type of big bath technique used as way to
increase future earnings when the economy recovers. These types of tactics generally have accounting
implications of increasing expenses in the current period and/or causing a ramp up effect portending
higher future stock compensation expenses.
There is a specific accounting treatment for modification of previously granted stock based
compensation. Typically, an additional expense often must be recognized if stock-based compensation
(options, restricted stock, etc.) awards are modified or their vesting is accelerated. Companies must
compare:
1. The revalued original (cancelled) stock-based compensation award (using updated assumptions
for volatility, interest rate, term, etc.) as of the modification date with
2. The value the newly modified/granted stock-based compensation award using current
assumptions.
If the value of the newly modified award exceeds the value of the cancelled stock/option, the company
must recognize additional stock-based compensation expense over the remaining employee service
period, which is usually the vesting period. The company would still recognize any stock-based
compensation expense related to the original award. If the value of the newly modified award is less
than the cancelled award (not typical), the expense related to the original option is still recognized.
Completely cancelling older stock options and simultaneously replacing them with new options is
considered a modification and treated as described above. If no replacement award is granted any
unrecognized compensation cost of that award is immediately expensed upon cancellation.
BEWARE OF OPTION VESTING ACCELERATION REDUCING NORMALIZED COMPENSATION EXPENSE

When options are deeply out of the money, some companies may accelerate the vesting of options as a
means to keep some form of incentive for the employees. When vesting is accelerated, all of the
unrecognized future stock option expense for those particular options will be recognized immediately.
Therefore, the normalized stock based compensation expense over the remaining vesting period that
would have otherwise been recorded ratably over the vesting period will no longer occur. If new stock
based compensation is granted, there will be a ramp-up effect the year after the acceleration as the
company makes its way back to a normalized stock compensation amount. In the past, Dell accelerated
the vesting of 20.9 million options with an average exercise price of $22.03. This resulted in a $106
million charge for the fiscal year ended February, 2009. Therefore, this $106 million was effectively
pulled forward from recognition in future years.
Dell (2011 Form 10-K): Accelerated Vesting of Stock Options
Stock Option Accelerated Vesting Charges Certain stockbased compensation charges incurred during Fiscal 2009 related to the
acceleratedvestingofunvestedoutofthemoneystockoptions(optionsthathaveanexercisepricegreaterthanthecurrentmarket
stockprice)areexcludedfromthenonGAAPfinancialmeasures.Stockbasedcompensationcostsunrelatedtotheacceleratedvestingof
outofthemoneystockoptionsarenotexcludedfromthenonGAAPfinancialmeasures.Weexcludechargesrelatedtotheaccelerated
vestingofoutofthemoneystockoptionsbecausewebelievetheydonotcontributetoameaningfulcomparisonofourpastoperating
resultstoourcurrentoperatingresults.
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INCOMETAXES
The income tax footnote is one of the most complex notes in a 10-K. However, we feel it is one of the
most important items to thoroughly review, particularly this year in light of the frameworks for corporate
tax reform proposed by both the GOP and the Obama administration, the potential for the existence of
tax loss carry-forwards generated in the recent recession, and the expiration of 100% bonus tax
depreciation.
Assessing the sustainability of a companys effective and cash tax rates is essential for company
analysis. In reviewing the disclosures, look for the main drivers of the current GAAP effective tax rate
(income tax expense divided by pre-tax GAAP income) and the cash tax rate (cash taxes as disclosed /
pre-tax GAAP income). These rates must be taken in context with industry peer companies and
geographic segments and incorporation.
Income taxes are one of the areas where we have witnessed low earnings quality recently. A low or high
tax rate is a classic reason companies may beat or miss earnings expectations. Unexpected tax rates /
provisions may occur for three reasons:
Quarterly tax rates are based on the estimated annual tax rate. Using a higher annual effective
tax rate assumption in an early quarter in the year allows the company to true-up the tax rate in
any particularly quarter. If the company deems the prospective tax rate to be lower, a catch-up
gain is recorded in earnings.
Tax reserve accounts. Companies must maintain an accrued liability for uncertain tax positions
(i.e., when a company deducts an expense on their tax return (saving cash taxes), but does not
record the tax benefit in its GAAP financial statements due to potential audit risk). These reserve
accounts have significant management discretion. Part of the liability could be reversed as a gain
offsetting income tax expense for a variety of reasons, such as a settlement with the IRS or some
other judgmental determination that the accrued tax liability is no longer necessary.
The presence of historical net operating losses often causes significant volatility in a companys
tax rate. Particularly, a company may have recorded a valuation allowance on its net deferred tax
assets if the company is in a 3 year cumulative loss position. When this occurs, the company will
report a very low GAAP effective tax rate. However, once the company returns to reporting
consistent (6-8 quarters) GAAP profitability, the tax rate will increase to a more normalized level.
The auditors will require the company to reverse the deferred tax asset valuation allowance as a
one-time gain offsetting income tax expense in earnings and then report a normal tax rate going
forward. This increase in tax rate may present a potential source of negative earnings surprise.
LOW TAX RATES UNDERPERFORM

As a group, our quantitative work has shown that companies with low effective tax rates historically
underperformed their sector, while the historical performance for low cash tax rate companies was
inconclusive. This is most likely due to the fact that there is significant volatility in cash tax payments on
a quarterly basis. Regardless, it is our view that a low cash tax rate is red flag of future problems and
therefore still closely monitor companies cash tax rates.
Perhaps the most glaring example was Enron. In 2000, Enron reported $1.4 billion in GAAP earnings.
However, the company reported a very low cash tax rate during periods where it was later found that
there was fraud. What this suggests is that the IRS did not deem the income reported by Enron as real
taxable income subject to taxes. The IRS uses a definition of taxable income closer to a cash basis
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income, meaning that companies overstating earnings through non-cash means will generally pay lower
cash taxes since the tax authorities dont deem the GAAP income as real income.
A Low Cash Tax Rate Was a Sign at Enron
ENRON
CalculatedCashTaxRate
($inmillions)
1998
Incomebeforetaxes
Cashtaxes,netofrefunds
Cashtaxrate
YearendedDecember31,
1999
$878
73
$1,128
51
8%
2000
$1,413
62
5%
4%
Below we explain and interpret some of the more common income tax footnote disclosures.
WHAT ARE THE DRIVERS OF A LOWER EFFECTIVE INCOME TAX RATE?

Compared to the US federal tax rate of 35%, many companies report materially lower effective income
tax rates for GAAP. The income tax footnote contains a reconciliation disclosure that will show in tabular
format the reasons the GAAP rate is different from the statutory rate. It will be reported in either tax rate
percentage terms or in absolute dollar terms. Over the long run, we view a low effective tax rate relative
to the higher corporate federal rate as generally unsustainable. For a U.S.-based company with mainly
domestic revenues, a typical effective income tax rate is between 35% and 40%, including state taxes.
Depending on the state, income tax rates range from 0% to 9% (companies receive a deduction on their
corporate tax return for state income taxes paid. Therefore, the state tax amount shown on this
reconciliation schedule is net of the federal income tax benefit).
Common reasons for a lower than statutory (35%) effective income tax rate include:
1.
2.
3.
4.
Net operating losses / valuation allowances.

Income earned in foreign countries that have lower tax rates.
Tax credits.
Changes in uncertain tax positions / settlements with IRS.
Next, we show 3M Companys 2011 income tax rate reconciliation. In 2011, 3M reported an effective
income tax rate of 27.8%. The largest item that causes the lower effective tax rate is International
income taxes net of 4.6% in 2011, which is due to earnings in lower taxed foreign countries. Most
countries have a lower statutory tax rate compared to the 35% U.S. rate. The U.S. will collect the
difference in that 35% rate and the actual taxes already paid to the jurisdiction where the profits were
earned only when the funds are brought back to the U.S. If a company makes the assertion that the
foreign income taxed at a lower rate is permanently reinvested abroad, GAAP does not require
companies to record U.S. income taxes on foreign earnings in the income statement (and a
corresponding deferred tax liability). Most companies make this assertion. If the permanently reinvested
assertion is not made for foreign earnings, the effective income tax rate would approximate the 35-40%
U.S. corporate and state blended income rate.
Generally, in order to use the profits generated overseas for returning capital to shareholders or
domestic M&A, the foreign profits must be repatriated, causing a taxable event. In our view, the lower
effective tax rate from foreign earnings may be unsustainable. We would prefer to see a normalized
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income tax rate recorded in earnings along with a deferred income tax liability for future foreign taxes
owed upon repatriation.
3M (2011 Form 10-K): Statutory to Effective Income Tax Rate Reconciliation
As previously mentioned, some companies present their reconciliation of statutory and effective tax rate
differently than 3Ms disclosure, using instead the actual dollars of income tax provision. Interestingly,
disclosing in this manner may somewhat mask a low tax rate as an additional step must be performed to
translate to percentage terms. In this method of disclosure, each line item can be converted to a
percentage by dividing by the earnings before income taxes (pre-tax GAAP income) line found in the
income statement.
Using Revlons disclosure below, we would divide each of the 2011 amounts in Revlon's disclosure
below by the pre-tax income amount of $89.6 million (from Revlons income statement). Dividing the
total tax provision of $36.8 million by $89.6 million results in an effective tax rate of 41.1% compared to
the 35% statutory corporate income tax rate.
Revlon (2011 Form 10-K): Statutory to Effective Tax Rate Alternative Calculation ($ in millions)
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Are There Large Unrepatriated Foreign Earnings?

Unrepatriated earnings are profits that the company earned in international jurisdictions on which
foreign, but not U.S., taxes have been paid. U.S. taxes will not be due until those profits are repatriated
by way of a dividend or deemed distribution from the foreign subsidiary to the U.S. parent company.
When this occurs, U.S. taxes must be paid at the 35% tax rate (the company will receive a foreign tax
credit for foreign taxes paid). Companies are not required to record GAAP U.S. income tax expense on
foreign earnings if they deem them permanently reinvested overseas. This allows companies to report
lower effective income tax rates. In this scenario, there is an off-balance sheet deferred tax liability for
any foreign taxes that would be owed upon the repatriation of foreign earnings.
The next exhibit is Procter & Gambles disclosure of the companys permanently reinvested
(unrepatriated) earnings from foreign subsidiaries.
Procter & Gamble (2011 Form 10-K): Unrepatriated Foreign Earnings
Wehaveundistributedearningsofforeignsubsidiariesofapproximately$35billionatJune30,2011,forwhichdeferredtaxeshavenot
beenprovided.Suchearningsareconsideredindefinitelyinvestedintheforeignsubsidiaries.Ifsuchearningswererepatriated,additional
taxexpensemayresult,althoughthecalculationofsuchadditionaltaxesisnotpracticable.
During the 2005 tax year, the American Jobs Creation Act of 2004 (Jobs Act) allowed a one-time
repatriation holiday. The Jobs Act provided companies with the ability to repatriate foreign earnings at an
effective 5.25% tax rate. While many large multinational companies are hoping for another repatriation
holiday, we do not believe any legislation will be passed in 2012.
Note that the unrepatriated earnings amounts are not necessarily equivalent to foreign cash. They may
represent something of an upper bound on the amount of cash that is actually held in foreign
subsidiaries, though in reality they are more akin to an untaxed retained earnings figure. As previously
highlighted, it may be difficult for companies to use trapped foreign cash for larger share repurchase
programs or dividend payments. To access this foreign cash for U.S. investment or corporate actions,
companies may incur incremental U.S. taxes generally equal to the difference between the 35% U.S.
corporate tax rate and the foreign effective tax rate paid.
FIN 48 UNCERTAIN TAX POSITIONS ARE THERE LARGE POTENTIAL TAX LIABILITIES?
Companies record a reserve (accrued liability) for tax positions taken on their tax return that may not
hold up under an IRS audit. Analysts should pay particularly close attention to this portion of the income
tax footnote as it is both a way to manage earnings and can also result in a large cash tax outflow for
income taxes. The accounting standard that sets forth this guidance and the related disclosures is FASB
Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes. While companies calculate
their current year GAAP and IRS income tax amounts annually, a long potential audit cycle (3 years,
perhaps longer once IRS contesting occurs), causes uncertainty within the actual tax amounts owed.
FIN 48 also requires increased annual disclosure of the companys uncertain (and perhaps aggressive)
tax positions. FIN 48 provides guidance on how to calculate GAAP income tax expense when there is
uncertainty as to the allowable amount of a tax deduction taken on the companys tax return.
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FIN 48 Reconciliation Disclosure

Analysts should pay attention to the reconciliation of unrecognized tax benefits. In tabular format, it
provides a beginning to end of year activity rollforward for the tax reserve. What this tax reserve
represents is the reserve for uncertain tax positions as follows:
The entirety of tax positions that would have less than a 50% chance of being sustained upon an
audit.
Portions of tax positions that have an at least 50% chance of being sustained upon an audit, but
not 100%. When this occurs, the company can record the tax benefit only up to the amount likely
to be sustained. For example, if a company received a $1,000 tax benefit from a tax deduction
taken and the highest probable amount likely to be sustained upon audit is $600, the remaining
$400 would be recorded as the unrecognized tax benefit on the FIN 48 schedule.
The next exhibit is an excerpt of Interpublic Groups unrecognized tax benefit (uncertain tax positions)
liability reconciliation. It shows the balance of $146.7 million at the beginning of the year and activity
within the account during the year that resulted in an ending balance of $161 million.
In 2011, there was an $18.1 million decrease in the total amount of unrecognized tax benefits due to
uncertain tax positions of prior years (due to either cash payments or a reduction in the reserve as an
offset (gain) to income tax expense in the income statement). New tax positions taken in 2011 on the
companys tax return, but not recognized for GAAP (as a reduction in income tax expense) increased
the reserve by $32.3 million.
Interpublic Group (2011Form 10-K): Income Taxes Reconciliation
The table below summarizes the activity related to our unrecognized tax benefits.
December 31,
2011
2010
2009
Balance at beginning of period

$
Increases as a result of tax positions taken during
a prior year
Decreases as a result of tax positions taken
during a prior year
Settlements with taxing authorities
Lapse of statutes of limitation
Increases as a result of tax positions taken during
the current year
146.7
160.5
174.9
5.3
4.6
7.8
(18.1 )
(28.1 )
(50.9 )
(5.0 )
(0.2 )
(10.2 )
(0.6 )
0.0
(5.0 )
32.3
20.5
33.7
Balance at end of period

$
161.0 $
146.7 $
160.5
Included in the total amount of unrecognized tax benefits of $161.0 as of December 31, 2011, is $160.1 of tax benefits that, if
recognized, would impact the effective income tax rate. The total amount of accrued interest and penalties as of December 31, 2011
and 2010 is $12.1 and $11.9, respectively, of which a detriment of $0.2 and a benefit of $5.0 is included in the 2011 and 2010
Consolidated Statements of Operations, respectively. In accordance with our accounting policy, interest and penalties accrued on
unrecognized tax benefits are classified as income taxes in the Consolidated Statements of Operations.
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LARGE NET OPERATING LOSS CARRYFORWARDS?

Large tax net operating loss carryforwards may be a hidden asset on balance sheets. When a
company experiences a loss on their tax books, there is no refund or credit given unless the loss can be
carried back to the 2 immediately prior years when taxes were paid. Instead, a net operating loss (NOL)
carryforward is created. This NOL carryforward can be used in a later year to offset positive taxable
income, thus, reducing a companys tax liability. Outside of an acquisition (and even then with some
limitations), NOLs are not easily monetizable. However, for a going concern company that once again
becomes profitable, they represent a significant source of value if utilized. NOLs are disclosed in the
table of deferred tax assets and liabilities at their tax effected amount.
Below we present the 2011 table of deferred tax assets and liabilities for E-Trade Financial. The table
discloses that the company has a $567 million NOL carryforward (tax value). In addition, there is a large
$1.3 billion deferred tax asset for reserves and allowances. As the bank has written down some of its
investment assets (through a loan loss reserve for loans or marking to market for securities), a tax
deduction is not allowed until the amounts are actually sold or charged-off. E-Trade has also written
down a small amount of its deferred tax assets with valuation allowance of $73.5 million.
E-Trade (2011 Form 10-K): NOL carryforwards
Deferred Taxes and Valuation Allowance
Deferred income taxes are recorded when revenues and expenses are recognized in different periods for financial statement and tax return purposes. Prior year
balances for the deferred tax assets and liabilities have been re-presented to ensure consistency between periods. The adjustments relate to the presentation of the basis
differences in investments and mark to market for certain loans and securities. The temporary differences and tax carry forwards that created deferred tax assets and
deferred tax liabilities are as follows (dollars in thousands):
December 31,
Deferred tax assets:

Reserves and allowances, net
Net operating losses
Basis differences in investments
Capitalized interest
Deferred compensation
Tax credits
Restructuring reserve and related write-downs
Other
Total deferred tax assets
Valuation allowance
Total deferred tax assets, net of valuation allowance
Deferred tax liabilities:
Depreciation and amortization
Mark to market
Total deferred tax liabilities
Net deferred tax asset
2011
2010
$ 1,216,487
567,774
67,738
65,767
44,512
16,169
15,092
27,109
$ 1,180,768
588,178
13,830
59,075
45,472
6,383
15,523
12,762
2,020,648
(73,533)
1,921,991
(75,959)
1,947,115
1,846,032
(260,600)
(107,811)
(184,616)
(187,822)
(368,411)
(372,438)
$ 1,578,704
$ 1,473,594
TheCompanyisrequiredtoestablishavaluationallowancefordeferredtaxassetsandrecordachargetoincomeifitisdetermined,
basedonavailableevidenceatthetimethedeterminationismade,thatitismorelikelythannotthatsomeportionorallofthedeferred
taxassetswillnotberealized.IftheCompanydidconcludethatavaluationallowancewasrequired,theresultinglosscouldhavea
materialadverseeffectonitsfinancialconditionandresultsofoperations.Theanalysisoftheneedforavaluationallowancerecognizes
thattheCompanyisinacumulativebooklosspositionasofthethreeyearperiodendedDecember31,2011,whichisconsidered
significantandobjectiveevidencethatitmaynotbeabletorealizesomeportionofthedeferredtaxassetsinthefuture.However,the
CompanydidnotestablishavaluationallowanceagainstitsfederaldeferredtaxassetsasofDecember31,2011asitbelievesthatitis
morelikelythannotthatalloftheseassetswillberealized.Approximatelytwothirdsofexistingfederaldeferredtaxassetsarenot
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relatedtonetoperatinglossesandtherefore,havenoexpirationdate.TheCompanyended2011with$781millionofgrossfederalnet
operatinglosseswhichwillexpirewithinthenext16years.
TheCompanysevaluationfocusedonidentifyingsignificant,objectiveevidencethatitwillbeabletorealizeitsdeferredtaxassets
inthefuture.TheCompanydeterminedthatitsexpectationsregardingfutureearningsareobjectivelyverifiableduetovariousfactors.
OnefactoristheconsistentprofitabilityoftheCompanyscorebusiness,thetradingandinvestingsegment,whichhasgenerated
substantialincomeforeachofthelasteightyears,includingthroughuncertaineconomicandregulatoryenvironments.Thecorebusiness
isdrivenbybrokeragecustomeractivityandincludestrading,brokeragecash,marginlending,longterminvestingandotherbrokerage
relatedactivities.Theseactivitiesdrivevariableexpensesthatcorrelatetothevolumeofcustomeractivity,whichhasresultedinstable,
ongoingprofitabilityinthisbusiness.
Anotherfactoristhemitigationoflossesinthebalancesheetmanagementsegment,whichgeneratedalargenetoperatinglossin
2007causedbythecrisisintheresidentialrealestateandcreditmarkets.Muchofthislosscamefromthesaleoftheassetbacked
securitiesportfolioandcreditlossesfromthemortgageloanportfolio.TheCompanynolongerholdsanyofthoseassetbackedsecurities
andshutdownmortgageloanacquisitionactivitiesin2007.Ineffect,thekeybusinessactivitiesthatledtothegenerationofthedeferred
taxassetswereshutdownoverfouryearsago.Asaresult,thelossesinthebalancesheetmanagementsegmenthavecontinuedto
declinesignificantly.Inaddition,theCompanycontinuestorealizethebenefitofvariouscreditlossmitigationactivitiesforthemortgage
loanspurchasedin2007andprior,mostnotably,activelyreducingorclosingunusedhomeequitylinesofcreditandaggressively
exercisingputbackclausestosellbackimproperlydocumentedloanstotheoriginators.Asaresultoftheselosscontainmentmeasures,
provisionforloanlosseshasdeclinedforthreeconsecutiveyears,down72%fromitspeakof$1.6billionfortheyearendedDecember31,
2008.
Important items to keep in mind when reviewing 10-K income tax footnote disclosures for NOLs:
(1) Within the deferred tax asset table, the amounts shown are the companys tax effected NOL
amounts. It is not net present valued. As an illustration, an NOL carryforward of $1,000 is
available to a company. This NOL could be used to offset $1,000 of pre-tax income. Within the
deferred tax asset table, the NOL line item would be $350 ($1,000 NOL multiplied by the U.S.
federal (or foreign/state income tax rates) statutory income tax rate of 35%). This $350 is the
amount that can offset taxes owed. In reality, the actual value of the NOL in the deferred tax
asset table is somewhat lower as no present value factors based on expected utilization are
taken into account (if used, the NOLs would likely be used over a number of forthcoming years
when pre-tax profit is generated). Also, the NOL deferred tax asset amount is often an aggregate
of all NOLs available to the company, which may include federal, state, foreign NOLs, and
possibly tax credits. Each of these may have different expiration periods and varying ease of use.
Next is a summary table of the carry forward periods and expiration of various tax NOLs and
credits.
NOL and Tax Credit Summary
TypeofNOLorTaxCredit
U.S.federalNOL
U.S.stateNOL
U.S.capitallosses
U.S.AMTcredit
U.S.foreigntaxcredit
ForeignNOL
ExpirationPeriod
2yearscarrybackand20yearscarryforward;lossesarecarriedbacktotheearliestperiodfirst
Variesbystate,butoften1020years;somestatesdonotallowanycarryback
3yearscarrybackand5yearscarryforward;mayonlyoffsetagainstcapitalgains
Indefinite
Typicially10years
Variesbyjurisdiction;somecountriesallowindefinitecarryforward
Source: Wolfe Trahan Accounting & Tax Policy Research; Internal Revenue Code.
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(2) Amounts listed in the narrative annual report disclosures before or after the table of deferred tax
assets and liabilities typically represent the amount that may be used to offset pre-tax income and
is not the NOLs value. In the previous example, a $1,000 NOL would likely be described in the
narrative.
(3) Certain limitations on the ability to use the NOLs may exist. For example, IRC Section 382 places
an annual limitation on the amount of NOLs that can be used to offset pre-tax income. Designed
to prevent the trafficking of NOLs, Section 382 will kick in if there has been an ownership
change in the corporation. Under IRC Section 382, an ownership change occurs when there has
been a more than 50% change in ownership of a company within any three-year period. When
this ownership change occurs, there will be a ceiling placed on the annual amount of NOLs that
may be used to offset taxable income. The limitation amount is formulaic and is calculated as the
acquired companys common and straight preferred equity value immediately prior to the
ownership change multiplied by the monthly long-term tax exempt rate published by the Treasury
(currently approximately 3.55% for acquisitions occurring in March 2012). The long-term tax
exempt interest rate may be found at www.irs.gov/irb.
Are Deferred Tax Valuation Allowances Required?
Deferred tax assets and liabilities are due to timing differences between GAAP and cash taxes. For
example, a deduction may be taken on the tax return, but not yet recorded as an expense for GAAP.
This is common due to accelerated depreciation methods used for tax purposes but straight-line for
book purposes and will result in a deferred tax liability as future additional cash will be required to pay
taxes. A deferred tax asset will arise when an expense is taken for GAAP book purposes, but the
corresponding deduction is not yet taken for tax purposes. The DTA is essentially a future cash savings
as lower taxes will be due in a future period when compared to the GAAP tax expense. Accounting rules
require that companies evaluate their net tax assets for realizability. A company must actually have
positive pre-tax income in the future in order to utilize / realize the value of these deferred tax assets.
When a company is valued on book value metrics, the evaluation of tax asset realizability and assessing
potential valuation allowances is critical. This is particularly true for financial institutions like banks and
insurers. In the last several years, deferred tax asset write-down issues have arisen for homebuilders (in
2007 after large impairment and inventory losses); Fannie Maes (in 2008 when deferred tax assets
represented a significant portion of reported GAAP shareholders equity balance), and banks more
recently (large deferred tax asset balances were built from loan losses with little visibility into future
profitability).
A deferred tax asset write-down, or valuation allowance, must be recorded if, based on available
evidence, there is a more than 50% chance that some portion or all of the deferred tax assets will not be
realized by the company. The accounting standards on valuation allowances are set forth in ASC 740
(formerly FAS No. 109, Accounting for Income Taxes). In determining whether tax assets should be
written-down to their realizable value, the rules require both positive and negative evidence to be
considered. In order to justify the realizability of the tax assets, the company must demonstrate the
ability to generate a specific type of taxable income that is of the same character as the tax assets
attributes (i.e., same jurisdiction and type [e.g. capital loss vs. ordinary income]).
The recording of a valuation allowance, or deferred tax asset write-down, is recorded as an increase to
income tax expense in the income statement with a corresponding increase to the deferred tax asset
valuation account. There will be a direct impact on GAAP shareholders equity due to the write-down. For
reporting purposes, the deferred tax valuation account is netted against the net deferred tax asset
amount on the balance sheet (a contra-asset account akin to bad debt allowance netted against
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accounts receivable). Its important to note that despite any deferred tax asset valuation allowance, the
actual tax attributes (e.g. NOLs) continue to exist and may be utilized so long as the taxable income
generated allows for it. GAAP tends to be overly conservative in this area in writing down DTAs.
LOW CASH TAX RATE?

The amount of cash taxes paid is a required annual disclosure. The location may vary - either at the
bottom of the cash flow statement as a supplemental item or in the financial statement footnotes
narrative. Analysts should pay close attention to these disclosures and calculate a cash tax rate. We
believe that a consistently low cash tax rate may suggest aggressive tax planning or aggressive GAAP
reporting. Certain circumstances (e.g., NOLs, large foreign earnings, etc.) may be exceptions. We
believe that one sign of early problems at Enron was a very low income tax rate. In the next exhibit, we
calculated Verizons cash tax rate from 2003 through 2010.
Verizons Low Cash Tax Rate ($ in millions)
Verizon
Cash taxes paid
Pre-tax income
Cash tax rate
2003
2004
2005
2006
2007
2008
2009
2010
(716)
6,256
-11%
152
10,306
1%
4,189
11,449
37%
3,299
12,192
27%
2,491
14,545
17%
1,206
15,914
8%
158
11,568
1%
430
11,780
4%
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poors; FactSet.
Cash taxes may vary from the GAAP income tax expense as the latter is based on an accrual basis
using pretax income reported to shareholders. Cash taxes paid represent what is actually paid to the
IRS. Cash flow from operations will reflect the cash taxes paid. U.S. calendar year-end companies
generally make federal quarterly estimated tax payments to the Treasury on April 15th, June 15th,
September 15th, and December 15th. Any final payment is payable on the tax returns due date, which
is March 15th (of the subsequent year) for calendar year-end companies. International country
estimated tax payment dates vary by country.
We suggest two primary methods to calculate cash tax rates:
1. Cash taxes paid / GAAP income before taxes. This cash tax rate reflects the actual cash tax
payments made during the current year. However, this calculation may be skewed by the
timing of cash tax payments which can be lumpy due to estimated tax payments and income
tax refunds.
2. Current income tax provision / GAAP income before taxes. To correct for the timing issues
discussed in Method #1 above, this is an alternative measure of the cash tax rate. We prefer
this method when cash tax payments are abnormally high or low in the current year. Its an
improvement as its based on taxes related to the current years earnings. In the annual tax
footnote, the total reported income tax provision is comprised of two parts: current and
deferred. The current year income tax expense is the amount of taxes owed as calculated on
the companys income tax return (corporate 35% tax rate multiplied by the companys tax
return pre-tax income).
Next, we calculate Humanas cash tax rates using both of the methods described above. The two
different methods of calculating cash tax rates have been relatively similar the last several years.
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Humana (2011 Form 10-K): Cash Tax Rate Calculations ($ in millions)
Cash paid for income taxes

Earnings before provision for taxes
2011
874
2,235
2010
785
1,750
2009
627
1,602
Cash tax rate using cash taxes paid
39%
45%
39%
Current tax expense

Earnings before provision for taxes
794
2,235
849
1,750
589
1,602
36%
49%
37%
Cash tax rate using current tax expense

The Impact of Bonus Depreciation on Cash Tax Rates

Bonus depreciation for tax purposes of 50% in 2008-2010 and 100% in 2011 will likely impact cash tax
rates for some time. Bonus depreciation will revert to 50% for 2012 and then be eliminated in 2013. As a
result of this legislation, analysts should be prepared for the cash tax rates of companies in cap-ex
intensive industries to potentially spike higher in the coming years due to the reversal of these benefits.
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SHAREREPURCHASES
In addition to the gross share repurchase amount shown in the statement of cash flows (within the
financing section), analysts may also look for more information on the buybacks within the companys
annual report filing. In either Item 5 of the 10-K or within the notes to the financial statements, share
repurchase activity must be disclosed in tabular format. Detailed information will be included pertaining
to the total number of shares repurchased, average price paid per share, total number of shares
purchased as part of publicly announced plans, and the approximate amount of the shares remaining
under approved stock repurchase plans. Either the fourth quarter or full-year share repurchase activity
may be disclosed (also required to be disclosed quarterly in a tabular format).
Below we present CCEs share repurchase disclosures from the companys 2011 10-K.
Coca-Cola Enterprises (2011 Form 10-K): Share Repurchase Disclosure
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EARNINGSPERSHARE&DILUTEDSHARECOUNT
A separate table in the footnotes must be disclosed showing the numerator and denominator
components of basic and diluted earnings per share calculations. This is an important section to review
for future potential EPS dilution. More information may also be found in the stock-based compensation
and debt footnotes (if convertible debt is outstanding).
The diluted share count will only include the impact of outstanding stock options to the extent they are in
the money. However, there may be a dilution overhang from at or out of the money options (see the
stock based compensation section of this report). Unvested restricted shares of stock are not fully
included in the diluted share count; therefore, beware of large recent grants that may begin to impact the
share count in future years. Yet another variation of stock based compensation is performance based
shares (e.g. subject to meeting EPS, ROE targets). These will not be included in the diluted share count
until the performance threshold has been met (considered to be contingently issuable shares).
On the other hand, a company's share count may not include the analytically correct number of shares.
This may occur most often with convertible debt outstanding. Plain vanilla convertible bonds will be
included in diluted EPS under the if converted method. This method assumes that the bond will always
be converted into stock, regardless of where the conversion price is relative to the market price of the
underlying stock. In some cases, this may result in too many shares being included in the diluted share
count from an 'economic' perspective. If the convertible bond is out of the money or the company plans
on redeeming the bond in cash, no shares would be issued. Analytically, this convertible debt instrument
should be treated as debt rather than equity and the shares should not be included in the diluted share
count. Keep in mind that if a convertible bond's principal amount is required to be settled in cash, the
treasury stock method may apply.
Within the EPS footnote, some companies may disclose the number of shares excluded from the diluted
share count due to their anti-dilutive effect. This helps frame the possible forward EPS dilution existing
at the balance sheet date.
Cisco (2011 Form 10-K): EPS Calculation
The following table presents the calculation of basic and diluted net income per share (in millions, except per-share amounts):
Years Ended
July 30, 2011
July 31, 2010
July 25, 2009
Net income
6,490
7,767
6,134
Weighted-average sharesbasic
Effect of dilutive potential common shares
5,529
34
5,732
116
5,828
29
Weighted-average sharesdiluted
5,563
5,848
5,857
Net income per sharebasic
1.17
1.36
1.05
Net income per sharediluted
1.17
1.33
1.05
Antidilutive employee share-based awards, excluded
379
344
977
Employee equity share options, unvested shares, and similar equity instruments granted by the Company are treated as potential common shares outstanding in
computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options, unvested restricted stock, and restricted stock
units. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury
stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet
recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are collectively assumed to be used
to repurchase shares.
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StatementofCashFlows
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STATEMENTOFCASHFLOWS
Generally we find that cash flows are a better indicator of company prospects than earnings as the
amounts are subject to less management discretion and accounting leeway. Most accounting
maneuvers are non-cash in nature so will be shown as a negative adjustment to operating or investing
cash flow. The balance sheet, income statement, and statement of cash flows are all inter-related. It is
important to note that the statement of cash flows is not without its shortcomings as accounting
deficiencies (e.g. capital leases) and other novel ways to increase reported operating cash flow do exist.
Below we discuss some items that result in non-comparable cash flows across companies.
While varying items are discussed throughout this report, below are 13 items with respect to cash flow
that analysts should check. Keep in mind that many items on the cash flow statement may be netted
together items that an analyst would not consider recurring operating cash flow may not be obvious at
first glance. Throughout the 10-K in the related footnotes, you may discover clues for unsustainable or
buried cash flow benefits.
1. Extension / Delaying Payments of Accounts Payable or Accrued Expenses
By delaying actual cash payments for accounts payable or accrued expenses until after the
period end, operating cash flow will receive a temporary boost.
2. Inventory Draw Downs
Many companies drew down their inventory balances in the prior recession when production and
customer demand slowed. This improved operating cash flows; however, upon recovery of the
markets, inventory balances will again rise, reversing this trend and creating a cash flow
headwind. This dynamic has made it difficult to obtain the normalized operating cash flow (and
free cash flow measures) of many companies.
3. Prepaid Expenses
A prepaid expense will impact cash flow negatively in the period the payment is made. For certain
recurring costs such as advertising or marketing, companies may prepay them in a year when
cash flows are increasing. This increase in prepaid assets results in an operating cash outflow in
the current period. However, the following period, the company will receive an operating cash
flow tailwind as no cash payments will be necessary. This is a temporary benefit for cash flow that
cannot likely be sustained.
4. Accelerated Cash Receipts
Receiving cash before the related revenue is recognized will result in deferred revenue (a
balance sheet liability) being recognized. Many examples of this accelerated cash receipt occur in
areas where there is a longer time horizon, such as subscription software or a long-term supply
agreement. The recording of the deferred revenue account will be shown as an operating cash
inflow in the current period. If more than a one period cycle of cash flows have been collected on
an accelerated basis, future periods will have a cash flow headwind. As an example of frontloading cash, a company may require cash deposits or encourage customers to pay in advance.
Some companies may lengthen the duration of certain contracts. Take the example of a
subscription license that is fully paid up-front. If the company begins switching customers to
minimum 2 year contracts from one-year contracts, reported cash flow would appear to be
growing. However, the increase in cash flow would be solely due to changes in the contractual
term, not the volume of subscriptions sold.
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5. Accounts Receivable Securitization

Many lower-rated companies utilize accounts receivable sales as a form of low-cost financing
(interest rate is typically based on short-term LIBOR or commercial paper rate). Some
securitizations will meet the criteria for sale accounting (A/R removed from the balance sheet and
recorded as operating cash inflow) and some will be required to be recorded as a secured
borrowing (A/R remains on balance sheet, securitized debt balance recorded - under the new
FAS No. 166 rules, if material recourse exists its likely the sale of the receivables would not
qualify for sale accounting).
No matter the actual accounting treatment that the securitization receives under GAAP, we feel
that economically (irrespective of the non-recourse nature of receivable sales), the transaction is
a financing decision and should analytically treated as such. The incoming cash flow is occurring
outside the normal cash flow collection process. To adjust, operating cash flow should be
reduced by the change in the uncollected receivables balance. This balance is the amount of
accounts receivable that has been sold but not collected by the third party (bank or securitization
trust). Correspondingly, financing cash flow is adjusted by the same amount. Assuming the
uncollected accounts receivable balances have increased year-over-year, there is a negative
adjustment to operating cash flow (from the change in the uncollected balance) and a positive
adjustment to financing cash flow.
Aside from potentially boosting operating cash flow, A/R securitizations will also mask
deterioration in DSOs and less conservative revenue recognition policies.
6. Cost Capitalization (Operating vs. Investing Cash Flow)
When costs are capitalized on balance sheet, the increase in the asset account must be shown
as a cash outflow somewhere on the cash flow statement. Some items may be shown as an
operating cash flow - there would be no overstatement of operating cash flow. More concerning
would be when the amount is reported as an investing cash outflow. Operating cash flow will be
permanently increased. The capitalized amount will eventually be expensed through earnings, but
as they would be non-cash at that point, the costs will be an add-back to the operating cash flow
amount. Note that this scenario will occur whether costs are properly or improperly capitalized.
7. Large Cash Outflows in From Investing Activities
Similar to the cost capitalization section above, any cash flow analysis should pay particular
attention to the amounts in the investing section, looking for amounts that should actually be
operating. Most traditional measures of cash flow focus on operating cash flow and capital
expenditures, so companies are incentivized to classify items as other investing cash outflows.
Next we compare WorldCom's 2000 and 2001 reported and restated cash flows. The company,
among other things, improperly capitalized recurring costs as capital expenditures and other
costs and classified them as investing cash outflows. A quick review of WorldCom's cash flow
statement revealed large unexplainable investing cash outflows.
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WorldCom: Classifying Costs as Investing Cash Outflows

YearEndedDecember31,
2000
2000
2001
2001
Reported Restated
Reported Restated
StatementofCashFlow
Cashflowfrominvesting
Capitalexpenditures
Acquisitionsandrelated
Increaseinintangibles
Decreaseinotherliabilities
Allotherinvestingactivities
Cashusedbyinvestingactivities
$7,666
$4,227
$7,994
$2,845
(11,484) (11,668)
(14)
0
(938)
0
(839)
0
(1,110)
505
($14,385) ($11,163)
(7,886)
(206)
(694)
(480)
(424)
($9,690)
(6,465)
(171)
0
0
514
($6,122)
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Bloomberg; Standard & Poors; FactSet as of 11/2/2011.
8. Lease Accounting a Source of Potential Cash Flow Management

As we discuss in the leases section of this report, new capital leases are not recorded as capital
expenditures on the cash flow statement. This is a shortcoming in GAAP that should be adjusted
for analytically by adding the amount of new capitalized leases entered into in the year (a
required supplemental disclosure) to reported capex.
Similarly, a mix shift from operating leases to more capital leases will boost operating cash flows.
Given the bright line accounting rules for classifying a lease, structuring the leases to fit
accounting conventions is relatively easy. Capital leases are recorded on balance sheet and the
primarily related expenses will be interest costs and non-cash depreciation. Operating leases
rental expense is fully recorded in operating cash flow, so a switch to capital leases will result in
only the interest expense portion of a capital lease remaining in operating cash flow.
9. Taxes Impact Cash Flows
Income tax payments are included in operating cash flow. A temporary boost may be received in
periods of low cash tax payments, which may not be sustainable. Substantial differences may
occur due to the timing of cash tax payments when compared to the normalized tax rate. Items
resulting in this divergence include net operating losses, special tax credits, the timing of tax
payments or other items. We suggest observing a cash tax rate and assessing the sustainability
(we view a low cash tax rate as generally unsustainable over the long-run). Analysts may utilize a
normalized long-term tax rate for valuation purposes for cash flow purposes and separately value
any tax benefits such as NOLs or tax credits.
10. Company Stock Contributions to Pension Plans
Many companies have been contributing stock in lieu of cash contributions in recent years. While
this will result in cash savings in any given year, a company that has a materially unfunded plan
cannot permanently avoid cash contributions. Only up to 10% of a companys pension plan
assets are allowed to be in company stock. If the company is contributing stock at a time when
their share price is depressed, it only serves to further dilute existing shareholders.
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11. Stock Based Compensation

As discussed in the stock-based compensation section of this report, stock option and restricted
stock expense are technically non-cash and are add-backs to arrive at operating cash flow. We
feel that operating cash flow should be adjusted to include the impact of stock based
compensation costs as the payment in stock options / restricted stock is a financing choice and
the compensation costs are actually cash costs. Additionally, to avoid dilution from these
programs, many companies choose to repurchase stock in the market, which is classified as a
financing cash outflow and this amount is often overlooked by the investment community. We
believe that GAAP overstates analytical operating cash flow for companies with significant stock
based compensation plans.
12. Working Capital Benefits After an Acquisition
Analysts should skeptically view any large working capital benefits in the quarters after a material
acquisition. Companies may undertake certain actions in an acquisition to increase subsequent
reported operating cash flow. The target company may either increase non-cash current assets
(slower collection of accounts receivable) or decrease current liabilities (faster payment of
accounts payable or accrued expenses). Upon acquisition on the parent companys cash flow
statement, the cost of acquired working capital is shown as a financing cash outflow for cash
acquisitions (will never appears on the cash flow statement for stock acquisitions). In subsequent
periods, if and when working capital levels return to normal levels, the consolidated company will
show the positive impact as an operating cash flow. In this sense, for highly acquisitive
companies, earnings may actually be the preferred measure of operating performance over cash
flow.
13. Include M&A Transactions as Capex
Companies may be described as serial acquirers if acquisitions are frequent and deemed
necessary to maintain revenue growth. For these companies free cash flow should be calculated
by including acquisition amounts akin to capital expenditures. When compared to other
companies that internally develop new products/markets resulting in current period cash
marketing/R&D costs, acquisitive companies will otherwise appear less expensive if adjustments
are not made. The acquisition costs can be treated as cap-ex in full or over a number of years
depending on the size and frequency of M&A.
Cash Flow Ratios to Monitor:
Operating cash flow / net income

Cash flow margin: Operating cash flow / revenue
Cash conversion margin: (operating cash flow net income) / revenue
Cash flow from operations / EBITDA
(EBITDA - operating cash flow) / revenue
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MATERIALNONCASHACTIVITIES/SUPPLEMENTALCASHFLOWINFORMATION
Companies are required to disclose supplemental cash flow information in their 10-K otherwise known
as significant noncash activities. The schedule may be found either at the bottom of the cash flow
statement or in the 10-K footnotes. We find this schedule a quick way in which to find the cash paid for
interest and income taxes. It includes such items as new capital leases initiated during the year,
conversions of debt into equity, stock acquisitions, and debt/liability assumptions. We use
Amazon.coms 2011 10-K to illustrate this disclosure in the next exhibit.
We carefully review this schedule for large transactions that are accounted for as non-cash under
GAAP, but may analytically be cash expenses. As an example, assets acquired under capital leases
during the year are disclosed. As we explain in this report in the lease section, we believe capital leases
are capital expenditures and, as such, should be deducted from free cash flow calculations. Additionally,
we find this schedule useful in assessing earnings quality as it provides an input into assessing if a
company is capitalizing interest expense or has a unsustainably low cash tax rate.
Amazon.com (2011 Form 10-K): Supplemental Cash Flow Information
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PensionAccounting
andDisclosures
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PENSIONANDPOSTRETIREMENTPLANDISCLOSURES
Pension and other postretirement benefits (OPEB) plan accounting and disclosure is one of the more
complex areas to understand when reviewing a 10-K. For specific company impacts and analysis please
refer to our related pension report published on January 3, 2012.
The following discussion focuses on defined benefit pension and OPEB plans. Defined contribution
plans (e.g. 401(k) plans) are typically very simple as they are expensed on a pay as you go basis.
Generally, there are three primary impacts analysts should consider when analyzing defined benefit
pension and OPEB plans:
1) Balance sheet. The net Funded Status (Pension Assets Pension Liability) is recorded on the
balance sheet and is only marked to market annually. We consider any unfunded amount as the
economic equivalent of debt. In the long-term, this unfunded amount will need to be funded in some
way, by way of contributions from the company or outsized asset returns from the pension plan.
2) The periodic pension cost. Pension cost is the amount related to pensions that is included in
earnings. It is a non-cash expense and reported on the income statement in the function area in
which the employee works (cost of sales, SG&A, R&D, etc.). In a later section, we walk through the
main components of pension cost.
3) Contributions. This is the actual cash impact of pensions, as determined by either the related
regulatory rules, union agreements or other discretionary choices made by the company. Cash
contributions would be made either to the pension asset trust for a funded plan or directly to the plan
beneficiaries in an unfunded plan. These amounts would be included in the operating sections of the
cash flow statement.
In the pension footnote, pension plans are aggregated together for combined funded status. There may
actually be individually separate plans underlying the combined amounts, each of which may have
varying funded levels. For example, there may technically be separate plans for union employees,
salaried employees, or executives. The combined disclosures may show a net overfunded pension plan,
but one plan may be overfunded while other smaller plans may be underfunded. Therefore, the
aggregate disclosure amounts may understate certain individual pension plans funding level.
GAAP VS. REGULATORY RULES

The funded status of a pension plan is typically very different on a GAAP basis compared to a regulatory
basis. Regulatory rules are used to determine the required cash contributions, which may be very
different than the periodic pension cost reported under GAAP. Regulatory pension funded status is not
generally disclosed. In some cases, investors may find that no cash regulatory pension funding
requirement is due despite a large underfunded pension plan for GAAP purposes.
Only certain plans, so-called qualified plans, are subject to the ERISA regulatory funding rules. Other
plans, such as some executive plans (non-qualified plans) may not be subject to the specific ERISA
cash funding requirement rules. Additionally, plan disclosures may segregate U.S. and international
pension plans. International plans typically follow the cash funding rules of their respective domiciles,
which vary greatly.
For defense contractor companies, certain cash pension costs/funding amounts may be indirectly
reimbursed by the government through negotiated contract rates under so-called CAS accounting (Cost
Accounting Standards).
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KEYPENSIONITEMS:FUNDEDSTATUS=PENSIONPLANASSETSPENSIONLIABILITY
Unless specifically noted, the majority of the following discussion pertains to the GAAP accounting rules
(see the subsequent pension Q&A section for a short primer on the regulatory rules).
Funded Status
The funded status of the pension plan is calculated as the plan assets less the pension liability (PBO).
An overfunded status would be included on the companys balance sheet as an asset or the
underfunded status (more typical in todays environment) would be included as a liability. If not
specifically broken out, amounts would typically be included on the balance sheet under some Other
assets or liabilities line item caption.
Pension Plan Assets
Pension assets are recorded and measured at fair value at year-end. The assets are not specifically
consolidated on the companys balance sheet, but rather as part of the funded status as discussed
above. The assets are typically held in a trust separate from the remainder of the companys assets.
Pension Liability - Projected Benefit Obligation and Accumulated Benefit Obligation
Corporate pension benefit payments are typically tied to a predetermined formula. Several inputs are
used in the calculation, notably, some average of the employees average salary and the number of
years of employment. From a GAAP perspective, the pension liability is a series of future cash outflows
(benefit payments) that are discounted back to today using an assumed discount rate. Many equate the
pension liability to a series of zero coupon bonds with maturities equal to the individual future benefit
payment date.
The reported GAAP pension liability is also known as the PBO or projected benefit obligation. The
PBO makes assumptions about future compensation increases and what salary levels may ultimately be
at the time current employees reach retirement. An alternative measure that is disclosed (but not used
for funded status recorded in the balance sheet) is the ABO or accumulated benefit obligation. The
primary difference is the treatment of assumed future compensation increases. The ABO is a measure
of the present value of the future benefit payments based on the employees current salary. The PBO
will always be larger than the ABO. The ABO represents the liability required if the pension were settled
today and is closer to the liability used for regulatory purposes.
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KEYPENSIONASSUMPTIONS
DISCOUNT RATE
The discount rate is one of the primary assumptions companies use to calculate the PBO when the
pension liability is marked to market each year-end. As a result, the discount rate assumed at the end of
one year will impact the service and interest cost for the following year. Management has some, but
generally not a significant amount of input into determining the discount rate as it is generally market
based. It is the spot Aa corporate bond yield at year-end. Actuaries hired by the company will calculate
the rate based on Aa corporate interest rates that match the duration of the companys pension plan
liabilities. We monitor several Aa indexes that track the level of corporate Aa rates. One publicly
available index that weve found to be highly correlated is the Citigroup Pension Curve Discount Rate
which is available on a monthly basis at the following location: http://www.soa.org/files/xls/pen-discountcurve.xls. While the Moodys Aa rate has not been a highly reliable proxy for the discount rate in several
years, some analysts may follow it at least for directional purposes due to its ease of availability
(Bloomberg ticker = MOODCAA Index).
For our analysis, we use the Merrill Lynch 15 year Aa corporate spot yield curve, which is published
daily. Based on our actuary contacts, we have found this yield to most closely track that used by pension
plans in valuing their pension liabilities.
IMPACT OF DISCOUNT RATE

As a function of present value, lower discount rates will increase the calculated pension liability. The
year-end assumed discount rate is used to mark the pension liability to fair value at year-end. It is also
used to determine the following years service and interest cost. The impact of discount rates on service
and interest cost include:
Higher discount rate lower service cost;

Higher discount rate higher interest cost (higher rate reduces the projected benefit obligation,
but the impact of a higher interest rate on a lower benefit obligation is typically larger); and,
The impact of a higher discount rate on the combined service and interest cost is the higher
discount rate typically reduces pension expense, as the effect of the lower service cost amount
exceeds that of the higher interest cost. However, if a pension plan has a large proportion of
retirees or older employees, as measured by a high interest cost relative to service cost, a higher
discount rate may increase pension expense.
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Discount Rate Proxy - Merrill Lynch 15+ year Aa Corporate Index Yield
MerrillLynch15+YrAaCorporateYield
6.5
ML15+YrAaCorporateYield(%)
6.0
5.5
5.0
4.5
December31,2010:5.40%
December31,2011:4.55%
4.0
Dec09
Feb10
Mar10
May10
Jun10
Aug10
Sep10
Oct10
Dec10
Jan11
Mar11
Apr11
Jun11
Jul11
Aug11
Oct11
Nov11
Source: Wolfe Trahan Accounting & Tax Policy Research; Bank of America-Merrill Lynch.
RATE OF COMPENSATION INCREASE (SALARY INFLATION RATE)

As discussed earlier, the primary measurement of the pension liability is the PBO, which incorporates
assumptions about future salary levels. The rate of compensation increase or salary inflation rate will be
disclosed by the company. The salary inflation rate acts as a pension benefit obligation growth rate.
Along with the employees expected retirement date and mortality, the companys actuary will use the
current salary amount and assumed salary inflation rate to calculate future pension benefit payments.
Lower salary inflation rate assumptions may be considered less conservative since they will result in
lower pension liabilities. Based on our reviews, a salary inflation rate of 4.00% to 4.25% is typical and
assumptions do not frequently change.
EXPECTED RATE OF RETURN ASSUMPTION

The expected rate of return assumption is a direct input into the calculation of periodic pension cost. As
discussed later, the expected return on plan assets is a component of pension cost and is a direct offset
to the other components in that it will lower the overall expense since it is a return measure. The
expected long-term rate of return on plan assets is an assumption reflecting 1) the current or target
asset allocations and 2) the anticipated average rate of return on the companys pension assets over the
long term. It is typically based on a long-term historical average of actual fund performance (anywhere
from 10-30 years is possible based on discussions with fund managers and actuaries). Therefore, year
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to year volatility in the performance of the pension funds actual returns will not immediately portend a
change in the expected rate of return assumption.
The reported pension expense in earnings is directly impacted by the expected rate of return. A higher
expected rate of return reduces pension cost and thus increases earnings. Conversely, a lower
expected rate of return would increase pension cost / lower earnings.
GAAP Guidance on the Expected Rate of Return Assumption:
ASC 715-30-35-47:
The expected long-term rate of return on plan assets shall reflect the average rate of earnings
expected on the funds invested or to be invested to provide for the benefits included in the PBO. In
estimating that rate, appropriate consideration shall be given to the returns being earned by the plan
assets in the funds and the rates of return expected to be available for reinvestment. The expected
long-term rate of return on plan assets is used (with the market related value of assets) to compute
the expected return on assets.
Over the last several years, the median expected rate of return assumption was 8%. Given the lower
equity returns over the last several years and the fact that many companies are allocating pension
assets into historically lower yielding fixed income assets, it is possible that we see declines in the
expected rate of return assumption at 2011 year-end of 25 to 50 basis points, perhaps more on an
individual company basis. Further, we would expect the median rate to trend down to around 7% over
the next several years.
Historical Median Discount Rate and Expected Rate of Return Assumptions for Russell 3000 Companies
Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
MedianDiscount MedianExpected
Rate(%)
RateofReturn(%)
7.50
9.00
7.25
9.00
6.75
9.00
7.50
9.00
7.50
9.00
7.25
9.00
6.75
8.75
6.25
8.50
5.75
8.50
5.50
8.25
5.75
8.00
6.25
8.00
6.25
8.00
5.85
8.00
5.40
8.00
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Bloomberg; Standard & Poors; FactSet.
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PENSIONCOST
Pension cost includes seven primary components:
1 Service cost: This cost is the ongoing expense due to new benefits being earned by current
employees for working during the current year and increasing their future benefit payments under
the pension benefit formula structure. It is, in effect, compensation cost. These incremental
benefits are being earned now, but will be paid out during retirement. Therefore, additional
future amounts due are calculated, discounted back to present values, and expensed as service
cost in the current period. This amount increases the projected benefit obligation.
2 Interest cost: Interest cost is calculated on the pension benefit obligation as a function of the
deferred nature of the pension benefit payments. A defined benefit pension plan is essentially a
deferred compensation arrangement. It is calculated as the end-of-prior-year benefit obligation
(PBO) multiplied by the year-end discount rate. This amount will be included within periodic
pension cost also increases the projected benefit obligation.
3 Expected return on pension plan assets: Due to smoothing mechanisms in GAAP pension
accounting, actual returns on pension plan assets are not used in determining periodic pension
cost. As discussed previously, a company must assume an expected rate of return on pension
plan assets when calculating pension expense. This is the return on the plan assets that the
company assumes will be achieved over the long-term on a smoothed basis. The expected return
on plan assets is an offset (income) amount to other pension costs and calculated as the assets
x the expected rate of return on plan assets. Companies can choose to use the fair value of plan
assets or up to a 5-year smoothed value (called the market-related value).
4 Amortization of gains/losses: The increase or decrease in the PBO from a change in the discount
rate or differences between the actual and expected returns on plan assets are directly reflected
in the balance sheet, but are not directly reflected in pension cost / earnings in the current period.
These items are the result of changes in actuarial assumptions that are smoothed into pension
expense over time and will dampen earnings volatility. When an actuarial mark occurs that
changes amounts on the balance sheet, instead of immediately expensed through earnings, they
are accumulated in AOCI (within equity) in an account called unrecognized net gain or loss. The
accumulated unrecognized net gains or losses are then recognized into earnings over time under
a complex calculation commonly referred to as the corridor. While overall EPS volatility is
understated through use of this smoothing technique, the impact of using the corridor may still
result in large swings in pension expense year-to-year.
5 Amortization of prior service cost: Particularly with union negotiated pension plans, companies
may amend their pension plan benefit terms to retroactively increase or decrease (less likely)
employee pension benefits. When a company makes an amendment to a pension plan that
changes future benefits, the costs / savings associated with the amendment are calculated by an
actuary and then recognized straight line over the remaining service life of the impacted
employees.
6 Curtailments: The FASB pension rules define a plan curtailment as an event that significantly
reduces the expected years of future service of present employees or eliminates for a significant
number of employees the accrual of defined benefit payments for some or all of their future
services (FAS No. 88). Essentially, employees will not continue to accrue future benefits in the
amount originally estimated. Freezing a pension plan is a typical example of a curtailment (the
discontinuing of accruals for any future benefit increases based on service life or salary increase).
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Another example is a restructuring event, such as the closing of a facility or a division of the
company. Curtailments will typically result in a reduction of the PBO as the value of future benefit
payments will be less than previously estimated. Based on the specific events, actuaries will
calculate the costs/savings associated with the action and the company will record a one-time
gain or loss in earnings.
7 Settlements: A settlement occurs when there is some irrevocable action taken by the company to
relieve a portion of its future pension liability. Common examples include: 1) making a lump sum
cash payment to the employee/retiree that relieves any obligation to pay the future benefit
payments or 2) the purchase of a nonparticipating annuity contract that will exactly offset the
future cash flows due for the benefit payments. Simply investing in high quality fixed income
securities with maturities similar to the benefit payment dates would not be considered a
settlement. Based on the specific events, actuaries will calculate the costs/savings associated
and the company will record a one-time gain or loss.
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PENSIONFOOTNOTEEXAMPLE3MCOMPANY
On the next several pages, we will walk through some of the common pension and OPEB footnote
disclosures using 3M company (MMM) as an example.
ASSUMPTIONS
The first part of the disclosure includes assumptions used to calculate the pension plan liability these
are 2011 year-end assumptions that will also be used to calculate the following years (2012) pension
expense. For example, 3M calculated the present value of its U.S. pension projected benefit obligation
at December 31, 2011 using a discount rate of 4.15% and 4.58% for its international plans. This rate will
also be used to calculate 2012 pension interest expense (prior year-end PBO multiplied by the discount
rate at prior year-end).
The bottom part of the table lists the assumptions that were used to calculate 3Ms 2011 pension
expense. As shown below, the 2010 year-end discount rate of 5.23% was used for the 2011 net pension
cost. The expected rate of return on plan assets was 8.50%. However, reading the discussion below the
table uncovers that the 3M will actually be reducing its expected return for 2012 pension cost purposes
to 8.25%.
3M Company (2011 Form 10-K): Pension & OPEB Assumptions
Weighted-average assumptions used to determine benefit obligations
2011
Discount rate
Compensation rate increase
Qualified and Non-qualified Pension Benefits

United States
International
2010
2009
2011
2010
4.15%
4.00%
5.23%
4.00%
5.77%
4.30%
4.58%
3.52%
5.04%
3.59%
2009
5.30%
3.72%
2011
Postretirement
Benefits
2010
4.04%
N/A
5.09%
N/A
2009
5.62%
N/A
Weighted-average assumptions used to determine net cost for years ended
2011
Discount rate
Expected return on assets
Compensation rate increase
Qualified and Non-qualified Pension Benefits

United States
International
2010
2009
2011
2010
5.23%
8.50%
4.00%
5.77%
8.50%
4.30%
6.14%
8.50%
4.30%
5.04%
6.58%
3.59%
5.30%
6.90%
3.72%
2009
5.53%
6.86%
3.50%
2011
Postretirement
Benefits
2010
5.09%
7.38%
N/A
5.62%
7.30%
N/A
2009
6.14%
7.24%
N/A
.For the U.S. qualified pension plans, the Companys assumption for the expected return on plan assets was 8.50% in 2011. The
Company is lowering the 2012 expected return on plan assets for its U.S. pension plan by 0.25 percentage points to 8.25%.
This will increase the 2012 expected pension expense by approximately $30 million
PENSION COST
The pension cost disclosure in the following exhibit details the individual components of pension
expense (U.S. and non-U.S.) and OPEB. The drivers of changes in pension cost include discount rates,
salary inflation rates, company contributions, actuarial changes, and the inherent smoothing
mechanisms in GAAP pension accounting (i.e., deferring some gains and losses). 3M reported 2011
U.S. pension and International pension expense of $251 million and $198 million, respectively. This is
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the amount of expense generally recorded in the income statement (allocated to cost of sales, SG&A,
and R&D) although some of the costs may be capitalized into inventory.
These amounts are non-cash and the only pension cash cost is the current years cash contribution to
the companys pension plan. The cash contribution amount is shown as an operating cash outflow on
the cash flow statement (pension expense, net of cash contributions are typically shown as one line item
in the operating section of the cash flow statement) and may be an inflow or outflow depending on if the
GAAP expense is higher or lower than the actual cash contribution. The amount may also be buried
within other operating cash flow.
3M Company (2011 Form 10-K): Pension & OPEB Cost ($ in millions)
Components of net periodic benefit cost and other amounts recognized in other comprehensive income
(Millions)
Net periodic benefit cost

(benefit)
Service cost
$
Interest cost
Expected return on plan
assets
Amortization of
transition (asset)
obligation
Amortization of prior
service cost (benefit)
Amortization of net
actuarial (gain) loss
(benefit)
$
Settlements, curtailments,
special termination
benefits and other
(benefit) after
settlements,
curtailments, special
termination benefits and
other
$
Qualified and Non-qualified

Pension Benefits
United States
International
2010
2009
2011
2010
2009
2011
206 $
626
201 $
638
2011
183 $ 124 $ 105 $ 98 $

619
241
235
261
(927)
(929)
(906)
(2)
11
13
16
(14)
334
221
99
116
250 $
144 $
11 $ 196 $ 149 $ 114 $
251 $
144 $
26
(289)
(278)
Postretirement
Benefits
2010
55 $
88
51
97
(77)
(83)
(86)
(4)
(4)
(72)
(94)
(81)
84
42
102
85
66
106 $
51 $
47
51 $
47
(22)
(260)
61 $
92
2009
25
37 $ 198 $ 127 $ 139 $
106 $
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FUNDED STATUS, PLAN ASSETS & LIABILITY ROLLFORWARDS

The next exhibit includes the two parts of the funded status for the pension & OPEB plans. It includes a
rollforward of 2011 activity and items impacting ending balances for each of the pension & OPEB plan
assets and liabilities.
At December 31, 2011, 3Ms fair market value of U.S. pension plan assets was $12.1 billion, while the
companys PBO (for its U.S. plan) was approximately $14.5 billion. Therefore, 3Ms U.S. pension plan
was underfunded by approximately $2.4 billion at December 31, 2011. Also, keep in mind that these
disclosures aggregate pension plans as most companies have multiple pension plans (salaried, union,
etc.).
The pension footnote rollforwards discloses the line-by-line changes in the pension & OPEB benefit
obligation and the fair market value of pension & OPEB plan assets. In 2011, the U.S. pension plans
PBO increased from $12.3 billion to $14.5 billion primarily due to $206 million of service cost, $626
million of interest cost, $2.0 billion actuarial loss (primarily due to a decline in discount rate), offset by
$680 million of benefit payments made. U.S. pension plan assets increased from $11.6 billion to $12.1
billion due to $972 million in actual market gains, $237 million in company contributions offset by $680
million of benefit payments made.
3M Company (2011 Form 10-K): Pension & OPEB Assets, Liabilities, Funded Status ($ in millions)
Following is a reconciliation of the beginning and ending balances of the benefit obligation and the fair value of plan assets as of
December 31:
Pension Benefits
United States
International
2011
2010
2011
2010
(Millions)
Change in benefit obligation

Benefit obligation at beginning of year
Acquisitions
Service cost
Interest cost
Participant contributions
Foreign exchange rate changes
Plan amendments
Actuarial (gain) loss
Medicare Part D Reimbursement
Benefit payments
Settlements, curtailments, special termination
benefits and other
Benefit obligation at end of year
Change in plan assets
Fair value of plan assets at beginning of year
Acquisitions
Actual return on plan assets
Company contributions
Participant contributions
Foreign exchange rate changes
Benefit payments
Settlements, curtailments, special termination
benefits and other
Fair value of plan assets at end of year
Funded status at end of year
$
$
$
$
Postretirement
Benefits
2011
2010
12,319 $
206
626
8
2,022
(680)
11,391 $
201
638
760
(668)
4,912 $
48
124
261
5
(84)
(31)
318
(221)
4,685 $
4
105
241
4
16
(75)
167
(194)
1,828 $
61
92
56
(9)
228
7
(155)
1,579
55
88
59
6
69
125
13
(166)
(2)
14,499 $
(3)
12,319 $
5,332
(41)
4,912 $
2,108
1,828
11,575 $
972
237
(680)
10,493 $
1,463
290
(668)
4,355 $
26
272
280
5
(74)
(221)
3,897 $
4
360
266
4
18
(194)
1,149 $
94
65
56
(155)
1,075
119
62
59
(166)
(2)
12,102 $
(2,397) $
(3)
11,575 $
(744) $
4,643 $
(689) $
4,355 $
(557) $
1,209 $
(899) $
1,149
(679)
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BALANCE SHEET LOCATION

Under FAS No. 158, the actual funded status of a companys pension (and OPEB) plan is recorded on
the companys balance sheet. However, the actual balance sheet location of the net pension
(under)/over-funded amount may differ among companies as shown in the next exhibit.
For example, at 2011 year-end, 3Ms approximately $2.4 billion underfunded U.S. pension plan is
recorded on the balance sheet primarily in non-current liabilities, but a small portion is also in current
liabilities.
3M Company (2011 Form 10-K): Pension & OPEB Funded Status Balance Sheet Location ($ in millions)
Pension Benefits
United States
International
2011
2010
2011
2010
(Millions)
Amounts recognized in the Consolidated

Balance Sheet as of Dec. 31,
Non-current assets
Accrued benefit cost
Current liabilities
Non-current liabilities
Ending balance
(41)
(2,356)
(2,397) $
(30)
(714)
(744) $
Postretirement
Benefits
2011
2010
74 $
(8)
(721)
(689) $
(7)
(624)
(557) $
40
(4)
(895)
(899) $
(4)
(675)
(679)
UNRECOGNIZED ACTUARIAL AMOUNTS

FAS No. 158 requires the pension plans economic funded status to be shown on the balance sheet, but
actuarial gains/losses are still smoothed into earnings over time. The cumulative unrecognized actuarial
gains/losses and unrecognized prior service cost are recorded in equity in AOCI.
As shown in the exhibit below, 3M had gross unrecognized U.S. pension actuarial losses of $5.6 billion
at 2011 year-end. These amounts will be recognized as pension expense in the future years based on a
complex amortization methods, known as the corridor approach. Prior service costs and credits will be
recognized on a straight line basis.
3M Company (2011 Form 10-K): Pension & OPEB Unrecognized Actuarial Losses ($ in millions)
Pension Benefits
United States
International
2011
2010
2011
2010
(Millions)
Amounts recognized in accumulated other

comprehensive income as of Dec. 31,
Net transition obligation (asset)
Net actuarial loss (gain)
Prior service cost (credit)
Ending balance
5,623
30
5,653
3,981
33
4,014
(8) $
1,858
(167)
1,683 $
(7) $
1,670
(144)
1,519 $
Postretirement
Benefits
2011
2010
$
1,171
(269)
902 $
1,063
(341)
722
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FUTURE RECOGNITION OF ACTUARIAL GAINS/LOSSES

Due to the overly complex corridor approach and smoothing of pension costs, actuarial gains and losses
are perhaps the most variable pension cost components on a year-to-year basis. Therefore, companies
are required to disclose the subsequent years expected recognition of net actuarial gains/losses
(currently held in AOCI as shown above). These amounts will be recognized into pension cost (income)
in the upcoming fiscal year. As shown below, 3M expects to recognize $470 million of actuarial losses
into pension cost for their U.S. plans in 2012.
3M Company (2011 Form 10-K): Pension & OPEB Expected Actuarial Gain/Loss Recognition ($ in millions)
Amounts expected to be amortized from accumulated other comprehensive income into net periodic benefit costs over next
fiscal year
Pension Benefits
United States
International
(Millions)
Amortization of transition (asset) obligation

Amortization of prior service cost (benefit)
Amortization of net actuarial (gain) loss
Total amortization expected over the next fiscal year
6
470
476
Postretirement
Benefits
(2) $
(17)
120
101 $
(72)
109
37
FUTURE BENEFIT PAYMENTS

Companies must disclose the upcoming future benefit payments to be paid to pension and OPEB plan
beneficiaries. As shown below, 3M expects to pay $730 million in benefit payments for its U.S. pension
plan. While these amounts typically are funded from pension trust assets for U.S. qualified plans, this
may not be the case for certain non-qualified, international pension, or OPEB plans (amounts may need
to be funded from operating cash flow).
3M Company (2011 Form 10-K): Pension & OPEB Future Benefit Payments ($ in millions)
Future Pension and Postretirement Benefit Payments
The following table provides the estimated pension and postretirement benefit payments that are payable from the plans to
participants, and also provides the Medicare subsidy receipts expected to be received.

Pension Benefits
United States
International
(Millions)
2012 Benefit Payments

Following five years
730
752
774
796
818
4,407
216
219
233
245
257
1,500
Medicare
Subsidy
Receipts
Postretirement
Benefits
112
122
135
137
152
771
10
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PLAN ASSET DISCLOSURES

The next exhibit includes the allocation of U.S. pension plan assets at 2011 year-end for 3M Company.
For its U.S. pension plans, 3M invested $3.3B (28%) of its assets in equities, $4.0B (33%) in fixedincome securities, and $4.7B (39%) in alternative assets. commodities and cash.
In reviewing the disclosures, it is helpful to ascertain where the companys target allocation is and if it
has changed (e.g. due to reduction of risk tolerance, more liability matching, etc.). Also, it is important to
look at these asset allocations in conjunction with the companys expected return on asset assumption
to assess their reasonableness.
3M disclosed the following regarding its asset allocation and expected return on plan assets:
For the U.S. qualified pension plans, the Companys assumption for the expected return on plan assets
was 8.50% in 2011. The Company is lowering the 2012 expected return on plan assets for its U.S.
pension plan by 0.25 percentage points to 8.25%. This will increase the 2012 expected pension expense
by approximately $30 million. Projected returns are based primarily on broad, publicly traded equity and
fixed-income indices and forward-looking estimates of active portfolio and investment management. As
of December 31, 2011, the Companys 2012 expected long-term rate of return on U.S. plan assets is
based on an asset allocation assumption of 37% global equities, with an expected long-term rate of
return of 7.75%; 16% private equities, with an expected long-term rate of return of 11.75%; 26% fixedincome securities, with an expected long-term rate of return of 4.23%; 16% absolute return investments
independent of traditional performance benchmarks, with an expected long term return of 6.0%; and 5%
commodities, with an expected long-term rate of return of 6.0%. The Company expects additional
positive return from active investment management. These assumptions result in an 8.25% expected
rate of return on an annualized basis in 2012.
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3M Company (2011 Form 10-K): U.S. Pension Asset Allocation ($ in millions)

The fair values of the assets held by the U.S. pension plans by asset class are as follows:
(Millions)
Asset Class
Equities
U.S. equities
Non-U.S. equities
Derivatives
EAFE index funds
Index funds
Long/short equity
Total Equities
Fixed Income
U.S. government
securities
Non-U.S.
government
securities
Preferred and
convertible
securities
U.S. corporate bonds
Non-U.S. corporate
bonds
Asset backed
securities
Collateralized
mortgage
obligations
Private placements
Derivative
instruments
Other
Total Fixed Income
Private Equity
Buyouts
Distressed debt
Growth equity
Mezzanine
Real estate
Secondary
Other
Venture capital
Total Private Equity
Absolute Return
Hedge funds and
hedge fund of
funds
Bank loan and other
fixed income
funds
Total Absolute Return
Commodities
Cash and Cash
Equivalents
Total
Level 1
2011
1,186
1,095
2,281
776
Fair Value Measurements Using Inputs Considered as

Level 2
2010
2011
2010
2011
1,190
1,244
2,434
684
253
942
14 $
1
(3)
476
128
616 $
562
869
473
2010
1
436
442
7$
499
506 $
1,205 $
1,096
(3)
476
129
436
3,339 $
1,202
1,244
684
253
499
3,882
1,645 $
1,035
314
289
314
289
20
28
168
168
1,049
874
1,222
1,042
244
205
244
205
23
16
23
16
137
125
31
135
69
144
137
194
31
279
74
144 $
202
24
4,014 $
(55)
34
2,904
618 $
333
28
90
148
181
665
2,063 $
613
376
23
93
159
165
67
583
2,079
950
$
$
(2)
748 $
$
$
$
$
$
295
3,527
Fair Value at
Dec 31,
2011
2010
Level 3
200
24
2,990
$
$
1,235
$
$
$
$
35
3,221
(53)
34
2,012 $
$
1,142
$
$
1,235
435
$
$
600
5,876
$
$
618
333
27
90
148
181
665
2,062
613 $
376
19
93
159
165
67
583
2,075 $
88
59 $
1,323 $
1,201
$
$
1,142
338
$
$
432
520
105
$
$
564
623 $
111 $
432
1,755 $
540 $
564
1,765
449
$
$
609
5,043
$
$
3,203
$
$
$
644
895 $
3,459 $ 12,606 $ 11,723
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MARKTOMARKETPENSIONACCOUNTING
Recently, several companies have voluntarily adopted pension accounting changes and switched to a
policy of marking their pension assets and liabilities to market at year-end. This improved their 2011
EPS by reducing their pension expense for amortization of stock market losses and discount rate
changes. Under this new policy, the companies record a fourth quarter expense or gain (depending on
direction of the markets) in earnings.
Since this amount is likely to be both unpredictable and large, most financial analysts chose to exclude it
from normalized earnings creating the illusion that the losses never occurred. However, we view them
as real economic losses since they will require a cash outlay absent a market recovery. Under their prior
pension accounting policies, the companies recognized pension plan gains or losses in earnings over a
number of years under complicated GAAP "smoothing" rules as is common for the overwhelming
majority of companies.
Companies that have adopted some form of mark to market pension accounting include:
UPS, AT&T, Verizon, Honeywell, Ashland, IHS, Graftech International
Other companies that have not formally adopted a change in accounting policy, but we note these
companies either report some form of adjusted earnings measure that excludes certain pension & OPEB
costs:
GE reports operating EPS and only includes pension service cost in EPS. The company excludes
non-operating retirement related costs from operating earnings.
IBM reports operating and non-operating results that only include pension service cost in
operating earnings. Other items are included in non-operating income.
Other companies that add-back pension cost to adjusted earnings: Brinks, NCR, UIS, JCP.
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UNFUNDEDMULTIEMPLOYERPENSIONPLANS
Some companies participate in multi-employer pension plans, but they are most popular amongst
grocery stores and transportation companies. Companies account for these multi-employer pension
plans under a pay-as-you-go system and only expense the annual contribution amounts through
earnings and cash flow.
A company's true liability from participating in a multi-employer pension plan has always been shrouded
in secrecy, with underfunded amounts largely unknown. Further, while a typical defined benefit pension
plans unfunded liability is disclosed and on the balance sheet, an unfunded multi-employer pension plan
is neither.
As a first step in addressing this significant shortcoming, in the Fall of 2011, FASB issued ASU 2011-09
requiring new disclosures for companies with multi-employer pension plans in 2011 10-K footnotes.
Current disclosures typically lack meaningful information other than recent years contributions. The new
disclosures are meant to be both quantitative and qualitative in nature. No changes were required to the
recognition and measurement of multi-employer pension plans (no balance sheet liability, remains to be
expensed on a pay-as-you-go basis). Disclosures for each significant multi-employer plan are required
in a tabular format if possible to include the following:
1) Name and identifying EIN number;
2) Level of employers participation (whether the employers contribution represents >5% of total
contributions to the plan);
3) Financial health of the plan based on the risk zone as indicated by the Pension Protection Act;
any funding improvement plans pending or implemented; any surcharges imposed; and
4) Expiration date and information about the collective bargaining agreements underlying the
required contributions to the plans.
Using the EIN number, investors may view the source document Form 5500 IRS pension plan filing for
more information on the pension plan (filed on a delayed basis at www.freeerisa.com).
Importantly, certain information about plan withdrawal liabilities will still not be required. This information
may prove useful when analyzing companies with multiemployer pension plans, if attainable by
voluntary disclosure, company inquiry, or otherwise. Below and on the next page are the new 10-K
disclosures for Safeway.
Multi-Employer Plan 10-K Disclosures - Safeway ($ in millions)
2011
United States plans
Canadian plans
262.7
49.5
2010
$
245.4
46.9
2009
$
236.8
41.3
$
312.2 $
Total
292.3 $
278.1
Additionally, the Company has incurred a partial withdrawal from the United Food and Commercial Workers Unions
and Employers Midwest Pension Plan to which it contributes on behalf of Dominick's. During 2011, the Company
expensed the withdrawal liability assessment of $6.6 million and began paying monthly installments of $0.3 million in
September 2011.
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Multi-Employer Plan 10-K Disclosures Safeway ($ in millions) (continued)

The following two tables contain information about Safeway's U.S. multiemployer pension plans.
Pension Protection Act zone

status
Safeway 5% of total plan

contributions
2011
2010
2010
2009
FIP/RP status
pending/implemente
d
Red
Red
Yes
Yes
Implemented
916145047 001
Green
Green
No
No
No
Southern California United Food & Commercial

Workers Unions and Food Employers Joint
Pension Plan
951939092 001
Red
3/31/2012
Red
3/31/2011
Yes
3/31/2010
Yes
3/31/2009
Implemented
Food Employers Labor Relations Association and

United Food and Commercial Workers
Pension Fund
526128473 001
Red
Red
Yes
Yes
Implemented
United Food and Commercial Workers Unions

and Employers Midwest Pension Plan
366508328 001
Red
11/30/2011
Red
11/30/2010
Yes
11/30/2010
Yes
11/30/2009
Implemented
Bakery and Confectionery Union and Industry

International Pension Fund
526118572 001
Green
Green
Yes
Yes
No
Rocky Mountain UFCW Unions & Employers

Pension Plan
846045986 001
Green
Red
Yes
Yes
No
Sound Retirement Trust (formerly Retail Clerks

Pension Trust)
916069306 001
Red
9/30/2011
Green
9/30/2010
Yes
9/30/2010
Yes
9/30/2009
Implemented
Desert States Employers & UFCW Unions

Pension Plan
846277982 001
Green
Yellow
Yes
Yes
No
Denver Area Meat Cutters and Employers

Pension Plan
846097461 001
Green
Red
Yes
Yes
No
Oregon Retail Employees Pension Trust
936074377 001
Red
Red
Yes
Yes
Implemented
Chicago Area I.B.of T. Pension Plan
362407063 001
Green
1/31/2012
Green
1/31/2011
Yes
1/31/2011
Yes
1/31/2010
No
Pension fund
UFCW-Northern California Employers Joint
Pension Trust Fund
EIN - PN
946313554 001
Western Conference of Teamsters Pension Plan
Total Safeway
contributions to U.S.
multiemployer pension
plans
$ 262.7
$ 245.4
$ 236.8
Atthedatethefinancialstatementswereissued,Forms5500weregenerallynotavailablefortheplanyearsendingin2011.Additionally,
for the plan year ending January 31, 2009, Safeway contributed more than 5% of the total contributions to the Chicago Area I.B. of T.
PensionPlan.
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. Note: Above disclosure is excerpt of entire multiemployer plan table in the 10-K.
Throughout the remaining pension section, we present our answers to the most common pension
questions received.
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PENSIONQ&A
In this section, we discuss commonly received questions on pensions.
How Does Pension Underfunding Affect a Companys Balance Sheet?
GAAP requires companies to mark their pension plan assets and liabilities to market at year-end and
true-up the respective balance sheet asset or liability. The actual over or under funded amount of the
pension plan is shown on the balance sheet either as a long term asset (if over-funded) or a liability (if
under-funded). Since almost all companies ended 2010 with a pension liability, at 2011 year-end,
companies recorded an increase in the pension liability on the balance sheet with a corresponding
charge to equity (net of a deferred tax asset).
For example, assume Company Alpha reported a $100 pension liability at 2010 year-end. Poor market
returns and a decline in Aa corporate bond rates results in a $120 pension liability at 2011 year-end
when assets and liabilities are marked to market. At 2011 year-end, the balance sheet is adjusted by
recording a $20 increase in the pension liability with a corresponding charge to equity for $12 ($20 x [1.40 assumed tax rate). A deferred tax asset for $8 ($20 x 40% assumed tax rate) is recorded and will
unwind as an actual tax deduction and cash tax savings when the company actually makes the $20
pension contribution.
Are Stock Contributions Allowed to a Pension Plan?
Yes, stock contributions are allowed, but cannot exceed 10% of the value of the total pension plan
assets. Generally, we've observed that if pension plan stock contributions are made, the pension plan
will sell down the stock over time.
United Technologies (2011 Form 10-K): Company Stock Pension Contributions
Thefundedstatusofourdefinedbenefitpensionplansisdependentuponmanyfactors,includingreturnsoninvestedassetsandthelevel
ofmarketinterestrates.Wecancontributecashorcompanystocktoourplansatourdiscretion,subjecttoapplicableregulations.Total
cash contributions to our global defined benefit pension plans were $551 million and $1.3 billion during 2011 and 2010, respectively.
During 2011 and 2010, we also contributed $450 million and $250 million, respectively, in UTC common stock to our defined benefit
pension plans. As of December 31, 2011, the total investment by the domestic defined benefit pension plans in our securities was
approximately 5% of total plan assets. We expect to make contributions of approximately $100 million to our foreign defined benefit
pension plans in 2012. Although our domestic defined benefit pension plans are approximately 87% funded on a projected benefit
obligationbasisandwearenotrequiredtomakeadditionalcontributionsthroughtheendof2012,wemayelecttomakediscretionary
contributions in 2012. Contributions to our global defined benefit pension plans in 2012 are expected to meet or exceed the current
fundingrequirements.
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USG Corp. (2011 Form 10-K): Company Stock Pension Contributions

During2011,wemadecontributionstoourpensionplansthatincluded2,084,781sharesofourcommonstock,ortheContributedShares.
TheContributedShareswerecontributedtotheUSGCorporationRetirementPlanTrust,orTrust,andwererecordedontheconsolidated
balancesheetattheJune 20,2011closingpriceof$14.84 pershare, orapproximately $30.9 millionin theaggregate. TheContributed
Shares are not reflected on the consolidated statement of cash flows because they were treated as a noncash financing activity. The
ContributedShareswerevaluedforpurposesofcreditingthecontributiontotheTrustatadiscountedvalueof$14.39pershare($14.84
lessa3%discount),orapproximately$30.0millionintheaggregate,byanindependentappraiserretainedbyEvercoreTrustCompany,
N.A.,orEvercore,anindependentfiduciarythathasbeenappointedasinvestmentmanagerwithrespecttotheContributedShares.The
ContributedSharesareregisteredforresale,andEvercorehasauthoritytosellsomeorallofthem,aswellasotherofoursharesinthe
Trust,initsdiscretionasfiduciary.AsofDecember31,2011,theTrustheld4,658,254sharesofourcommonstockwithanaggregatefair
valueof$47.3millionbasedonaclosingpriceof$10.16pershareonthatdate.During2011,wealsocontributed$10millionincashto
theTrustand$14millionincashtoourpensionplaninCanada.
What is the Cash Cost of a Pension Plan?

The pension expense amount recognized on the income statement is non-cash and calculated under the
GAAP rules. The current year cash cost of pensions is the actual amount of cash contributed to the
companys pension trust(s). The GAAP and the cash contribution number are calculated under a
different set of rules and often are materially different.
Is There an Earnings Benefit (or Carry) from Contributing Cash to the Pension Plan?
In todays low interest rate environment, contributing money to a pension plan generally provides a noncash EPS benefit as there is a significant positive carry between the interest rate at which the cash
balance is earning (or debt interest rate paid) and the return at which the contributed cash is assumed to
earn in the pension plan (8% median rate expected pension plan rate of return for S&P 500 companies).
If a company contributes to its pension plan, the contribution amount is assumed to earn the companys
pension plan expected rate of return. The pre-tax income impact is equal to the pension contribution
amount multiplied by the expected pension plan rate of return less the cost of funds/foregone interest
income.
Do Funding Relief Measures Exist?
In June 2010, the Pension Relief Act (the Act) was signed into law (H.R. 3962). The change allowed
companies an election to fund their U.S. pension plans based on either a 2+7 year schedule or 15 year
ratable funding. Under the 2+7 option, companies only fund interest cost during the first two years
(discount rate x the pension shortfall amount) and then, beginning in year 3, fund the shortfall amount
ratably over the next 7 years. Under the 15 year amortization funding option, companies fund ratably
over 15 years rather than the required 7 years. Funding relief was available for two of the four plan years
between 2008 and 2011.
Based on reviewing company disclosures and discussions with contacts, it appears that most
companies did not elect funding relief as there were strings attached to it. The Act increased the
required pension contribution amounts (up from the lower funding relief calculated amount) if there were
extraordinary dividends, buybacks or excessive employee compensation. In this respect, additional
matching contributions were required insofar as (i) any employees taxable compensation is greater than
$1 million and (ii) any extraordinary dividends plus stock buybacks exceed company EBITDA. Such
dividends were defined as amounts greater than the previous 5 years. These limitations apply during the
first 5 years if a company elected 15 year funding and during the first 3 years if 2+7 funding relief was
elected.
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After 2011 and assuming a funding relief election was made, any new incremental pension underfunding
amounts revert back to a 7 year ratable funding schedule. However, pension losses occurring during the
periods in which funding relief was elected (max. 2 out of 4 years from 2008-2011) are still subject to the
longer funding schedule (in effect, there are tranches for each year). Among those few companies
availing themselves of funding relief, we have heard that 15 year funding relief is the more common
option elected by companies as it provides more optionality to smooth out market returns over a longer
period of time.
Will Companies Change their Expected Rate of Return Assumption?
The current 8% median pension plan expected rate of return assumption is too high considering the
current overall pension plan asset mix is 53% stocks, 37% bonds, 9% other, and 1% real estate. Absent
a more immediate push by the regulatory bodies, we believe companies will decrease the return
assumption in decrements over a number of years to mitigate the possible EPS headwind. As a point of
reference, between 2001 and 2006 the median expected rate of return assumption declined from 9% to
8%.
Primer on the Regulatory U.S. Pension Funding Rules
The regulatory pension funding rules are promulgated by the Pension Protection Act of 2006 and
originally promulgated under ERISA rules. The rules have changed several times over the past 20 years
which only adds to their complexity. The rules are complex and materially different than the GAAP rules,
so companies will value their pension plans under two different calculations. Invariably, a third-party
actuary calculates a companys pension liability and asset amounts under the rules based on detailed
company data. Most defined benefit pension plans are so-called qualified plans and, therefore, subject
to regulatory funding requirements. A company may also have a non-qualified pension plan. These
plans are not subject to the regulatory pension funding rules (plans are often called a SERP or
supplemental executive retirement plan).
Under the ERISA rules, the pension assets and liabilities are valued on the first day of each plan year
(GAAP values on the last day of the year). Therefore, for a calendar year-end company, 1/1/12 was the
most recent pension valuation date. For plan assets, a company either uses the actual fair market value
of plan assets on the valuation date or a 24 month smoothed asset value (used by most companies to
mitigate year-to-year asset volatility) and switching methods is not allowed unless IRS approval is
obtained (very difficult to do). If a smoothed asset value is used, it is calculated based on the trailing 24
months average pension assets value adjusted for an assumed expected return. This smoothed value
may not be less than 90% or greater than 110% of the pension plans actual fair market value. The
pension liability is calculated as the present value of all pension benefits earned or accrued as of the
pension plans valuation date and is calculated by an actuary. It is most comparable to the accumulated
benefit obligation (ABO) under the GAAP rules.
Companies are allowed to use one of two discount rate options in calculating the pension liability: (1)
three segment 24 month trailing average Aaa-A corporate bond yield curve as listed monthly in the IRS
Internal Revenue Bulletin (www.irs.gov/irb) or (2) a spot corporate Aaa-A yield curve based on the
average of the daily corporate bond rates for the prior month (the rate used for a January 1st pension
valuation date is the average daily Aaa-A corporate bond for December). The IRS publishes this rate
monthly at the beginning of the month and our experience is that it approximates the average daily ML
Aaa-A yield curve for the month. Similar to the asset smoothing option, companies are not allowed to
move back and forth between the more favorable discount rate without IRS approval (very difficult to
obtain). As an added twist, if a company uses the 24 month trailing average Aaa-A corporate rate, it may
use the rate for the month in which the pension plan valuation is completed (January 2011) or any of the
four proceeding months (September 2010, October 2010, November 2010 or December 2010).
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However, once a certain month is elected to be used, it may not be changed in a subsequent year (e.g.,
once November, always November).
The company then calculates if the pension plan is underfunded based on the difference between the
pension plan assets and liabilities. The shortfall amount, if any, must be ratably funded over 7 years
(unless pension funding relief was elected for the 2008-2011 pension plan years as discussed
previously in pension Q&A). The annual minimum required pension contribution amount consists of:
1. Service cost: net present value of pension benefits that were accrued by employees in the current
year (very similar to the GAAP service cost); and,
2. Seven year ratable funding of the pension plans underfunded amount (pension assets pension
liabilities).
Until 2011, companies were required to only fund up to a certain percentage based on an upward sliding
scale (in 2010: 96% - lower underfunded amount (if any) over 7 years). However, for 2011 pension plan
years, the entire difference between the pension assets and liabilities must be funded ratably over 7
years. Importantly, the pension funding amounts are trued-up each year. For example, if the pension
plan is underfunded in one year and favorable market returns eliminate the underfunding in a
subsequent year, no contributions would be required in the subsequent year.
Another complicating factor in assessing minimum required pension contributions is the existence of
credit balances, which are not generally disclosed in the GAAP financial statements. A company may
have accumulated credit balances in prior years from pension contributions in excess of the minimum
required amount. Companies are allowed to use these credits to reduce their minimum pension plan
contributions. However, credits are not allowed to be used if the pension funding percentage for the prior
plan year is below 80% (1/1/11 for the 1/1/12 pension valuation). Further, in calculating the current
funding ratio (assets divided by liabilities), credit balances created after the Pension Protection Act was
enacted are subtracted from pension assets. In turn, the pension liability is divided into this adjusted
pension asset amount to calculate the current funded ratio.
Required pension contributions are due by 8.5 months after the pension plan year-end. To illustrate, the
next required pension valuation date for calendar year-end companies was January 1, 2012 since
pensions are valued on the first day of each pension plan year. Using the 8.5 months after plan year-end
timeline, the mandatory pension plan contributions are not due until September 15, 2013. However, the
pension rules require quarterly contributions if a pension plan was not at least 100% funded in the
previous year (1/1/11 in our example and the majority of pension plans were underfunded on this date)
and such amounts are due on 4/15, 7/15, 10/15 and the following 1/15 (for non-calendar year-end
companies such amounts are due on the 15th of the fourth, seventh and tenth months and the 15th day
after year-end). The required quarterly contribution amounts are calculated based on the lower of: (1)
90% of the current years minimum pension contribution or (2) 100% of the prior years minimum
pension contribution amount.
At Risk Rules
Higher contributions will be required if a pension plan is considered at-risk. A pension plan is
considered at-risk if its funded ratio using a one-year lookback (e.g. 1/1/2011 for the valuation date that
took place on 1/1/2012) was less than 80%. An at-risk plan must calculate its funded ratio using the
following formula, which essentially nullifies the potential use of credit balances that would otherwise be
available to reduce required contributions:
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1/1/2012 Market value of assets (smoothed or actual FMV)

- 1/1/08 existing credit balance
- Post 12/31/07 credit balance
= Adjusted market value of pension assets
/ 1/1/2012 Pension liability (what the PPA terms funding target)
= Pension funded ratio under at-risk rules
Further, if the pension plan was less than 70% funded using the one year lookback period (e.g. as of
1/1/2011), then the current year pension regulatory liability will be calculated differently. The plan will
have to use more stringent actuarial assumptions that will essentially calculate the liability based upon
the maximum potential benefits that could be paid out (e.g. using lump sum payments vs. annuity). If the
current year funded ratio is less than 70%, using this newly calculated pension regulatory liability, then
this will be the funding ratio used to calculate the minimum required contribution.
Benefit Restriction Thresholds
Two important pension funding percentage thresholds are 60% and 80%. If a company falls under these
thresholds, various benefit restrictions are imposed and, therefore, some companies with active pension
plans will endeavor to maintain an at least 80% funded pension plan (based on regulatory rules).
Funded Ratio < 60%
Using the previously discussed at-risk rules, plans with a funded ratio less than 60% will have certain
restrictions enforced. For example, benefits may be required to be frozen (no new benefit accruals) and
payments must be made in annuity form as opposed to lump sum payouts. In order to avoid these
restrictions, companies may choose to waive their credit balance amount if this action would increase
the funding level back to at least 60%. Alternatively, a company may accept the pension plan
restrictions, keep the credit balance, and use it to offset part (or all) of the minimum contribution amount.
We believe many companies would endeavor to keep their plans at least 60% funded under the at-risk
rules to avoid benefit restrictions unless the company itself is in a distressed scenario.
One important note to keep in mind the 60% funded ratio restrictions at 1/1/2009 and 1/1/2010 were
temporarily relaxed to look back to a time period when plans were much better funded under the
Worker, Retiree and Employer Recovery Act of 2008 (HR 7327) and the Pension Relief Act,
respectively. However, the rules came back into effect for the 1/1/2011 plan valuation date.
Funded Ratio: 60% to <80%
There are several restrictions placed on a companys pension plan if its 60% or more funded, but less
than 80% funded as calculated under the at-risk rules. If a companys pension plan is still open to
employees, these restrictions may become an HR issue and, therefore, the company may choose to
incrementally and voluntarily fund its pension plan to meet the 80% funding threshold. The restrictions
are as follows:
1. Company is required to file Form 4010. This form notifies pension plan participants of the current
funded status of the pension plan,
2. There are no benefit increases allowed unless this amount is immediately fully funded (an issue
since some union contracts require annual benefit increases),
3. Lump sum benefit payments are limited to 50% of an employees accrued pension benefit (most
employees are given an option for a 100% lump sum distribution or an annuity when retiring or
leaving the company).
Assuming a pension valuation date on 1/1/12, the voluntarily contributions required to reach an 80%
funding level would need to be made by 9/15/13.
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OtherDisclosures
andAuditOpinions
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MARKETRISKDISCLOSURES
This footnote identifies companies that experienced material changes in market risk exposures and
derivatives. The market risk disclosure section must be disclosed by companies annually and include
both quantitative and qualitative information about the market risks impacting them.
Typical items included in the market risk disclosure section are interest rate risk, equity price risk,
commodity price risk, and foreign currency exchange rate risk. All of a companys financial instrument
market risks are categorized into (1) instruments entered into for trading purposes and (2) instruments
entered into for purposes other than trading. The quantitative and qualitative information mentioned
above must be provided for each of these two categories.
Within the qualitative section of a companys market risk footnote, management must disclose at least
the following few items:
1. The companys primary market risk exposures;
2. The manner in which market risk exposures are managed; and
3. How the primary market risk exposures are managed compared to the prior year and whether
there were any changes in these exposures.
Under the SECs disclosure rules, a companys quantitative disclosure for these exposures may be
presented in one of following three formats:
1. A tabular presentation of instruments sensitive to market risks grouped by similar risk
characteristics. The information included in this table should include the fair market values,
contract terms, and expected maturity dates for each of the exposures, allowing investors to
determine the exposures next five years of expected cash flows.
2. A sensitivity table that quantifies potential losses in earnings, cash flows, and fair values from one
or more hypothetical changes in interest rates, commodity prices, exchange rates, and/or other
market prices over a selected time period. The different categories and market risk exposures
may have varying magnitudes of hypothetical rate changes. Management is required to provide a
description of the model, the assumptions used in the sensitivity analysis, and some parameters
to help the investors understand the disclosure.
3. Potential losses in future earnings, cash flows, or fair values may be disclosed using a value at
risk methodology over a selected time period. Probabilities of occurrence from changes in items
such as interest rates, commodity prices, and/or exchange rates must also be disclosed. For
each value at risk disclosure category, companies must include at least one of following three
additional disclosures:
a. The average, high, and low amounts or distribution of value at risk amounts for the reporting
period;
b. The average, high, and low amounts or the distribution of actual change in earnings, cash
flow, or fair value from the market risk sensitive instruments that occurred over the reporting
period; or
c. The number of times or percentage of actual changes in earnings, cash flows, or fair value
from the market risk sensitive instruments exceed the value at risk amounts during the
reporting period.
Given a material disclosure alternative is changed, management must provide the (1) reason(s) for the
change and (2) comparable information for either new disclosure methodology or the current year
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disclosure under the prior years methodology. In the following exhibit, we present Hewlett-Packards
quantitative market risk section.
Hewlett-Packard (2011 Form 10-K): Quantitative Market Risk Disclosure
ITEM7A.QuantitativeandQualitativeDisclosuresAboutMarketRisk.
In the normal course of business, we are exposed to foreign currency exchange rate, interest rate and equity price risks that could
impactourfinancialpositionandresultsofoperations.Ourriskmanagementstrategywithrespecttothesethreemarketrisksmayinclude
theuseofderivativefinancialinstruments.WeusederivativecontractsonlytomanageexistingunderlyingexposuresofHP.Accordingly,
wedonotusederivativecontractsforspeculativepurposes.Ourrisks,riskmanagementstrategyandasensitivityanalysisestimatingthe
effectsofchangesinfairvaluesforeachoftheseexposuresareoutlinedbelow.
Actualgainsandlossesinthefuturemaydiffermateriallyfromthesensitivityanalysesbasedonchangesinthetimingandamountof
interestrate,foreigncurrencyexchangerateandequitypricemovementsandouractualexposuresandhedges.
Foreigncurrencyexchangeraterisk
Weareexposedtoforeigncurrencyexchangerateriskinherentinoursalescommitments,anticipatedsales,anticipatedpurchasesand
assets, liabilities and debt denominated in currencies other than the U.S. dollar. We transact business in approximately 76 currencies
worldwide, of which the most significant foreign currencies to our operations for fiscal 2011 were the euro, the Japanese yen, Chinese
yuan renminbi and the British pound. For most currencies, we are a net receiver of the foreign currency and therefore benefit from a
weakerU.S.dollarandareadverselyaffectedbyastrongerU.S.dollarrelativetotheforeigncurrency.Evenwhereweareanetreceiver,a
weaker U.S. dollar may adversely affect certain expense figures taken alone. We use a combination of forward contracts and options
designatedascashflowhedgestoprotectagainsttheforeigncurrencyexchangeraterisksinherentinourforecastednetrevenueand,to
alesserextent,costofsalesandintercompanyleaseloandenominatedincurrenciesotherthantheU.S.dollar.Inaddition,whendebtis
denominatedinaforeigncurrency,wemayuseswapstoexchangetheforeigncurrencyprincipalandinterestobligationsforU.S.dollar
denominated amounts to manage the exposure to changes in foreign currency exchange rates. We also use other derivatives not
designatedashedginginstrumentsconsistingprimarilyofforwardcontractstohedgeforeigncurrencybalancesheetexposures.Forthese
typesofderivativesandhedgeswerecognizethegainsandlossesontheseforeigncurrencyforwardcontractsinthesameperiodasthe
remeasurementlossesandgainsoftherelatedforeigncurrencydenominatedexposures.Alternatively,wemaychoosenottohedgethe
foreigncurrencyriskassociatedwithourforeigncurrencyexposures,primarilyifsuchexposureactsasanaturalforeigncurrencyhedge
forotheroffsettingamountsdenominatedinthesamecurrencyorthecurrencyisdifficultortooexpensivetohedge.
WehaveperformedsensitivityanalysesasofOctober31,2011and2010,usingamodelingtechniquethatmeasuresthechangeinthe
fairvaluesarisingfromahypothetical10%adversemovementinthelevelsofforeigncurrencyexchangeratesrelativetotheU.S.dollar,
with all other variables held constant. The analyses cover all of our foreign currency contracts offset by the underlying exposures. The
foreign currency exchange rates we used were based on market rates in effect at October 31, 2011 and 2010. The sensitivity analyses
indicatedthatahypothetical10%adversemovementinforeigncurrencyexchangerateswouldresultinaforeignexchangelossof$96
millionand$122millionatOctober31,2011andOctober31,2010,respectively.
Interestraterisk
Wealsoareexposedtointerestrateriskrelatedtoourdebtandinvestmentportfoliosandfinancingreceivables.Weissuelongterm
debtineitherU.S.dollarsorforeigncurrenciesbasedonmarketconditionsatthetimeoffinancing.Wethentypicallyuseinterestrate
and/or currency swaps to modify the market risk exposures in connection with the debt to achieve primarily U.S. dollar LIBORbased
floatinginterestexpense.Theswaptransactionsgenerallyinvolvetheexchangeoffixedforfloatinginterestpayments.However,wemay
choosenottoswapfixedforfloatinginterestpaymentsormayterminateapreviouslyexecutedswapifwebelievealargerproportionof
fixedrate debt would be beneficial. In order to hedge the fair value of certain fixedrate investments, we may enter into interest rate
swapsthatconvertfixedinterestreturnsintovariableinterestreturns.WemayusecashflowhedgestohedgethevariabilityofLIBOR
basedinterestincomereceivedoncertainvariablerateinvestments.Wemayalsoenterintointerestrateswapsthatconvertvariablerate
interestreturnsintofixedrateinterestreturns.
WehaveperformedsensitivityanalysesasofOctober31,2011and2010,usingamodelingtechniquethatmeasuresthechangeinthe
fairvaluesarisingfromahypothetical10%adversemovementinthelevelsofinterestratesacrosstheentireyieldcurve,withallother
variablesheldconstant.Theanalysescoverourdebt,investmentinstruments,financingreceivablesandinterestrateswaps.Theanalyses
useactualorapproximatematuritiesforthedebt,investments,interestrateswapsandfinancingreceivables.Thediscountratesweused
werebasedonthemarketinterestratesineffectatOctober31,2011and2010.Thesensitivityanalysesindicatedthatahypothetical10%
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adversemovementininterestrateswouldresultinalossinthefairvaluesofourdebt,investmentinstrumentsandfinancingreceivables,
netofinterestrateswappositions,of$145millionatOctober31,2011and$28millionatOctober31,2010.
Equitypricerisk
Wearealsoexposedtoequitypriceriskinherentinourportfolioofpubliclytradedequitysecurities,whichhadanestimatedfairvalue
of$117millionatOctober31,2011and$9millionatOctober31,2010.Wemonitorourequityinvestmentsforimpairmentonaperiodic
basis. Generally, we do not attempt to reduce or eliminate our market exposure on these equity securities. However, we may use
derivativetransactionstohedgecertainpositionsfromtimetotime.Wedonotpurchaseourequitysecuritieswiththeintenttousethem
forspeculativepurposes.Ahypothetical30%adversechangeinthestockpricesofourpubliclytradedequitysecuritieswouldresultina
loss in the fair values of our marketable equity securities of approximately $35 million and $3 million at October 31, 2011 and 2010,
respectively.Theaggregatecostofinvestmentsinprivatelyheldcompanies,andotherinvestmentswas$57millionatOctober31,2011
and$163millionatOctober31,2010.
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HEDGINGANDDERIVATIVEDISCLOSURES
Hedge accounting and interpreting the related derivative disclosures is one of the most complex areas of
accounting. At a high level, the accounting is straightforward record derivatives on the balance sheet
at fair market value. In turn, the changes in fair value each period must be reflected either in earnings or
equity and this is where the accounting guidance becomes complicated and is a function of the
instrument and the related risk it hedges.
Under GAAP, three types of hedges qualify for special accounting treatment:
1. Foreign currency hedge of a net investment: This is when a derivative is used to hedge the
foreign exchange risk in the net assets (book equity) held in a foreign subsidiary in a foreign
currency.
2. Fair value hedge: This is when a company uses derivatives to hedge changes in the fair value of
a balance sheet asset/liability or unrecognized firm commitment. As an example, a company
enters into an interest rate derivative to hedge the fair value of fixed rate debt.
3. Cash flow hedge: This is when a derivative is used to hedge the cash flows of a specific balance
sheet risk (derivative used to hedge interest expense on floating rate debt) or a forecasted
transaction (foreign sales and A/R).
We find that some companies utilize foreign currency derivatives as a means to hedge exchange rate
risk on sales, gross margin, or SG&A, among other items. This type of transaction is usually classified
as a cash flow hedge under GAAP. Under a cash flow hedge, the unrealized gains/losses are recorded
in equity in other accumulated comprehensive income (AOCI) until the forecasted transaction occurs. In
the period when the transaction actually occurs (e.g., revenue is recognized along with accounts
receivable), the derivative unrealized gain or loss held in AOCI is transferred out of AOCI and into the
income statement. It is classified in the income statement in the same line item as the risk that it is
hedging (e.g., as an addition or subtraction to revenue).
To illustrate, a company hedges its foreign subsidiarys cost of goods sold. During the period in which
the derivative is outstanding, but before the sale transaction occurs, the unrealized losses are assumed
to be $1,000 and, accordingly, recorded in AOCI in equity for $1,000. Next, the sale occurs. If the
company is perfectly hedged, the unrealized losses on the cash flow hedge are transferred from AOCI in
equity and used to offset the natural foreign exchange gain reported in cost of sales. Therefore, the net
foreign exchange impact on cost of sales is $0.
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In the next exhibit, we summarize and describe the different types of hedges under GAAP.
Description of the Different Types of Hedges Based on FAS No. 133
TYPEOFHEDGE
FairValueHedge
DESCRIPTION
Hedging an exposure to changes in the fair
value of a balance sheet asset or liability or an
unrecognized firm commitment attributable to
a particular risk. The derivative's FMV is
recordedasanassetorliability.
GAIN/LOSSRECOGNITION
Derivativegain/lossrecordedinearningsineachperiod.
The change in fair value on the hedged item attributable to the hedged risk is
added/subtractedtoitsbalancesheetvaluewithacorrespondinggain/loss.
If the derivative's change in fair value is different than the fair value of the
hedgedassetorliability,thedifferenceisrecordedasagainorlossinearnings.
CashFlowHedge
Hedging exposure to variability of all or a

specific portion of a balance sheet item cash
flows or a forecasted transaction attributable to
a particular risk. The FMV of the derivative is
recordedasanassetorliability.
Portion of the derivative gain/loss equal to the change in hedged transaction's

expected cash flows (the effective portion of the hedge) is deferred and
reported in "other comprehensive income" in equity on the balance sheet until
thehedgedtransactionimpactsearnings.Theineffectiveportionofthehedgeis
recordedinearningsinthecurrentperiod.
In the period that the hedged transaction is reported in earnings, the deferred
derivativegain/lossinAOCIisreportedinearnings.
HedgeofNet
InvestmentofForeign
Ops.
Macro type hedge of the change in value of a Changesinfairvalueoftheforeignsubsidiaries'netassetsarerecordedinother

company's foreign subsidiary's net assets due comprehensive income in equity in the "cumulative translation adjustment"
toF/Xmovements.
accountuntilthesubsidiaryissoldordisposedof.
HedgeAccountingNot
Met
Derivative contract recorded on the balance Derivative is markettomarket with the gain or loss reported in earnings during
sheetasanassetorliabilityatfairvalue.
eachperiod.
Source: Wolfe Trahan Accounting & Tax Policy Research. FASB.
If a derivative transaction does not qualify for hedge accounting treatment under FAS 133, then its fair
value change is recorded in earnings each period.
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DERIVATIVES:AN8POINTCHECKLISTTOANALYZEDISCLOSURES
Derivative and hedging disclosures provide details on a companys hedging policies and the financial
statement amount and location of derivative contracts. Companies are required to disclose the balance
sheet and income statement location of the derivatives, their fair value amounts, the impact on earnings,
and the amount of gain/loss deferred from cash flow hedges that are recorded in accumulated other
comprehensive income in equity. Over the next few pages, we provide a methodology to analyze the
disclosures.
Its important to keep in mind that despite many pages of detailed disclosures in the 10-K, company
derivative disclosures are very high level. Therefore, we suggest using them to assess tail risks of the
company, if the company is actively hedging risks, or is speculating. One common question we receive
is whether these disclosures are useful in estimating the impact of foreign exchange rate changes on
earnings and margins. Oddly, GAAP has no requirement in this area and the best 10-K area in which to
ferret out possible exchange rate translation impacts is in the MD&A section. Disclosure is usually
spotty. However, McDonalds is an exception and clearly discloses the financial statement impact of
foreign exchange translation as we show in the next exhibit.
McDonalds Corp (2011 Form 10-K): Foreign Currency Translation Impact on Financial Statements ($ in millions)
IMPACTOFFOREIGNCURRENCYTRANSLATIONONREPORTEDRESULTS
Whilechangesinforeigncurrencyexchangeratesaffectreportedresults,McDonaldsmitigatesexposures,wherepractical,byfinancingin
localcurrencies,hedgingcertainforeigndenominatedcashflows,andpurchasinggoodsandservicesinlocalcurrencies.
In 2011, foreign currency translation had a positive impact on consolidated operating results driven by the stronger Euro and
AustralianDollaraswellasmostothercurrencies.In2010,foreigncurrencytranslationhadapositiveimpactonconsolidatedoperating
resultsdrivenbystrongerglobalcurrencies,primarilytheAustralianDollarandCanadianDollar,partlyoffsetbytheweakerEuro.In2009,
foreigncurrencytranslationhadanegativeimpactonconsolidatedoperatingresults,primarilycausedbytheweakerEuro,BritishPound,
RussianRuble,AustralianDollarandCanadianDollar.
Impactofforeigncurrencytranslationonreportedresults
Inmillions,exceptpersharedata
Revenues
Companyoperatedmargins
Franchisedmargins
Selling,general&administrativeexpenses
Operatingincome
Netincome
Earningspercommonsharediluted
2011
$27,006
3,455
7,232
2,394
8,530
5,503
5.27
Reportedamount
2010
2009
$24,075
$22,745
3,173
2,807
6,464
5,985
2,333
2,234
7,473
6,841
4,946
4,551
4.58
4.11
2011
$944
134
213
(55)
301
195
0.19
Currencytranslation
benefit/(cost)
2010
2009
$ 188
$(1,340)
35
(178)
(14)
(176)
(12)
75
13
(273)
13
(164)
0.01
(0.15)
We suggest using derivative disclosures to answer the following the questions about possible risk
exposures and related hedging:
(1) What risks are derivatives used to hedge?
(2) What are outstanding derivatives fair market values on the balance sheet? Are they material?
(3) What is the notional amount outstanding for derivative hedges?
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(4) What is the derivatives duration? Longer-term cash flow foreign currency hedges raise a concern
to us since the forecasted transaction might not occur. To that end, we view long-term hedges
exceeding two years as very uncommon based on our history of reviewing disclosures.
(5) Does the company hold derivatives that dont qualify for hedge accounting under GAAP? Keep in
mind that there are some derivative contracts not qualifying for hedge accounting since the
derivative is not considered highly effective at hedging the related risk. Instead, the derivative is
marked to fair value on the balance sheet and the changes therein are recorded in earnings each
period. An example of this would be option contracts since an investor initially pays a premium for
the derivative. In an extreme situation, holding derivatives that do not qualify for hedge
accounting may be a sign that the company is inappropriately engaged in currency speculation.
(6) What is the size of the unrealized derivative gain or loss recorded in AOCI in equity from cash
flow hedges (e.g., hedging future sales or gross margins)? We suggest analyzing whether there
have been any large quarterly or year-over-year changes. A large unrealized gain or loss in
equity (from a cash flow hedge) indicates that the company has actively hedged an underlying
risk exposure (commodity, foreign margins) that has yet to occur and impact the income
statement.
(7) Does the company hedge equity in its foreign subsidiaries?
(8) Have there been large realized gains or losses in prior quarters impacting the income statement?
In the exhibits on the next several pages, we use Becton Dickinsons (BDX) derivative footnote
disclosure to answer our eight questions.
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ANALYZINGDERIVATIVEDISCLOSURES:BECTONDICKINSONILLUSTRATION
The exhibit below is Becton Dickinson's general derivative and hedging disclosure of foreign currency
risks and related strategies. Derivatives designated for special hedge accounting treatment under FAS
No. 133 are separately disclosed from those not designated.
(1) WHAT RISKS ARE DERIVATIVES USED TO HEDGE?

The disclosure below describes the general risks the company is hedging.
Becton Dickinson (2011 Form 10-K): Derivative and Hedging Activities
ForeignCurrencyRisksandRelatedStrategies
TheCompanyhasforeigncurrencyexposuresthroughoutEurope,AsiaPacific,Canada,JapanandLatinAmerica.Fromtimetotime,the
Company may partially hedge forecasted export sales denominated in foreign currencies using forward and option contracts, generally
with oneyear terms. The Companys hedging program has been designed to mitigate exposures resulting from movements of the U.S.
dollar,fromthebeginningofareportingperiod,againstotherforeigncurrencies.TheCompanysstrategyistooffsetthechangesinthe
presentvalueoffutureforeigncurrencyrevenueresultingfromthesemovementswitheithergainsorlossesinthefairvalueofforeign
currency derivative contracts. Forward contracts were used to hedge forecasted sales in fiscal year 2010. The Company did not hedge
forecastedsalesinfiscalyear2011andasofSeptember30,2011,theCompanyhasnotenteredintocontractstohedgecashflowsfor
fiscalyear2012.
TheCompanydesignatesforwardcontractsusedtohedgethesecertainforecastedsalesdenominatedinforeigncurrenciesascashflow
hedges.ChangesintheeffectiveportionofthefairvalueoftheCompanysforwardcontractsthataredesignatedandqualifyascashflow
hedges(i.e.,hedgingtheexposuretovariabilityinexpectedfuturecashflowsthatisattributabletoaparticularrisk)areincludedinOther
comprehensive income (loss) until the hedged transactions are reclassified in earnings. These changes result from the maturity of
derivativeinstrumentsaswellasthecommencementofnewderivativeinstruments.Thechangesalsoreflectmovementsintheperiod
endforeignexchangeratesagainsttheforwardratesatthetimetheCompanyentersintoanygivenderivativeinstrumentcontract.Once
thehedgedrevenuetransactionoccurs,therecognizedgainorlossonthecontractisreclassifiedfromAccumulatedothercomprehensive
income(loss)toRevenues.TheCompanyrecordsthepremiumordiscountoftheforwardcontracts,whichisincludedintheassessmentof
hedgeeffectiveness,toRevenues.
In the event that the revenue transactions underlying a derivative instrument are no longer probable of occurring, accounting for the
instrument under hedge accounting is discontinued. Gains and losses previously recognized in Other comprehensive income (loss) are
reclassified into Other income (expense). If only a portion of the revenue transaction underlying a derivative instrument is no longer
probableofoccurring,onlytheportionofthederivativerelatingtothoserevenueswouldnolongerbeeligibleforhedgeaccounting.
(2) WHAT ARE OUTSTANDING DERIVATIVES FAIR MARKET VALUES ON THE BALANCE SHEET? ARE
THEY MATERIAL?
Discussed as part of question 5.
(3) WHAT IS THE NOTIONAL AMOUNT OUTSTANDING FOR DERIVATIVE HEDGES?

As shown in the next exhibit, BDX discloses $2.2 billion of outstanding notional amount of foreign
exchange contracts, primarily used to hedge sales. In turn, we suggest comparing this outstanding
notional amount to the companys most recently reported or forecasted foreign revenues to calculate
what percentage of future sales are hedged. Its very uncommon and a concern to us if more than one
years future foreign revenues are hedged.
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Becton Dickinson (2011 Form 10-K): Derivative and Hedging Activities ($ in thousands)
Transactionalcurrencyexposuresthatarisefromenteringintotransactions,generallyonanintercompanybasis,innonhyperinflationary
countries that are denominated in currencies other than the functional currency are mitigated primarily through the use of forward
contractsandcurrencyoptions.Hedgesofthetransactionalforeignexchangeexposuresresultingprimarilyfromintercompanypayables
andreceivablesareundesignatedhedges.Assuch,thegainsorlossesontheseinstrumentsarerecognizedimmediatelyinincome.The
offsetofthesegainsorlossesagainstthegainsandlossesontheunderlyinghedgeditems,aswellasthehedgingcostsassociatedwiththe
derivativeinstruments,isrecognizedinOtherincome(expense).
ThetotalnotionalamountsoftheCompanysoutstandingforeignexchangecontractsasofSeptember30,2011andSeptember30,2010
were$2,209,780and$1,776,046,respectively.
(4) WHAT IS THE DERIVATIVES DURATION?

Not disclosed.
(5) DOES THE COMPANY HOLD DERIVATIVES THAT DONT QUALIFY FOR HEDGE ACCOUNTING UNDER
GAAP?
The next exhibit is BDXs disclosure of derivatives fair value amounts and their balance sheet
geography as of September 30, 2011 (fiscal year-end). Recall that all derivatives are recorded on the
balance sheet at fair value. Derivatives that qualify and are designated for hedge accounting are
separately disclosed. A review of this disclosure and consistent with qualitative disclosures previously
analyzed indicates that a majority of derivatives are used to hedge foreign currency risks.
The fair market value of the company's outstanding derivative asset contracts at 9/30/11 was $43.2
million and $39.6 million for outstanding derivative liability contracts. One reason for why there is both an
asset and liability is that contracts may have been initiated at various points in time and, as such, the
amounts are not allowed to be netted on the balance sheet under GAAP unless a right of set-off exists.
Although GAAP requires some of the derivatives to be reported at gross on the balance sheet as assets
and liabilities, for financial analysis, we suggest netting them in assessing the overall outstanding size of
derivative hedges. The net size of the outstanding net derivative asset was $3.6 million at September
30, 2011. In our view, this isn't very material.
Additionally, the disclosure identifies certain derivatives that are not designated under FAS No. 133
hedge accounting since they either do not qualify or the company chose not to designate the derivative
for accounting purposes. There are tedious administrative requirements with complying with FAS No.
133 and, to save time and money, some companies simply choose to leave the derivatives
undesignated for accounting purposes. Nonetheless, its worth investigating a company with a large
percentage of undesignated derivatives to ferret out if they are used for speculative purposes or, more
appropriately, risk management. BDX discloses a material amount of undesignated derivatives for
hedge accounting purposes and the reasons therefor is a question for company management.
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EffectsonConsolidatedBalanceSheets
The location and amounts of derivative instrument fair values in the consolidated balance sheet are segregated below between
designated,qualifyinghedginginstrumentsandonesthatarenotdesignatedforhedgeaccounting.
(6) WHAT IS THE SIZE OF THE UNREALIZED DERIVATIVE GAIN OR LOSS RECORDED IN AOCI IN EQUITY
FROM CASH FLOW HEDGES (E.G, HEDGING FUTURE SALES OR GROSS MARGINS)?
This item is discussed as part of another question below.
(7) DOES THE COMPANY HEDGE EQUITY IN ITS FOREIGN SUBSIDIARIES?

BDX did not disclose that it is hedging equity in its foreign subsidiaries and we generally find this type of
hedging to be uncommon. There is a good reason for our caution. In 2003 and 2004, Baxter used longterm cross-currency swaps as a way to hedge the net equity (book value) in certain foreign subsidiaries
and was caught on the wrong side of an illiquid trade. During this time period, the U.S. dollar weakened
and the net book equity in Baxters foreign subsidiaries increased. At the same time, the related
derivative used to hedge the balance sheet exposure was in a loss position. The contract came due and
needed to be settled. There was no offsetting cash flow gain that could be used as payment for the
hedge losses since the gain was related to the increase in value of the foreign subsidiarys net assets.
These assets couldnt be easily liquidated (such as PP&E and working capital) to pay off the derivative
losses. The companys pre-tax liability exceeded $1 billion at December 31, 2004 and resulted in
significant cash payments to settle the contract. A careful reading of Baxters prior year 10-K would have
identified such hedges. However, the 10-K did not disclose the total amount of outstanding derivatives at
that time. GAAP rules have since changed requiring disclosure.
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As an illustration of one disclosure, below is an excerpt on net investment hedges from Bunges 2008
10-K.
Bunge Net Foreign Subsidiary Investment Hedges Disclosure 2008 10-K
Weusenetinvestmenthedgestomitigatethetranslationadjustmentsarisingfromremeasuringourinvestmentincertainofourforeign
subsidiaries.Forderivativeinstrumentsthataredesignatedandqualifyasnetinvestmenthedges,werecordtheeffectiveportionofthe
gainorlossonthederivativeinstrumentsinaccumulatedothercomprehensiveincome(loss).During2008,weenteredintofixedinterest
ratecurrencyswapswithanotionalvalueof$69milliontohedgethenetassetexposureinourBraziliansubsidiaries.Underthetermsof
theseswaps,wepayBrazilianinterestratesandreceivefixedU.S.dollarinterestrates.Theexchangeofprincipalatthematurityofthe
swap is expected to offset the foreign exchange translation adjustment of our net investment in our Brazilian real functional currency
subsidiaries.TheseswapsmatureinDecember2010.AtDecember31,2008,thefairvalueofthefixedinterestratecurrencyswapswasa
lossof$1million,whichwasrecordedinaccumulatedothercomprehensiveincome(loss)intheconsolidatedbalancesheetasanoffsetto
theforeigncurrencytranslationgainfromtheunderlyingBrazilianrealnetassetexposure.
(8) HAVE THERE BEEN LARGE REALIZED GAINS OR LOSSES IN PRIOR QUARTERS IMPACTING THE
INCOME STATEMENT?
The next several exhibits are disclosures on the income statement location and impact of derivative
gains and losses. There are separate disclosures for those derivatives classified as hedges of cash
flows, fair values, and undesignated hedges. For cash flow hedges, two tables are disclosed. The first
table discloses the amount of derivative gains/losses due to fair value changes not recognized in
earnings during the period. Becton Dickinson discloses $33.2 million of interest rate swap losses in
AOCI in equity at year-end. The losses remain in equity since the underlying transaction it is hedging
had not yet occurred. The losses would be reclassified out of equity and into the income statement when
the related hedged item was recognized in earnings.
The second table (on the right of the exhibit) discloses the amount of gains and/or losses that were
reclassified from AOCI to earnings during the year. As the related revenues for which the derivative was
hedging were recognized in the current quarter, approximately $1.7 million of foreign currency hedging
losses were removed out of AOCI in equity and reported in revenues. This hedge loss presumably offset
gains from the underlying revenue transactions. For forward looking analysis, we find this disclosure to
be historical and not particularly useful in predicting the future. However, it provides context in assessing
past hedging activities for cash flow hedges. In 2011, the company reported that no gains or loss were
reclassified from AOCI into income suggesting that they werent hedging future cash flows related to
revenues or cost of goods sold. This was a change in practices from 2010 and 2009 when there were
material cash flow hedging gains and losses in revenue.
EffectsonConsolidatedStatementsofIncome
Cashflowhedges
Thelocationandamountofgainsandlossesondesignatedderivativeinstrumentsrecognizedintheconsolidatedstatementofincomefor
theyearsendedSeptember30,consistedof:
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The next exhibit is BDXs disclosure of the amount of cash flow hedges expected to be reclassified from
AOCI in equity to earnings over the next 12 months. This disclosure provides a general sense of the size
of the embedded gain/loss on derivatives from hedging future cash flows, such as sales.
The Companys designated derivative instruments are perfectly effective. As such, there were no gains or losses, related to hedge
ineffectivenessoramountsexcludedfromhedgeeffectivenesstesting,recognizedimmediatelyinincomefortheyearsendedSeptember
30, 2011, 2010 and 2009. The loss recorded in Other comprehensive income (loss) for the year ended September 30, 2011 represents
unrealizedlossesoninterestrateswapsenteredintoduringthefourthquarteroffiscalyear2011inanticipationofissuinglongtermdebt
inthefirstquarteroffiscalyear2012,partiallyoffsetbygainsrealizedoninterestrateswapsthatwereenteredintointhefirstquarterof
fiscalyear2011inanticipationofissuinglongtermdebtduringthatquarter.Theseswapsweredesignatedashedgesofthevariabilityin
interest payments attributable to changes in the benchmark interest rates against which the longterm debt was priced. The amounts
recordedinOthercomprehensiveincome(loss)relativetotheseswapswillbeamortized,overthelifeoftherespectivenotes,withan
offsettoInterestexpense.
In the disclosure of fair value hedges, BDX displays the location of the gains/losses recorded under fair
value hedge accounting. In the third quarter, BDX recorded a loss on derivative positions of $2.7 million
which perfectly offset a recorded fair value gain on its hedged fixed rate debt.
Fairvaluehedge
The location and amount of gains or losses on the hedged fixed rate debt attributable to changes in the market interest rates and the
offsettinggain(loss)ontherelatedinterestrateswapfortheyearsendedSeptember30wereasfollows:
The next exhibit is BDXs disclosure of the amount and location of gains/losses due to its undesignated
hedges. The company classified a $1.4 million loss in other expense in fiscal 2011 from foreign
exchange contracts. The company discloses that these derivatives are used to hedge inter-company
transactions, but they do not qualify for hedge accounting. This seems reasonable to us.
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Undesignatedhedges
Thelocationandamountofgainsandlossesrecognizedinincomeonderivativesnotdesignatedforhedgeaccountingfortheyearsended
September30wereasfollows:
WATCH INTERCOMPANY ACCOUNTS PAYABLE AND FOREIGN CURRENCY TRANSACTIONS

Do foreign subsidiaries receive short-term funding from the U.S. parent company?
The foreign currency translation of short-term inter-company obligations, such as accounts payable, is
an area prone to significant management discretion and where non-economic gains may be created. A
shortcoming in FAS No. 52 requires gains and losses from foreign currency translations on short-term
inter-company obligations to be recorded in earnings. An inter-company transaction between a U.S.
company and its foreign subsidiary is rather easy to create (or eliminate) as a company may
conveniently use a gain on intercompany payables to increase earnings. Given the weakening dollar
over the past several years, some companies have received an additional earnings boost from these
inter-company foreign currency translation gains. If the dollar begins to appreciate vis a vis other
currencies in which a company conducts business, this prior source of non-economic earnings would
become an unexpected earnings headwind.
To illustrate how gains on inter-company obligations may be recorded in earnings, consider a U.S.
company loaning $10 to its European subsidiary (1.5 /$ exchange rate). On its balance sheet, the U.S.
company records a $10 inter-company accounts receivable. On the other side, the European subsidiary
records an inter-company accounts payable of 15 on the date the transaction is initiated. Next, assume
that the exchange rate changes to 1.25 /$ at the end of the quarter. Given the change in the exchange
rate, there is a new accounts payables balance of 12.50 for a 2.50 exchange rate gain. The European
subsidiary reports a 2.50 gain in earnings in the current period. In turn, when translating the European
subsidiarys financial statements into U.S. dollars, the gain is also translated into U.S. dollars and
reported in the parents consolidated income statement. It is not eliminated as a gain or loss in
consolidation. Meanwhile, the U.S. parent companys receivable is already in U.S. dollars; therefore,
there is no foreign currency translation gain or loss. Finally, the inter-company balances of accounts
receivable and accounts payable are eliminated and offset each other (once translated into dollars).
Economically, the transaction and gains or losses should cancel out, but they dont on a reported
consolidated GAAP basis since the accounting rules do not require it (FAS No. 52).
There are several issues with this transaction. First, the inter-company gain/loss is uneconomic and
generates no real cash flows. Second, a company may fully control inter-company balances and require
subsidiaries to repay inter-company amounts at any time. Therefore, its relatively easy to create noneconomic gains if currencies are moving in the favorable direction. Third, inter-company short-term
foreign payables (i.e., borrowings) may be turned into long-term inter-company debt. Long-term intercompany obligations foreign exchange gains or losses are not reported in earnings in the current
period. Instead, they are recorded in accumulated other comprehensive income in equity.
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SUBSEQUENTEVENTDISCLOSURES
A subsequent event is something of importance that happens after a companys year-end, but before
the financial statements are issued. Examples of common subsequent events would be a completed
equity/debt offering or an announced JV/partnership with another company. The subsequent event
footnote, commonly found as one of the last disclosures towards the end of a 10-K, is divided into the
following two events based on accounting guidelines:
Type I Event: A Type I subsequent event is an event relating to something on a companys

balance sheet at year-end that occurred after the balance sheet date, but prior to the issuing of
financial statements. If a Type I subsequent event occurs, GAAP year-end financial statements
would be adjusted to reflect the subsequent event since the event is deemed to have existed on
the ending balance sheet date.
A lot of estimates are made by management to prepare financial statements, including items such
as probable loss accruals, bad debt expense, and PP&E salvage values, and these
estimates/assumptions could change within the aforementioned timeframe. Type I subsequent
events provide useful additional information for a companys condition (e.g., bad debt) that
existed on the balance sheet date. An example of a Type I event would be a lawsuit, settled after
year-end, but prior to the issuance of the companys financials.
Type II Event: Type II subsequent events are related to circumstances that did not exist at yearend, but occurred prior to issuing financial statements. Material Type II subsequent events are
required GAAP disclosures, but a companys year-end financial statements are not adjusted to
reflect them since the event occurred after year-end and it was not already included on the
balance sheet. Common examples of Type II events include a stock issuance or JV/acquisition.
In the following two exhibits, we provide examples of subsequent event disclosures, namely Coinstars
JV with Verizon and acquisition of NCR Entertainment and Entropic Communications agreement with
Trident Microsystems.
Coinstar (2011 Form 10-K): Subsequent Events Disclosure Example
NOTE19:SUBSEQUENTEVENTS
JointVenture
OnFebruary3,2012,RedboxandVerizonVenturesIVLLC(Verizon),awhollyownedsubsidiaryofVerizonCommunicationsInc.,entered
intoaLimitedLiabilityCompanyAgreement(theLLCAgreement)andrelatedarrangements.TheLLCAgreementgovernstherelationship
ofthepartieswithrespecttoajointventure(theJointVenture)formedfortheprimarypurposeofdeveloping,launching,marketingand
operating a nationwide overthetop video distribution services providing consumers with access to video programming content,
includinglinearcontent,deliveredviabroadbandnetworkstovideoenabledviewingdevicesandofferingrentalofphysicalDVDsandBlu
rayDiscsfromRedboxkiosks.Redboxisinitiallyacquiringa35.0%ownershipinterestintheJointVentureandwillmakeaninitialcapital
contributionof$14.0millionincash.TheJointVentureboardmayrequesteachmembertomakeadditionalcapitalcontributions,onapro
ratabasisrelativetoitsrespectiveownershipinterest.Ifamemberdoesnotmakeanyorallofitsrequestedcapitalcontributions,asthe
casemaybe,theothercontributingmembergenerallymaymakesuchcapitalcontributions.SolongasRedboxcontributesitsprorata
shareofthefirst$450.0millionofcapitalcontributionstotheJointVenture,Redboxsinterestcannotbedilutedbelow10.0%.Inaddition,
RedboxhascertainrightstocauseVerizontoacquireRedboxsinterestintheJointVenture(generallyfollowingthefifthanniversaryofthe
LLCAgreementorinlimitedcircumstances,atanearlierperiodoftime)andVerizonhascertainrightstoacquireRedboxsinterestinthe
JointVenture(generallyfollowingtheseventhanniversaryoftheLLCAgreement,or,inlimitedcircumstances,thefifthanniversaryofthe
LLCAgreement).RedboxsownershipinterestintheJointVenturewillbeaccountedforusingtheequitymethodofaccounting.
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AcquisitionofNCREntertainmentBusiness
OnFebruary3,2012,RedboxenteredintoapurchaseagreementwithNCRCorporation(NCR)(theNCRAgreement),toacquirecertain
assetsofNCRrelatedtoNCRsselfserviceentertainment DVDkioskbusiness.Thepurchasedassetsinclude,amongothers,selfservice
DVD kiosks, DVD inventory, intellectual property, and certain related contracts. The purchase price includes a $100.0 million cash
payment, as adjusted if certain contracts are not transferred at closing, and the assumption of certain liabilities of NCR related to the
purchasedassets.Weexpectthetransactionwillberecordedasabusinesscombination.Closingofthetransactionissubjecttocertain
customaryclosingconditions,includingappropriategovernmentalapprovalundertheHartScottRodinoAntitrustImprovementsAct,as
amended (HSR). If the NCR Agreement is terminated under certain circumstances relating to failure to obtain appropriate antitrust
approvals,RedboxisrequiredtopayNCRa$10.0millionbreakfeewithinfivedaysofsuchtermination.Inaddition,inconnectionwiththe
NCR Agreement, we intend to enter into a strategic arrangement with NCR for manufacturing and services during the fiveyear period
postclosing.Attheendofthefiveyearperiod,iftheaggregateamountpaidinmargintoNCRformanufacturingandservicesdelivered
equaled less than $25.0 million, we would pay NCR the difference between such aggregate amount and $25.0 million. Assuming HSR
approval,weexpectthetransactiontoclosenolaterthanthethirdquarterof2012.
Entropic Communications (2011 Form 10-K): Subsequent Events Disclosure Example

11.SubsequentEvent
OnJanuary4,2012,weannouncedthatweagreedtobecomeastalkinghorsebiddertoacquiretheassetsofTridentMicrosystems,Inc.
andcertainofitssubsidiaries,orTrident,usedinorrelatedtoTrident'ssettopboxbusiness,orSTBBusiness,forapurchasepriceof$55.0
million,subjecttoaworkingcapitaladjustment,ortheAcquisition,pursuanttoanAssetPurchaseAgreement,orPurchaseAgreement.
TridentfiledthePurchaseAgreementwiththeUnitedStatesBankruptcyCourtfortheDistrictofDelawarealong withTrident'smotion
seekingtheestablishmentofbidproceduresforanauctionthatallowsotherqualifiedbidderstosubmithigherorotherwisebetteroffers,
asrequiredunderSection363oftheU.S.BankruptcyCode.OnJanuary18,2012,theCourtapprovedthebidproceduresandTridentand
EntropicexecutedthePurchaseAgreement.TheclosingoftheAcquisition,whichisexpectedtooccurinthefirstquarterof2012,remains
subjecttohigherorotherwisebetteroffersapprovalbytheUnitedStatesBankruptcyCourtandcustomaryclosingconditions.IfTrident
acceptsanofferotherthanourPurchaseAgreement,wewillbeentitledtobepaidabreakupfeeandareimbursementofcertainofour
transactionexpenses.
PursuanttothePurchaseAgreement,wewillacquireallofTrident'sspecificSTBBusinessproducts,patentsandotherintellectualproperty
ownedbyTrident,certaincontractsandprepaidexpenses,certaintangibleassets,accountsreceivable,inventoryandequipment.Trident
willretainitsdigitaltelevision,PCtelevision,audioandterrestrialdemodbusinesses.WewillalsoacquireleasedfacilitiesinAustin,Texas,
San Diego, California, Belfast, Northern Ireland and Hyderabad, India and the right to use other facilities of Trident under short term
FacilitiesUseAgreements.WewillassumecertainspecifiedliabilitiesofTrident.
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DATEDFINANCIALSTATEMENTS
SUBSIDIARY FINANCIAL STATEMENTS MUST BE LESS THAN 93 DAYS OLD
When consolidating a companys financial statements, the SEC allows subsidiary financial statements to
be consolidated if they are less than 93 days old. If a company has a consolidation date different than its
subsidiaries, it must disclose:
The closing date of the subsidiary;

Why different dates were used; and
Subsequent events to the subsidiaries closing date that would materially affect the consolidated
financial statements.
Companies use dated financial statements for various reasons, but typical reasons relate to
uncompleted JV audits or foreign subsidiaries. Though not a large timing difference, dated financial
statements could cause a material difference in times of great economic uncertainty or high volatility.
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INTERNALCONTROLS
The Sarbanes-Oxley Act of 2002 (SOX) requires management teams to assess the effectiveness of
the companys financial reporting internal controls. The results of managements assessment are stated
at year-end in managements annual report on internal controls over financial reporting.
There are three degrees of internal control deficiencies: (1) inconsequential deficiency, (2) significant
deficiency, and (3) material weakness. A material weakness would be an internal control deficiency
that results in a more than remote likelihood that a material misstatement would not be detected or
prevented.
Management evaluates the effectiveness of its internal controls over financial reporting. Then the
auditors issue two opinions of their own: (1) do they agree or disagree with managements assessment
on the effectiveness of internal controls and (2) their official opinion. The auditors opinion falls into one
of the following three categories:
Unqualified: No scope limitations and no material weaknesses were identified;

Qualified or disclaimer opinion: The auditor cant express an opinion on certain controls due to a
scope limitation; or
Adverse opinion: Significant internal control deficiencies based on one or more material
weaknesses in its internal controls.
Companies must disclose material weaknesses over internal controls. The severity of internal control
weakness depends on facts and circumstances and should be evaluated holistically along with other
information to discover the existence of larger, unknown problems at the company. That being said,
companies may have significant internal control deficiencies that they choose not to correct due to cost
reasons. Material weaknesses tend often are precursors to earnings restatements, in our view.
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Below we use KPMGs audit opinion of Netflixs internal controls as a common example of an opinion on
the effectiveness of internal controls over financial reporting.
Netflix (2011 Form 10-K): Financial Reporting Internal Controls
REPORTOFINDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRM
TheBoardofDirectorsandStockholders
Netflix,Inc.:
WehaveauditedtheaccompanyingconsolidatedbalancesheetsofNetflix,Inc.andsubsidiaries(theCompany)asofDecember31,2011
and 2010, and the related consolidated statements of operations, stockholders equity and comprehensive income, and cash flows for
eachoftheyearsinthethreeyearperiodendedDecember31,2011.WealsohaveauditedNetflix,Inc.sinternalcontroloverfinancial
reportingasofDecember31,2011,basedoncriteriaestablishedinInternalControlIntegratedFrameworkissuedbytheCommitteeof
SponsoringOrganizationsoftheTreadwayCommission(COSO).Netflix,Inc.smanagementisresponsiblefortheseconsolidatedfinancial
statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal
controloverfinancialreporting,includedintheaccompanyingManagementsAnnualReportonInternalControlOverFinancialReporting
appearingunderitem9A(b).Ourresponsibilityistoexpressanopinionontheseconsolidatedfinancialstatementsandanopiniononthe
Companysinternalcontroloverfinancialreportingbasedonouraudits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those
standardsrequirethatweplanandperformtheauditstoobtainreasonableassuranceaboutwhetherthefinancialstatementsarefreeof
materialmisstatementandwhethereffectiveinternalcontroloverfinancialreportingwasmaintainedinallmaterialrespects.Ouraudits
of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the
financialstatements,assessingtheaccountingprinciplesusedandsignificantestimatesmadebymanagement,andevaluatingtheoverall
financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal
controloverfinancialreporting,assessingtheriskthatamaterialweaknessexists,andtestingandevaluatingthedesignand operating
effectivenessofinternalcontrolbasedontheassessedrisk.Ourauditsalsoincludedperformingsuchotherproceduresasweconsidered
necessaryinthecircumstances.Webelievethatourauditsprovideareasonablebasisforouropinions.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles.Acompanysinternalcontroloverfinancialreportingincludesthosepoliciesandproceduresthat(1)pertaintothemaintenance
of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
withgenerallyacceptedaccountingprinciples,andthatreceiptsandexpendituresofthecompanyarebeingmadeonlyinaccordancewith
authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial
statements.
Becauseofitsinherentlimitations,internalcontroloverfinancialreportingmaynotpreventordetectmisstatements.Also,projectionsof
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in
conditions,orthatthedegreeofcompliancewiththepoliciesorproceduresmaydeteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of
Netflix,Inc.andsubsidiariesasofDecember31,2011and2010,andtheresultsoftheiroperationsandtheircashflowsforeachofthe
years in the threeyear period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also in our
opinion,Netflix,Inc.maintained,inallmaterialrespects,effectiveinternalcontroloverfinancialreportingasofDecember31,2011,
basedoncriteriaestablishedinInternalControlIntegratedFrameworkissuedbytheCommitteeofSponsoringOrganizationsofthe
TreadwayCommission.
/s/KPMGLLP
SantaClara,California
February10,2012
Note: Emphasis added

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AUDITORSOPINION
Investors should always review a companys audit opinion for an unqualified (clean) audit, without any
going concern notation. An unqualified audit opinion means that the companys financial statements
are fairly presented in accordance with GAAP. If a company receives a going concern opinion, it
means that there is substantial doubt that it will be able to continue operations over the next year and
that a potential bankruptcy might be around the corner.
Most credit indentures require companies to have unqualified audit opinions, so a going concern or
qualified opinion would probably technically trigger a debt default. Another debt covenant sometimes
triggered by companies is the timely filing of financial statements.
Audit opinions fall into one of the following categories:
Unqualified: Financial statements are fairly presented in accordance with GAAP.

Qualified: A limitation or exception to the accounting standards exists, which must be explained
and disclosed in an additional paragraph within the audit opinion.
Adverse: Material departures from accounting standards exist and the financial statements are
not fairly presented in accordance with GAAP.
Disclaimer of opinion: Unable to issue an audit opinion.
The following exhibits we present a going concern audit opinion for Raptor Pharmaceutical and then a
clean audit opinion for Altria based on the companys 2011 Form 10-K disclosures.
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Raptor Pharmaceutical (2011 Form 10-K): Going Concern Example

REPORTOFINDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRM
TotheBoardofDirectorsandStockholdersof
RaptorPharmaceuticalCorp.
WehaveauditedtheaccompanyingconsolidatedbalancesheetsofRaptorPharmaceuticalCorp.anditssubsidiaries(theCompany)(a
development stage enterprise) as of August 31, 2011 and 2010, and the related consolidated statements of comprehensive loss,
stockholdersequity(deficit),andcashflowsfortheyearsendedAugust31,2011and2010andthecumulativeamountsfromSeptember
8,2005(inception)toAugust31,2011.TheseconsolidatedfinancialstatementsaretheresponsibilityoftheCompanysmanagement.Our
responsibilityistoexpressanopinionontheseconsolidatedfinancialstatementsbasedonouraudits.
standardsrequirethatweplanandperformtheaudittoobtainreasonableassuranceaboutwhetherthefinancialstatementsarefreeof
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as
evaluatingtheoverallfinancialstatementpresentation.Webelievethatourauditsprovideareasonablebasisforouropinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of
RaptorPharmaceuticalCorp.anditssubsidiariesasofAugust31,2011and2010,andtheresultsoftheiroperationsandtheircashflows
fortheyearsendedAugust31,2011and2010andthecumulativeamountsfromSeptember8,2005(inception)to August31,2011in
conformitywithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica.
TheaccompanyingconsolidatedfinancialstatementshavebeenpreparedassumingthattheCompanywillcontinueasagoingconcern.
As discussed in Note 2 to the consolidated financial statements, the Companys significant operating losses raise substantial doubt
aboutitsabilitytocontinueasagoingconcern.TheseconditionsraisesubstantialdoubtabouttheCompanysabilitytocontinueasa
goingconcern.ManagementsplansinregardtothosemattersarealsodescribedinNote2.Thefinancialstatementsdonotincludeany
adjustmentsthatmightresultfromtheoutcomeofthisuncertainty.
AsdiscussedinNote1totheconsolidatedfinancialstatements,effectiveSeptember29,2009,theCompanyswhollyownedsubsidiary,
ECPAcquisition,Inc.,mergedwithandintoRaptorPharmaceuticalsCorp.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
effectiveness of the Companys internal control over financial reporting as of August 31, 2011, based on criteria established in Internal
ControlIntegratedFrameworkissuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommission,andourreportdated
November14,2011expressedanunqualifiedopinionthereon.
/s/BurrPilgerMayer,Inc.
BurrPilgerMayer,Inc.
SanFrancisco,California
November14,2011
Note: Emphasis added

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Altria Group (2011 Form 10-K): Example of a Clean Audit Opinion

ReportofIndependentRegisteredPublicAccountingFirm
TotheBoardofDirectorsand
StockholdersofAltriaGroup,Inc.:
Inouropinion,theaccompanyingconsolidatedbalancesheetsandtherelatedconsolidatedstatementsofearnings,stockholdersequity,
andcashflows,presentfairly,inallmaterialrespects,thefinancialpositionofAltriaGroup,Inc.anditssubsidiariesatDecember31,2011
and2010,andtheresultsoftheiroperationsandtheircashflowsforeachofthethreeyearsintheperiodendedDecember31,2011in
conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Altria Group, Inc.
maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria
establishedinInternalControlIntegratedFrameworkissuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommission
(COSO).
Altria Group, Inc.s management is responsible for these financial statements, for maintaining effective internal control over financial
reportingandforitsassessmentoftheeffectivenessofinternalcontroloverfinancialreporting,includedintheaccompanyingReportof
ManagementonInternalControloverFinancialReporting.Ourresponsibilityistoexpressopinionsonthesefinancialstatementsandon
AltriaGroup,Inc.sinternalcontroloverfinancialreportingbasedonourintegratedaudits.
standardsrequirethatweplanandperformtheauditstoobtainreasonableassuranceaboutwhetherthefinancialstatementsarefreeof
materialmisstatementandwhethereffectiveinternalcontroloverfinancialreportingwasmaintainedinallmaterialrespects.Ouraudits
of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements,assessingtheaccountingprinciplesusedandsignificantestimatesmadebymanagement,andevaluatingtheoverallfinancial
statementpresentation.Ourauditofinternalcontroloverfinancialreportingincludedobtaininganunderstandingofinternalcontrolover
financialreporting,assessingtheriskthatamaterialweaknessexists,andtestingandevaluatingthedesignandoperatingeffectivenessof
internalcontrolbasedontheassessedrisk.Ourauditsalsoincludedperformingsuchotherproceduresasweconsiderednecessaryinthe
circumstances.Webelievethatourauditsprovideareasonablebasisforouropinions.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles.Acompanysinternalcontroloverfinancialreportingincludesthosepoliciesandproceduresthat(i)pertaintothemaintenance
of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
withgenerallyacceptedaccountingprinciples,andthatreceiptsandexpendituresofthecompanyarebeingmadeonlyinaccordancewith
authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial
statements.
Becauseofitsinherentlimitations,internalcontroloverfinancialreportingmaynotpreventordetectmisstatements.Also,projectionsof
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in
conditions,orthatthedegreeofcompliancewiththepoliciesorproceduresmaydeteriorate.
/s/PricewaterhouseCoopersLLP
Richmond,Virginia
January27,2012
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DifferencesBetween
U.S.GAAPandIFRSGAAP
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BALANCESHEET:FINANCIALASSETS
Summary: IFRS classifies more assets at amortized cost and less OTTI write-downs are recorded on
securities. We believe that these factors lower a companys overall quality of reported book
value/shareholders equity.
Detailed Financial Asset Differences Between U.S. GAAP and IFRS
U.S.GAAP
Marketablesecurities:Classifiedastrading,availableforsale,orheldtomaturity.
Nontradedequityinvestments:Recordedathistoricalcost,unlesselectedtobeaccountedforatfairvalueunderFASNo.159.
OTTI: Occurs based on a twostep test: (1) management does not intend on selling the security and theres a 50%+ chance that it
wouldnthavetosellbeforerecoveringinvaluetoatleastcostand(2)managementexpectstorecovertheentirecostbasis.Ifthe
answerisnotoeitheroneofthesesteps,thenanimpairmentisrecorded.Reversalsarenotallowed.
Loans:Classifiedaseitherheldforsale(lowerofcostormarket)orheldforinvestment(amortizedcost).Mostloansfallunderthe
heldforinvestmentcategory.Similartonontradedequityinvestments,managementmayelecttorecordloansatfairmarketvalue
underFASNo.159.
Loansheldforsale:Carriedonthebalancesheetatthelowerofcostormarket.
Classificationofdebt:Drivenbylegalform.
Nettingassetsandliabilities:Generallyallowedwhenarightofsetoffexistsunderamasternettingagreement.Becauseofthisrule,
manyitemssuchasoffsettingderivativeswiththesamecounterpartyarereportednetonthebalancesheet.
Transferofassetsbetweencategories:Strictrulesforreclassifyingsecuritiesfromavailableforsaletoheldtomaturity.
IFRS
Marketablesecurities:Classifiedastrading,availableforsale,orheldtomaturity.
Nontradedequityinvestments:Recordedatfairvalue.
OTTI: Only objective evidence of a credit default triggers an impairment (not based on intent or an interest rate change). Things
considered include (1) high probability of bankruptcy, (2) significant financial difficulty, (3) granting of concessions, (4) breach of
contract,(5)disappearanceofactivemarketduetofinancialstruggles,and/or(6)measurabledeclineinfuturecashflows.Reversals
throughtheincomestatementarerequired.
Loans:Recordedonthebalancesheetatfairmarketvalueoramortizedcost.Loansarenotcarriedatthelowerofcostormarket.
Loans held for sale: This category does not exist. Loans held for sale or securitization areclassified as trading and recorded at fair
value.
Classification ofdebt: Notdrivenby legal form.Thusfinancialassetsthatareasecurity inthe legalsenseareoftenclassifiedas a

loan/receivableunderIFRS,resultinginmoresecuritiesbeingrecordedathistoricalcost.
Nettingassetsandliabilities:Generallyallowedwhenalegallyenforceablerighttosetoffexistsandthecompanyintendsoneither
settlingonanetbasisorrealizeassetandsettleliabilitysimultaneously.Masternettingagreementsalonearenotenoughtooffset
unlessalloftheabovecriteriaaremet,leadingtosignificantlymorepresentationatgrossonthebalancesheet.
Transfer of assets between categories: More common than under U.S. GAAP. Trading and/or availableforsale debt instruments
(carriedatfairvalue)maybeclassifiedintotheloancategory(recordedatamortizedcost)ifthecompanyhasboththeintentand
abilitytoholditfortheforeseeablefuture.
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BALANCESHEET:INVENTORY
Summary: U.S. GAAP allows either FIFO or LIFO accounting methods, but IFRS does not allow LIFO
accounting. Moving from LIFO to FIFO would typically increase a companys net income and decrease
operating cash flow, during a period of normal inflation. Operating cash flow would decline because the
LIFO tax shield would disappear.
LIFO inventory accounting is most often used in the following industries: retail, industrial, gas, and
pharmaceutical. Approximately 250 companies in the Russell 3000 account for at least a portion of their
inventories using the LIFO method.
Detailed Inventory Differences Between U.S. GAAP and IFRS
U.S.GAAP
Costingmethodology:AfewofthecommonlyallowedinventorymethodsincludeLIFO,FIFO,andaveragecost.IRCsLIFObook/tax
conformityrulerequirescompaniesthatuseLIFOfortaxpurposesalsouseLIFOforGAAPpurposes.
Writedowns:Inventorywritedownreversalsarenotallowed.Recoveryininventoryvalueiscapturedthroughhighergrossmargins
whenthewrittendowninventoryissubsequentlysold.
IFRS
Costingmethodology:FIFOandweightedaverageareallowableinventorycostingmethods.LIFOisnotallowedunderIFRS.
Writedowns: Inventory writedown reversals are required to be recorded in COGS, up to the original inventory value, before the
inventoryissold.
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BALANCESHEET:PP&EANDINTANGIBLES
Summary: IFRS allows the revaluation of PP&E to fair market value, which may lead to asset and
equity balance distortions. This could also lead to misleading and/or highly volatile financial ratios such
as ROE and ROIC. Under IFRS, real estate companies may also account for their investment properties
at fair value, with the changes in value recorded into earnings.
Detailed PP&E and Intangible Differences Between U.S. GAAP and IFRS
U.S.GAAP
Cost: Generally depreciable and recorded at historical cost. PP&E cant be revalued to fair market value unless the company is
acquiredandpurchaseaccountingrulesapply.
Depreciation:Usuallydepreciated,straightline,overXnumberofyears.U.S.GAAPdoesnotrequireacomponentsbasedapproach
fordepreciationexpense.
Investmentproperties:Recordedathistoricalcostformostrealestatecompanies;norevaluationstofairmarketvaluepermitted.
Intangibleassets:Norevaluationstofairmarketvaluepermitted.
Leveragedleaseaccounting: Permitted.Underleveraged leaseaccounting,thelessor oftenrecognizedleasingincome quickerand
thenonrecourseleveragedleasedebtamountisnettedagainsttheleveragedleasedinvestmentassetonthelessorsbalancesheet.
IFRS
Cost:Generallydepreciableandrecordedathistoricalcost.PP&Ecanberevaluedtofairmarketvaluewithagaincreditedtoequity
underarevaluationsurplusaccount.Ifafutureimpairmentoccurs,thelossmaybeoffsetagainsttherevaluationsurplus.Historical
costanddepreciatedamountsmustbedisclosed.
Depreciation:Componentsbasedapproachusedtodepreciateassets.MaterialcomponentsofPP&Ewithdifferentusefullivesare
depreciatedseparately.
Investmentproperties:Recordedatfairmarketvalueorhistoricalcost.Thechangeinfairmarketvalueisrecordedinearningsineach
periodandinvestmentpropertyisnotdepreciated.Theserulesalsoapplytoleasedproperties.
Intangibleassets:Revaluationstofairmarketvaluearepermitted,althoughthisisuncommonsincethe standardrequiresthefair
marketvaluetobeinspecificreferencetoanactivemarketforthespecificintangibleasset.
Leveragedleaseaccounting:Notpermitted.UnderIFRS,nonrecoursedebtisrecordedatgrossonthebalancesheet.
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BALANCESHEET:ASSETIMPAIRMENTSANDLEASES
Summary: Due to IFRS impairment testing mechanics, companies under IFRS might recognize
impairments before companies in the same situation that report under U.S. GAAP. Furthermore, these
impairments may be reversed back into the income statement as gains if certain criteria are met. These
differences generally result in more volatile earnings.
There are slightly different criteria for lease accounting, but the accounting for leases is very similar
under each standard.
Detailed Asset Impairment and Lease Differences Between U.S. GAAP and IFRS
U.S.GAAP
Reversingimpairmentcharges:Notallowed.Impairmentsaretestedunderatwostepapproach:
o Initialrecoverabilitytestbasedonanassetscarryingvaluevs.totalundiscountedfuturecashflows.Iftheassetscarryingvalueis
greaterthanthesumoftheassetsundiscountedfuturecashflows,proceedtostep2.
o Instep2,theassetscarryingvalueiswrittendowntofairmarketvaluebasedonFASNo.157.
Leases:Fourbrightlinecriteriatodeterminewhetheraleaseisclassifiedasacapitallease(onbalancesheet)oroperatinglease(off
balancesheet).
IFRS
Reversing impairment charges: Allowed if certain criteria are met. The reversal of an impairment charge is recorded and flows
through the income statement as a gain. However, the reversals of goodwill impairment charges are not permitted. Under IFRS,
impairmentsaretestedbasedonaonestepapproach:
o Ifimpairmentindicatorsexist,animpairmentlossshouldbecalculated.Animpairmentchargeisrecordedifanassetscarrying
valueisgreaterthanthefuturediscountedcashflowsortheassetsfairmarketvalue,lesscostofselling.
Leases: Classification of leases is based on principles and the overall substance of the transaction. It also depends on whether the
lease transfers substantially all of the risks and rewards of ownership to the lessee. Under IFRS, there are no bright line tests or
quantitativebreakpoints.
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BALANCESHEET:PENSIONS
Summary: Pension accounting is one of the major differences between U.S. and IFRS GAAP. The most
significant differences with regard to pension accounting relate to underfunding amounts, recording
gains and losses, and treatment of interest cost and actuarial gains and losses.
The International Accounting Standards Board (IASB) recently issued revised pension accounting rules
under IAS 19 that will impact those companies following IFRS beginning January 2013. The rules will
require accounting that somewhat resembles some of the mark to market type pension accounting U.S.
companies have been adopting.
Detailed Pension Differences Between U.S. GAAP and IFRS
U.S.GAAP
Typesofplans:Multiemployerplansaretypicallyconsideredtobedefinedcontributionpayasyougoplans.
Terminology: Postretirement benefits (OPEB) include postretirement benefits other than pensions and other postemployment
benefits.
Pension plan asset value: U.S. GAAP permits the use of a smoothed plan asset value (up to 5 years) to calculate expected rate of
returnonplanassets.ExpectedReturnonPlanAssets=MarketValuexExpectedRateofReturn.
Fundedstatus:Theactualeconomicfundedstatusisrecordedonthebalancesheet.Thepensionsassetsminusliabilities(PBO)are
bookedasanassetorliability.
Pension cost component classification: The net pension cost may be allocated to line items such as COGS, SG&A, or R&AD, but
pensionexpenseisreportedasonenetnumberontheincomestatement.
Actuarialgains/losses:Arisefromchangesinthediscountrate,actuarialtablechanges,anddifferencesbetweenthepensionplans
expected rate of return and actual returns. These gains or losses are either recognized over time based on the corridor approach
(common)orimmediatelyrecognizedthroughtheincomestatement(uncommon).
IFRS
Typesofplans:Multiemployerplansthataresimilarinstructuretoadefinedbenefitplanareclassifiedasdefinedbenefitplans.
Terminology:Postemploymentincludespension,postretirement(OPEB),andotherpostemploymentbenefits.
Pensionplanassetvalue:Smoothedmarketrelatedplanassetvaluesarenotallowed.Planassetsusedtocalculateexpectedreturns
mustbebasedoncurrentfairmarketvalue.ExpectedReturnonPlanAssets=FairValueofPensionAssetsxExpectedRateofReturn.
Fundedstatus:Thebalancesheetwillbemarkedtomarketsothattheactualfundedstatusoftheplanisrecordedonthebalance
sheet.Previously,economicfundedstatuswasonlyreportedinacompanysfootnotes,butnotonthebalancesheet.
Pension cost component classification: For recognition of periodic pension and OPEB costs, service cost will remain the same, but
therewillnolongerbespecificinterestcostandexpectedreturnonplanassetcomponents.Insteadtherewillbeoneamount,net
interestincome/(expense)thatwillberecorded.Thisamountwillbebasedonthediscountrateoftheplanxthenetfundedstatus.
The pension components are disaggregated so that the net interest income or expense will be below operating income in the
financingsectionoftheearningsstatementsimilartootherinterestcostitems.
Actuarialgains/losses:Remeasurements,oractuarialgains/losses,willberecognizedannuallydirectlyintoOtherComprehensive
Income,anequityholdingaccount.UnderthenewIFRSrules,theseamountswillnotbesubjecttorecyclingthroughearnings(e.g.
therewillbenoamortizationorcharges).Essentially,theonlyitemsthatwillgothroughearningsonaperiodicbasiswillbethe
servicecostandthenetinterestincome/(expense).
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BALANCESHEET:JVANDM&AACCOUNTING
Summary: A companys net income will be the same irrespective of whether it accounts for its
investments/partnership/acquisitions under the consolidation, equity, or proportional accounting method.
Although net income will be the same under each methodology, a companys margins and financial
ratios might be skewed depending on whether or not operating metrics are included in EBITDA.
Detailed JV and M&A Differences Between U.S. GAAP and IFRS
U.S.GAAP
Consolidation: Must be used if a company owns >50% of the voting rights and risks/rewards of an entity (regardless of ownership
interests,isthecompanytheprimarybeneficiaryoftheentityanddoesithavethepowertodirectitsactivities?).
Proportionateconsolidation:NotallowedunderU.S.GAAP.
Jointventures(5050%ownership):Equitymethodofaccountingisrequired.
IFRS
Consolidation:ThereisgreaterflexibilityunderIFRStoissuefinancialstatementsthatdonotconsolidateallentitieswithovera50%
ownership.MoreleniencytousetheequitymethodorproportionateconsolidationisallowedunderIFRS.
Proportionate consolidation: Allowed under IFRS. Proportionate consolidation records a companys ownership percentage of each
income,expense,andassetitem.Netincomewillbeunchanged,butthecompanysmarginsandfinancialratioswilldiffer.
Joint ventures (5050% ownership): Either the equity method or proportionate consolidation is allowed, but must be consistently
appliedgoingforward.
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BALANCESHEET:RESERVEACCOUNTSRESTRUCTURINGANDOTHERACCRUEDLIABILITIES
Summary: Based on IFRS, restructuring and other accrued liability charges are typically recorded in
earlier periods and often in larger amounts than U.S. GAAP. These differences arise because of IFRS
lower probability threshold (~50%) of when the charges are recorded on the books.
We believe that higher reserve account balances and the lack of policing result in a higher probability of
booking excess reserves to manage earnings. Weve observed that companies under IFRS tend to
reverse accrued liabilities as gains in earnings with greater frequency than companies under U.S.
GAAP.
Detailed Reserve Differences Between U.S. GAAP and IFRS
U.S.GAAP
Recordingreserves/provisions:BasedonFASNo.5,reserves(accruedliabilities)arerecordedonthebookswhentheliabilityisboth
probableandreasonablyestimable.Probableisgenerallyinterpretedtomeanatleasta75%chanceofoccurring.
Recordedreserveamounts:Themostlikelyoutcomeshouldberecordedonthebooks.Ifeachoutcomehasthesameprobability,the
lowestliabilityamongtherangeofpossibleoutcomesshouldberecorded.
Restructuring cost expensing and timing: Once management decides and commits to a detailed restructuring plan, each cost is
reviewedforwhenitshouldberecognizedandrecordedasanexpenseinearnings.
Unfavorablecontracts:Recordedoncethecompanystopsusingtheasset.
IFRS
Recordingreserves/provisions:Recordedwhenprobable,interpretedtomeanmorelikelythannotoragreaterthan50%change
ofoccurring.ThisisalowerthresholdthanunderU.S.GAAP.
Recorded reserve amounts: Similar to U.S. GAAP, the most likely outcome should be recorded on the books, but when a range of
potentialliabilitiesexist,themidpointshouldbeselected,resultinginahigherrecordedreserve.
Restructuringcostexpensingandtiming:Lessrestrictive,withrestructuringchargesbeingrecognizableearlier,thanU.S.GAAP.IFRS,
specificallyIAS37,onlyrequiresthatmanagementasdemonstrablycommittedtoarestructuring(detailedexitplan)andfocuseson
anexitplanasawholeratherthanindividualcostcomponentsoftheplan.Therestructuringdoesnotneedtobecommunicatedto
thecompanysemployees.
Unfavorable contracts: Recorded for an unfavorable contract, despite the fact that the company is still using its rights under the
contract.UnderIFRS,amountsaretypicallyexpensedsooner.
Contingent liabilities: Reduced disclosure for contingent liabilities is allowed if it is severely prejudicial to an entitys position in a
dispute.
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BALANCESHEET:COSTCAPITALIZATION
Summary: Under IFRS, if certain criteria are met, development costs may be capitalized and expensed
over the assets life. IFRS tends to lead to higher earnings due to the fact that more costs are capitalized
on the balance sheet instead of being immediately run through the income statement.
Detailed Cost Capitalization Differences Between U.S. GAAP and IFRS
U.S.GAAP
Advertising:Companiesmayeitherexpenseasincurredorcapitalizecosts(prepaidasset)andexpensethroughearningswhenthe
advertisingactuallyhappens.Directresponseadvertisingcostsmaybecapitalizedandsubsequentlyamortizedifcertainrequirements
aremet.
Research:Expensedasincurred.
Development: Typicallyexpensedasincurred,unlessspecificguidancesuggestscapitalizationinstead(e.g.,FASNo.86, resulting in

thecapitalizationofcertaincostssuchassoftwaredevelopment).
IFRS
Advertising:Notallowedtodefercostsuntiladvertisingoccursandmustbeexpensedimmediately.Capitalizationofdirectresponse
advertisingcostsasassetsisnotpermitted.
Research:Expensedasincurred.
Development:Ifcertaincriteriaaremet,developmentcostsmaybecapitalizedasanintangibleassetandamortizedovertheassets
expectedlife.Thereisnodistinguishmentbetweenassetsdevelopedforinternalorexternaluses.
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BALANCESHEET:CONVERTIBLEBONDS
Summary: IFRS requires companies to allocate convertible debt into debt and equity amounts on the
balance sheet. On the income statement, interest expense is recorded at the companys straight-debt
interest rate compared to the convertible bonds cash coupon rate. Only cash settled principal
convertible bonds in the U.S. use bifurcation accounting.
Detailed Convertible Bond Differences Between U.S. GAAP and IFRS
U.S.GAAP
Accounting: In general, the entire amount of a plain vanilla convertible bond is recorded as debt on the balance sheet. FASB Staff
PositionNo.APB141changedtheaccountingforcertaintypesofconvertiblebondstoabifurcationaccountingmodel,discussedin
depthintheconvertibledebtsection.
Interestexpense:Recordedbasedonabondseffectiveinterestrate,whichistypicallythecashcouponrate(unlessazerocoupon
discountbondforplainvanillaconverts).
IFRS
Accounting: Recorded as both debt and equity on the balance sheet. IAS requires bifurcation calculated under the residual
approach.Theinitialdebtamountrecordedonthebalancesheetisthefairvalueofdebtwithoutconsideringtheequityconversion
optionandtheresidualamount(parvaluelessfairvalueofdebt)isrecordedasequity.
Interestexpense:Recordedatthebondseffectiveinterestratewithoutconsideringtheequityconversionoption.
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INCOMESTATEMENT:REVENUERECOGNITION
Summary: Conceptually, revenue recognition is similar between U.S. GAAP and IFRS, however U.S.
GAAP tends to be more rules based and standardized within industries whereas IFRS is more principles
based. Due to the somewhat looser revenue recognition definitions and the presence of more
management discretions, we believe that under certain situations, IFRS may lead to earlier recognition
of revenue.
Detailed Revenue Recognition Differences Between U.S. GAAP and IFRS
U.S.GAAP
Based on: Principlesbased, including extensive guidance and rules. Detailed industry rules, common practices, and common
exceptionsalsoexist.
ExamplePercentageofCompletionAccounting:Typicallyonlyusedforconstructionorproductiontypecontractsanddisallowed
forservicetypecontracts.Sometimescompletedcontractrevenuerecognitionaccountingisused.
IFRS
Based on: Principlesbased, but unlike U.S. GAAP, there are no extensive guidance, rules, or specific industry practices. Extensive
professionaljudgmentisrequired.
Example Percentage of Completion Accounting: Required for service type contracts. Either straightline or revenue recognition
milestonesmaybeusedtorecognizerevenue.Thecompletedcontractaccountingmethodisgenerallydisallowed.
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INCOMESTATEMENT:CLASSIFICATION&PRESENTATION
Summary: Analysts should pay extra attention when comparing margins across a bunch of companies
due to the fact that certain expenses are classified in different areas of the income statement under U.S.
GAAP and IFRS.
Detailed Income Statement Classification & Presentation Differences Between U.S. GAAP and IFRS
U.S.GAAP
Expenses:Reportedbasedonfunction(COGS,SG&A,etc.)andmaybeclassifiedindifferingareasoftheincomestatementthanunder
IFRS.
Extraordinaryitems:Unusualandinfrequenteventsreportedasaseparatelineitembelowtheincomefromcontinuingoperations
line.
Comparativefinancialinformation:TheSECrequiresatleasttwoyearsofcomparativefinancialstatements,excludingthebalance
sheet,whichonlyrequiresoneyear.
Performancemeasures:TheSECmandatescertainpresentationrequirementssuchasheadingsandsubtotals.
IFRS
Expenses: Reported by either function or nature and may be classified in different areas of the income statement than under U.S.
GAAP.
Extraordinaryitems:Notallowed.
Comparative financial information: On year of comparative financial information is required for all numerical financial statement
information.
Performancemeasures:TraditionalU.S.GAAPconceptssuchasoperatingincomearenotdefined,sosignificantlydiversepractices
mayexistwithregardtoincomestatementheadings,subtotals,andlineitems.
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INCOMESTATEMENT:STOCKBASEDCOMPENSATION
Summary: Most of the stock based compensation accounting differences have been eliminated. The
largest remaining difference between U.S. GAAP and IFRS relates to taxes. When comparing a U.S.
and non-U.S. company, the U.S. companys operating cash flow should be adjusted higher by the
excess tax benefit from stock based compensation deductions reported as a cash financing inflow.
Detailed Stock Based Compensation Differences Between U.S. GAAP and IFRS
U.S.GAAP
Stock based compensation: Expense recognized on a straightline or accelerated basis. Accelerated basis is used for options with
gradedvestingschedulesandfrontendloadsstockbasedcompensationexpenseintoearlieryearsofthevestingschedule.
Excesstaxbenefits:Classifiedasfinancingcashflowson thecashflowstatementunderFASNo.123(R).Anexcesstaxbenefitis
whentheoption/restrictedstockvalueonthevestingdateishigherthanthesharepriceonthegrantdate.Thisisusuallymaterialto
heavyoption/restrictedstockcompanies.
Deferred tax accounting: Unusual and infrequent events reported as a separate line item below the income from continuing
operationsline.
IFRS
Stockbasedcompensation:Optionswithgradedvestingschedulesmustberecognized/expensedonanacceleratedbasis,resultingin
expenseamountsbeingrecognizedearlier.
Excesstaxbenefits:Classifiedasoperatingcashflowsonthecashflowstatement.
Deferredtaxaccounting:Remeasuredeachperiodbasedonchangesinthecompanysstockpricewiththeimpacttypicallyflowing
throughearnings.Forexample,ifacompanysstockpricedeclines,alowerfuturetax deduction results whenthestockvests.The
existing DTA must be written down by increasing income tax expense in the current period, resulting in more volatile quarterly
incometaxrates.
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INCOMESTATEMENT:INCOMETAXES
Summary: Under IFRS, income tax rates may be highly volatile for companies with high stock option
expense. This is due to the fact that stock based compensation deferred tax benefits are recorded
through earnings as they occur. Additionally, due to differing income tax rules, effective tax rates may
not be comparable to a U.S. company.
Other highly technical tax differences exist, but weve excluded them from the lists below since they
typically lead to only small differences.
Detailed Income Tax Differences Between U.S. GAAP and IFRS
U.S.GAAP
Deferred tax assets: Recognized in full on the balance sheet. A valuation allowance is also recoded that reduces the DTA to the
amountthatismorelikelythannot(greaterthan50%chance)toberealized.
Stock based compensation DTA: Recorded as the stock awards vest and not truedup for a stocks exercise price or changes in a
stocksintrinsicvalueuntilexerciseormaturity.
Balancesheetclassification:TheDTA/DTLisrecordedaseitheracurrentornoncurrentassetorliabilitybasedontherelatedassetor
liabilityforfinancialreportingpurposes.Ifthisisnotavailable,theDTA/DTLisclassifiedbasedonthetimeofexpectedreversal.
IFRS
Deferredtaxassets:Recognizedonlyifitisprobable(similartoU.S.GAAPsmorelikelythannotstandard(>50%))thattheDTAwill
berealized,butnovaluationallowancesarerecorded.ThisissimilartoU.S.GAAP,whichreportsDTAsatgrossamountsandrecordsa
valuationallowanceforamountsmorelikelythannottoberealized.
StockbasedcompensationDTA:Onlyrecordedwhenthestockawardistaxdeductibleandhasintrinsicvalue.Forstockoptions,as
thecompanysstockpricechanges,theDTAchangesarerecordedthroughearningsviatheincometaxexpense,resultinginamuch
morevolatileeffectivetaxrate.
Balancesheetclassification:AllDTA/DTLclassifiedasanetnoncurrentassetorliability.
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STATEMENTOFCASHFLOWS
Summary: The format of a companys cash flow statement is the same under U.S. GAAP and IFRS, but
there are a few differences in the classification of certain items within the cash flow statement, resulting
in differing operating and free cash flows.
We believe that management teams have greater flexibility in the interpretation of cash flows from
operations or investing, resulting in cash flow arbitrage (classifying cash outflows as investing and
inflows as operating). Though generally immaterial, the cash balance on a companys balance sheet
may be different under IFRS depending on where overdrafts are classified.
Detailed Cash Flow Statement Differences Between U.S. GAAP and IFRS
U.S.GAAP
Interestincome:Cashflowfromoperations.
Interestexpense:Cashflowfromoperations.
Dividendsreceived:Cashflowfromoperations.
Dividendspaid:Cashflowfromfinancing.
Taxespaid:Typicallycashflowfromoperations.
Overdrafts: Classified as borrowings within cash flow from financing and not included as a part of cash and equivalents. VIEs and
jointlycontrolledentitiesmayresultindifferentcashbalances.
IFRS
Interestincome:Cashflowfrominvestingoroperations.
Interestexpense:Cashflowfromfinancingoroperations.
Dividendsreceived:Cashflowfrominvestingoroperations.
Dividendspaid:Cashflowfromfinancingoroperations.
Taxespaid:Typicallycashflowfromoperations,unlessitisrelatedtoaspecificfinancingorinvestingactivity.
Overdrafts:Maybeincludedincashbalance.DifferententitiesconsolidatedunderIFRSwillresultindifferentreportedcashamounts
onthebalancesheet.
Note:Anaccountingpolicychoicemustbemaderegardingtheclassificationoftheseitemsandmustbeconsistentlyfollowed.
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Appendix:
AccountingCaseStudies
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PROQUEST(REVENUERECOGNITION)
In this case study, we review ProQuests accounting issues and the financial ratio warning signs.
ProQuest was an information service provider specializing in aggregating, organizing and packaging
licensed data from publishers and selling this information on microfilm, print and electronically to schools
and libraries. From 2001 through the first three quarters of 2005, ProQuests financial results were
boosted through decreasing expenses and increasing revenues. The financial impact of the fraud was to
increase pre-tax earnings by $130 million or 31% over the 2001 through Q3 2005 time period.
ProQuest
ProQuest
Announces earningsrestatement
$35
10
Delays10Kfiling
$30
StockPrice
12
Announces moredetail
onearningsrestatement
$25
$20
8
6
$15
$10
2
$5
$0
Jan05
Volume(millionsofshares)
$40
0
Jul05
Jan06
Jul06
Jan07
Jul07
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FactSet; Standard & Poors.
The scheme included several common areas of accounting abuses. First, the companys deferred
revenue account was understated as the company prematurely recognized revenue from the sale of its
software and learning products. The company sold some products to educational institutions over a
subscription based period. As shown in the exhibit below, one warning sign of this was the continued
decline in the companys days deferred revenue ratio in 2004 and early 2005. This suggested that the
company was managing the deferred revenue account to inflate earnings. Below we calculate the ratio
before and after the restatement obtaining materially different metrics.
ProQuest: Calculation of Short and Long Term Days Deferred Revenue
'Q12004
Shorttermdaysdeferredrevenue
102
Shorttermdaysdeferredrevenue,restated 106
Longtermdaysdeferredrevenue
35
Longtermdaysdeferredrevenue,restated 36
'Q22004
87
87
38
38
'Q32004 'Q42004 'Q12005 'Q22005 'Q32005

111 89 76 52 59
111 89 76 350 283
37
37
26
26
23 17 13
23 116 60
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Second, the company improperly capitalized software and other costs as assets on the balance sheet.
Third, prepaid assets for royalties were overstated as the company kept the expense of paying royalties
to content creators on the balance sheet rather than recording as an expense through earnings and also
made fictitious entries to increase this account balance. Fourth, acquisition accounting issues occurred
as the company allocated a significant portion of acquisitions purchase price amounts to goodwill and
did not fair value the intangibles and deferred revenue liability. When they restated earnings for this
issue, they were required to increase PP&E / long-lived assets and decrease goodwill. Below we show
ProQuests originally reported and restated cash flow statement and highlight key differences.
ProQuests Cash Flow Statement: As Originally Reported and As Restated
ProQuest:
The following table presents the effect of the Restatement

on the Consolidated Statements of Cash
Flows: (in thousands)
At January 3, 2004 (FY 2003)

At January 1, 2005 (FY 2004)
As
As
Previously
Previously
Reported
As Restated
As Restated
Reported
Operating activities:
Net earnings (loss)
$ 66,992 $ (180,051) $ 49,821 $ 18,574
Adjustments to reconcile net earnings (loss) to net
cash provided by operating activities:
Goodwill impairment
180,503
Gain on sale of discontinued operations

(13,484)
(16,049)
(908)
(717)
Equity in earnings of affiliate
Depreciation and amortization

71,561
71,893
60,696
62,281
64
Stock-related compensation
Gain on sale of fixed assets

(900)
(900)
21,894
27,722
26,544
3,396
Deferred income taxes
Changes in operating assets and liabilities, net of
acquisitions:
Accounts receivable, net

(174)
(12,496)
12,729
20,673
Inventory, net
(923)
252
167
1,429
(8,772)
6,626
(5,733)
(6,786)
Other current assets
Long-term receivables
(2,911)
(2,912)
(471)
(471)
(2,916)
(269)
(623)
1,908
Other assets
Accounts payable
623
4,060
4,647
9,049
(2,563)
(1,693)
(12,368)
(1,642)
Accrued expenses
Deferred income
(25,560)
3,267
(12,510)
5,172
Other long-term liabilities
3,692
12,683
37
331
Other, net
1,257
747
(1,858)
(204)
Net cash provided by operating activities

107,816
92,539
121,078
112,993
Investing activities:
Expenditures for property, plant, equipment,

product masters curriculum development
(66,774)
(49,049)
(70,819)
(63,604)
costs, and software
Proceeds from disposal of fixed assets
900
900
(25,767)
(23,587)
(51,754)
(56,354)
Acquisitions, net of cash acquired
Purchase of equity investments available for
sale
(7,893)
(7,825)
(1,978)
(1,660)
Proceeds from disposal of equity

4,261
4,261
490
490
investments available for sale
Proceeds from (expenditures associated
with) sales of discontinued operations

32,918
32,918
(2,540)
(2,540)
Net cash used in investing activities

(62,355)
(42,382)
(126,601)
(123,668)
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DIEBOLD(REVENUERECOGNITION)
In this case study, we review Diebolds accounting. Diebold is a manufacturer and servicer of ATM
machines. Through various improper accounting schemes, the company overstated pre-tax earnings by
approximately $127 million from 2002 through 2007.
Diebold
Diebold
$55
20
Delays'Q2earnings
18
16
$50
14
StockPrice
$45
UTXwithdraws
bid
$40
12
10
$35
$30
$25
UTXbidto
acquireDiebold
$20
$15
Jan06 Jul06
$60
2
0
Jan07 Jul07
Jan08
Jul08
Jan09 Jul09
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FactSet; Standard & Poors.
The scheme included several common areas of accounting abuses. First, the company prematurely
recognized revenue through improper use of bill and hold accounting. Second, inventory, revenue and
accrued expense reserves were reversed periodically as a gain in earnings without any justification.
Third, Diebold delayed expenses into future periods by delaying finished goods inventory write-downs
and capitalized expenses related to an Oracle software implementation project. Fourth, the company
wrote up used inventory, reducing cost of goods sold. Fifth, Diebold under-accrued the companys longterm incentive plan (LTIP) expense in 2002 and 2003 by reducing liability accounts. Instead of
recording the LTIP as compensation expense on the income statement, the company improperly
decreased other balance sheet liability accounts, including accounts payable and deferred revenue.
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February28,2012
VERIFONE(INVENTORYRESTATEMENT)
In this case study, we review VeriFones accounting issues and the financial ratio warning signs.
VeriFone sells and services automated electronic transaction payment systems. By improperly
overstating ending period inventory balances, the company overstated pre-tax earnings by
approximately $37 million in the first three quarters of 2007. The effect of overstating ending inventory is
to understate cost of goods sold and overstate net income. VeriFone's accounting issues came to light
during annual audit and, on 12/3/07, announced a financial restatement. As shown below, the
company's days inventory outstanding ratio began to spike and trend higher throughout the first three
quarters of 2007 signaling potential problems at the company.
VeriFone
Originallyreported
Asrestated
VeriFone
$60
StockPrice
$50
60
Announcesrestatement
of'Q1'Q32007earnings
anddelays'Q4results
50
$40
40
$30
30
$20
20
$10
10
$0
Jan06
DaysInventory(average)
'Q12006 'Q22006 'Q32006

'Q42006 'Q12007 'Q22007 'Q32007
69 69 87 92 96
46 49
69 69 73 84 73
46 49
0
Jul06
Jan07
Jul07
Jan08
Jul08
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February28,2012
YELLOWROADWAY(CHANGESTODEPRECIATIONMETHODS)
Changing an asset's depreciable life or residual value is very uncommon and, therefore, we use it a
strong signal of possible deeper issues at a company. In this case study, we review Yellow Roadway's
accounting issues and the financial ratio warning signs. First, the company lowered its 2006 earnings
guidance in March 2006. Next, approximately six months later beginning in Q3 2006, the company
changed equipment depreciable lives from 3 to 14 years to 10 to 20 years and modified certain salvage
values. This change increased EPS $.27 in 2006 ($26 million pre-tax). Yellow Roadway disclosed the
accounting changes in the footnotes of its 'Q3 2006 10-Q. However, the average depreciable life ratio
(gross PP&E divided by LTM depreciation expense) also flagged possible issues. As shown below, this
ratio jumped from 11.1 years to 13.0 years in 'Q3 2006, the quarter in which the depreciable life changes
occurred.
Yellow Roadway's Depreciation Changes
AverageDepreciableLife(Yrs)
'Q12006 'Q22006 'Q32006 'Q42006 'Q12007 'Q22007

10.9
11.1
13.0
13.6
14.6
14.6
YellowRoadway
Lowers2006
earningsguidance
1,800
$350
1,600
1,400
$300
$250
2,000
1,200
1,000
10Q disclosureof
depr.change(11/9)
$200
Volume
StockPrice(000sofUSD)
$400
800
600
400
$150
200
$100
Jan06 Apr06 Jul06 Oct06 Jan07 Apr07 Jul07 Oct07
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poors; FactSet. Securities and Exchange Commission.
WolfeTrahan.com
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February28,2012
HEALTHSOUTH(COSTCAPITALIZATION)
In this case study, we review HealthSouths accounting issues and the financial ratio warning signs.
HealthSouth provides outpatient surgery, diagnostic, and rehabilitative healthcare services in facilities
throughout the U.S. The company improperly reversed a revenue reserve account contractual
adjustment account as a gain in earnings and correspondingly increased (overstated) PP&E balances.
The contractual adjustment account was a revenue reserve account that is the difference between the
gross amount billed to a patient for a procedure and the amount actually paid by healthcare insurers. As
shown below for the yearly overstatement impacts, this accounting fraud overstated pre-tax earnings by
approximately $1.4 billion between 1999 and 'Q2 2002. Two financial ratios signaling potential problems
at HealthSouth were the increase in PP&Es average depreciable life and the high level of capital
expenditures relative to property, plant and equipment. In the exhibit below, we show these ratios as
originally reported and after their financial restatement (the company didnt restate 1998 and 1999
numbers).
HealthSouth
($ in millions)
Income before taxes
Reported
Actual
Difference
%
1999
230
-191
2000
559
194
2001
434
9
421
220%
365
188%
425
4722%
Six Months
2002
340
157
183
117%
AverageDepreciableLife(Yrs)
AverageDepreciableLife(Yrs),restatedin20002003
CapEx/PP&E,asoriginallyreported
CapEx/PP&E,asrestated
1998
8
NA
1999
9
NA
2000
10
12
2001
10
12
2002
11
12
30%
NA
16%
NA
18%
8%
11%
9%
8%
12%
Healthsouth
$90
16
Stockdelisted
$80
12
StockPrice
$70
10
$60
$50
8
CEOScrushyresigns
$40
$30
SECinvestigation
$20
$10
$0
Jan99
14
$100
0
Oct99
Jul00
Apr01
Jan02
Oct02
Jul03
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. Standard & Poors; FactSet; Securities and Exchange Commission.
WolfeTrahan.com
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Two Examples of Companies Changing Depreciation Accounting Policies
Whirlpool201010K
Property
Property,plantandequipmentisstatedatcost,netofaccumulateddepreciation.In2009,wechanged
our method of depreciation prospectively for substantially all longlived production machinery and
equipment to a modified units of production depreciation method. Under this method, we record
depreciationbasedonunitsproduced,unlessunitsproduceddropbelowaminimumthresholdatwhich
point depreciation is recorded using the straightline method. Prior to 2009, all machinery and
equipment was depreciated using the straightline method. We believe depreciating machinery and
equipmentbasedonunitsofproductionisapreferablemethodasitbestmatchestheusageofassets
withtherevenuesderivedfromthoseassets.Fornonproductionassets,wedepreciatecostsbasedon
the straightline method. Depreciation expense for property, plant and equipment was $527 million,
$497millionand$569millionin2010,2009and2008,respectively.
Asaresultofthischangeinmethodandloweroverallproductionlevels,depreciationexpensein2009
decreasedby$83millionfromwhatwouldhavebeenrecordedusingthestraightlinemethod.Netof
amounts capitalized into ending inventories and income taxes, net earnings increased $48 million for
2009,or$0.64perdilutedshare.Inaddition,theestimatedusefullivesofourmachineryandequipment
wasincreasedfrom3to10yearsto3to25years.[emphasisadded]
YellowRoadway200610K
DepreciableLivesofAssets
We perform annual internal studies to confirm the appropriateness of depreciable lives for each
categoryofpropertyandequipment.Thesestudiesutilizemodels,whichtakeintoaccountactualusage,
physicalwearandtear,andreplacementhistorytocalculateremaininglifeofourassetbase.Wealso
make assumptions regarding future conditions in determining potential salvage values. These
assumptionsimpacttheamountofdepreciationexpenserecognizedintheperiodandanygainorloss
oncetheassetisdisposed.
In2006,theCompanyrevisedtheestimatedusefullivesandsalvagevaluesofcertainclassesofproperty
andequipmenttomoreappropriatelyreflecthowtheassetsareexpectedtobeusedovertime.During
2006,theCompanyincreasedrevenueequipmentlivestoarangeoftentotwentyyearsfromthreeto
fourteen years and modified certain salvage values. If the Company had not changed the estimated
useful lives and salvage values of such property and equipment, additional depreciation expense of
approximately $26.3 million would have been recorded during the year ended December 31, 2006.
Accordingly,thechangesinestimatesresultedinanincreaseinincomefromcontinuingoperationsof
approximately$26.3million(a$16.0millionincreaseinnetincome)fortheyearendedDecember31,
2006. The change in estimate also increased diluted earnings per share by $0.27 for the year ended
December31,2006.[emphasisadded]
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CASESTUDY:LONGTOPFINANCIALTECHNOLOGIES
We thought it would be timely to review an in-process accounting investigation to see if there were
potential financial statement warning signs. As an example, we use Longtop Financial Technologies, a
seller of software for the financial services industry in China. Similar to certain other Chinese U.S. listed
companies, the company has been undergoing an investigation into accounting irregularities. On May
20, 2011 the CFO resigned followed by resignation of their auditor Deloitte on May 23, 2011.
Interestingly, in the Deloitte resignation letter, the Chairman of the company called a Deloitte Managing
Partner and informed him that there were fake revenue in the past so there were fake cash recorded on
the books. Some reasons Deloitte cited for resigning included: (i) cash at banks and loan balances
appear false, (ii) managements interference in the audit process, and (iii) detention of Deloittes audit
files. There is an ongoing SEC inquiry and the company hasnt filed its 2010 20-F annual report with the
SEC.
Longtop Financial Technologies: Historical Share Price
LongtopFinancialTechnologies
$45
$40
SharePrice(USD)
$35
$30
$25
$20
$15
$10
$5
$0
Jan09
May09
Sep09
Jan10
May10
Sep10
Jan11
May11
Sep11
Source: Wolfe Trahan Accounting & Tax Policy Research; Standard & Poors.
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February28,2012
CASESTUDY:LONGTOPFINANCIALTECHNOLOGIES(CONTINUED)
On the subsequent pages, we assembled the companys balance sheet, income statement and cash
flow statement used in our analysis and calculated various financial ratios.
In analyzing the current financial statements, we found several possible red flags. We summarize the
four red flag financial ratios below. First, the companys cash gross margin has been steadily declining
over the past several quarters and there is a material difference between the companys reported gross
margin and their cash gross margin. This suggests there has been more non-cash income likely related
to the sharp decline in deferred revenue over this same time period. Lower collections and payments on
accounts receivable and payables may also be a contributor. Second, since the company sells software,
in some situations they receive cash up-front for the sale/license of software. The balance sheet effect of
this is to increase cash and a deferred revenue liability. We closely monitor companies with deferred
revenue balances since it is a possible tool to manage earnings by aggressively recognizing revenue
from this account or reducing it to meet financial forecasts.
Based on our analysis, this account has been wildly volatile over the past eight quarters and steadily
declining. We also calculated days deferred revenue [(deferred revenue / revenue) x 365 days] which
standardizes this account relative to sales of the company. This item has been generally trending
downward. We find this ratio puzzling as it should be stable or growing for a company significantly
growing sales unless there has been a change in the business model. Third, the company has a very
high cash balance to total assets. Usually a high cash balance is an investment positive. However, this
balance is very high and one of the possible areas of accounting issues according to auditor statements.
Furthermore, the timing and amount of $133 million equity offering completed in the quarter ending
12/31/09 raises a red flag in light of an already high cash balance of $226 million at 9/30/09. It appears
that the capital raised was used to fund a $70 million cash acquisition completed in the period ending
March 31, 2010. However, prior to the equity offering, there was already a very high reported cash
balance raising suspicion as to why equity capital was raised. Last, the company maintains a very high
ratio of accrued liabilities to revenue. It is not clear why the balance is so high and atypical to see a ratio
this high based on our experiences.
Longtop Financial Technologies: Financial Ratios
3/31/09
6/30/09
MaterialDifferenceBetweenReported&CashMargins
Cashgrossmargin
Grossmargin
DeferredRevenueHighlyVolatile
Deferredrevenue/revenue
Daysdeferredrevenue
HighCashBalance
Cash/totalassets
($133mmequityofferingin'Q409)
HighAccruedLiabilities
Accruedliabilities/revenue
9/30/09
12/31/09
3/31/10
6/30/10
9/30/10
12/31/10
62.9%
53.8%
58.1%
54.9%
57.9%
62.8%
55.3%
66.0%
62%
56
56%
50
41%
40
51%
61
73%
54
48%
40
36%
33
40%
45
70%
59%
56%
63%
55%
54%
56%
57%
92%
93%
71%
64%
96%
95%
88%
79%
*Alsouseofadjusted/proformaearningsmeasures
Note:cashgrossmargincalculatedas1(LTMCOGSinAP+ininventory)/(LTMrevenueinAR+indeferredrevenue).
WolfeTrahan.com
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February28,2012
Longtop Financial Technologies Balance Sheet
($inthousands)
3/31/09
6/30/09
9/30/09
12/31/09
3/31/10
6/30/10
9/30/10
12/31/10
Currentassets
Cashandcashequivalents
Restrictedcash
Accountsreceivable,net
Inventories
Amountsduefromrelatedparties
Deferredtaxassets
Othercurrentassets
Totalcurrentassets
238,295
463
29,861
4,982
682
979
4,712
279,974
215,121
38
41,514
4,246
1,181
673
10,512
273,285
226,430
536
56,384
4,520
1,268
1,016
12,041
302,195
389,699
3,745
87,625
5,864
681
1,449
12,549
501,612
331,889
8,904
65,581
6,381
1,029
250
13,967
428,001
342,429
2,198
72,518
8,191
485
263
18,570
444,654
378,960
1,952
86,963
5,818
2,822
273
12,500
489,288
423,219
3,663
97,145
6,165
564
773
13,063
544,592
Fixedassets,net
Prepaidlanduseright
Intangibleassets,net
Goodwill
Investmentinanassociate
Deferredtaxassets
Otherassets
Totalassets
14,858
5,167
11,526
24,837
0
1,479
632
338,473
20,137
5,143
28,081
38,651
0
1,479
541
367,317
26,169
5,117
27,193
38,531
0
1,479
450
401,134
26,468
5,090
27,041
35,177
0
1,479
17,933
614,800
26,343
5,064
45,676
96,323
0
1,443
3,334
606,184
26,330
5,063
46,550
102,063
0
1,443
2,966
629,069
27,271
5,103
47,768
103,832
4,831
1,234
2,219
681,546
27,893
5,135
45,040
106,451
4,639
1,234
1,929
736,913
Liabilitiesandequity
Currentliabilities
Shorttermborrowings
Accountspayable
Deferredrevenue
Amountsduetorelatedparties
Deferredtaxliablities
Accruedandothercurrentliabilities
Totalcurrentliabilities
486
3,299
16,010
17
867
23,810
44,489
4,788
3,995
15,745
36
933
29,092
54,589
4,709
9,436
19,001
77
935
31,808
65,966
27,183
22,283
37,240
110
1,064
37,892
125,772
169
14,963
25,725
156
1,430
44,380
86,823
8,839
12,809
21,524
204
1,680
48,740
93,796
16,026
16,612
22,370
234
1,885
58,088
115,215
10,570
14,302
38,869
2,458
1,642
64,092
131,933
Longtermliabilities
Deferredtaxliabilities
Othernoncurrentliabilities
Totalliabilities
1,242
384
46,115
5,554
3,662
63,805
5,554
3,620
75,140
3,943
3,872
133,587
6,842
22,517
116,182
7,628
19,715
121,139
7,653
21,940
144,808
7,389
21,503
160,825
Equity
Ordinaryshares$0.01parvalue
APIC
Retainedearnings
AOCI
Totalequity
Totalliabilitiesandequity
510
243,194
29,451
19,203
292,358
338,473
513
245,811
37,835
19,353
303,512
367,317
517
249,262
56,744
19,471
325,994
401,134
562
378,583
82,551
19,517
481,213
614,800
562
381,262
88,542
19,636
490,002
606,184
564
384,723
100,572
22,071
507,930
629,069
569
474,592
32,935
28,642
536,738
681,546
571
478,061
62,691
34,765
576,088
736,913
WolfeTrahan.com
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February28,2012
Longtop Financial Technologies Balance Sheet
($inthousands,exceptshares)
3/31/09
6/30/09
9/30/09
12/31/09
3/31/10
6/30/10
9/30/10
12/31/10
Revenues:
Softwaredevelopment
Otherservices
Totalrevenue
21,050
4,832
25,882
24,717
3,776
28,493
36,995
5,839
42,834
46,397
8,267
54,664
37,091
5,975
43,066
38,744
10,142
48,886
55,477
4,987
60,464
72,498
4,429
76,927
Costofrevenues:
Softwaredevelopment
Otherservices
Totalcostofrevenues
Grossprofit
7,178
3,243
10,421
15,461
8,319
3,374
11,693
16,800
10,825
3,767
14,592
28,242
12,756
4,389
17,145
37,519
13,980
5,935
19,915
23,151
15,567
6,477
22,044
26,842
18,395
4,126
22,521
37,943
22,877
3,312
26,189
50,738
Operatingexpenses:
R&D
S&M
G&A
Goodwillimpairment
Totaloperatingexpenses
Incomefromoperations
1,541
3,160
2,339
0
7,040
8,421
1,517
3,259
2,766
0
7,542
9,258
1,962
5,304
2,734
0
10,000
18,242
2,549
5,549
3,639
0
11,737
25,782
2,191
6,854
4,844
1,982
15,871
7,280
2,220
7,268
4,017
0
13,505
13,337
2,022
6,392
4,903
0
13,317
24,626
2,519
8,553
5,102
0
16,174
34,564
Otherincome(expense):
Interestincome
Interestexpense
Otherincome,net
Totalotherincome
1,151
55
123
1,329
1,008
(16)
85
1,077
Incomebeforetax
Incometaxexpense
Lossfromdiscontinuedops.
Lossfrominvestmentinanassociate
Netincome
9,750
918
0
0
8,832
DilutedSharesOutstanding
DilutedEPS
992
(178)
220
1,034
1,096
(336)
8
768
1,219
(247)
377
1,349
1,494
(32)
63
1,525
1,448
(221)
(1)
1,226
1,802
(270)
239
1,771
10,335
1,951
0
0
8,384
19,276
367
0
0
18,909
26,550
743
0
0
25,807
8,629
2,638
0
0
5,991
14,862
2,832
0
0
12,030
25,852
4,317
0
48
21,487
36,335
6,239
0
340
29,756
52,368,317 53,237,958
0.17
0.16
53,375,287
0.35
55,597,313 55,174,468 58,327,801

0.46
0.11
0.21
56,628,591
0.38
58,826,842
0.51
WolfeTrahan.com
Page198of203
February28,2012
Longtop Financial Technologies Cash Flow Statement
($inthousands)
3/31/09
6/30/09
9/30/09
12/31/09
OperatingCashFlow
Netincome
8,832
8,384
Sharebasedcompensation
Depreciation
Amortization
Lossonpartialdisposalofsubsidiary
Lossfrominvestmentinanassociate
Provisionfordoubtfulaccounts
Impairmentofintangibleassets
Impairmentofgoodwill
Changeinfairvalueofcontingentconsideration
Lossondisposaloffixedassets
Deferredincometaxes
1,443
699
724
0
0
33
0
0
0
61
(389)
1,474
703
833
0
0
(26)
0
0
0
5
307
1,528
719
984
0
0
57
0
0
0
0
(341)
2,196
1,253
1,103
0
0
268
0
0
0
26
(433)
Accountsreceivable
Inventories
Othercurrentassets
Prepaidlanduseright
Othernoncurrentassets
Othernoncurrentliabilities
Accountspayable
Deferredrevenue
Accruedandothercurrentliabilities
Netcashfromoperations
3,751
(1,505)
1,283
(682)
28
(180)
(65)
(398)
(5,994)
17
72
7,730
(11,347)
816
(5,657)
(498)
27
91
4
(821)
(274)
19
(1,968)
(7,928)
(14,909)
(272)
(1,569)
(86)
28
91
57
3,529
3,250
41
6,832
18,848
InvestingCashFlow
Changeinrestrictedcash
Proceedsfromsaleoffixedassets
Purchaseoffixedassets
Purchaseofintangibleassets
Acquisitions,netofcashacquired
Depositmadeonacquisition
Proceedsfrompartialdisposalofsubsidiary,netofcash
Netcashfrominvestments
710
0
(2,370)
(46)
(5,577)
0
0
0
(7,283)
425
0
(3,902)
(138)
(16,779)
0
0
0
(20,394)
0
0
0
0
0
1,580
(116)
0
0
1,464
4,391
0
0
0
0
824
(187)
0
0
5,028
(48)
1,863
236,432
238,295
120
(23,174)
238,295
215,121
FinancingCashFlow
Proceedsfromshorttermborrowings
Repaymentofshorttermborrowings
Proceedsfromsaleofordinaryshares
Paymentofshareissuancecosts
Dividendpaid
Stockoptionsexercised
Paymentofcapitalleaseobligations
Paymentofacquisitionconsideration
Netcashfromfinancing
F/X
Netincrease(decrease)incash
Cashatbeginningofperiod
Cashatendofperiod
18,909
6/30/10
9/30/10
12/31/10
5,991
12,030
21,487
29,756
2,483
518
1,704
0
0
328
2,494
1,982
447
54
525
2,418
875
2,570
0
0
154
0
0
447
233
248
0
856
2,008
858
48
(550)
0
0
485
58
299
2,649
998
1,906
(241)
340
150
0
0
485
(2)
(685)
(31,339)
(1,343)
(474)
587
24
91
43
14,409
18,238
33
8,671
39,160
22,515
(515)
1,688
(350)
31
51
109
(6,805)
(11,521)
46
(8,931)
12,844
(7,074)
(1,796)
(4,665)
541
28
53
(2,996)
(2,441)
(4,181)
47
3,019
(490)
(14,746)
2,447
6,707
(3)
28
339
473
3,066
272
0
7,465
31,597
(9,204)
(278)
(741)
(3)
27
313
(880)
(2,069)
16,148
0
5,231
43,900
(498)
0
(4,929)
(84)
0
0
0
0
(5,511)
(3,209)
0
(3,066)
(280)
(548)
(17,574)
0
0
(24,677)
(5,159)
0
(1,073)
(1)
(52,546)
14,547
0
0
(44,232)
6,706
0
(614)
(41)
(2,899)
(2,708)
0
0
444
246
0
(1,850)
(105)
(7,389)
0
3,669
(1,714)
(7,143)
(1,711)
59
(1,758)
(436)
0
0
301
4,501
956
0
0
0
0
0
1,927
(81)
(3,949)
0
(2,103)
22,556
0
132,969
(6,321)
0
522
(84)
(896)
0
148,746
0
(26,947)
0
(23)
0
541
(63)
0
0
(26,492)
8,794
0
0
0
0
1,045
(166)
(564)
0
9,109
15,951
(8,954)
0
0
0
750
(3)
0
0
7,744
0
(5,580)
0
0
0
674
0
0
0
(4,906)
40
163,269
226,430
389,699
70
(57,810)
389,699
331,889
1,477
10,540
331,889
342,429
4,333
36,531
342,429
378,960
75
11,309
215,121
226,430
25,807
3/31/10
4,309
44,259
378,960
423,219
WolfeTrahan.com
Page199of203
February28,2012
CASESTUDY:KRISPYKREME
In this case study, we review Krispy Kremes (KKD) accounting issues and the financial ratio warning
signs. Krispy Kreme is a doughnut retailer and franchisor with both company owned stores and
franchised locations, the latter of which resulted in several accounting issues. Managements incentive
plan was based on achieving a pre-defined EPS growth hurdle and an EBTIDA return on assets ratio.
This created the motive for engaging in aggressive accounting.
There were multiple issues which came to surface when the company surprised the market by lowering
its earnings guidance in the first fiscal quarter of 2005 (beginning in February 2004 and shown in the
next chart). The companys issues stemmed from improper accrued liability accounting, long depreciable
lives on dough making equipment and aggressive acquisition accounting when buying out its Area
Developers. To a lesser extent, there were issues with overcapitalizing costs on balance sheet and
under-accruing liabilities (vacation pay), among other items.
First, the company used the accrued compensation expense liability to manage earnings by reversing
(reducing) it as a gain in earnings in several periods and, in other periods, increased earnings by under
accruing bonus expense (bonus accrued liability was lower than normal). Second, the company used
long depreciation periods for donut making equipment, thereby increasing EPS. There was negative free
cash flow throughout much of the periods in question.
The franchise business model also lent itself to accounting maneuvers. Operating 183 stores, the
company utilized 26 Area Developers (AD) to open stores in their territories under a pre-set minimum
store growth schedule. KKD owned a controlling interest in two ADs and a minority equity interest in 15
ADs. Investments were made in the minority equity interests through either capital contributions and/or
notes receivable to KKD. The minority investments were not consolidated onto KKDs balance sheet and
this understated true leverage levels at KKD since it was a guarantor of certain debt and lease
obligations for some of the joint ventures.
In certain circumstances when the ADs became profitable or otherwise, the company re-acquired the
majority interest in the franchises. This lead to several franchise re-acquisition accounting issues. KKD
assigned a material portion of the purchase price of ADs to reacquired franchise rights/goodwill. Such
items are accounted for as an indefinite life intangible assets and not expensed. This enhanced the
post-acquisition EPS from the lack of intangible amortization expense. In addition to this item, the
company restated earnings due to: (i) improper accounting for the Dallas, Michigan, and Northern
California franchise re-acquisitions, (ii) there was improper (early) revenue recognition on equipment
sales to franchisees, and (iii) improper incentive compensation accounting after the company completed
the buy-outs of ADs. In this regard, amounts paid subsequently to Area Development managing partners
who continued to work for the company were accounted for as part of the purchase price accounting, in
effect, increasing goodwill.
Since the employees continued to work for the company and the amount paid was dependent upon the
selling owners rendering services to the company after the acquisition, it should have been accounted
for as KKDs post-acquisition period compensation expense. By improperly accounting for it as an
acquisition related purchase accounting adjustment, it increased goodwill. KKDs operating expenses
were understated as a result. The next exhibit is a price chart and two possible warning signs of issues
at the company. The company reported a very high total accruals ratio and LTM capital expenditures to
PP&E was high.
WolfeTrahan.com
Page200of203
February28,2012
CASESTUDY:KRISPYKREME(CONTINUED)
Krispy Kreme
TotalAccruals/LTMRevs
LTMCapex/PP&E
TotalAssetGrowth
2/3/2002
2/2/2003
2/1/2004
11.1%
33.1%
48.9%
16.1%
41.1%
60.7%
22.5%
28.0%
60.9%
KrispyKreme
$60
Lowers fullyear
earningsestimates
StockPrice
$40
20
Announcesinformal
inquirybySEC
$30
15
Announcesearnings
restatements
$20
10
$10
$0
Jan03
25
$50
0
Jul03
Jan04
Jul04
Jan05
Jul05
Jan06
Jul06
Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; Standard & Poors; FactSet; Securities and Exchange Commission.
WolfeTrahan.com
Page201of203
February28,2012
ACCOUNTING&TAXPOLICYRESEARCHLIBRARY
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
ReportTitle
EuropeanFinancialCrisis:MarktoMarketManeuvers
CITDeepDive
Spinoffs,PostBankruptcyEquity&ValueOpportunities
PensionFundingDeteriorates$250Billion
SynovusFinancial:DTAValuedat$500Million
CompaniesInitiatingDividendsOutperform
ShareholderValueCreationStockIdeas:TREEAnalysis
Yahoo!PossibleAvenuestoUnlockTaxValue
Banks:EarningsQualityAnalysis
LargeShareRepurchasesandDeepValue
EarningsQuality:IdeasandaGuidetoAvoidAccountingPitfalls
ADiveIntoBanks'OffBalanceSheetVehicles
AudioUpdate:PensionUnderfundingwithChrisSenyek
2012PensionOutlook
VerizonCashFlowDeepDive:Taxes&WirelessSupportDividend
2012StockPickingIdeas:CapitalCreationandEarningsQuality
AudioUpdate:KeyThemesinFinancialswithChrisSenyek
Spinoffs,PostBankruptcyEquity&ValueOpportunities
DividendIncreasesSignalStockPriceOutperformance
WeeklySpinoffUpdate(IncludingPostHoldingsAnalysis)
Reincorporating:WillOthersFollowAon'sMove?
AudioUpdate:CorporateTaxReformUnveiledwithChrisSenyek
Topic
FinancialInstitutions
CorporateActions/Fin.Institutions
CorporateActions
Pensions
CorporateActions
CapitalAllocation
CorporateActions
EarningsQuality/Fin.Institutions
CapitalAllocation
EarningsQuality
Pensions
Pensions
Telecom
CapitalAllocation&EarningsQuality
CorporateActions
CorporateActions
CorporateActions
CorporateActions/Taxes
Taxes
Date
9/23/2011
9/28/2011
10/7/2011
10/12/2011
10/24/2011
10/31/2011
11/8/2011
11/15/2011
11/21/2011
11/30/2011
12/6/2011
12/16/2011
12/20/2011
1/3/2012
1/5/2012
1/9/2012
1/12/2012
1/13/2012
1/30/2012
2/3/2012
2/15/2012
2/23/2012
* EveryFriday,wesendoutSenyeksWeeklySpinoffUpdate,abrieflookatnewannouncements,updates,andactivitiesin
spinoffandpostbankruptcyequities.Wemaintainaseparatedistributionlistforthisreport.Ifyouwouldliketobeadded,
pleasecontactchris@wolfetrahan.comoryourWolfeTrahansalesperson.
WolfeTrahan.com
Page202of203
February28,2012
DISCLOSURES
The content of this report is to be used solely for informational purposes and should not be regarded as
an offer, or a solicitation of an offer, to buy or sell a security, financial instrument or service discussed
herein. Opinions in this communication constitute the current judgment of the author as of the date and
time of this report and are subject to change without notice. Information herein is believed to be reliable
but Wolfe Trahan & Co. and its affiliates, including but not limited to WR Securities, LLC, makes no
representation that it is complete or accurate. The information provided in this communication is not
designed to replace a recipient's own decision-making processes for assessing a proposed transaction
or investment involving a financial instrument discussed herein. Recipients are encouraged to seek
financial advice from their financial advisor regarding the appropriateness of investing in a security or
financial instrument referred to in this report and should understand that statements regarding the future
performance of the financial instruments or the securities referenced herein may not be realized. Past
performance is not indicative of future results. This report is not intended for distribution to, or use by,
any person or entity in any location where such distribution or use would be contrary to applicable law,
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location. For additional important disclosures, please see www.WolfeTrahan.com/Disclosures.
The views expressed in Wolfe Trahan & Co. research reports with regards to sectors and/or specific
companies may from time to time be inconsistent with the views implied by inclusion of those sectors
and companies in other Wolfe Trahan & Co. analysts research reports and modeling screens.
Copyright Wolfe Trahan & Co. 2012. All rights reserved. All material presented in this document,
unless specifically indicated otherwise, is under copyright to Wolfe Trahan & Co. None of the material,
nor its content, nor any copy of it, may be altered in any way, or transmitted to or distributed to any other
party, without the prior express written permission of Wolfe Trahan & Co.
This report is limited for the sole use of clients of Wolfe Trahan & Co. Authorized users have received an
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February28,2012

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ACCOUNTING&TAXPOLICY

Important Disclosures to Review Include: Cost capitalization, equity investments, depreciation,

Chris Senyek, CFA, CPA

Adam Calingasan, CFA, CPA

Clinton Chang, CFA, CPA

Market for Registrants Common Equity and Related Stockholder Matters

Directors and Executive Officers of the Registrant

Exhibits and Financial Statement Schedules

Effective Date / Status

ASU No. 2011-09, Compensation Retirement Benefits - Multiemployer

Requires additional disclosures in tabular formats for each significant

Effective for 2011 10-Ks for calendar year

ASU No. 2011-08, IntangiblesGoodwill and Other (Topic 350):

Adds a preliminary qualitative assessment to the testing for goodwill impairment.

Effective 'Q1 2012.

ASU No. 2011-05, Comprehensive

Clarifies the presentation of items recognized in Other Comprehensive Income.

Effective 'Q1 2012.

ASU No. 2011-11, Balance Sheet

Effective 'Q1 2013 with retrospective

Effective Date / Status

Joint FASB/IASB project. Will result in complete overhaul of current lease

Significant changes have been made since

Financial Instruments Accounting

Joint FASB/IASB project. Will result in overhaul of accounting for financial

There have been significant changes since

Re-deliberations are ongoing based on

Tax Policy Changes

Effective Date / Status

Individual Tax Increases

Expiration of lower individual Pre-Bush tax cut rates resulting in increased

Source: Wolfe Trahan Accounting & Tax Policy Research.

The SECs written comment remains unresolved at the10-K filing date;

OFF-BALANCE SHEET EXPOSURES

Carrying value asset (liability)

Maximum exposure to loss

USING OFF-BALANCE SHEET VEHICLES TO HIDE DEBT, INVENTORY, AND/OR EXPENSES

CONTRACTUAL OBLIGATIONS AND FIXED CASH FLOW COMMITMENTS

Delta Air Lines (2011 Form 10-K): Contractual Obligations Table

CASH BALANCES ARE OFTEN OVERSTATED IN VALUATION

LARGE INVENTORY RESERVE CHANGES MAY INFLATE PROSPECTIVE GROSS MARGINS

ANY LARGE CHANGES IN THE MIX OF INVENTORY RELATIVE TO TOTAL INVENTORIES?

HAVE THERE BEEN MATERIAL REDUCTIONS IN THE LIFO INVENTORY RESERVE?

INVENTORY ACCOUNTING POLICY CHANGES (E.G. LIFO TO FIFO)?

As of and for the Year

Cost of goods sold

ARE INVENTORY RESERVES BOOSTING MARGINS?

IS LOWER PRODUCTION DEPRESSING MARGINS FROM EXCESS OVERHEAD?

IS HIGHER PRODUCTION BOOSTING MARGINS?

ARE OTHER COSTS CAPITALIZED INTO INVENTORY?

INVENTORY: EARNINGS QUALITY

Change in inventory accounting methods;

HOW TO SPOT INVENTORY ISSUES

DEPRECIATION CHANGES: TWO WAYS TO USE PP&E TO BOOST EARNINGS

Source: Wolfe Trahan Accounting & Tax Policy Research.

Example of Depreciation Changes in Estimated Lives Archer Daniels Midland

Source: Wolfe Trahan Accounting & Tax Policy Research.

Source: Wolfe Trahan Accounting & Tax Policy Research; IRS.

of a companys gross receipts or 2% of a companys total depreciation and amortization

BONUS DEPRECIATION: FINANCIAL STATEMENTS IMPACT

The three tests of significance are:

ARE INTANGIBLE ASSETS AND GOODWILL TAX-DEDUCTIBLE?

HAVE THERE BEEN MATERIAL CHANGES IN PURCHASE PRICE ALLOCATIONS?

WHAT PERCENTAGE OF THE PURCHASE PRICE WAS ALLOCATED TO GOODWILL?