PORTABLE
MBA
in
FINANCE AND
ACCOUNTING
The Portable MBA Series
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Livingstone and Theodore Grossman
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PORTABLE
MBA
in
FINANCE AND
ACCOUNTING
THIRD EDITION
Edited by
John Leslie Livingstone
and
Theodore Grossman
John Wiley & Sons, Inc.
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v
Preface
Do you know how to accomplish these important business tasks?
• Understand financial statements.
• Measure liquidity of a business.
• Analyze business profitability.
• Differentiate between regular income and extraordinary items.
• Predict future bankruptcy for an enterprise.
• Prepare a budget.
• Do a break-even analysis.
• Measure productivity.
• Figure out return on investment.
• Compute the cost of capital.
• Put together a business plan.
• Legitimately minimize income taxes payable by you or your business.
• Decide whether your business should be a limited partnership, a C or S
corporation, or some other type of entity.
• Take your company public.
• Manage foreign currency exposure.
• Evaluate a merger or acquisition target.
• Serve as a director of a corporation.
• Build a successful e-business.
• Understand and use financial derivatives.
• Use information technology for competitive advantage.
• Value a business.
These are some of the key topics explained in this book. It is a book designed
to help you learn the basics in finance and accounting, without incurring
the considerable time and expense of a formal MBA program.
vi Preface
The first edition of this book was published in 1992, and the second edition
in 1997. Both editions, hardback and paperback, have been highly successful
and have sold many, many copies. In addition, the book has been translated
into Chinese (Cantonese and Mandarin), French, Indonesian, Portuguese, and
Spanish. We are delighted that so many readers in various countries have found
this book useful. Now, the entire book has been updated for the third edition.
The following new chapters have been added:
• Chapter 1: Using Financial Statements
• Chapter 3: Cost-Volume-Profit Analysis
• Chapter 5: Information Technology and You
• Chapter 6: Forecasts and Budgets
• Chapter 9: The Business Plan
• Chapter 10: Planning Capital Expenditure
• Chapter 17: Profitable Growth by Acquisition
• Chapter 18: Business Valuation
Also, there are eight new authors, substantial revisions of four chapters
and complete updates of all remaining chapters. The book consists of valuable,
practical how-to-do-it information, applicable to an entire range of businesses,
from the smallest startup to the largest corporations in the world.
Each chapter of the book has been written by an outstanding expert in the
subject matter of that particular chapter. Some of these experts are full-time
practitioners in the real world, and others are part-time consultants who also
serve as business school professors. Most of these professors are on the faculty
of Babson College, which is famous for its major contributions to the
field of entrepreneurship and which, year after year, is at the top of the annual
list of leading independent business schools compiled by U.S. News and
World Report.
This book can be read, and reread, with a great deal of profit. Also, it can
be kept handy on a nearby shelf in order to pull it down and look up answers to
questions as they occur. Further, this book will help you to work with finance
and accounting professionals on their own turf and in their own jargon. You
will know what questions to ask, and you will better understand the answers
you receive without being confused or intimidated.
Who can benefit from this book? Many different people, such as:
• Managers wishing to improve their business skills.
• Engineers, chemists, scientists and other technical specialists preparing
to take on increased management responsibilities.
• People already operating their own businesses, or thinking of doing so.
• Business people in nonfinancial positions who want to be better versed in
financial matters.
• BBA or MBA alumni who want a refresher in finance and accounting.
Preface vii
• People in many walks of life who need to understand more about financial
matters.
Whether you are in one, some, or even none of the above categories, you
will find much of value to you in this book, and the book is reader friendly.
Frankly, most finance and accounting books are technically complex, boringly
detailed, or just plain dull. This book emphasizes clarity to nonfinancial readers,
using many helpful examples and a bright, interesting style of writing.
Learn, and enjoy!
JOHN LESLIE LIVINGSTONE
THEODORE GROSSMAN
ix
Acknowledgments
A book like this results only from the contributions of many talented people.
We would like to thank the chapter authors that make up this book for their
clear and informative explanations of the powerful concepts and tools of finance
and accounting. In this world of technology and the Internet, while most
of the underlying concepts remain fixed, the applications are ever changing,
requiring the authors to constantly rededicate themselves to their professions.
Our deepest appreciation goes to our wives, Trudy Livingstone and Ruth
Grossman, and to our children Robert Livingstone, Aaron and Melissa Grossman,
and Michael Grossman. They provide the daily inspiration to perform our
work and to have undertaken this project.
J. L. L.
T. G.
xi
Contents
Preface v
Acknowledgments ix
PART ONE UNDERSTANDING THE NUMBERS 1
1. Using Financial Statements 3
John Leslie Livingstone
2. Analyzing Business Earnings 35
Eugene E. Comiskey and Charles W. Mulford
3. Cost-Volume-Profit Analysis 102
William C. Lawler
4. Activity-Based Costing 126
William C. Lawler
5. Information Technology and You 149
Edward G. Cale Jr.
6. Forecasts and Budgets 173
Robert Halsey
7. Measuring Productivity 199
Michael F. van Breda
xii Contents
PART TWO PLANNING AND FORECASTING 223
8. Choosing a Business Form 225
Richard P. Mandel
9. The Business Plan 260
Andrew Zacharakis
10. Planning Capital Expenditure 291
Steven P. Feinstein
11. Taxes and Business Decisions 314
Richard P. Mandel
12. Global Finance 353
Eugene E. Comiskey and Charles W. Mulford
13. Financial Management of Risks 423
Steven P. Feinstein
PART THREE MAKING KEY
STRATEGIC DECISIONS 457
14. Going Public 459
Stephen M. Honig
15. The Board of Directors 510
Charles A. Anderson and Robert N. Anthony
16. Information Technology and the Firm 536
Theodore Grossman
17. Profitable Growth by Acquisition 561
Richard T. Bliss
18. Business Valuation 593
Michael A. Crain
Glossary 626
About the Authors 643
Index 649
PART ONE
UNDERSTANDING
THE NUMBERS
3
1 USING FINANCIAL
STATEMENTS
John Leslie Livingstone
WHAT ARE FINANCIAL STATEMENTS? A CASE STUDY
Pat was applying for a bank loan to start her new business, Nutrivite, a retail
store selling nutritional supplements, vitamins, and herbal remedies. She described
her concept to Kim, a loan officer at the bank.
Kim: How much money will you need to get started?
Pat: I estimate $80,000 for the beginning inventory, plus $36,000 for store
signs, shelves, fixtures, counters, and cash registers, plus $24,000 working
capital to cover operating expenses for about two months. That's a total of
$140,000 for the startup.
Kim: How are you planning to finance the investment of the $140,000?
Pat: I can put in $100,000 from my savings, and I'd like to borrow the remaining
$40,000 from the bank.
Kim: Suppose the bank lends you $40,000 on a one-year note, at 15% interest,
secured by a lien on the inventory. Let's put together projected financial
statements from the figures you gave me. Your beginning balance sheet
would look like what you see on my computer screen:
4 Understanding the Numbers
Nutrivite
Projected Balance Sheet as of January 1, 200X
Assets Liabilities and Equity
Cash $ 24,000 Bank loan $ 40,000
Inventory 80,000
Current assets 104,000 Current liabilities 40,000
Fixed assets: Equity:
Equipment 36,000 Owner capital 100,000
Total assets $140,000 Liabilities and equity $140,000
The left side shows Nutrivite's investment in assets. It classifies the assets
into "current" (which means turning into cash in a year or less) and
"noncurrent" (not turning into cash within a year). The right side shows how
the assets are to be financed: partly by the bank loan and partly by your equity
as the owner.
Pat: Now I see why it's called a "balance sheet." The money invested in assets
must equal the financing available—its like the two sides of a coin. Also, I
see why the assets and liabilities are classified as "current" and "noncurrent"—
the bank wants to see if the assets turning into cash in a year or less
will provide enough cash to repay the one-year bank loan. Well, in a year
there should be cash of $104,000. That's enough cash to pay off more than
twice the $40,000 amount of the loan. I guess that guarantees approval of
my loan!
Kim: We're not quite there yet. We need some more information. First, tell
me, how much do you expect your operating expenses will be?
Pat: For year 1, I estimate as follows:
Store rent $36,000
Phone and utilities 14,400
Assistants' salaries 40,000
Interest on the loan 6,000 (15% on $40,000)
Total $96,400
Kim: We also have to consider depreciation on the store equipment. It probably
has a useful life of 10 years. So each year it depreciates by 10% of its cost
of $36,000. That's $3,600 a year for depreciation. So operating expenses
must be increased by $3,600 a year, from $96,400 to $100,000. Now, moving
on, how much do you think your sales will be this year?
Pat: I'm confident that sales will be $720,000 or even a little better. The
wholesale cost of the items sold will be $480,000, giving a markup of
$240,000—which is 331⁄3% on the projected sales of $720,000.
Using Financial Statements 5
Kim: Excellent! Let's organize this information into a projected income statement.
We start with the sales, then deduct the cost of the items sold to arrive
at the gross profit. From the gross profit we deduct your operating
expenses, giving us the income before taxes. Finally we deduct the income
tax expense in order to get the famous "bottom line," which is the net income.
Here is the projected income statement shown on my computer
screen:
Nutrivite
Projected Income Statement for the
Year Ending December 31, 200X
Sales $720,000
Less cost of goods sold 480,000
Gross profit 240,000
Less expenses
Salaries $ 40,000
Rent 36,000
Phone and utilities 14,400
Depreciation 3,600
Interest 6,000 100,000
Income before taxes 140,000
Income tax expense (40%) 56,000
Net income $ 84,000
Pat, this looks very good for your first year in a new business. Many
business startups find it difficult to earn income in their first year. They do
well just to limit their losses and stay in business. Of course, I'll need to carefully
review all your sales and expense projections with you, in order to
make sure that they are realistic. But first, do you have any questions about
the projected income statement?
Pat: I understand the general idea. But what does "gross profit" mean?
Kim: It's the usual accounting term for sales less the amount that your suppliers
charged you for the goods that you sold to your customers. In other words,
it represents your markup from the wholesale cost you paid for goods and the
price for which you sold those goods to your customers. It is called "gross
profit" because your operating expenses have to be deducted from it. In
accounting, the word gross means "before deductions." For example "gross
sales" means sales before deducting goods returned by customers. Sales after
deducting goods returned by customers are referred to as "net sales." In accounting,
the word net means "after deductions." So "gross profit" means income
before deducting operating expenses. By the same token, "net income"
means income after deducting operating expenses and income taxes. Now,
moving along, we are ready to figure out your projected balance sheet at the
6 Understanding the Numbers
end of your first year in business. But first I need to ask you how much cash
you plan to draw out of the business as your compensation?
Pat: My present job pays $76,000 a year. I'd like to keep the same standard of
compensation in my new business this coming year.
Kim: Let's see how that works out after we've completed the projected balance
sheet at the end of year 1. Here it is on my computer screen:
Nutrivite
Projected Balance Sheet as of December 31, 200X
Assets Liabilities and Equity
Cash $ 35,600 Bank loan $ 40,000
Inventory 80,000
Current assets 115,600 Current liabilities 40,000
Fixed assets: Equity:
Equipment $36,000 Capital: Jan 1 100,000
Less depreciation 3,600 Add net income 84,000
Net equipment $32,400 32,400 Less drawings (76,000)
Capital: Dec 31 108,000
Total assets $148,000 Liabilities and equity $148,000
Let's go over this balance sheet together, Pat. It has changed compared
to the balance sheet as of January 1. On the Liabilities and Equity side of
the balance sheet, the Net Income of $84,000 has increased Capital to
$184,000 (because earning income adds to the owner's Capital), and deducting
Drawings of $76,000 has reduced Capital to $108,000 (because
Drawings take Capital out of the business). On the asset side, notice that the
Equipment now has a year of depreciation deducted, which writes it down
from the original $36,000 to a net (there's that word net again) $32,400 after
depreciation. The Equipment had an expected useful life of 10 years, now
reduced to a remaining life of 9 years. Last but not least, notice that the
Cash has increased by $11,600 from $24,000 at the beginning of the year to
$35,600 at year-end. This leads to a problem: The Bank Loan of $40,000 is
due for repayment on December 31. But there is only $35,600 in Cash available
on December 31. How can the Loan be paid off when there is not
enough Cash to do so?
Pat: I see the problem. But I think it's bigger than just paying off the loan.
The business will also need to keep about $25,000 cash on hand to cover two
months operating expenses and income taxes. So, with $40,000 to repay the
loan plus $25,000 for operating expenses, the cash requirements add up to
$65,000. But there is only $35,600 cash on hand. This leaves a cash shortage
of almost $30,000 ($65,000 less $35,600). Do you think that will force me to
Using Financial Statements 7
cut down my drawings by $30,000, from $76,000 to $45,000? Here I am
opening my own business, and it looks as if I have to go back to what I was
earning five years ago!
Kim: That's one way to do it. But here's another way that you might like better.
After your suppliers get to know you and do business with you for a few
months, you can ask them to open credit accounts for Nutrivite. If you get
the customary 30-day credit terms, then your suppliers will be financing one
month's inventory. That amounts to one-twelfth of your $480,000 annual
cost of goods sold, or $40,000. This $40,000 will more than cover the cash
shortage of $30,000.
Pat: That's a perfect solution! Now, can we see how the balance sheet would
look in this case?
Kim: Sure. When you pay off the Bank Loan, it vanishes from the balance
sheet. It is replaced by Accounts Payable of $40,000. Then the balance sheet
looks like this:
Nutrivite
Projected Balance Sheet as of December 31, 200X
Assets Liabilities and Equity
Cash $ 35,600 Accounts payable $ 40,000
Inventory 80,000
Current assets 115,600 Current liabilities 40,000
Fixed assets: Equity:
Equipment $36,000 Capital: Jan 1 100,000
Less depreciation 3,600 Add net income 84,000
Net equipment $32,400 32,400 Less drawings (76,000)
Capital: Dec 31 108,000
Total assets $148,000 Liabilities and equity $148,000
Now the cash position looks a lot better. But it hasn't been entirely
solved: There is still a gap between the Accounts Payable of $40,000 and the
Cash of $35,600. So you will need to cut your drawings by about $5,000 in
year 1. But that's still much better than the cut of $30,000 that had seemed
necessary before. In year 2 the Bank Loan will be gone, so the interest expense
of $6,000 will be saved. Then you can use $5,000 of this saving to restore
your drawings back up to $76,000 again.
Pat: That's good news. I'm beginning to see how useful projected financial
statements are for business planning. Can we look at the revised projected
balance sheet now?
Kim: Of course. Here it is:
8 Understanding the Numbers
Nutrivite
Projected Balance Sheet as of December 31, 200X
Assets Liabilities and Equity
Cash $ 40,600 Accounts payable $ 40,000
Inventory 80,000
Current assets 120,600 Current liabilities 40,000
Fixed assets: Equity:
Equipment $36,000 Capital: Jan 1 100,000
Less depreciation 3,600 Add net income 84,000
Net equipment $32,400 32,400 Less drawings (71,000)
Capital: Dec 31 113,000
Total assets $153,000 Liabilities and equity $153,000
As you can see, Cash is increased by $5,000 to $40,600—which is sufficient
to pay the Accounts Payable of $40,000. Drawings is decreased by
$5,000 to $71,000, which provided the $5,000 increase in Cash.
Pat: Thanks. That makes sense. I really appreciate everything you've taught
me about financial statements.
Kim: I'm happy to help. But there is one more financial statement to discuss.
Besides the balance sheet and income statement, a full set of financial statements
also includes a cash f low statement. Here is the projected cash flow
statement:
Nutrivite
Projected Cash Flow Statement for the
Year Ending December 31, 200X
Sources of Cash
From Operations:
Net income $ 84,000
Add depreciation 3,600
Add increase in current liabilities 40,000
Total cash from operations (a) $ 127,600
From Financing:
Drawings $ (71,000) Negative cash
Bank loan repaid (40,000) Negative cash
Net cash from financing (b) (111,000) Negative cash
Total sources of cash (a + b) $ 16,600
Using Financial Statements 9
Uses of Cash
Total uses of cash 0
Total sources less total uses of cash $ 16,600 Net cash increase
Add cash at beginning of year 24,000
Cash at end of year $ 40,600
Pat, do you have any questions about this Cash Flow Statement?
Pat: Actually, it makes sense to me. I realize that there are only two sources
that a business can tap in order to generate cash: internal (by earning income)
and external (by obtaining cash from outside sources, such as bank
loans). In our case the internal sources of cash are represented by the "Cash
from Operations" section of the Cash Flow Statement, and the external
sources are represented by the "Cash from Financing" section. It happens
that the "Cash from Financing" is negative because no additional outside financing
is received for the year 200X, but cash payments are incurred for
Drawings and for repayment of the Bank Loan. I also understand that there
are no "Uses of Cash" because no extra Equipment was acquired. In addition,
I can see that the Total Sources of Cash less the Total Uses of Cash
must equal the Increase in Cash, which in turn is the Cash at the end of the
year less the Cash at the beginning of the year. But I am puzzled by the
"Cash from Operations" section of the Cash Flow Statement. I can understand
that earning income produces Cash. However why do we add back Depreciation
to the Net Income in order to calculate Cash from Operations?
Kim: This can be confusing, so let me explain. Certainly Net Income increases
Cash, but first an adjustment has to be made in order to convert Net Income
to a cash basis. Depreciation was deducted as an expense in figuring Net Income.
So adding back depreciation to Net Income just reverses the charge
for depreciation expense. We back it out because depreciation is not a cash
outflow. Remember that depreciation represents just one year's use of the
Equipment. The cash outf low for purchasing the Equipment was incurred
back when the Equipment was first acquired and amounted to $36,000. The
Equipment cost of $36,000 is spread out over the 10-year life of the Equipment
at the rate of $3,600 per year, which we call Depreciation expense. So
it would be double counting to recognize the $36,000 cash outf low for the
Equipment when it was originally acquired and then to recognize it a second
time when it shows up as Depreciation expense. We do not write a check to
pay for Depreciation each year, because it is not a cash outflow.
Pat: Thanks. Now I understand that Depreciation is not a cash outflow. But I
don't see why we also added back the Increase in Current Liabilities to the
Net Income to calculate Cash from Operations. Can you explain that?
Kim: Of course. The increase in Current Liabilities is caused by an increase in
Accounts Payable. These Accounts Payable are amounts owed to our suppliers
10 Understanding the Numbers
for our purchases of goods for resale in our business. Purchasing goods for
resale from our suppliers on credit is not a cash outflow. The cash outflow
only occurs when the goods are actually paid for by writing out checks to our
suppliers. That is why we added back the Increase in Current Liabilities to
the Net Income in order to calculate Cash from Operations. In the future,
the Increase in Current Liabilities will, in fact, be paid in cash. But that will
take place in the future and is not a cash outf low in this year. Going back to
the Cash Flow Statement, notice that it ties in neatly with our balance sheet
amount for Cash. It shows how the Cash at the beginning of the year plus the
Net Cash Increase equals the Cash at the end of the year.
Pat: Now I get it. Am I right that you are going to review my projections and
then I'll hear from you about my loan application?
Kim: Yes, I'll be back to you in a few days. By the way, would you like a printout
of the projected financial statements to take with you?
Pat: Yes, please. I really appreciate your putting them together and explaining
them to me. I picked up some financial skills that will be very useful to me
as an aspiring entrepreneur.
POINTS TO REMEMBER ABOUT
FINANCIAL STATEMENTS
When Pat arrived home, she carefully reviewed the projected financial statements,
then made notes about what she had learned.
1. The basic form of the balance sheet is Assets = Liabilities + Owner Equity.
2. Assets are the expenditures made for items, such as Inventory and Equipment,
that are needed to operate the business. The Liabilities and Owner
Equity ref lect the funds that financed the expenditures for the Assets.
3. Balance sheets show the financial position of a business at a given moment
in time.
4. Balance sheets change as transactions are recorded.
5. Every transaction is an exchange, and both sides of each transaction are
recorded. For example, when a company obtains a bank loan, there is an
increase in the asset cash that is matched by an increase in a liability entitled
"Bank Loan." When the loan is repaid, there is a decrease in cash
which is matched by a decrease in the Bank Loan liability. After every
transaction, the balance sheet stays in balance.
6. Income increases Owner Equity, and Drawings decrease Owner Equity.
7. The income statement shows how income for the period was earned.
8. The basic form of the income statement is:
a. Sales − Cost of Goods Sold = Gross Income.
b. Gross Income − Expenses = Net Income.
Using Financial Statements 11
9. The income statement is simply a detailed explanation of the increase in
Owner Equity represented by Net Income. It shows how the Owner Equity
increased from the beginning of the year to the end of the year because
of the Net Income.
10. Net Income contributes to Cash from Operations after it has been adjusted
to a cash basis.
11. Not all expenses are cash outflows—for instance, Depreciation.
12. Changes in Current Assets (except Cash) and Current Liabilities are not
cash outf lows nor inf lows in the period under consideration. They represent
future, not present, cash f lows.
13. Cash can be generated internally by operations or externally from sources
such as lenders or equity investors.
14. The Cash Flow Statement is simply a detailed explanation of how cash at
the start developed into cash at the end by virtue of cash inf lows, generated
internally and externally, less cash outf lows.
15. As previously noted:
a. The Income Statement is an elaboration of the change in Owner Equity
in the Balance Sheet caused by earning income.
b. The Cash Flow Statement is an elaboration of the Balance-Sheet
change in beginning and ending Cash.
Therefore, all three financial statements are interrelated or, to use the
technical term, "articulated." They are mutually consistent, and that is
why they are referred to as a "set" of financial statements. The threepiece
set consists of a balance sheet, income statement, and cash flow
statement.
16. A set of financial statements can convey much valuable information about
the enterprise to anyone who knows how to analyze them. This information
goes to the core of the organization's business strategy and the effectiveness
of its management.
While Pat was making her notes, Kim was carefully analyzing the Nutrivite
projected financial statements in order to make her recommendation to the
bank's loan committee about Nutrivite's loan application. She paid special attention
to the Cash Flow Statement, keeping handy the bank's guidelines on
cash flow analysis, which included the following issues:
• Is cash from operations positive? Is it growing over time? Is it keeping
pace with growth in sales? If not, why not?
• Are cash withdrawals by owners only a small portion of cash from operations?
If owners' cash withdrawals are a large share of cash from operations,
then the business is conceivably being milked of cash and may not
be able to finance its future growth.
12 Understanding the Numbers
• Of the total sources of cash, how much is being internally generated by
operations versus obtained from outside sources? Normally wise businesses
rely more on internally generated cash for growth than on external
financing.
• Of the outside financing, how much is derived from equity investors and
how much is borrowed? Normally, a business should rely more on equity
than debt financing.
• What kind of assets is the company acquiring with the cash being expended?
Are these asset expenditures likely to be profitable? How long
will it take for these assets to repay their cost and then to earn a reasonable
return?
Kim ref lected carefully on these issues and then finalized her recommendation,
which was to approve the loan. The bank's loan committee accepted
Kim's recommendation and even went further. They authorized Kim to tell Pat
that—if she met all her responsibilities in regard to the loan throughout the
year—the bank would renew the loan at the end of the year and even increase
the amount. Kim called Pat with the good news. Their conversation included
the following dialogue:
Kim: To renew the loan, the bank will ask you for new projected financial
statements for the subsequent year. Also, the loan agreement will require
you to submit financial statements for the year just past—that is, not projected
but actual financial statements. The bank will require that these actual
financial statements be reviewed by an independent CPA before you
submit them.
Pat: Let me be sure I understand: Projected financial statements are forwardlooking,
whereas actual financial statements are backward looking, is that
correct?
Kim: Yes, that's right.
Pat: Next, what is an independent CPA?
Kim: As you probably know, a CPA is a certified public accountant, a professional
trained in finance and accounting and licensed by the state. Independent
means a CPA who is not an employee of yours or a relative. It means
someone in public practice in a CPA firm, someone who will likely make an
objective and unbiased evaluation of your financial statements.
Pat: And what does reviewed mean?
Kim: Good question. CPAs offer three levels of service relating to financial
statements:
• An audit is a thorough, in-depth examination of the financial statements
and test of the supporting records. The result is an audit report, which
states whether the financial statements are free of material misstatements
(whether caused by error or fraud). A "clean" audit report provides
assurance that the financial statements are free of material
misstatements. A "modified" report gives no such assurance and is cause
Using Financial Statements 13
for concern. Financial professionals always read the auditor's report
first, even before looking at any financial statement, to see if the report
is clean. The auditor is a watchdog, and this watchdog barks by issuing a
modified audit report. By law all companies that have publicly traded
securities must have their financial statements audited as a protection to
investors, creditors, and other financial statement users. Private companies
are not required by law to have audits, but sometimes particular
investors or creditors demand them. An audit provides the highest level
of assurance that a CPA can provide and is the most expensive level of
service. Less expensive and less thorough levels of service include the
following.
• A review is a less extensive and less expensive level of financial statement
inspection by a CPA. It provides a lower level of assurance that the financial
statements are free of material misstatements.
• Finally, the lowest level of service is called a compilation, where the outside
CPA puts together the financial statements from the client company's
books and records without examining them in much depth. A
compilation provides the least assurance and is the least expensive level
of service.
So the bank is asking you for the middle level of assurance when it requires
a review by an independent CPA. Banks usually require a review
from borrowers that are smaller private businesses.
Pat: Thanks. That makes it very clear.
We now leave Pat and Kim to their successful loan transaction and
move on.
FINANCIAL STATEMENTS:
WHO USES THEM AND WHY
Here is a brief list of who uses financial statements and why. This list gives
only a few examples and is by no means complete.
1. Existing equity investors and lenders, to monitor their investments and to
evaluate the performance of management.
2. Prospective equity investors and lenders, to decide whether or not to
invest.
3. Investment analysts, money managers, and stockbrokers, to make
buy/sell/hold recommendations to their clients.
4. Rating agencies (such as Moody's, Standard & Poor's, and Dun & Bradstreet),
to assign credit ratings.
5. Major customers and suppliers, to evaluate the financial strength and
staying power of the company as a dependable resource for their business.
14 Understanding the Numbers
6. Labor unions, to gauge how much of a pay increase a company is able to
afford in upcoming labor negotiations.
7. Boards of directors, to review the performance of management.
8. Management, to assess its own performance.
9. Corporate raiders, to seek hidden value in companies with underpriced
stock.
10. Competitors, to benchmark their own financial results.
11. Potential competitors, to assess how profitable it may be to enter an
industry.
12. Government agencies responsible for taxing, regulating, or investigating
the company.
13. Politicians, lobbyists, issue groups, consumer advocates, environmentalists,
think tanks, foundations, media reporters, and others who are supporting
or opposing any particular public issue the company's actions
affect.
14. Actual or potential joint venture partners, franchisors or franchisees, and
other business interests who need to know about the company and its financial
situation.
This brief list shows how many people and institutions use financial statements
for a large variety of business purposes and suggests how essential the ability to
understand and analyze financial statements is to success in the business world.
FINANCIAL STATEMENT FORMAT
Financial statements have a standard format whether an enterprise is as small
as Nutrivite or as large as a major corporation. For example, a recent set of financial
statements for Microsoft Corporation can be summarized in millions of
dollars as follows:
Income Statement
Years Ended June 30 XXX1 XXX2 XXX3
Revenue $15,262 $19,747 $22,956
Cost of revenue 2,460 2,814 3,002
Research and development 2,601 2,970 3,775
Other expenses 3,787 4,035 5,242
Total expenses $ 8,848 $ 9,819 $12,019
Operating income $ 6,414 $ 9,928 $10,937
Investment income 703 1,963 3,338
Income before income taxes 7,117 11,891 14,275
Income taxes 2,627 4,106 4,854
Net income $ 4,490 $ 7,785 $ 9,421
Using Financial Statements 15
Cash Flow Statement
Years Ended June 30 XXX1 XXX2 XXX3
Operations
Net income $ 4,490 $ 7,785 $ 9,421
Adjustments to convert net
income to cash basis 3,943 5,352 4,540
Cash from operations $ 8,433 $ 13,137 $ 13,961
Financing
Stock repurchased, net $(1,509) $ (1,600) $ (2,651)
Stock warrants sold 538 766 472
Preferred stock dividends (28) (28) (13)
Cash from financing $ (999) $ (862) $ (2,192)
Investing
Additions to property and equipment $ (656) $ (583) $ (879)
Net additions to investments (6,616) (10,608) (11,048)
Net cash invested $(7,272) $ (11,191) $(11,927)
Net change in cash 162 1,084 (158)
Balance Sheet
Years Ended June 30 XXX2 XXX3
Current Assets
Cash and equivalents $ 4,975 $ 4,846
Short-term investments 12,261 18,952
Accounts receivable 2,245 3,250
Other 2,221 3,260
Total current assets $21,702 $30,308
Property and equipment, net $ 1,611 $ 1,903
Investments 15,312 19,939
Total fixed assets $16,923 $21,842
Total assets $38,625 $52,150
Current Liabilities
Accounts payable $ 874 $ 1,083
Other 7,928 8,672
Total current liabilities 8,802 9,755
Noncurrent liabilities 1,385 1,027
Total liabilities $10,187 $10,782
Preferred stock $ 980
Common stock 13,844 $23,195
Retained earnings 13,614 18,173
Total equity $28,438 $41,368
Total liabilities and equity $38,625 $52,150
Note: There are only two years of balance sheets but three years of income statements and cash f low
statements. This is because the Microsoft financial statements above were obtained from filings with
the U.S. Securities and Exchange Commission (SEC), and the SEC requirements for corporate annual
report filings are two years of balance sheets, plus three years of income statements and cash f low
statements.
16 Understanding the Numbers
The Microsoft financial statements contain numbers very much greater
than those for Nutrivite. But there is no difference in the general format of
these two sets of financial statements.
HOW TO ANALYZE FINANCIAL STATEMENTS
Imagine that you are a nurse or a physician and you work in the emergency
room of a busy hospital. Patients arrive with all kinds of serious injuries or illnesses,
barely alive or perhaps even dead. Others arrive with less urgent injuries,
minor complaints, or vaguely suspected ailments. Your training and
experience have taught you to perform a quick triage, to prioritize the most
endangered patients by their vital signs—respiration, pulse, blood pressure,
temperature, and ref lexes. A more detailed diagnosis follows based on more
thorough medical tests.
We check the financial health of a company in much the same fashion by
analyzing the financial statements. The vital signs are tested mostly by various
financial ratios that are calculated from the financial statements. These vital
signs can be classified into three main categories:
1. Short-term liquidity.
2. Long-term solvency.
3. Profitability.
We explain each of these three categories in turn.
SHORT-TERM LIQUIDITY
In the emergency room the first question is: Can this patient survive? Similarly,
the first issue in analyzing financial statements is: Can this company survive?
Business survival means being able to pay the bills, meet the payroll, and
come up with the rent. In other words, is there enough liquidity to provide the
cash needed to pay current financial commitments? "Yes" means survival. "No"
means bankruptcy. The urgency of this question is why current assets (which
are expected to turn into cash within a year) and current liabilities (which are
expected to be paid in cash within a year) are shown separately on the balance
sheet. Net current assets (current assets less current liabilities) is known as
working capital. Because most businesses cannot operate without positive
working capital, the question of whether current assets exceed current liabilities
is crucial.
When current assets are greater than current liabilities, there is sufficient
liquidity to enable the enterprise to survive. However, when current liabilities
exceed current assets the enterprise may well be in immanent danger of bankruptcy.
The financial ratio used to measure this risk is current assets divided
Using Financial Statements 17
by current liabilities, and is known as the current ratio. It is expressed as "2.5
to 1" or "2.5_1" or just "2.5." Keeping the current ratio from dropping below
1 is the bare minimum to indicate survival, but it lacks any margin of safety. A
company must maintain a reasonable margin of safety, or cushion, because the
current ratio, like all financial ratios, is only a rough approximation. For this
reason, in most cases a current ratio of 2 or more just begins to provide credible
evidence of liquidity.
An example of a current ratio can be found in the current sections of the
balance sheets shown earlier in this chapter:
Nutrivite
Selected Sections of Projected Balance Sheet
as of December 31, 200X
Assets Liabilities and Equity
Cash $ 40,600 Accounts payable $40,000
Inventory 80,000
Current assets $120,600 Current liabilities $40,000
The current ratio is 120,600/40,000, or 3. This is only a rough approximation for
several reasons. First, a company can, quite legitimately, improve its current
ratio. In the earlier case of Nutrivite, assume the business wanted its balance
sheet to ref lect a higher current ratio. One way to do so would be to pay off
$20,000 on the bank loan on December 31. This would reduce current assets to
$100,600 and current liabilities to $20,000. Then the current ratio is changed
to $100,600/$20,000, or 5. By perfectly legitimate means, the current ratio has
been improved from 3 to 5. This technique is widely used by companies that
want to put their best foot forward in the balance sheet, and it always works
provided that the current ratio was greater than 1 to start with.
Current assets usually include:
• Cash and Cash Equivalents.
• Securities expected to become liquid by maturing or being sold within
a year.
• Accounts Receivable (which Nutrivite did not have, because it did not sell
to its customers on credit).
• Inventory.
Current liabilities usually include:
• Accounts Payable.
• Other current payables, such as taxes, wages, or insurance.
• The current portion of long-term debt.
Some items included in Current Assets need a further explanation.
These are:
18 Understanding the Numbers
• Cash Equivalents are near-cash securities such as U.S. Treasury bills maturing
in three months or less.
• Accounts Receivable are amounts owed by customers and should be reported
on the balance sheet at "realizable value," which means "the
amount reasonably expected to be collected in cash." Any accounts whose
collectibility is in doubt must be reduced to realizable value by deducting
an allowance for doubtful debts.
• Inventories in some cases may not be liquid in a crisis (except at fire-sale
prices). This condition is especially likely for goods of a perishable, seasonal,
high-fashion, or trendy nature or items subject to technological obsolescence,
such as computers. Since inventory can readily lose value, it
must be reported on the balance sheet at the "lower of cost or market
value," or what the inventory cost to acquire (including freight and insurance),
or the cost of replacement, or the expected selling price less costs
of sale—whichever is lowest.
Despite these requirements designed to report inventory at a realistic
amount, inventory is regarded as an asset subject to inherent liquidity
risk, especially in difficult economic times and especially for items that
are perishable, seasonal, high-fashion, trendy, or subject to obsolescence.
For these reasons the current ratio is often modified by excluding inventory
to get what is called the quick ratio or acid test ratio:
• In the case of Nutrivite, the quick ratio as of December 31 is $40,600/
$40,000, or 1. This indicates that Nutrivite has a barely adequate quick
ratio, with no margin of safety at all. It is a red f lag or warning signal.
The current ratio and the quick ratio deal with all or most of the current
assets and current liabilities. There are also short-term liquidity ratios that
focus more narrowly on individual components of current assets and current liabilities.
These are the turnover ratios, which consist of:
• Accounts Receivable Turnover.
• Inventory Turnover.
• Accounts Payable Turnover.
Turnover, which means "making liquid," is a key factor in liquidity. Faster
turnover allows a company to do more business without increasing assets. Increased
turnover means that less cash is tied up in assets, and that improves
liquidity. Moving to the other side of the balance sheet, slower turnover of liabilities
conserves cash and thereby increases liquidity. Or more simply, achieving
better turnover of working capital can significantly improve liquidity.
Turnover ratios thus provide valuable information. The working capital
turnover ratios are described next.
Quick Ratio
Current Assets Inventory
Current Liabilities
=
−
Using Financial Statements 19
Accounts Receivable Turnover
The equation is:
So, if Credit Sales are $120,000 and Accounts Receivable are $30,000, then
On average, Accounts Receivable turn over 4 times a year, or every 91 days.
The 91-day turnover period is found by dividing a year, 365 days, by the
Accounts Receivable Turnover ratio of 4. This average of 91 days is how long it
takes to collect Accounts Receivable. That is fine if our credit terms call for
payment 90 days from invoice but not fine if credit terms are 60 days, and it is
alarming if credit terms are 30 days.
Accounts Receivable, unlike vintage wines or antiques, do not improve with
age. Accounts Receivable Turnover should be in line with credit terms; turnover
sliding out of line with credit terms signals increasing danger to liquidity.
Inventory Turnover
Inventory turnover is computed as follows:
If Cost of Goods Sold is $100,000 and Inventory is $20,000, then
or about 70 days. Note that the numerator for calculating Accounts Receivable
Turnover is Credit Sales but for Inventory Turnover is Cost of Goods Sold. The
reason is that both Accounts Receivable and Sales are measured in terms of the
selling price of the goods involved. That makes Accounts Receivable Turnover
a consistent ratio, where the numerator and denominator are both expressed at
selling prices in an "apples-to-apples" manner. Inventory Turnover is also an
"apples-to-apples" comparison in that both numerator, Cost of Goods Sold, and
denominator, Inventory, are expressed in terms of the cost, not the selling
price, of the goods.
In our example, the Inventory Turnover was 5, or about 70 days. Whether
this is good or bad depends on industry standards. Companies in the autoretailing
or the furniture-manufacturing industry would accept this ratio. In
the supermarket business or in gasoline retailing, however, 5 would fall far
Inventory Turnover = = times a year $ ,
$ ,
100 000
20 000
5
Inventory Turnover
Cost of Goods Sold
Inventory
=
Accounts Receivable Turnover= = $ ,
$ ,
120 000
30 000
4
Accounts Receivable Turnover
Credit Sales
Accounts Receivable
=
20 Understanding the Numbers
below their norm of about 25 times a year, or roughly every 2 weeks. As with
Accounts Receivable Turnover, an Inventory Turnover that is out of line is a
red f lag.
Accounts Payable Turnover
This measure's equation is:
If Cost of Goods Sold is $100,000 and Accounts Payable is $16,600, then
which is about 6, or around 60 days. Again, note the consistency of the numerator
and denominator, both stated at the cost of the goods purchased. Accounts
Payable Turnover is evaluated by comparison with industry norms. An Accounts
Payable Turnover that is appreciably faster than the industry norm is
fine, if liquidity is satisfactory, because prompt payments to suppliers usually
earn cash discounts, which in turn lower the Cost of Goods Sold and thus
lead to higher income. However, such faster-than-normal Accounts Payable
Turnover does diminish liquidity and is therefore unwise when liquidity is
tight. Accounts Payable Turnover that is slower than the industry norm enhances
liquidity and is therefore wise when liquidity is tight but inadvisable
when liquidity is fine, because it sacrifices cash discounts from suppliers and
thus reduces income.
This concludes our survey of the ratios relating to short-term liquidity—
the current ratio; quick, or acid test, ratio; Accounts Receivable Turnover; Inventory
Turnover; and Accounts Payable Turnover.
If these ratios are seriously deficient, our diagnosis may be complete. The
subject business may be almost defunct, and even desperate measures may be
insufficient to revive it. If these ratios are favorable, then short-term liquidity
does not appear to be a threat and the financial doctor should proceed to the
next set of tests, which measure long-term solvency.
It is worth noting, however, that there are some rare exceptions to these
guidelines. For example, large gas and electric utilities typically have current
ratios less than 1 and quick ratios less than 0.5. This is due to utilities' exceptional
characteristics:
• They usually require deposits before providing service to customers, and
they can shut off service to customers who do not pay on time. Customers
are reluctant to go without necessities such as gas and electricity and
therefore tend to pay their utility bills ahead of most other bills. These
factors sharply reduce the risk of uncollectible accounts receivable for
gas and electric utility companies.
Accounts Payable Turnover =$ ,
$ ,
100 000
16 600
Accounts Payable Turnover
Cost of Goods Sold
Accounts Payable
=
Using Financial Statements 21
• Inventories of gas and electric utility companies are not subject to much
risk from changing fashion trends, deterioration, or obsolescence.
• Under regulation, gas and electric utility companies are stable, low-risk
businesses, largely free from competition and consistently profitable.
This reduced risk and increased predictability of gas and electric utility
companies make short-term liquidity and safety margins less crucial. In turn,
the ratios indicating short-term liquidity become less important, because shortterm
survival is not a significant concern for these businesses.
LONG-TERM SOLVENCY
Long-term solvency focuses on a firm's ability to pay the interest and principal
on its long-term debt. There are two commonly used ratios relating to servicing
long-term debt. One measures ability to pay interest, the other the ability to
repay the principal. The ratio for interest compares the amount of income
available for paying interest with the amount of the interest expense. This ratio
is called Interest Coverage or Times Interest Earned.
The amount of income available for paying interest is simply earnings before
interest and before income taxes. (Business interest expense is deductible
for income tax purposes; therefore, income taxes are based on earnings after
interest, otherwise known as earnings before income taxes.) Earnings before
interest and taxes is known as EBIT. The ratio for Interest Coverage or Times
Interest Earned is EBIT/Interest Expense. For instance, assume that EBIT is
$120,000 and interest expense is $60,000. Then:
This shows that the business has EBIT sufficient to cover 2 times its interest
expense. The cushion, or margin of safety, is therefore quite substantial.
Whether a given interest coverage ratio is acceptable depends on the industry.
Different industries have different degrees of year-to-year f luctuations in
EBIT. Interest coverage of 2 times may be satisfactory for a steady and mature
firm in an industry with stable earnings, such as regulated gas and electricity
supply. However, when the same industry experiences the uncertain forces of
deregulation, earnings may become volatile, and interest coverage of 2 may
prove to be inadequate. In more-turbulent industries, such as movie studios and
Internet retailers, an interest coverage of 2 may be regarded as insufficient.
The long-term solvency ratio that ref lects a firm's ability to repay principal
on long-term debt is the "Debt to Equity" ratio. The long-term capital structure
of a firm is made up principally of two types of financing: (1) long-term debt and
(2) owner equity. Some hybrid forms of financing mix characteristics of debt
and equity but usually can be classified as mainly debt or equity in nature.
Therefore the distinction between debt and equity is normally clear.
Interest Coverage or Times Interest Earned= = $ ,
$ ,
120 000
60 000
2
22 Understanding the Numbers
If long-term debt is $150,000 and equity is $300,000, then the debtequity
relationship is usually measured as:
Long-term debt is frequently secured by liens on property and has priority
on payment of periodic interest and repayment of principal. There is no priority
for equity, however, for dividend payments or return of capital to owners.
Holders of long-term debt thus have a high degree of security in receiving full
and punctual payments of interest and principal. But, in good times or bad,
whether income is high or low, long-term creditors are entitled to receive no
more than these fixed amounts. They have reduced their risk of gain or loss in
exchange for more certainty. By contrast, owners of equity enjoy no such certainty.
They are entitled to nothing except dividends, if declared, and, in the
case of bankruptcy, whatever funds might be left over after all obligations have
been paid. Theirs is a totally at-risk investment. They prosper in good times
and suffer in bad times. They accept these risks in the hope that in the long run
gains will substantially exceed losses.
From the firm's point of view, long-term debt obligations are a burden
that must be carried whether income is low, absent, or even negative. But longterm
debt obligations are a blessing when income is lush since they receive no
more than their fixed payments, even if incomes soar. The greater the proportion
of long-term debt and smaller the proportion of equity in the capital structure,
the more the incomes of the equity holders will f luctuate according to
how good or bad times are. The proportion of long-term debt to equity is
known as leverage. The greater the proportion of long-term debt to equity, the
more leveraged the firm is considered to be. The more leveraged the firm is,
the more equity holders prosper in good times and the worse they fare in bad
times. Because increased leverage leads to increased volatility of incomes, increased
leverage is regarded as an indicator of increased risk, though a moderate
degree of leverage is thus considered desirable. The debt-to-equity ratio is
evaluated according to industry standards and each industry's customary
volatility of earnings. For example, a debt-to-equity ratio of 80% would be considered
conservative in banking (where leverage is customarily above 80% and
earnings are relatively stable) but would be regarded as extremely risky for
toy manufacturing or designer apparel (where earnings are more volatile). The
well-known junk bonds are an example of long-term debt securities where
leverage is considered too high in relation to earnings volatility. The increased
risk associated with junk bonds explains their higher interest yields. This illustrates
the general financial principle that the greater the risk, the higher the
expected return.
Debt to Equity Ratio
Long-Term Debt
Long-Term Debt Equity
=
+
=
+
=
$ ,
($ , $ , )
%
150 000
150 000 300 000
33 1
3
Using Financial Statements 23
In summary, the ratios used to assess long-term solvency are Interest Coverage
and Long-Term Debt to Equity.
Next, we consider the ratios for analyzing profitability.
PROFITABILITY
Profitability is the lifeblood of a business. Businesses that earn incomes can
survive, grow, and prosper. Businesses that incur losses cannot stay in operation,
and will last only until their cash runs out. Therefore, in order to assess
business viability, it is important to analyze profitability.
When analyzing profitability, it is usually done in two phases, which are:
1. Profitability in relation to sales.
2. Profitability in relation to investment.
Profitability in Relation to Sales
The analysis of profitability in relation to sales recognizes the fact that:
or, rearranging terms:
Therefore, Expenses and Income are measured in relation to their sum, which is
Sales. The expenses, in turn, may be broken down by line item. As an example,
we use the Nutrivite Income Statement for the first three years of operation.
Income Statements for the
Years Ending December 31
Year 1 Year 2 Year 3
Sales $720,000 $800,000 $900,000
Less cost of goods sold 480,000 530,000 600,000
Gross profit $240,000 $270,000 $300,000
Less expenses
Salaries $ 40,000 $ 49,600 $ 69,000
Rent 36,000 49,400 54,400
Phone and utilities 14,400 19,400 26,000
Depreciation 3,600 3,600 3,600
Interest 6,000 6,000 6,000
Total expenses $100,000 $128,000 $159,000
Income before taxes $140,000 $142,000 $141,000
Income tax expense (40%) 56,000 56,800 56,400
Net income $ 84,000 $ 85,200 $ 84,600
Sales = Expenses + Income
Income = Sales − Expenses
24 Understanding the Numbers
These income statements show a steady increase in Sales and Gross Profits
each year. Despite this favorable result, the Net Income has remained virtually
unchanged at about $84,000 for each year. To learn why this is the case, we
need to convert expenses and income to percentages of sales. The income statements
converted to percentages of sales are known as "common size" income
statements and look like the following:
Common Size Income Statements for the
Years Ending December 31
Change
Year 1 Year 2 Year 3 Years 1–3
Sales 100.0% 100.0% 100.0% 0.0%
Less cost of goods sold 66.7 66.2 66.7 0.0
Gross profit 33.3% 33.8% 33.3% 0.0%
Less expenses
Salaries 5.6% 6.2% 7.7% 2.1%
Rent 5.0 6.2 6.0 1.0
Phone and utilities 2.0 2.4 2.9 0.9
Depreciation 0.5 0.4 0.4 −0.1
Interest 0.8 0.8 0.7 −0.1
Total expenses 13.9% 16.0% 17.7% 3.8%
Income before taxes 19.4% 17.8% 15.6% −3.8%
Income tax expense (40%) 7.8 7.2 6.2 −1.6
Net income 11.6% 10.6% 9.4% −2.2%
From the percentage figures above it is easy to see why the Net Income
failed to increase, despite the substantial growth in Sales and Gross Profit.
Total Expenses rose by 3.8 percentage points, from 13.9% of Sales in Year 1 to
17.7% of Sales in Year 3. In particular, the increase in Total Expenses relative
to Sales was driven mainly by increases in Salaries (2.1 percentage points),
Rent (1 percentage point) and Phone and Utilities (0.9 percentage point). As a
result, Income before Taxes relative to Sales fell by 3.8 percentage points from
Year 1 to Year 3. The good news is that the drop in Income before Taxes caused
a reduction of Income Tax Expense relative to Sales of 1.6 percentage points
from Year 1 to Year 3. The net effect was a drop in Net Income, relative to
Sales, of 2.2 percentage points from Year 1 to Year 3.
This useful information shows that:
1. The profit stagnation is not related to Sales or Gross Profit.
2. It is entirely due to the disproportionate increase in Total Expenses.
3. Specific causes are the expenses for Salaries, Rent, and Phone and
Utilities.
4. Action to correct the profit slump requires analyzing these particular expense
categories.
Using Financial Statements 25
The use of percent-of-sales ratios is a simple but powerful technique for
analyzing profitability. Generally used ratios include:
• Gross Profit.
• Operating Expenses:
a. In total.
b. Individually.
• Selling, General, and Administrative Expenses (often called SG&A).
• Operating Income.
• Income before Taxes.
• Net Income.
The second category of profitability ratios is profitability in relation to
investment.
Profitability in Relation to Investment
To earn profits, usually a firm must invest capital in items such as plant, equipment,
inventory, and/or research and development. Up to this point we have
analyzed profitability without considering invested capital. That was a useful
simplification in the beginning, but, since profitability is highly dependent
on the investment of capital, it is now time to bring invested capital into the
analysis.
We start with the balance sheet. Recall that Working Capital is Current
Assets less Current Liabilities. So we can simplify the balance sheet by including
a single category for Working Capital in place of the separate categories for
Current Assets and Current Liabilities. An example of a simplified balance
sheet follows:
Example Company
Simplified Balance Sheet as of December 31, 200X
Assets Liabilities and Equity
Working capital $ 40,000 Long-term debt $ 30,000
Fixed assets, net 80,000 Equity 90,000
Total assets $120,000 Liabilities and equity $120,000
A simplified Income Statement for Example Company for the year 200X is
summarized below:
Income before interest and taxes (EBIT) $36,000
Less interest expense 3,000
Income before income taxes 33,000
Less income taxes (40%) 13,200
Net income $19,800
26 Understanding the Numbers
The first ratio we will consider is EBIT (also known as Operating Profit)
to Total Assets. This ratio is often referred to as Return on Total Assets
(ROTA), and it can be expressed as either before tax (more usual) or after tax.
From the Example Company, the calculations are as follows:
Return on Total Assets Before Tax After Tax
EBIT/total assets = $36,000/$120,000 30%
EBIT/total assets = $21,600/$120,000 18%
This ratio indicates the raw (or basic) earning power of the business. Raw earning
power is independent of whether assets are financed by equity or debt.
This independence exists because:
1. The numerator (EBIT) is free of interest expense.
2. The denominator, Total Assets, is equal to total capital regardless of how
much capital is equity and how much is debt.
Independence allows the ratio to be measured and compared:
• For any business, from one period to another.
• For any period, from one business to another.
These comparisons remain valid, even if the debt to equity ratio may vary from
one period to the next and from one business to another.
Now that we have measured basic earning power regardless of the debt to
equity ratio, our next step is to take the debt to equity ratio into consideration.
First, it is important to note that long-term debt is normally a less expensive
form of financing than equity because:
1. Whereas Dividends paid to stockholders are not a tax deduction for the
paying company, Interest Expense paid on Long-Term Debt is. Therefore
the net after-tax cost of Interest is reduced by the related tax deduction.
This is not the case for Dividends, which are not deductible.
2. Debt is senior to equity, which means that debt obligations for interest
and principal must be paid in full before making any payments on equity,
such as dividends. This makes debt less risky than equity to the investors,
and so debt holders are willing to accept a lower rate of return than holders
of the riskier equity securities.
This contrast can be seen from the simplified financial statements of Example
Company above. The interest of $3,000 on the Long-Term Debt of
$30,000 is 10% before tax. But after the 40% tax deduction the interest after
tax is only $1,800 ($3,000 − 40% tax on $3,000), and this $1,800 represents an
after-tax interest rate of 6% on the Long-Term Debt of $30,000. For comparison
let us turn to the rate of return on the Equity. The Net Income, $19,800,
represents a 22% rate of return on the Equity of $90,000. This 22% rate of return
is a financial ratio known as Return on Equity, sometimes abbreviated
ROE. Return on Equity is an important and widely used financial ratio.
Using Financial Statements 27
There is much more to be said about Return on Equity, but first it may be
helpful to recap brief ly the main points we have covered about profitability in
relation to investment.
The EBIT of $36,000 represented a 30% return on total assets, before income
tax, and this $36,000 was shared by three parties, as follows:
1. Long-Term Debt holders received Interest of $3,000, representing an interest
cost of 10% before income tax, and 6% after income tax.
2. City, state, and/or federal governments were paid Income Taxes of
$13,200.
3. Stockholder Equity increased by the Net Income of $19,800, which represented
a 22% Return on Equity.
If there had been no Long-Term Debt, there would have been no Interest
Expense. The EBIT of $36,000 less income tax at 40% would provide a Net Income
of $21,600, which is larger than the prior Net Income of $19,800 by
$1,800. This $1,800 equals the $3,000 amount of Interest before tax less the
40% tax, which is $1,200. In the absence of Long-Term Debt, the Total Assets
would have been funded entirely by equity, which would have required equity
to be $120,000. In turn, with Net Income of $21,600, the revised Return on
Equity would be
The increase in the Return on Equity, from this 18% to 22% was attributable
to the use of Long-Term Debt. The Long-Term Debt had a cost after taxes of
only 6% versus the Return on Assets after tax of 18%. When a business earns
18% after tax, it is profitable to borrow at 6% after tax. This in turn improves
the Return on Equity from 18% to 22%, which illustrates the advantage of
leverage: A business earning 18% on assets can, with a little leverage, earn
22% on equity.
But what if EBIT is only $3,000? The entire $3,000 would be used up to
pay the interest of $3,000 on the Long-Term Debt. The Net Income would be
$0, resulting in a 0% Return on Equity. This illustrates the disadvantage of
leverage. Without Long-Term Debt, the EBIT of $3,000 less 40% tax would result
in Net Income of $1,800. Return on Equity would be $1,800 divided by
equity of $120,000, which is 1.5%. A Return on Equity of 1.5% may not be impressive,
but it is certainly better than the 0% that resulted with Long-Term
Debt.
Leverage is a fair-weather friend: It boosts Return on Equity when earnings
are robust but depresses ROE when earnings are poor. Leverage makes
the good times better but the bad times worse. Therefore, it should be used in
moderation and in businesses with stable earnings. In businesses with volatile
earnings, leverage should be used sparingly and cautiously.
We have now described all of the main financial ratios, and they are summarized
in Exhibit 1.1.
Net Income
Equity
= = $ ,
$ ,
%
21 600
120 000
18
28 Understanding the Numbers
USING FINANCIAL RATIOS
Some important points to keep in mind when using financial ratios are:
• Whereas all balance sheet numbers are end-of-period numbers, all income
statement numbers relate to the entire period. For example, when
calculating the ratio for Accounts Receivable Turnover, we use a numerator
of Credit Sales, which is an entire-period number from the income
statement, and a denominator of Accounts Receivable, which is an end-ofperiod
number from the balance sheet. To make this an apples-to-apples
ratio, the Accounts Receivable can be represented by an average of the
beginning-of-year and end-of-year figures for Accounts Receivable. This
average is closer to a mid-year estimate of Accounts Receivable and therefore
is more comparable to the entire-period numerator, Credit Sales. Because
using averages of the beginning-of-year and end-of-year figures for
balance sheet numbers helps to make ratios more of an apples-to-apples
EXHIBIT 1.1 Summary of main financial ratios.
Ratio Numerator Denominator
Short-Term Liquidity
Current ratio Current assets Current liabilities
Quick ratio (acid test) Current assets Current liabilities
(excluding inventory)
Receivables turnover Credit sales Accounts receivable
Inventory turnover Cost of sales Inventory
Payables turnover Cost of sales Accounts payable
Long-Term Solvency
Interest coverage EBIT Interest on L/T debt
Debt to capital Long-term debt L/T debt + equity
Profitability on Sales
Gross profit ratio Gross profit Sales
Operating expense ratio Operating expenses Sales
SG&A expense ratio SG&A expenses Sales
EBIT ratio EBIT Sales
Pretax income ratio Pretax income Sales
Net income ratio Net income Sales
Profitability on Investment
Return on total assets:
Before tax EBIT Total assetsa
After tax EBIT times (1-tax rate) Total assetsa
Return on equity Net income: Commonb Common equity
a Total Assets = Fixed Assets + Working Capital (Current Assets less Current Liabilities)
b Net Income less Preferred Dividends
Using Financial Statements 29
comparison, averages should be used for all balance sheet numbers when
calculating financial ratios.
• Financial ratios can be no more reliable than the data with which the ratios
were calculated. The most reliable data is from audited financial
statements, if the audit reports are clean and unqualified.
• Financial ratios cannot be fully considered without yardsticks of comparison.
The simplest yardsticks are comparisons of an enterprise's current
financial ratios with those from previous periods. Companies often provide
this type of information in their financial reporting. For example,
Apple Computer Inc., recently disclosed the following financial quarterly
information, in millions of dollars:
Quarter 4 3 2 1
Net sales $1,870 $1,825 $1,945 $2,343
Gross margin $1,122 $1,016 $1,043 $1,377
Gross margin 25% 30% 28% 28%
Operating costs $ 383 $ 375 $ 379 $ 409
Operating income $ 64 $ 168 $ 170 $ 100
Operating income 4% 9% 9% 4%
This table compares four successive quarters of information, which
makes it possible to see the latest trends in such important items as Sales,
and Gross Margin and Operating Income percentages. Other types of
comparisons of financial ratios include:
1. Comparisons with competitors. For example, the financial ratios of
Apple Computer could be compared with those of Compaq, Dell, or
Gateway.
2. Comparisons with industry composites. Industry composite ratios can
be found from a number of sources, such as:
a. The Almanac of Business and Industrial Financial Ratios, authored
by Leo Troy and published annually by Prentice-Hall (Paramus,
NJ). This publication uses Internal Revenue Service data for
4.6 million U.S. corporations, classified into 179 industries and divided
into categories by firm size, and reporting 50 different financial
ratios.
b. Risk Management Associates: Annual Statement Studies. This is a
database compiled by bank loan officers from the financial statements
of more than 150,000 commercial borrowers, representing
more than 600 industries, classified by business size, and reporting
16 different financial ratios. It is available on the Internet at
www.rmahq.org.
c. Financial ratios can also be obtained from other firms who specialize
in financial information, such as Dun & Bradstreet, Moody's,
and Standard & Poor's.
30 Understanding the Numbers
COMBINING FINANCIAL RATIOS
Up to this point we have considered financial ratios one at a time. However,
there is a useful method for combining financial ratios known as Dupont1
analysis. To explain it, we first need to define some financial ratios, together
with their abbreviations, as follows:
Ratio Calculation Abbreviation
Profit margin2 Net income/sales NI/S
Asset turnover Sales/total assets S/TA
Return on assets3 Net income/total assets NI/TA
Leverage Total assets/common equity TA/CE
Return on equity Net income/common equity NI/CE
Now, these financial ratios can be combined in the following manner:
and
In summary:
This equation says that Profit Margin × Asset Turnover × Leverage = Return
on Equity.
Also, this equation provides a financial approach to business strategy. It
recognizes that the ultimate goal of business strategy is to maximize stockholder
value, that is, the market price of the common stock. This goal requires
maximizing the return on common equity. The Dupont equation above breaks
the return on common equity into its three component parts: Profit Margin
(Net Income/Sales), Asset Turnover (Sales/Total Assets), and Leverage (Total
Assets/Common Equity). If any one of these three ratios can be improved
(without harm to either or both of the remaining two ratios), then the return
on common equity will increase. A firm thus has specific strategic targets:
• Profit Margin improvement can be pursued in a number of ways. On the
one hand, revenues might be increased or costs decreased by:
N1
S
S
TA
TA
CE
N1
CE
× × =
Return on Assets Leverage Return on Equity
Net Income
Total Assets
Total Assets
Common Equity
Net Income
Common Equity
× =
× =
Profit Margin Asset Turnover Return on Assets
Net Income
Sales
Sales
Total Assets
Net Income
Total Assets
× =
× =
Using Financial Statements 31
1. Raising prices perhaps by improving product quality or offering extra
services. Makers of luxury cars have done this successfully by providing
free roadside assistance and loaner cars when customer cars are
being serviced.
2. Maintaining prices but reducing the quantity of product in the package.
Candy bar manufacturers and other makers of packaged foods
often use this method.
3. Initiating or increasing charges for ancillary goods or services. For example,
banks have substantially increased their charges to stop checks
and for checks written with insufficient funds. Distributors of computers
and software have instituted fees for providing technical assistance
on their help lines and for restocking returned items.
4. Improving the productivity and efficiency of operations.
5. Cutting costs in a variety of ways.
• Asset Turnover may be improved in ways such as:
1. Speeding up the collection of accounts receivable.
2. Increasing inventory turnover, perhaps by adopting "just in time" inventory
methods.
3. Slowing down payments to suppliers, thus increasing accounts payable.
4. Reducing idle capacity of plant and equipment.
• Leverage may be increased, within prudent limits, by means such as:
1. Using long-term debt rather than equity to fund additions to plant,
property, and equipment.
2. Repurchasing previously issued common stock in the open market.
The chief advantage of using the Dupont formula is to focus attention on
specific initiatives that will improve return on equity by means of enhancing
profit margins, increasing asset turnover, or employing greater financial leverage
within prudent limits.
In addition to the Dupont formula, there is another way to combine financial
ratios, one that serves another useful purpose—predicting solvency or
bankruptcy for a given enterprise. It uses what is known as the z score.
THE Z SCORE
Financial ratios are useful not only to assess the past or present condition of
an enterprise, but also to reliably predict its future solvency or bankruptcy.
This type of information is of critical importance to present and potential
creditors and investors. There are several different methods of analysis for
obtaining this predictive information. The best-known and most time-tested
is the z score, developed for publicly traded manufacturing firms by Professor
32 Understanding the Numbers
Edward Altman of New York University. Its reliability can be expressed in
terms of the two types of errors to which all predictive methods are vulnerable,
namely:
1. Type I error: predicting solvency when in fact a firm becomes bankrupt
(a false positive).
2. Type II error: predicting bankruptcy when in fact a firm remains solvent
(a false negative).
The predictive error rates for the Altman z score have been found to be as
follows:
Years Prior to % False % False
Bankruptcy Positives Negatives
1 6 3
2 18 6
Given the inherent difficulty of predicting future events, these error rates are
relatively low, and therefore the Altman z score is generally regarded as a reasonably
reliable bankruptcy predictor. The z score is calculated from financial
ratios in the following manner:
A z score above 2.99 predicts solvency; a z score below 1.81 predicts bankruptcy;
z scores between 1.81 and 2.99 are in a gray area, with scores above
2.675 suggesting solvency and scores below 2.675 suggesting bankruptcy.
Since the z score uses equity at market value, it is not applicable to private
firms, which do not issue marketable securities. A variation of the z score
for private firms, known as the z′ score, has been developed that uses the book
value of equity rather than the market value. Because of this modification, the
multipliers in the formula have changed from those in the original z score, as
have the scores that indicate solvency, bankruptcy, or the gray area. For nonmanufacturing
service-sector firms, a further variation in the formula has
been developed. It omits the variable for asset turnover and is known as the z′′
score. Once again, the multipliers in the formula have changed from those in
the z′ score, and so have the scores that indicate solvency, bankruptcy, or the
gray area.
Professor Altman later developed a bankruptcy predictor more refined
than the z score and named it ZETA. ZETA uses financial ratios for times interest
earned, return on assets (the average and the standard deviation), and
debt to equity. Other details of ZETA have not been made public. ZETA is
proprietary and is made available to users for a fee.
z= × + × + ×
+ × + ×
1 2 1 4 3 3
0 6 1 0
. . .
. .
Working Capital
Total Assets
Retained Earnings
Total Assets
EBIT
Total Assets
Equity at Market Value
Debt
Sales
Total Assets
Using Financial Statements 33
SUMMARY AND CONCLUSIONS
Financial statements contain critical business information and are used for
many different purposes by many different parties inside and outside the business.
Clearly all successful businesspeople should have a good basic understanding
of financial statements and of the main financial ratios. For further
information and explanations about financial statements, see the following
chapters in this book:
Chapter 2: Analyzing Business Earnings
Chapter 6: Forecasts and Budgets
Chapter 15: The Board of Directors
Chapter 18: Business Valuation
INTERNET LINKS
Some useful Internet links on financial statements and financial ratios are:
www.aicpa.org Web site for the American Institute of Certified
Public Accountants.
www.freedgar.com This site lets users download financial statements
and other key financial information filed with the
SEC and maintained in Edgar (the name of its
database) for all corporations with securities that
are publicly traded in the United States. This
service is free of charge. Another Web site,
Spredgar.com, displays financial ratios calculated
from freedgar.com.
www.10k.com Provides free downloads of annual reports (which
include financial statements) filed with the SEC
for all corporations with securities that are
publicly traded in the United States.
www.rmahq.org Web site of the Risk Management Association
(RMA) that contains financial ratios classified by
size of firm for more than 600 industries.
www.cpaclass.com Information and instruction on many finance and
accounting topics.
www.financeprofessor.com Information and instruction on many finance and
accounting topics.
www.smallbusiness.org Information and instruction from public television
on many finance and accounting topics.
34 Understanding the Numbers
www.wmw.com The World Market Watch (wmw) provides
business research information, including financial
ratios, for many companies and 74 different
industries.
FOR FURTHER READING
Anthony, Robert N., Essentials of Accounting, 6th ed. (Boston, MA: Addison-Wesley,
1996).
Brealey, Richard A., and Stewart C. Myers, Fundamentals of Corporate Finance, 3rd
ed. (New York: McGraw-Hill, 2001).
Fridson, Martin S., Financial Statement Analysis: A Practitioner's Guide, 2nd ed.
(New York: John Wiley, 1995).
Simini, Joseph P., Balance Sheet Basics for Nonfinancial Managers (New York: John
Wiley, 1990).
Tracy, John A., How to Read a Financial Report: Wringing Cash Flow and Other
Vital Signs Out of the Numbers, 4th ed. (New York: John Wiley, 1994).
Troy, Leo, Almanac of Business and Industrial Financial Ratios (Paramus, NJ:
Prentice-Hall, Annual).
Financial Studies of the Small Business (Winter Haven, FL: Financial Research Associates,
Annual).
Industry Norms and Key Business Ratios (New York: Dun & Bradstreet, Annual).
RMA Annual Statement Studies (Philadelphia, PA: Risk Management Association,
Annual).
Standard and Poor's Industry Surveys (New York: Standard & Poor's, Quarterly).
NOTES
1. The name comes from its original use at the Dupont Corporation.
2. After income taxes.
3. Ibid.
35
2
ANALYZING
BUSINESS
EARNINGS
Eugene E. Comiskey
Charles W. Mulford
A special committee of the American Institute of Certified Public Accountants
(AICPA) concluded the following about earnings and the needs of those
who use financial statements:
Users want information about the portion of a company's reported earnings
that is stable or recurring and that provides a basis for estimating sustainable
earnings.1
While users may want information about the stable or recurring portion of
a company's earnings, firms are under no obligation to provide this earnings series.
However, generally accepted accounting principles (GAAPs) require separate
disclosure of selected nonrecurring revenues, gains, expenses, and losses
on the face of the income statement or in notes to the financial statements.
Further, the Securities and Exchange Commission (SEC) requires the disclosure
of material nonrecurring items.
The prominence given the demand by users for information on nonrecurring
items in the above AICPA report is, no doubt, driven in part by the explosive
growth in nonrecurring items over the past decade. The acceleration of
change together with a passion for downsizing, rightsizing, and reengineering
have fueled this growth. The Financial Accounting Standards Board's (FASB)
issuance of a number of new accounting statements that require recognition of
previously unrecorded expenses and more timely recognition of declines in
asset values has also contributed to the increase in nonrecurring items.
A limited number of firms do provide, on a voluntary basis, schedules that
show their results with nonrecurring items removed. Mason Dixon Bancshares
36 Understanding the Numbers
provides one such example. Exhibit 2.1 shows a Mason Dixon schedule that adjusts
reported net income to a revised earnings measure from which nonrecurring
revenues, gains, expenses, and losses have been removed. This is the type
of information that the previously quoted statement of the AICPA's Special
Committee calls for.
Notice the substantial number of nonrecurring items that Mason Dixon
removed from reported net income in order to arrive at a closer measure of
core or sustainable earnings. In spite of the number of nonrecurring items removed
from reported net income, the revised earnings differ by only about 6%
from the original reported net income.
Firms that record either a large nonrecurring gain or loss frequently attempt
to offset its effect on net income by recording a number of offsetting
items. In the case of Mason Dixon, the large gain on the sale of branches if not
offset may raise earnings expectations to levels that are unattainable. Alternatively,
the recording of offsetting charges may be seen as a way to relieve future
earnings of their burden. We do not claim that this was done in the case of
Mason Dixon Bancshares, but its results are consistent with this practice.
Though exceptions like the Mason Dixon Bancshares example do occur,
the task of developing information on a firm's recurring or sustainable results
normally falls to the statement user. Companies do provide, to varying degrees,
the raw materials for this analysis; however, the formidable task of creating—an
analysis comparable to that provided by Mason Dixon—is typically left to the
user. The central goal of this chapter is to help users develop the background
and skills to perform this critical aspect of earnings analysis. The chapter will
discuss nonrecurring items and outline efficient approaches for locating them in
financial statements and associated notes. As key background we will also discuss
and illustrate income statement formats and other issues of classification.
Throughout the chapter, we illustrate concepts using information drawn from
EXHIBIT 2.1 Core business net income: Mason Dixon Bancshares Inc.,
year ended December 31 (in thousands).
1998
Reported net income $10,811
Adjustments, add (deduct), for nonrecurring items:
Gain on sale of branches (6,717)
Special loan provision for loans with Year 2000 risk 918
Special loan provision for change in charge-off policy 2,000
Reorganization costs 465
Year 2000 costs 700
Impairment loss on mortgage sub-servicing rights 841
Income tax expense on the nonrecurring items above 1,128
Core (sustainable) net income $10,146
SOURCE: Mason Dixon Bancshares Inc., annual report, December 1998. Information obtained from
Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC
(Bethesda, MD: Disclosure Inc., June 2000).
Analyzing Business Earnings 37
the financial statements of many companies. As a summary exercise, a comprehensive
case is provided that removes all nonrecurring items from reported results
to arrive at a sustainable earnings series.
THE NATURE OF NONRECURRING ITEMS
Defining nonrecurring items is difficult. Writers often begin with phrases like
"unusual" or "infrequent in occurrence." Donald Keiso and Jerry Weygandt in
their popular intermediate accounting text use the term irregular to describe
what most statement users would consider nonrecurring items.2 For our purposes,
irregular or nonrecurring revenues, gains, expenses, and losses are not
consistent contributors to results, in terms of either their presence or their
amount. This is the manner in which we use the term nonrecurring items
throughout this chapter.
From a security valuation perspective, nonrecurring items have a smaller
impact on share price than recurring elements of earnings. Some items, such as
restructuring charges, litigation settlements, f lood losses, product recall costs,
embezzlement losses, and insurance settlements, can easily be identified as
nonrecurring. Other items may appear consistently in the income statement
but vary widely in sign (revenue versus expense, gain versus loss) and amount.
For example, the following gains on the disposition of f light equipment were
reported over a number of years by Delta Air Lines:3
1992 $35 million
1993 65 million
1994 2 million
1995 0 million
1996 2 million
The gains averaged about $25 million over the 10 years ending in 1996
and ranged from a loss of $1 million (1988) to a gain of $65 million (1993). The
more recent five years typify the variability in the amounts for the entire 10-
year period. These gains did recur, but they are certainly irregular in amount.
There are at least three alternative ways to handle this line item in revising
results to identify sustainable or recurring earnings. First, one could simply
eliminate the line item based on its highly inconsistent contribution to
results.4 Second, one could include the line item at its average value ($25 million
for the period 1987 to 1996) for some period of time. Third, one could attempt
to acquire information on planned aircraft dispositions that would make
possible a better prediction of the contribution of gains on aircraft dispositions
to future results. While the last approach may appear to be the most
appealing, it may prove to be difficult to implement because of lack of information,
and it may also be less attractive when viewed from a cost-benefit perspective.
In general, we would normally recommend either removing the gains
38 Understanding the Numbers
or simply employing a fairly recent average value for the gains in making earnings
projections.
After 1996, Delta Air Lines disclosed little in the way of nonrecurring
gains on the sale of f light equipment. Its 2000 annual report, which covered
the years from 1998 to 2000, did not disclose any gains or losses on the disposition
of f light equipment.5 With hindsight, the first option, which would remove
all of the gains and losses on f light equipment, may have been the most
appropriate alternative.
The Goodyear Tire and Rubber Company provides a timeless example of
the impact of nonrecurring items on the evaluation of earnings performance.
Exhibit 2.2 shows pretax results for Goodyear, with and without losses on foreign
exchange.
As with Delta Air Lines, it may seem questionable to characterize as nonrecurring
exchange losses that appear repeatedly. However, in line with the key
characteristics of nonrecurring items given earlier, Goodyear's foreign exchange
losses are both irregular in amount and unlikely to be consistent contributors to
results in future years. Across the period 1993 to 1995 the reduction in foreign
exchange losses contributed to Goodyear's pretax results by $35.5 million in
1994 and $60.2 million in 1995. That is, the entire $60.1 million increase in earnings
for 1995 could be attributed to the $60.2 million decline in foreign exchange
losses. The only way that the foreign exchange line could contribute a further
$60.2 million to pretax earnings in 1996 would be for Goodyear to produce a foreign
exchange gain of $42.8 million ($60.2 − $17.4).6
Other examples of irregular items of revenue, gain, expense, and loss
abound. For example, there were temporary revenue increases and decreases
associated with the Gulf War. ("Sales to the United States government increased
substantially during the Persian Gulf War. However, sales returned to
more normal levels in the second half of the year."7) Temporary revenue increases
have been associated with expanded television sales due to World Cup
EXHIBIT 2.2 The Goodyear Tire and Rubber Company, results with
and without foreign-exchange losses, years ended
December 31 (in millions).
1993 1994 1995
Income before income taxes, extraordinary
item and cumulative effect of
accounting change $784.9 $865.7 $925.8
Add back foreign exchange losses 113.1 77.6 17.4
Income exclusive of foreign-exchange losses $898.0 $943.3 $943.2
Percentage income increase:
Income as reported 10.3% 6.9%
Income exclusive on foreign-exchange losses 5.0% 0.0%
SOURCE: The Goodyear Tire and Rubber Company, annual report, December 1995, 24.
Analyzing Business Earnings 39
soccer. Temporary increases or decreases in earnings have resulted from adjustments
to loan loss provisions resulting from economic downturns and subsequent
recoveries in the financial services industry. Most recently, there have
been widely publicized problems with tires produced for sports utility vehicles
that will surely create substantial nonrecurring increases in legal and warranty
expenses.
Identifying nonrecurring or irregular items is not a mechanical process;
it calls for the exercise of judgment and involves both line items and as the
period-to-period behavior of individual income statement items.
THE PROCESS OF IDENTIFYING NONRECURRING ITEMS
Careful analysis of past financial performance aimed at removing the effects
of nonrecurring items is a more formidable task than one might suspect. This
task would be fairly simple if (1) there was general agreement on just what constitutes
a nonrecurring item and (2) if most nonrecurring items were prominently
displayed on the face of the income statement. However, neither is the
case. Some research suggests that fewer than one-fourth of nonrecurring items
are likely to be found separately disclosed in the income statement.8 Providing
guidance for locating the remaining three-fourths is a key goal of this chapter.
Identifying Nonrecurring Items:
An Efficient Search Procedure
The search sequence outlined in the following discussion locates a high cumulative
percentage of material nonrecurring items and does so in a cost-effective
manner. Search cost, mainly in time spent by the financial analyst, is an important
consideration. Time devoted to this task is not available for another and,
therefore, there is an opportunity cost to consider. The discussion and guidance
that follows are organized around this recommended search sequence
(see Exhibit 2.3). Following only the first five steps in this search sequence is
likely to locate almost 60% of all nonrecurring items.9 Continuing through
steps six and seven will typically increase this location percentage. However,
the 60% discovery rate is higher if the focus is only on material nonrecurring
items. The nonrecurring items disclosed in other locations through steps 6 and
7 are fewer in number and normally less material than those initially found
through the first five.
NONRECURRING ITEMS IN THE INCOME STATEMENT
An examination of the income statement, the first step in the search sequence,
requires an understanding of the design and content of contemporary income
statements. This knowledge will aid in the location and analysis of nonrecurring
40 Understanding the Numbers
components of earnings. Generally accepted accounting principles (GAAPs)
determine the structure and content of the income statement. Locating nonrecurring
items in the income statement is a highly efficient and cost-effective
process. Many nonrecurring items will be prominently displayed on separate
lines in the statement. Further, leads to other nonrecurring items, disclosed
elsewhere, may be discovered during this process. For example, a line item that
summarizes items of other income and expense may include an associated note
reference detailing its contents. These notes should always be reviewed—step
5 in the search sequence—because they will often reveal a wide range of nonrecurring
items.
Alternative Income Statement Formats
Examples of the two principal income statement formats under current GAAPs
are presented below. The income statement of Shaw Industries Inc., in Exhibit
2.4 is single step and that of Toys "R" Us Inc. in Exhibit 2.5 is multistep.
An annual survey of financial statements conducted by the American Institute
of Certified Public Accountants (AICPA) reveals that about one-third of the
600 companies in its survey use the single-step format and the other two-thirds
the multistep.10
EXHIBIT 2.3 Ef f icient search sequence for nonrecurring items.
Search
Step Search Location
1 Income statement.
2 Statement of cash flows—operating activities section only.
3 Inventory note, generally assuming that the firm employs the LIFO inventory
method. However, even with non-LIFO firms, inventory notes may reveal
inventory write-downs.
4 Income tax note, with attention focused on the tax-reconciliation schedule.
5 Other income (expense) note in cases where this balance is not detailed on the
face of the income statement.
6 MD&A of Financial Condition and Results of Operations—a Securities and
Exchange Commission requirement and therefore available only for public
companies.
7 Other notes which often include nonrecurring items:
Note Nonrecurring items revealed
a. Property and equipment Gains and losses on asset sales
b. Long-term debt Foreign currency and debt-retirement gains and losses.
c. Foreign currency Foreign currency gains and losses
d. Restructuring Current and prospective impact of of restructuring
activities
e. Contingencies Prospective revenues and expenses
f. Segment disclosures Various nonrecurring items
g. Quarterly financial data Various nonrecurring items
Analyzing Business Earnings 41
The distinguishing feature of the multistep statement is that it provides
intermediate earnings subtotals that are designed to measure pretax operating
performance. In principle, operating income should be composed almost entirely
of recurring items of revenue and expense, which result from the main
operating activities of the firm. In practice, numerous material nonrecurring
items are commonly included in operating income. For example, "restructuring"
charges, one of the most common nonrecurring items of the past decade,
is virtually always included in operating income.
Shaw Industries' single-step income statement does not partition results
into intermediate subtotals. For example, there are no line items identified as
either "gross profit" or "operating income." Rather, all revenues and expenses
are separately listed and "income before income taxes" is computed in a single
step as total expenses are deducted from total revenues. However, the Toys "R"
Us multistep income statement provides both gross profit and operating income/(
loss) subtotals.
Note that Shaw Industries has a number of different nonrecurring items in
its income statements. While they vary in size, the following would normally be
considered to be nonrecurring: charges related to residential retail operations,
EXHIBIT 2.4 Consolidated single-step statements of income: Shaw
Industries Inc. (in thousands).
Year Ended
Jan. 3 Jan. 2 Jan. 1
1998 1999 2000
Net sales $3,575,774 $3,542,202 $4,107,736
Cost of sales $2,680,472 $2,642,453 $3,028,248
Selling, general and administrative 722,590 620,878 627,075
Charge to record loss on sale of residential
retail operations, store closing costs and
write-down of certain assets — 132,303 4,061
Charge to record plant closing costs — — 1,834
Pre-opening expenses 3,953 — —
Charge to record store closing costs 36,787 — —
Write-down of U.K. assets 47,952 — —
Interest, net 60,769 62,553 62,812
Loss on sale of equity securities — 22,247 —
Other expense (income), net (7,032) 4,676 1,319
Income before income taxes 30,283 57,092 382,387
Provision for income taxes 5,586 38,407 157,361
Income before equity in income of joint ventures 24,697 18,685 225,026
Equity in income of joint ventures 4,262 1,947 2,925
Net income $ 28,959 $ 20,632 $ 227,951
Note: Per share amounts omitted.
SOURCE: Shaw Industries Inc., annual report, January 2000, 24.
42 Understanding the Numbers
plant closing costs, record-store closing costs, write-down of U.K. assets, the
loss on sale of equity investments, and the preopening expenses.
There will usually be other nonrecurring items lurking in other statements
or footnotes. Note the approximately $12-million change in the Other expense
(income) net balance for the year ending January 2, 1999, compared to the year
ending January 3, 1998. Also, there must be something unusual about income
taxes in the year ending January 3, 1998. The effective tax rate ($5,586,000 divided
by $30,283,000) is only about 18%, well below the 35% statutory federal
tax rate for large companies. By contrast, the effective tax rate ($38,407,000 divided
by $57,092,000) for the year ending January 2, 1999, is about 67%.
Nonrecurring Items Located in Income
from Continuing Operations
Whether a single- or multistep format is used, the composition of income from
continuing operations is the same. It includes all items of revenue, gain, expense,
and loss except those (1) identified with discontinued operations, (2)
meeting the definition of extraordinary items, and (3) resulting from the cumulative
effect of changes in accounting principles. Because income from continuing
operations excludes only these three items, it follows that all other
nonrecurring items of revenues or gains and expenses or losses are included in
this key profit subtotal.
EXHIBIT 2.5 Consolidated multi-step statements of earnings:
Toys "R" Us Inc. (in millions).
Year Ended
Jan. 31 Jan. 30 Jan. 29
1998 1999 2000
Net sales $11,038 $11,170 $11,862
Cost of sales 7,710 8,191 8,321
Gross Profit 3,328 2,979 3,541
Selling, general and administrative expenses 2,231 2,443 2,743
Depreciation, amortization and asset write-offs 253 255 278
Restructuring charge — 294 —
Total Operating Expenses 2,484 2,992 3,021
Operating Income/(Loss) 844 (13) 520
Interest expense 85 102 91
Interest and other income (13) (9) (11)
Interest Expense, Net 72 93 80
Earnings/(loss) before income taxes 772 (106) 440
Income taxes 282 26 161
Net earnings/(loss) $ 490 $ (132) $ 279
Note: Per share amounts omitted.
SOURCE: Toys "R" Us Inc., annual report, January 2000, 25.
Analyzing Business Earnings 43
The Nature of Operating Income
Operating income is designed to ref lect the revenues, gains, expenses, and losses
that are related to the fundamental operating activities of the firm. Notice, however,
that the Toys "R" Us operating loss for the year ending January 30, 1999,
included two nonrecurring charges. These were the asset write-offs and a restructuring
charge. While operating income or loss may include only operationsrelated
items, some of these items may be nonrecurring. Hence, operating
income is not the "sustainable" earnings measure called for in our opening quote
from the AICPA Special Committee on Financial Reporting. Even at this early
point in the operations section of the income statement, nonrecurring items have
been introduced that will require adjustment in order to arrive at an earnings
base "that provides a basis for estimating sustainable earnings."11 Also be aware
that "operating income" in a multistep format is an earlier subtotal than "income
from continuing operations." Moreover, operating income is a pretax measure,
whereas income from continuing operations is after tax. A more extensive sampling
of items included in operating income is provided next.
Nonrecurring Items Included in Operating Income
Reviewing current annual reports reveals that corporations very often include
nonrecurring revenues, gains, expenses, and losses in operating income. A
sample of nonrecurring items included in the operating income section of
multistep income statements is provided in Exhibit 2.6. As is typical, nonrecurring
expenses and losses are more numerous than nonrecurring revenues
and gains. This imbalance is due in part to GAAP, which require firms to recognize
unrealized losses but not unrealized gains. Moreover, fundamental accounting
conventions, such as the historical cost concept and conservatism,
may also provide part of the explanation.
Many of the nonrecurring expense or loss items involve declines in the
value of specific assets. Restructuring charges have been among the most common
items in recent years in this section of the income statement. These
charges involve asset write-downs and liability accruals that will be paid off in
future years. Seldom is revenue or gain recorded as a result of writing up assets.
Further, unlike the case of restructuring charges, the favorable future
consequences of a management action would seldom support current accrual of
revenue or gain.
There is substantial variety in the nonrecurring expenses and losses included
in operating income. Many of the listed items appear closely linked to
operations, and their classification seems appropriate. However, some appear
to be at the fringes of normal operating items. Examples related to expenses
and losses include the f lood costs of Argosy Gaming, merger-related charges
incurred by Brooktrout Technologies, the embezzlement loss of Osmonics, and
the loss on the sale of Veeco Instruments' leak detection business. Among the
gains, the Fairchild and H.J. Heinz gains on selling off businesses would seem
to be candidates for inclusion further down the income statement.
44 Understanding the Numbers
Comparing the items included in operating income to those excluded reveals
a reasonable degree of f lexibility and judgment in the classification of
many of these items. In any event, operating income may not be a very reliable
measure of ongoing operating performance given the wide range of nonrecurring
items that are included in its determination.
Nonrecurring Items Excluded from Operating Income
Unlike the multistep format, the single-step income statement omits a subtotal
representing operating income. The task of identifying core or operating income
is therefore more difficult. Nonrecurring items of revenue or gain and
EXHIBIT 2.6 Nonrecurring items of revenue, gain, expense, and loss
included in operating income.
Company Nonrecurring Item
Expenses and Losses
Air T Inc. (2000) Start-up/merger expense
Akorn Inc. (1999) Relocation costs
Amazon.Com Inc. (1999) Stock-based compensation
Argosy Gaming Company (1995) Flood costs
Avado Brands Inc. (1999) Asset revaluation charges
Brooktrout Technologies Inc. (1998) Merger related charges
Burlington Resources Inc. (1999) Impairment of oil and gas properties
Cisco Systems Inc. (1999) Charges for purchased R&D
Colonial Commercial Corporation (1999) Costs of an abandoned acquisition
Dean Foods Company (1999) Plant closure costs
Delta Air Lines Inc. (2000) Asset write-downs and other special charges
Detection Systems Inc. (2000) Shareholder class action litigation charge
Escalon Medical Corporation (2000) Write-down of patents and goodwill
Gerber Scientific Inc. (2000) Write-downs of inventory and receivables
Holly Corporation (2000) Voluntary early retirement costs
JLG Industries Inc. (2000) Restructuring charges
Osmonics Inc. (1993) Embezzlement loss
Saucony Inc. (1999) Write-down of impaired real estate
Silicon Valley Group Inc. (1999) Inventory write-downs
Veeco Instruments Inc. (1999) Loss on sale of leak detection business
Wegener Corporation (1999) Write-down of capitalized software
Revenues and Gains
Alberto-Culver Company (2000) Gain on sale of European trademark
The Fairchild Corporation (2000) Gains on the sale of subsidiaries
H.J. Heinz Company (1995) Gain on sale of confectionery business
Lufkin Industries Inc. (1999) LIFO-liquidation benefit
National Steel Corporation (1999) Benefit from property-tax settlement
Praxair Inc. (1999) Hedge gain in Brazil and income-hedge gain
Tyco International Ltd. (2000) Reversal of restructuring accrual
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example was drawn.
Analyzing Business Earnings 45
expense or loss are either presented as separate line items within the listing of
revenues or gain and expense or loss, or are included in an "other income (expense)"
line. A sampling of nonrecurring items found in the other-income-andexpense
category of the multistep income statements of a number of
companies is provided in Exhibit 2.7.
A comparison of the items in two exhibits reveals some potential for overlap
in these two categories. The first, nonrecurring items in operating income,
should be dominated by items closely linked to company operations. The nonrecurring
items in the second category, below operating income, should fall outside
the operations area of the firm. Notice that there is a litigation charge
included in operating income (Exhibit 2.6, Detection Systems) as well as several
excluded from operating income (Exhibit 2.7, Advanced Micro Devices,
Cryomedical Sciences, and Trimark Holdings). Gains on the sale of investments
are found far less frequently within operating income. Firms may avoid
EXHIBIT 2.7 Nonrecurring items of revenue or gain and expense or
loss excluded from operating income.
Company Nonrecurring Item
Expenses or Losses
Advanced Micro Devices Inc. (1999) Litigation settlement charge
Baltek Corporation (1997) Foreign currency loss
Champion Enterprises (1995) Environmental reserve
Cryomedical Sciences Inc. (1995) Settlement of shareholder class action suit
Galey & Lord Inc. (1998) Loss on foreign-currency hedges
Global Industries (1993) Fire loss on marine vessel
Hollywood Casino Corporation (1992) Write-off of deferred preacquisition costs
Imperial Holly Corporation (1994) Workforce reduction charge
Trimark Holdings Inc. (1995) Litigation settlement
Revenues or Gains
Artistic Greetings Inc. (1995) Unrealized gains on trading securities
Avado Brands Inc. (1999) Gain on asset disposals
Colonial Commercial Corporation (1999) Gain on land sale
Delta Air Lines Inc. (2000) Gains from the sale of investments
The Fairchild Corporation (2000) Gains on the sale of subsidiaries and affiliates
Freeport-McMoRan Inc. (1991) Insurance settlement (tanker grounding)
Gerber Scientific Inc. (2000) Litigation award
Imperial Sugar Company (1999) Realized securities gains
Meredith Corporation (1994) Sale of broadcast stations
National Steel Corporation (1999) Gain on disposal of noncore assets
New England Business Service Inc. (1996) Gain on sale of product line
Noble Drilling (1991) Insurance on rig abandoned in Somalia
Pollo Tropical Inc. (1995) Business-interruption insurance recovery
Raven Industries Inc. (2000) Gain on sale of investment in affiliate
Saucony Inc. (1999) Foreign currency gains
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example was drawn.
46 Understanding the Numbers
classifying these nonrecurring gains within operating income to prevent shareholders'
unrealistic expectations for earnings in subsequent periods. It is common
to see foreign-currency gains and losses classified below operating
income. This is somewhat difficult to rationalize because currency exposure
is an integral part of operations when a firm does business with foreign customers
and/or has foreign operations.
The operating income subtotal should measure the basic profitability of a
firm's operations. It is far from a net earnings number because its location in
the income statement is above a number of other nonoperating revenues, gains,
expenses, and losses, as well as interest charges and income taxes. Clearly, the
range and complexity of nonrecurring items create difficult judgment calls
in implementing this concept of operating income. Management may use this
f lexibility to manage the operating income number. That is, the classification
of items either inside or outside operating income could be inf luenced by the
goal of maintaining stable growth in this key performance measure.
Some of the items in Exhibit 2.7 would seem to have been equally at home
within the operating income section. An environmental reserve (Champion Enterprises)
appears to be closely tied to operations, as are the workforce reduction
charges, a common element of restructuring charges (Imperial Holly); the
insurance settlement from the tanker grounding (Freeport-McMoRan); and
business interruption insurance (Pollo Tropical).
Nonrecurring Items Located below Income from
Continuing Operations
The region in the income statement below income from continuing operations
has a standard organization and is the same for both the single- and multistep
income statement. This format is outlined in Exhibit 2.8. The income statement
of AK Steel Holding Corporation, shown in Exhibit 2.9, illustrates this format.
Each of the special line items—that is, discontinued operations, extraordinary
EXHIBIT 2.8 Income statement format with
special items.
Income from continuing operations $000
Discontinued operations 000
Extraordinary items 000
Cumulative effect of changes in accounting principles 000
Net income 000
Other comprehensive income 000
Comprehensive income $000
SOURCES: Key guidance is found in Accounting Principles Board Opinion
No. 30, Reporting the Results of Operations (New York: AICPA, June 1973)
and Statement of Financial Accounting Standards (SFAS), No. 130, Reporting
Comprehensive Income (Norwalk, CT: FASB, June 1997).
Analyzing Business Earnings 47
items, and changes in accounting principles—along with examples is discussed
in the following sections. All of these items are presented in the income statement
on an after-tax basis.
Discontinued Operations
The discontinued operations section is designed to enhance the interpretive
value of the income statement by separating the results of continuing operations
EXHIBIT 2.9 Consolidated statements of income: AK Steel Holding
Corp., years ended December 31 (in millions).
1997 1998 1999
Net sales $4,176.6 $4,029.7 $4,284.8
Cost of products sold 3,363.3 3,226.5 3,419.8
Selling, general and administrative expense 288.0 278.0 309.8
Depreciation 141.0 161.2 210.7
Special charge — — 99.7
Total operating costs 3,792.3 3,665.7 4,040.0
Operating profit 384.3 364.0 244.8
Interest expense 111.7 84.9 123.7
Other income 48.4 30.3 20.8
Income from continuing operations before income
taxes and minority interest 321.0 309.4 141.9
Income tax provision 127.5 105.5 63.9
Minority interest 8.1 8.1 6.7
Income from continuing operations 185.4 195.8 71.3
Discontinued operations 1.6 — 7.5
Income before extraordinary item and cumulative
effect of a change in accounting 187.0 195.8 78.8
Extraordinary loss on retirement of debt, net of tax 1.9 — 13.4
Cumulative effect of change in accounting,
net of tax — 133.9 —
Net income 185.1 329.7 65.4
Other comprehensive income, net of tax:
Foreign currency translation adjustment (1.4) 0.3 (1.4)
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising
during the period 2.1 (0.5) (1.2)
Less: reclassification for gains included in net
income (0.2) (1.0) (1.9)
Minimum pension liability adjustment — (2.6) 1.2
Comprehensive income $ 185.6 $ 325.9 $ 62.1
Note: Note references as well as earnings-per-share data included in the AK Steel income statement
were omitted from the above.
SOURCE: AK Steel Holdings Corp., annual report, December 1999, 20.
48 Understanding the Numbers
from those that have been or are being discontinued. Only the discontinuance
of operations that constitute a separate and complete segment of the business
have normally been reported in this special section. The current segmentreporting
standard, SFAS 131, Disclosures about Segments of an Enterprise and
Related Information, identifies the following as characteristics of a segment:
1. It engages in business activities from which it may earn revenues and
incur expenses (including revenues and expenses relating to transactions
with other components of the same enterprise).
2. Its operating results are regularly reviewed by the enterprise's chief operating
decision maker to allocate resources to the segment and assess its
performance.
3. Discrete financial information is available.12
Some examples of operations that have been viewed as segments and
therefore classified as "discontinued operations" are provided in Exhibit
2.10. Most of the discontinued operations that are disclosed in Exhibit 2.10
appear to satisfy the traditional test of being separate and distinct segments
of the business. The retail furniture business of insurance company Atlantic
American is a good example. The case of Textron is a somewhat closer call.
Textron reports its operations in four segments: Aircraft, Automotive, Industrial,
and Finance. The disposition of Avco Financial Services could be seen
as a product line within the Finance segment. However, it may very well qualify
as a segment under the newer guidance of SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information, previously presented.
The treatment of vegetables as a separate segment of the food processor
Dean Foods also suggests that there are judgment calls in deciding
whether a disposition is a distinct segment or simply a product line and thus
only part of a segment.
Extraordinary Items
Income statement items are considered extraordinary if they are both (1) unusual
and (2) infrequent in occurrence.13 Unusual items are not related to the
typical activities or operations of the firm. Infrequency of occurrence simply
implies that the item is not expected to recur in the foreseeable future.
In practice the joint requirement of "unusual and nonrecurring" results
in very few items being reported as extraordinary. GAAPs identify two types of
extraordinary transactions the gains or losses from which do not have to be
both unusual and nonrecurring. These are (1) gains and losses from the extinguishment
of debt14 and (2) gains or losses resulting from "troubled debt restructurings."
15 Included in the latter type are either the settlement of
obligations or their continuation with a modification of terms.
A tabulation of extraordinary items, based on an annual survey of
600 companies conducted by the American Institute of CPAs, is provided in
Analyzing Business Earnings 49
Exhibit 2.11. This summary highlights the rarity of extraordinary items under
current reporting requirements. Debt extinguishments represent the largest
portion of the disclosed extraordinary items. This leaves only from two to five
discretionary extraordinary items per year among the 600 companies surveyed.
The small number of gains and losses classified as extraordinary is consistent
with their definition. However, this rarity adds to the challenge of locating
all nonrecurring items as part of a thorough earnings analysis. Few nonrecurring
items will qualify for the prominent disclosure that results from display in
one of the special sections, such as for extraordinary items, of the income
statement. A sample of discretionary extraordinary items—that is, items not
treated as extraordinary by a specific standard—is provided in Exhibit 2.12.
Natural disasters and civil unrest are some of the more typical causes of
extraordinary items. The extraordinary gain of American Building Maintenance
may appear to fail the criterion of unusual since small earthquakes are
EXHIBIT 2.10 Examples of discontinued operations.
Discontinued
Company Principal Business Operation
American Standard Companies Inc. Air conditioning, bathroom Medical systems
(1999) fixtures, and electronics
Atlantic American Corporation Insurance Retail furniture
(1999)
Bestfoods Inc. (1999) Food preparations Corn refining
Dean Foods Inc. (1999) Food processor Vegetables segment
Decorator Industries Inc. (1999) Interior furnishing products Manufacture and sale
for the retail market
The Fairchild Corporation (2000) Aerospace fasteners and Fairchild technologies
aerospace parts distribution business
Gleason Corporation (1995) Gear machinery and Metal stamping and
equipment fabricating
Maxco Inc. (1996) Manufacturing, distri- Automotive refinishing
bution, and real estate products
A.O. Smith Corporation (1999) Motors and generators Storage tank and
fiberglass pipe markets
Standard Register Company (1999) Document management Promotional direct
and print production mail operation
Textron Inc. (1999) Aircraft engines, automotive Avco Financial
parts, and finance Services
Watts Industries Inc. (1999) Valves for plumbing, heating Industrial oil and gas
and water quality industries businesses
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example was drawn.
50 Understanding the Numbers
EXHIBIT 2.11 Frequency and nature of extraordinary items.
1996 1997 1998 1999
Debt extinguishments 60 62 73 56
Other 5 3 2 6
Total extraordinary items 65 65 75 62
Companies presenting extraordinary items 63 64 74 61
Companies not presenting extraordinary items 537 536 526 539
Total companies 600 600 600 600
SOURCE: American Institute of Certified Public Accountants, Accounting Trends and Techniques (New
York: AICPA, 1999), 392.
EXHIBIT 2.12 Discretionary extraordinar y items.
Company Item or Event
American Building Maintenance Gain on an insurance settlement for damage to a
Inc. (1989) building from a San Francisco earthquake
Avoca Inc. (1995) Insurance proceeds from the destruction of a
building by a fire
BLC Financial Services Inc. (1998) Settlement of a lawsuit
KeyCorp Ohio (1999) Gain on the sale of residential mortgage loan-servicing
operations
Noble Drilling Corporation (1991) Insurance settlement due to deprivation of use of
logistics and drilling equipment abandoned in
Somalia due to civil unrest
NACCO Industries Inc. (1995) Gain on a downward revision of an obligation to the
United Mine Workers of America Combined Benefit
Fund
NS Group Inc. (1992) Loss from an accidental melting of radioactive
substance in the steel-making operation
Phillips Petroleum Company (1990) Gain from a settlement with the government of Iran
over the expropriation of Phillips' oil production
interests
SunTrust Banks Inc. (1999) Gain on the sale of the Company's consumer credit
portfolio
Weyerhaeuser Company (1980) Losses from Mount St. Helens eruption
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example was drawn.
Analyzing Business Earnings 51
frequent in the Bay Area. However, the magnitude of this quake, at about 7.0
on the Richter scale, was probably enough for it to qualify as both unusual and
nonrecurring. Earthquakes of such magnitude have not occurred since the San
Francisco quake of 1906. The Mount St. Helens eruption (Weyerhaeuser) was
certainly enormous on the scale of volcanic eruptions.
The discretionary character of the definition of extraordinary items
combined with the growing complexity of company operations results in considerable
diversity in the classification of items as extraordinary. For example,
Sun Company (not displayed in Exhibit 2.12) had a gain from an expropriation
settlement with Iran. Unlike Phillips Petroleum, however, Sun did not classify
the gain as extraordinary. Neither Exxon nor Union Carbide (also not in Exhibit
2.12) classified as extraordinary their substantial losses from what could
be seen as accidents related to their operating activities.16 The classifications
as extraordinary of gains on the sale of servicing operations by KeyCorp and
on a consumer credit portfolio by SunTrust are rather surprising. These two
items would seem to fail the unusual part of the test for extraordinary items.
The task of locating all nonrecurring items of revenue or gain and expense
or loss is aided only marginally by the presence of the extraordinary category
in the income statement, because the extraordinary classification is
employed so sparingly. Location of most nonrecurring items calls for careful
review of other parts of the income statement, other statements, and notes to
the financial statements.
Changes in Accounting Principles
The cumulative effects (catch-up adjustments) of changes in accounting principles
are also reported below income from continuing operations (see Exhibit
2.8). Most changes in accounting principles result from the adoption of
new standards issued by the Financial Accounting Standards Board (FASB).
The most common reporting treatment when a firm changes from one accepted
accounting principle to another is to show the cumulative effect of the
change on the results of prior years in the income statement for the year of the
change. Less common is the retroactive restatement of the prior-year statements
to the new accounting basis. Under this method, the effect of the
change on the years prior to those presented in the annual report for the year of
the change is treated as an adjustment to retained earnings of the earliest year
presented.
As noted previously, in recent years accounting changes have been dominated
by the requirement to adopt new generally accepted accounting principles
(GAAPs). Discretionary changes in accounting principle are a distinct
minority. Examples of discretionary changes would be a switch from accelerated
to straight-line depreciation or from the LIFO to FIFO inventory method.
Information on accounting changes in both accounting principles and in
estimates is provided in Exhibit 2.13. This information is drawn from an annual
survey of the annual reports of 600 companies conducted by the American
52 Understanding the Numbers
Institute of Certified Public Accountants (AICPA). The distribution of adoption
dates across several years, especially for SFAS 121, occurs because some
firms adopt the new statement prior to its mandatory adoption date. In addition,
the required adoption date for new standards is typically for years beginning
after December 15 of the year specified. This means that firms whose
fiscal year starts on January 1 are the first to be required to adopt the new
standard. Other firms adopt throughout the following year.
Most recent changes in accounting principles have been reported on a cumulative-
effect basis. The cumulative effect is reported net of tax in a separate
section (see Exhibit 2.8) of the income statement. The cumulative effect is the
impact of the change on the results of previous years. The impact of the change
on the current year, that is, year of the change, is typically disclosed in a note
describing the change and its impact. However, it is not disclosed separately on
the face of the income statement. An example of the disclosure of both the cumulative
effect of an accounting change and its effect on income from continuing
operations is provided below:
Cumulative effect
Effective January 1, 1998, Armco changed its method of amortizing unrecognized
net gains and losses related to its obligations for pensions and other
postretirement benefits. In 1998, Armco recognized income of $237.5 million,
or $2.20 per share of common stock, for the cumulative effect of this accounting
change.
Effect on income from continuing operations for the year of change
EXHIBIT 2.13 Accounting changes.
Number of Companies
Subject of the Change 1996 1997 1998 1999
Software development costs (SOP 98-1) — 1 37 66
Start-up costs (SOP 98-5) — 2 29 39
Inventories 5 4 5 5
Revenue recognition (SAB 101) — — — 5
Depreciable lives 3 3 4 4
Software revenue recognition — — 4 3
Derivatives and hedging activities — — — 3
Market-value valuation of pension assets — — — 3
Bankruptcy code reporting (SOP 90-7) — — — 3
Recoverability of goodwill — — — 2
Depreciation method 4 3 — 2
Business process reengineering (EITF 97-13) — 28 10 2
Impairment of long-lived assets (SFAS 121) 134 39 3 —
Reporting entity 1 1 2 —
Other 28 57 13 10
SOURCE: American Institute of Certified Public Accountants, Accounting Trends and Techniques (New
York: AICPA, 2000), 79.
Analyzing Business Earnings 53
Adoption of the new method increased 1998 income from continuing operations
by approximately $3.0 million or $0.03 per share of common stock.17
In analyzing earnings, the effect of an accounting change on the results of
previous years will be prominently displayed net of its tax effect on the face of
the income statement. However, the effect on the current year's income from
continuing operations appears only in the note describing the change. While
not the case for the Armco example, the current-year effect of the change is
often large and should be considered in interpreting the performance of the
current year in relation to previous years.
Most of the entries in Exhibit 2.13 represent the mandatory adoption of
new GAAP. Two statements of position (SOP), SOP 98-1 and 98-5, produced
most of the accounting changes in 1998. Statements of position are issued by
the AICPA and are considered part of the body of GAAP. The same is true for
EITF 97-13. An EITF represents a consensus reached on a focused technical
accounting and reporting issue by the Emerging Issues Task Force of FASB.
The item listed as SAB 101 is a document issued by the SEC and will continue
to cause changes in the timing of the recognition of income by many companies.
18 The single listed FASB statement, SFAS 121, illustrates the multiyear
adoption pattern that ref lects early adopters in 1995, followed by mandatory
adopters in subsequent years.
Some of the items listed in Exhibit 2.13 represent changes in accounting
estimates as opposed to accounting principles. Changes in depreciation method
are changes in accounting principle, whereas changes in depreciable lives are
changes in estimate. The accounting treatments of the two different types of
changes are quite different. Changes in accounting estimates are discussed next.
Changes in Estimates
Whereas changes in accounting principles are handled on either a cumulativeeffect
(catch-up) or retroactive restatement basis, changes in accounting estimates
are handled on a prospective basis only. The impact of a change is
included only in current or future periods; retroactive restatements are not
permitted. For example, effective January 1, 1999, Southwest Airlines changed
the useful lives of its 737-300 and 737-500 aircraft. This is considered a change
in estimate. Southwest's change in estimate was disclosed in the following note:
Change in Accounting Estimate
Effective January 1, 1999, the Company revised the estimated useful lives of its
737-300 and 737-500 aircraft from 20 years to 23 years. This change was the result
of the Company's assessment of the remaining useful lives of the aircraft
based on the manufacturer 's design lives, the Company's increased average
aircraft stage (trip) length, and the Company's previous experience. The effect
of this change was to reduce depreciation expense approximately $25.7 million
and increase net income $.03 per diluted share for the year ended December
31, 1999.19
54 Understanding the Numbers
The $25.7 million reduction in 1999 depreciation was not set out separately
in Southwest's 1999 income statement, as would be the case if the
depreciation reduction resulted from a change to straight-line from the accelerated
method. Unlike the case of AK Steel (Exhibit 2.9), there is no cumulativeeffect
adjustment in the Southwest income statement.
Southwest reported pretax earnings of $774 million in 1999. Pretax earnings
in 1998 were $705 million. On an as-reported basis, Southwest's pretax
earnings grew by 10% in 1999. Without the $25.7 million benefit from the increase
in aircraft useful lives, however, the pretax earnings increase in 1999
would have been only 6%. That is, on a consistent basis Southwest's improvement
in operating results is sharply lower than the as-reported results would
suggest. Locating the effect of this accounting change and determining its contribution
to Southwest's 1999 net income is essential in any effort to judge its
1999 financial performance.
Identifying nonrecurring items in the income statement as outlined above
is a key first step in earnings analysis; many such items will be located at other
places in the annual report. The discussion that follows considers other locations
where additional nonrecurring items may be located.
NONRECURRING ITEMS IN THE STATEMENT
OF CASH FLOWS
After the income statement, the operating activities section of the statement
of cash f lows is an excellent secondary source to use in locating nonrecurring
items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of
this section of the statement of cash f lows results from two factors. First,
gains and losses on the sale of investments and fixed assets must be removed
from net income in arriving at cash f low from operating activities. Second,
noncash items of revenue or gain and expense or loss must also be removed
from net income. All cash inf lows associated with the sale of investments and
fixed assets must be classified in the investing activities section of the statement
of cash f lows. This classification requires removal of the gains or losses
typically nonrecurring in nature from net income in arriving at cash flow
from operating activities. Similarly, because many nonrecurring expenses or
losses do not involve a current-period cash outflow, such items must be adjusted
out of net income in arriving at cash f low from operating activities.
Such adjustments, if not simply combined in a miscellaneous balance, often
highlight nonrecurring items.
The partial statement of cash flows of Escalon Medical Corporation in
Exhibit 2.14 illustrates the disclosure of nonrecurring items in the operatingactivities
section of the statement of cash flows. The nonrecurring items would
appear to be (1) the write-down of intangible assets, (2) the net gain on sale of
the Betadine product line, (3) the net gain on the sale of the Silicone Oil product
Analyzing Business Earnings 55
line, and (4) the write-down of patent costs and goodwill. The Escalon income
statement also disclosed, on separate lines, each of the nonrecurring items revealed
in the operating activities section, with the exception of the intangible
assets write-down.
The asset write-downs, items (1) and (4) above, are added back to net income
or loss because they are noncash. The gains on the product-line sales are
deducted from net income or loss because all cash from such transactions, including
the portion represented by the gain, must be classified in the investing
activities section of the cash f low statement. As the gains are part of net income
or loss, a failure to remove them would both overstate cash f lows from
operating activities and understate investing cash inf lows.
Examples of nonrecurring items disclosed in the operating activities section
of a number of different companies are presented in Exhibit 2.15. Frequently,
nonrecurring items appear in both the income statement and operating
activities section of the statement of cash flows. However, some nonrecurring
items are disclosed in the statement of cash f lows but not the income statement.
Exhibit 2.15 provides examples of both types of disclosure.
EXHIBIT 2.14 Nonrecurring items disclosed in the statement of cash
f lows: Escalon Medical Corporation, partial consolidated
statements of cash f lows, years ended June 30.
1998 1999 2000
Cash Flows from Operating Activities
Net income (loss) $ 171,472 $1,193,787 $ (862,652)
Adjustments to reconcile net income (loss)
to net cash provided from (used in)
operating activities:
Depreciation and amortization 331,987 363,687 666,770
Equity in net loss of joint venture — — 33,382
Income from license of intellectual
laser property (75,000) — —
Write-down of intangible assets — 24,805 —
Net gain on sale of Betadine product line — (879,159) —
Net gain on sale of Silicone Oil product line — — (1,863,915)
Write-down of patents and goodwill — — 417,849
Change in operating assets and liabilities:
Accounts receivable (353,113) (48,451) 586,424
Inventory 115,740 (410,476) 162,862
Other current and long-term assets (16,862) (116,491) (164,960)
Accounts payable and accrued expenses (360,396) 519,764 (416,506)
Net cash provided from (used in)
operating activities $(186,172) $647,466 $(1,440,746)
SOURCE: Escalon Medical Corporation, annual report, June 2000, F-6.
56 Understanding the Numbers
Interpreting Information in the Operating
Activities Section
The statement of cash f lows is an important additional source of information
on nonrecurring items. It enables one to detect items that are not disclosed separately
in the income statement but appear in the statement of cash flows
because of either their noncash or nonoperating character. To realize the diagnostic
value of the statement of cash f lows, one must determine which items in
the operating activities section of the statement of cash f lows are nonrecurring.
The appearance in the statement of cash f lows as merely an addition to
or deduction from net income or loss does not signify that the item is nonrecurring.
Some entries in this section simply ref lect the noncash character of
EXHIBIT 2.15 Disclosure of nonrecurring items in both the income
statement and operating activities section of the
statement of cash f lows.
Company Nonrecurring Item
Separately disclosed in both the income statement and statement of cash f lows
Advanced Micro Devices Inc. (1999) Gain on sale of Vantis
Air T Inc. (2000) Loss on the sale of assets
AmSouth Bancorporation (1999) Merger-related costs
Armstrong World Industries Inc. (1999) Charge for asbestos liability
Baycorp Holdings Ltd. (1999) Unrealized loss on energy trading contracts
Callon Petroleum Company (1999) Impairment of oil and gas properties
Corning Inc. (1999) Nonoperating gains
Delta Air Lines Inc. (2000) Asset write-downs and other special charges
The Fairchild Corporation (2000) Restructuring charges
Gerber Scientific Inc. (2000) Nonrecurring special charges
Hercules Inc. (1999) Charge for acquired in-process R&D
Raven Industries Inc. (2000) Gain on sale of investment in affiliate
Separately disclosed only in the statement of cash f low
Advanced Micro Devices Inc. (1999) Charge for settlement of litigation
Brush Wellman Inc. (1999) Impairment of fixed assets and related intangibles
Chiquita Brands International Inc. (1999) Write-down of banana production assets, net
Dal-Tile International Inc. (1999) Impairment of assets and foreign-currency gain
Evans & Sutherland Computer Inventory write-downs
Corporation (1998)
M.A. Hanna Company (1999) Provision for loss on sale of assets
H.J. Heinz Company (1999) Gain on sale of bakery products unit
JLG Industries Inc. (2000) Restructuring charges
Kulicke & Soffa Industries Inc. (1999) Provision for impairment of goodwill
Petroleum Helicopters Inc. (1999) Gain on asset dispositions
Schnitzer Steel Industries Inc. (1999) Environmental reserve reversal
Synthetech Inc. (2000) Realized gain on sale of securities
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which the example was drawn.
Analyzing Business Earnings 57
certain items of revenue, gain, expense, and loss. For example, depreciation
and amortization are added back to Escalon's net income or loss (Exhibit 2.14)
because they are not cash expenses.20 The two asset write-downs are likewise
added back to net income or loss because of their noncash character. However,
a separate judgment may also be made that, unlike depreciation, these two
items are both noncash and nonrecurring.
Also notice that two different gains on sales of product lines are deducted
in arriving at operating cash flow. It would be tempting to assume that these
are noncash gains. However, the investing activities section of the Escalon
statement of cash f lows, a portion of which is included in Exhibit 2.16, reveals
this not to be the case. Cash inf lows of $2,059,835 and $2,117,180 from the
sales of Betadine and Silicone Oil, respectively, are disclosed in cash flows
from investing activities. The gains are fully backed by cash inf lows, but they
are deducted from net income because they are not considered a source of operating
cash flow. Whatever the specific basis for deducting these gains from
net income to arrive at cash f low from operating activities, the process of deduction
simultaneously discloses these nonrecurring items.
Two other items in Escalon's operating activities section (Exhibit 2.14)
require comment. First, the addition to the 2000 net loss of $33,382 for "equity
in net loss of joint venture" is required because of the noncash nature of this
loss. GAAPs require that a firm (the investor) with an ownership position that
permits it to exercise significant inf luence over another company (the investee)
short of control must recognize its share of the investee's results. This principle
caused Escalon to recognize its share of its investee's loss in 2000. However,
there is no cash outflow on Escalon's part associated with simply
recognizing this loss in its income statement.21 Therefore, the addition of the
loss to net income simply ref lects its noncash character. Determining whether
the loss is nonrecurring would require an examination of the income statement
of the underlying investee company.
The second item is the $75,000 of "income from license of intellectual
laser property." This item is deducted from 1998 net income in arriving at
EXHIBIT 2.16 Investing cash f lows: Escalon Medical Corporation,
partial investing cash f lows section, years ended
June 30.
1998 1999 2000
Cash Flows from Investing Activities:
Purchase of investments $(470,180) $ (259,000) $(7,043,061)
Proceeds from maturities of investments 375,164 589,016 7,043,061
Net change in cash and cash
equivalents—restricted — (1,000,000) 1,000,000
Proceeds from the sale of Betadine product line — 2,059,835 —
Proceeds from sales of Silicone Oil product line — — 2,117,180
SOURCE: Escalon Medical Corporation, annual report, June 2000, F-6.
58 Understanding the Numbers
operating cash flow. This deduction may indicate either that no cash was collected
in connection with recording this income or that the income is not considered
to be an operating cash-f low item. The absence of a cash inf low is the
more likely explanation. But should the $75,000 be seen as nonrecurring? If
this were a one-time licensing fee, then it should be treated as nonrecurring
in evaluating the $171,472 of 1998 net income. Escalon has a substantial
net-operating-loss carryforward, and its 1998 pretax and after-tax results are
the same. As a result, this $75,000 of income amounted to 44% of Escalon's
1998 net income. The absence of this item in the cash f lows statement in either
1999 or 2000 gives the licensing fee the appearance of being nonrecurring.
NONRECURRING ITEMS IN THE INVENTORY
DISCLOSURES OF LIFO FIRMS
The carrying values of inventories maintained under the LIFO method are
sometimes significantly understated in relationship to their replacement cost.
For public companies, the difference between the LIFO carrying value and
replacement cost (frequently approximated by FIFO) is a required disclosure
under SEC regulations.22 An example of a substantial difference between
LIFO and current replacement value is found in a summary of the inventory
disclosures of Handy and Harman Inc. in Exhibit 2.17.
A reduction in the physical inventory quantities of a LIFO inventory is
called a LIFO liquidation. With a LIFO liquidation a portion of the firm's cost
of sales for the year will consist of the carrying values associated with the liquidated
units. These costs are typically lower than current replacement costs,
resulting in increased profits or reduced losses.
As with the differences between the LIFO cost and the replacement
value of the LIFO inventory, SEC regulations also call for disclosures of the effect
of LIFO liquidations.23 Handy and Harman had LIFO liquidations in both
1996 and 1997. In line with these SEC requirements, Handy and Harman provided
the following disclosure of the effects of these inventory reductions:
Included in continuing operations for 1996 and 1997 are profits before taxes of
$33,630,000 and $6,408,000, respectively, from reduction in the quantities of
EXHIBIT 2.17 LIFO inventory valuation differences: Handy and Harman
Inc. inventory footnote, years ended December 31
(in thousands).
1996 1997
Precious metals stated at LIFO cost $24,763 $ 20,960
LIFO inventory—excess of year-end market value over LIFO cost 97,996 106,201
SOURCE: Data obtained from Disclosure Inc., Compact D/SEC: Corporate Information on Public Companies
Filing with the SEC (Bethesda, MD: Disclosure Inc., June 1998).
Analyzing Business Earnings 59
precious metal inventories valued under the LIFO method. The after-tax effect
on continuing operations for 1996 and 1997 amounted to $19,260,000 ($1.40 per
basic share) and $3,717,000 ($.31 per basic share), respectively.24
The effect of the Handy and Harman LIFO liquidation is quite dramatic.
Including the effects of the LIFO liquidations, Handy and Harman reported
after-tax income from continuing operations of $33,773,000 in 1996 and
$20,910,000 in 1997. Of the after-tax earnings from continuing operations 57%
in 1996 and 18% in 1997 resulted from the LIFO liquidations. Handy and Harman
reported benefits from LIFO liquidations for most years between 1991
and 1997.
Although Handy and Harman reported LIFO liquidations with some regularity,
an analysis of sustainable earnings should consider the profit improvements
from the liquidations to be nonrecurring. The LIFO-liquidation benefits
result from reductions in the physical quantity of inventory. There are obvious
limits on the ability to sustain these liquidations in future years; as a practical
matter, the inventory cannot be reduced to zero.25 Moreover, the variability in
the size of the liquidation benefits argues for the nonrecurring classification.
The profit improvements resulting from the LIFO liquidations simply represent
the realization of an undervalued asset and are analogous to the gain associated
with the disposition of an undervalued investment, piece of equipment,
or plot of land.
A statement user cannot rely on the disclosure requirements of the SEC
when reviewing the statements of nonpublic companies, especially where an
outside accountant has performed only a review or compilation.26 However,
one can infer the possibility of a LIFO liquidation through the combination of
a decline in the dollar amount of inventory across the year and an otherwise
unexplainable improvement in gross margins. Details on the existence and impact
of a LIFO liquidation could then be discussed with management.27
NONRECURRING ITEMS IN THE INCOME TAX NOTE
Income tax notes are among the more challenging of the disclosures found in
annual reports. They can, however, be a rich source of information on nonrecurring
items. Fortunately, our emphasis on the persistence of earnings requires
a focus on a single key schedule found in the standard income tax note.
The goal is simply to identify nonrecurring tax increases and decreases in this
schedule.
The key source of information on nonrecurring increases and decreases in
income taxes is a schedule that reconciles the actual tax expense or tax benefit
with the amount that would have resulted if all pretax results had been taxed at
the statutory federal rate. This disclosure for Archer Daniels Midland Company
(ADM) is presented in Exhibit 2.18.
Notice that ADM's effective tax rate is reduced in 2000 by 17 percentage
points as a result of redetermining taxes in prior years. This percentage reduction
60 Understanding the Numbers
is expressed in terms of the relationship of the tax reduction to income from
continuing operations before taxes. ADM's 2000 pretax income from continuing
operations is $353,237,000 and its total tax provision was $52,334,000. The
2000 effective tax rate, disclosed in Exhibit 2.18, is derived by dividing the
total tax provision by income from continuing operations before taxes:
$52,334,000 divided by $353,237,000 equals 14.8%.
The dollar, as opposed to percentage tax savings, is found by multiplying
17% times the 2000 pretax earnings: $353,237,000 × 0.17 = $60 million. ADM
explained that "The decrease in income taxes for 2000 resulted primarily from
a $60 million tax credit related to a redetermination of foreign sales corporation
benefits and the resolution of various other tax issues."28 ADM had a dispute
with tax authorities over taxes for previous years, and it won. While there
may be some ongoing benefit from this outcome, the $60 million should be
viewed as nonrecurring in evaluating ADM's earnings performance. Ongoing
tax savings from its foreign sales corporations will continue to be realized and
will be ref lected in the reduced level of the ADM effective tax rate.
ADM's 1998 effective tax rate was also increased by 1.4 percentage points
as a result of fines and litigation settlements being deducted in arriving at pretax
earnings. For income tax purposes, however, these amounts are not deductible,
which means that unlike most other expenses these fines and settlements reduce
after-tax earnings by the full amount of the expenses. There are no associated income
tax savings, and the 1.4-percentage-point increase in the effective tax rate
for 1998 is due to the nondeductible character of the litigation settlements and
fines. The nonrecurring item in this case is simply the total of the fines and settlements.
The tax benefit not realized because of the nondeductibility of the
fines and settlements is not a separate nonrecurring item.
ADM's net income increased from about $266 million in 1999 to about
$301 million in 2000. Without the $60 million nonrecurring tax benefit, ADM's
2000 net income would have declined to $241 million: $301 million − $60 million
= $241 million. Identifying and adjusting 2000 earnings for this nonrecurring
tax benefit results in a far different message: a decline in earnings in
contrast to the reported increase.
EXHIBIT 2.18 Reconciliation of statutory and actual federal tax rates:
Archer Daniels Midland Company, years ended June 30.
1998 1999 2000
Statutory rate 35.0% 35.0% 35.0%
Prior years tax redetermination — — (17.0)
Foreign sales corporation (4.7) (4.5) (6.3)
State income taxes, net of federal benefit 2.4 2.2 2.7
Indefinitely invested foreign earnings 0.7 (1.8) (0.3)
Litigation settlements and fines 1.4 — —
Other (1.0) 2.1 0.7
Effective rate 33.8% 33.0% 14.8%
SOURCE: Archer Daniels Midland Company, annual report, June 2000, 32.
Analyzing Business Earnings 61
The benefit from the tax redetermination is clearly a nonrecurring item.
The tax reductions due to the foreign sales corporation feature of the tax law may
or may not be sustainable. Any profit component that relies on a specific feature
of the current tax law should be viewed as somewhat vulnerable. That is, its continuance
requires that (1) this feature of the tax law be preserved and (2) that
ADM continues to take the actions necessary to earn these tax benefits.
The ADM disclosures provide one example of a nonrecurring tax benefit
plus at least one example of a benefit that may be somewhat more vulnerable
than other sources of operating profit. Exhibit 2.19 provides a sampling of
other nonrecurring tax benefits and tax charges that were found in recent company
tax notes.
The tax benefits of both Biogen and Dana result from utilizing loss carryforwards
whose benefits had not previously been recognized. The losses that
produced the tax savings originated in earlier periods. Because the likelihood
of their realization was not sufficiently high, the potential tax savings of the
losses were not recognized in the income statements in the years in which
these losses were incurred. The subsequent realization of these benefits occurs
when the operating and capital loss carryforwards are used to shield operating
earnings and capital gains, respectively, from taxation. These benefits should
be treated as nonrecurring in analyzing earnings performance for the year in
which the benefits are realized.
Gerber Scientific's effective tax rate was reduced as a result of its recognizing
benefits from research and development tax credits. This feature of the
tax law is designed to encourage R&D spending. As with all other tax credits,
continuation of this source of tax reduction requires that the feature continue
to be part of the tax law and that Gerber make the R&D expenditures necessary
to earn future benefits.
The nonrecurring items of First Aviation Services and Micron Technology
both result from adjustments of their tax valuation allowances. The allowance
balances represent the portion of tax benefits that have been judged
unlikely to be realized.29 Increasing this balance will create a nonrecurring tax
EXHIBIT 2.19 Examples of nonrecurring income tax charges
and benef its.
Company Nonrecurring Charge or Benefit
Biogen Inc. (1999) Benefits from net operating loss utilization
Dana Corporation (1999) Capital loss utilization tax benefit
Detection Systems Inc. (2000) Benefit from lower foreign tax rates
First Aviation Services Inc. (1999) Benefit from valuation allowance decrease
The Fairchild Corporation (2000) Benefit from revision of estimate for tax accruals
Gerber Scientific Inc. (2000) Research and development tax credit
M.A. Hanna Company (1999) Benefit from reversal of tax liability—tax settlement
Micron Technology Inc. (2000) Charge for valuation allowance increase
Pall Corporation (2000) Tax benefit of Puerto Rico operations
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which the example was drawn.
62 Understanding the Numbers
charge; decreasing it, a benefit. The prospects for realization of the tax benefit
must have declined for Micron Technology but improved for First Aviation
Services.
Both the Fairchild Corporation and M.A. Hanna Company tax benefits
were the result of reducing previously recorded tax obligations. Subsequent information
indicated that the liabilities where overstated. The liability reduction
was offset by a comparable reduction in the tax provision. This benefit
should also be viewed as nonrecurring.
Pall Corporation has a tax reduction that is associated with operations located
in Puerto Rico. In fact, most firms with operations in other countries
produce such tax benefits. Foreign states offer these benefits to encourage
companies, typically manufacturing companies, to locate within their borders.
In many cases these benefits are for a limited period of time, though renewals
are sometimes possible. As a result, while the benefits are real, there remains
a possibility that they will cease at some point. In fact, Pall Corporation disclosed
just such a change in its income tax note:
The Company has two Puerto Rico subsidiaries that are organized as "possessions
corporations" as defined in Section 936 of the Internal Revenue Code.
The Small Business Job Protection Act of 1996 repealed Section 936 of the Internal
Revenue Code, which provided a tax credit for U.S. companies with operations
in certain U.S. possessions, including Puerto Rico. For companies with
existing qualifying Puerto Rico operations, such as Pall, Section 936 will be
phased out over a period of several years, with a decreasing credit being available
through the last taxable year beginning before January 1, 2006.
This change in U.S. tax law means that previous tax benefits from the operations
in Puerto Rico are not sustainable. When a company reports tax benefits
because of operations in other countries, the possibility that the benefits might
end or be reduced should be considered.
NONRECURRING ITEMS IN THE OTHER INCOME
AND EXPENSE NOTE
An "other income (expense), net," or equivalent line item is commonly found in
both the single- and multistep income statement. In the case of the multistep
format, the composition of other income and expenses is sometimes detailed on
the face of the income statement. In both the multi- and single-step formats,
the most typical presentation is a single line item with a supporting note. Even
though a note detailing the contents of other income and expense may exist,
companies typically do not specify its location. Other income and expense
notes tend to be listed close to the end of the notes to the financial statements.
The other income and expense note of The Sherwin-Williams Company is
provided in Exhibit 2.20. The balance (income) of the Sherwin-Williams other
income and expense note shows a modest increase between 1997 to 1998 and
Analyzing Business Earnings 63
1998 to 1999. In the absence of sharp changes in the balance over time, an analyst
would be less inclined to look for a note detailing the makeup of the balance
on the face of the income statement. However, some large nonrecurring
items underlie this net balance.
Notice the very large increase in the provision for environmental matters.
This increase is in turn offset in part by the sharp decline in the provision for
disposition and termination of operations. Similarly, the foreign currency loss
declined by about $12 million over the three years covered by the note. Some
or all of the large 1999 increase in the provision for environmental matters
should be considered to be nonrecurring. This would mean that results for 1999
would appear somewhat stronger with the provision added back to earnings.
Some or all of the $12 million provision for disposition and termination of operations
should also be added back to results for 1998.
Foreign currency gains and losses usually are not treated as nonrecurring.
However, the case was made in Exhibit 2.2 (Goodyear Tire and Rubber Company)
for treating them as nonrecurring when they are very irregular, either in
terms of amount or sign (i.e., gain versus loss). The Sherwin-Williams foreigncurrency
loss declined by about $12 million between 1997 and 1999. Nonrecurring
elements are included in at least three of the line items in the
Sherwin-Williams other income and expense note. The net balance of the
other income and expense line item has changed only modestly in the face of
very substantial changes in the components of the net balance. The smooth and
modest growth in this net balance contributes in turn to preserving the growth
and stability of the bottom line, or net income. There is always the possibility
that some of the offsetting balances in the Sherwin-Williams note were
recorded for the purpose of producing smooth growth in this line item.
The location and careful analysis of the other income and expense note is
especially important in the case of income statements with very little detail. In
this regard, firm size and the level of detail in the income statement appear to
EXHIBIT 2.20 Composition of an other income and expense note:
The Sherwin-Williams Company, years ended
December 31 (in thousands).
1997 1998 1999
Dividend and royalty income $ (3,361) $ (3,069) $ (4,692)
Net expense of financing and investing activities 3,688 2,542 7,084
Provisions for environmental matters, net 107 695 15,402
Provisions for disposition and termination
of operations 4,152 12,290 3,830
Foreign currency transaction losses 15,580 11,773 3,333
Miscellaneous 3,199 1,815 4,583
$23,365 $26,046 $29,540
Note: Note references included in the Sherwin-Williams this schedule have been omitted.
SOURCE: The Sherwin-Williams Company, annual report, December 1999, 30.
64 Understanding the Numbers
be inversely related. For example, excluding subtotals and the bottom line of
the income statement, C.R. Bard had a total of only eight line items on its 1997
to 1999 income statements. However, its other income and expense note (Exhibit
2.21) includes numerous nonrecurring items.
A review only of C.R. Bard's 1997 to 1999 income statements would have
yielded a single nonrecurring item. Depending on what is judged to be nonrecurring,
Bard's other income and expense note yields an additional nine to
eleven nonrecurring items. As with the Sherwin-Williams note, there is a tendency
for nonrecurring items to offset each other. Notice that Bard booked a
$24.5 million gain in 1997, when it also had a restructuring charge of $44.1
million. Also, an asset write-down of $34.1 million partially offset a $48.6 million
gain from legal and patent settlements in 1998.30
Careful analysis of the composition of other income and expense line
items is very important in locating nonrecurring items. As the disclosures of
both Sherwin-Williams and C.R. Bard illustrate, this task is made far easier if
a note is provided detailing the line item's composition. However, you should
not expect to be guided to the note by a reference attached to this line item in
the income statement.
NONRECURRING ITEMS IN MANAGEMENT'S
DISCUSSION AND ANALYSIS (MD&A)
Management's Discussion and Analysis of Financial Condition and Results of
Operations (MD&A) is an annual and a quarterly Securities and Exchange
Commission reporting requirement. Provisions of this regulation have a direct
bearing on the goal of locating nonrecurring items. As part of the MD&A, the
SEC requires registrants to:
Describe any unusual or infrequent events or transactions or any significant
economic changes that materially affected the amount of reported income from
EXHIBIT 2.21 Composition of the other income and expense note:
C.R. Bard Inc., years ended December 31 (in thousands).
1997 1998 1999
Interest income $ (3,500) $(6,000) $(2,100)
Foreign exchange (gains) losses — (2,100) (900)
Legal and patent settlements, net 2,000 (48,600) —
Asset write-down 8,500 34,100 9,700
Restructuring 44,100 3,200 —
Gains from sale of product lines and other (24,500) — —
Acquired R&D — 6,400 —
Other, net — 10,100 (200)
Total $26,600 $(2,900) $ 6,500
SOURCE: C.R. Bard Inc., annual report, December 1999, 27.
Analyzing Business Earnings 65
continuing operations and, in each case, indicate the extent to which income
was so affected. In addition, describe any other significant components of revenues
and expenses that, in the registrant's judgment, should be described in
order to understand the registrant's results of operations.31
Complying with this regulation will require some firms to identify and discuss
items that may have already been listed in other financial statements and notes.
In reviewing the MD&A with a view to locating nonrecurring items, the analyst
should focus on the section dealing with results of operations. Here management
presents a comparison of results over the most recent three years;
comparing, for example, 2001 with 2002 and 2002 with 2003 is standard.
Locating nonrecurring items in MD&A is somewhat more difficult than
locating them in other places. Typically the nonrecurring items in MD&A are
discussed in text and are not set out in schedules or statements. However, a
small number of firms do summarize nonrecurring items in schedules within
MD&A. These tend to be more comprehensive and user-friendly than piecemeal
disclosures embedded in text.
The disclosure presented earlier in Exhibit 2.1 provided a restatement of
the as-reported net income of Mason Dixon Bancshares. This restatement removed
the effects of all items considered by Mason Dixon to be nonrecurring.
32 This disclosure was found in the MD&A of Mason Dixon. An additional
example of the disclosure of nonrecurring items from the MD&A of Phillips
Petroleum Company is presented in Exhibit 2.22. Unlike Mason Dixon, Phillips
Petroleum's schedule simply presents a listing of their nonrecurring items.
Phillips Petroleum uses the term "special items" to describe the items in
Exhibit 2.22. The reluctance to refer to these items as "nonrecurring" is understandable.
Four of the seven line items include amounts in each of the three
EXHIBIT 2.22 Nonrecurring items included in MD&A of
f inancial condition and results of operations:
Phillips Petroleum Company, years ended
December 31 (in millions).
1997 1998 1999
Kenai tax settlement $83 $115 —
Property impairments (46) (274) $(34)
Tyonek prospect dry hole costs — (71) —
Net gains on asset sales 16 21 73
Work force reduction charges (3) (60) (3)
Pending claims and settlements 15 108 35
Other items — 23 (10)
Total special items $65 $(138) $61
Note: The above numbers have been presented on an after-tax basis. Also, in a footnote to
this schedule, not provided here, Phillips disclosed that the 1997 and 1998 numbers had
been restated to exclude foreign-currency transaction gains and losses. That is, they were
previously considered to be special (nonrecurring) items but now are not.
SOURCE: Phillips Petroleum Company, annual report, December 1999, 33.
66 Understanding the Numbers
years. This might seem inconsistent with the term nonrecurring. Phillips Petroleum
provides the following explanation of the special items:
Net income is affected by transactions defined by management and termed special
items, which are not representative of the company's ongoing operations.
These transactions can obscure the underlying operating results for a period
and affect comparability of operating results between periods.33
While Phillips Petroleum uses special to describe what we have referred to as
nonrecurring, the above description of its special items is consistent with earlier
discussion in this chapter.
Phillips provided the following discussion of the effects of the information
in Exhibit 2.22 on net income:
Phillips's net income was $609 million in 1999, up 157 percent from net income
of $237 million in 1998. Special items benefited 1999 net income by $61 million,
while reducing net income in 1998 by $138 million. After excluding these
items, net operating income for 1999 was $548 million, a 46 percent increase
over $375 million in 1998.34
The above comments reveal a sharply lower growth in profit in 1999 after adjusting
for the effects of the nonrecurring (special) items. A 157% increase in
net income drops to 46% after adjustment for the nonrecurring items. Notice
that the above discussion refers to the adjusted net income numbers as the "net
operating income." This is consistent with the characterization of the special
items as "not representative of the company's ongoing operations." Nevertheless,
we will continue to use the term sustainable to refer to earnings that have
been adjusted for nonrecurring items.
Presenting information on nonrecurring items in MD&A schedules is still
a fairly limited practice but may be on the rise.35 Though helpful in locating
nonrecurring items, such schedules must be viewed as useful complements to
but not substitutes for a complete search and restatement process. Textual discussion
and disclosure of the effects on nonrecurring items on earnings is far
more common than user-friendly schedules. The disclosures of C.R. Bard Inc.
are illustrative:
In 1999, Bard reported net income of $118.1 million or diluted earnings per
share of $2.28. Excluding the impact of the after-tax gain on the sale of the cardiopulmonary
business of $0.12 and the impact of the fourth quarter writedown
of impaired assets of $0.11, diluted earnings per share was $2.27.36
Bard included information on revised results for each of the three years included
in its 1999 annual report. The adjusted earnings-per-share series provides
a better indicator of underlying trends in operating performance and is a
more reliable base on which to develop projections of future earnings. The asreported
and revised earnings-per-share information is summarized in Exhibit
2.23. As is common, the adjusted earnings, from which the effects of nonrecurring
items have been removed, are less volatile.
Analyzing Business Earnings 67
The discussion to this point has taken us through the first six steps in the
nonrecurring-items search process outlined in Exhibit 2.3. The seventh and
last step illustrates how additional nonrecurring items may sometimes be located
in other selected notes to the financial statements.
NONRECURRING ITEMS IN OTHER SELECTED NOTES
Typically, most material nonrecurring items will have been located by proceeding
through the first six steps of the search sequence in Exhibit 2.3. However,
some additional nonrecurring items may be located in other notes. Nonrecurring
items can surface in virtually any note to the financial statements. We will
now discuss three selected notes that frequently contain other nonrecurring
items: notes on foreign exchange, restructuring, and quarterly and segment financial
data. Recall that inventory, income tax, and other income and expense
notes have already been discussed in steps 3 to 5.
Foreign Exchange Notes
Foreign exchange gains and losses can result from both transaction and translation
exposure. Transaction gains and losses result from either unhedged or partially
hedged foreign-currency exposure.37 This exposure is created by items
such as accounts receivable and accounts payable resulting from sales and purchases
denominated in foreign currencies. As foreign-currency exchange rates
change, the value of the foreign-currency assets and liabilities will expand and
contract. This results, in turn, in foreign currency transaction gains and losses.
This is the essence of the concept of currency exposure.
Translation gains and losses result from either unhedged or partially
hedged exposure associated with foreign subsidiaries. Translation exposure depends
on the mix of assets and liabilities of the foreign subsidiary. In addition,
the character of the operations of the foreign subsidiary and features of the
foreign economy are also factors in determining both exposure and the translation
method applied. There are two possible statement translation methods,
and of the two only one results in translation gains or losses that appear as
EXHIBIT 2.23 Reported and revised earnings per
share: C.R. Bard Inc., years ended
December 31.
As-Reported Earnings Adjusted Earnings
Year per Share per Share
1997 $1.26 $1.67
1998 4.51 1.76
1999 2.28 2.27
SOURCE: C.R. Bard Inc., annual report, December 1999.
68 Understanding the Numbers
part of net income. With the other method, the translation adjustment will be
reported as part of other comprehensive income.38
Foreign-currency gains and losses can also result from the use of various
currency contracts, such as forwards, futures, options, and swaps, entered into
for both hedging and speculation. It is not uncommon to observe foreign exchange
gains and losses year after year in a company's income statement. The
amounts of these items, however, as well as whether they are gains or losses are
often very irregular, making them candidates for nonrecurring classification.
To illustrate, a portion of a note titled "foreign currency translation" from
the 1993 annual report of Dibrell Brothers Inc. follows:
Net gains and losses arising from transaction adjustments are accumulated on a
net basis by entity and are included in the Statement of Consolidated Income,
Other Income—Sundry for gains, Other Deductions—Sundry for losses. For
1993, the transaction adjustments netted to a gain of $4,180,000. The transaction
adjustments were losses of $565,000 and $206,000 for 1992 and 1991, respectively,
and were primarily related to the Company's Brazilian operations.39
The gains and losses disclosed above appeared as adjustments, ref lecting either
their noncash or nonoperating character, in the operating activities of Dibrell's
statement of cash f lows. The effect of the 1993 currency exchange gain is also
referenced in Dibrell's MD&A as part of the comparison of earnings in 1993
to those in 1992.40
While appearing in each of the past three years, Dibrell's foreigncurrency
gains and losses were far from stable—two years of small losses followed
by a year with a large gain. One way to gauge the significance of these
exchange items is to compute their contribution to the growth in income before
income taxes, extraordinary items, and cumulative effect of accounting
changes. This computation is outlined for 1993 in Exhibit 2.24.
EXHIBIT 2.24 Contribution of foreign-currency gains to pretax income
from continuing operations: Dibrell Brothers Inc.,
years ended December 31.
Pretax income from continuing operations
1993 $58,259,560
1992 43,246,860
Increase $15,012,700
Foreign-currency gains and losses
1993 gain $ 4,180,000
1992 loss 565,000
Improvement $ 4,745,000
Contribution of the improvement in foreign currency results to 1993
pretax income from continuing operations:
$4,745,000/$15,012,700 32%
Analyzing Business Earnings 69
Dibrell's currency gain made a major contribution to its profit growth in
1993. Hence, a separate note to the financial statements is devoted to its discussion
and disclosure. Following the recommended search sequence, these
items would be identified at step 2, the statement of cash f lows, or step 6,
MD&A. If search failures occur at these steps, then examination of the foreign
exchange note would be a backup to ensure that the important information
contained in this note is available in assessing Dibrell's 1993 performance.
Restructuring Notes
The past decade has been dominated by the corporate equivalent of a diet program.
Call it streamlining, downsizing, rightsizing, redeploying, or strategic
repositioning—the end result is that firms have been recording nonrecurring
charges of a size and frequency that are unprecedented in our modern economic
history. The size and scope of these activities ensure that they leave their
tracks throughout the statements and notes. Notes on restructuring charges are
among the most common transaction-specific notes. The Fairchild Corporation's
restructuring note is provided in Exhibit 2.25.
A number of different items make up the Fairchild restructuring charge.
Included are severance benefits, asset write-offs, and integration costs.
Fairchild declares that the charges recorded in fiscal 2000 "were the direct result
of formal plans to move equipment, close plants and to terminate employees."
This point is made to counter criticism that some restructuring charges
go well beyond restructuring activities to accrue unrelated costs plus costs that
should properly be charged against future operations.
A tendency to overaccrue restructuring charges has a number of possible
explanations. First, firms facing a poor year for profits may decide to take a "big
EXHIBIT 2.25 Sample restructuring note: The Fairchild Corporation,
year ended June 30, 2000 (in thousands).
In fiscal 1999, we recorded $6,374 of restructuring charges. Of this amount, $500 was
recorded at our corporate office for severance benefits and $348 was recorded at our aerospace
distribution segment for the write-off of building improvements from premises vacated.
The remaining $5,526 was recorded as a result of the Kaynar Technologies initial
integration into our aerospace fasteners segment, i.e., for severance benefits ($3,932), for
product integration costs incurred as of June 30, 1999 ($1,334) and for the write-down of
fixed assets ($260). In fiscal 2000, we recorded $8,578 of restructuring charges as a result of
the continued integration of Kaynar Technologies into our aerospace fasteners segment. All
of the charges recorded during the current year were a direct result of product and plant integration
costs incurred as of June 30, 2000. These costs were classified as restructuring and
were the direct result of formal plans to move equipment, close plants and to terminate employees.
Such costs are nonrecurring in nature. Other than a reduction in our existing cost
structure, none of the restructuring charges resulted in future increases in earnings or represented
an accrual of future costs. As of June 30, 2000, significantly all of our integration plans
have been executed and our integration process is substantially complete.
SOURCE: The Fairchild Corporation, annual report, June 2000, F-27.
70 Understanding the Numbers
bath" and recognize excessive amounts of restructuring costs. The assumption
is that simply increasing a current-period loss will not have additional negative
consequences for share values. Moreover, by writing off costs currently, future
profits are relieved of this burden and will therefore look stronger.
Restructuring charges have attracted the attention of the SEC. Arthur
Levitt, chairman of the SEC, has registered strong objections against the use of
overstated restructuring accruals to increase the earnings of subsequent periods.
41 The chairman refers to these excessive reserves as "cookie jar" reserves.42
There has also been some resistance to considering restructuring charges
to be nonrecurring. The very need for restructuring charges indicates that
earnings in previous periods were overstated. Moreover, restructuring charges
commonly recur with some frequency. Note that the Fairchild disclosure in
Exhibit 2.25 reveals a second charge following the initial charge for the restructuring
of Kaynar Technologies. In some circles restructuring charges are
referred to as "cockroach" charges—from the old saying that if you see one
cockroach there are many more where that one came from.
Restructuring charges will continue to be common in income statements
until the level of restructuring activity in the economy subsides. In the meantime,
restructuring charges and associated reversals of charges should typically
be treated as nonrecurring, even though they may appear with some repetition.
At some point firms will complete the bulk of their restructuring activities,
and the charges will either disappear or drop to immaterial levels.
The materiality of most restructuring charges is such that it would be difficult
to miss them. In the case of The Fairchild Corporation (Exhibit 2.25),
the restructuring charges were disclosed in at least five separate locations
as follows:
1. On a separate line item within the operating income section of the income
statement (step one in the nonrecurring items search sequence).
2. Within the operating activities section of the statement of cash f lows,
with the noncash portion of the charges added back to net earnings or loss
(step 2 in the search sequence).
3. Disclosed in the section of the MD&A dealing with earnings (step 6 in
the search sequence).
4. Disclosed in a separate note to the financial statements on restructuring
charges (step 7[d]).
5. Disclosed in a note dealing with segment reporting (step 7[f] in the
search sequence).
Quarterly and Segmental Financial Data
Quarterly and segmental financial disclosures frequently reveal nonrecurring
items. In the case of segment disclosures, the goal is to aid in the evaluation
of profitability trends by segments. The Fairchild Corporation discussion (Exhibit
2.25) disclosed its restructuring charges in the reports of segment results.
Analyzing Business Earnings 71
Quarterly financial data of Office Depot Inc. disclosed inventory writedowns
of $56.1 million for the third quarter of 1999, a store closure and relocation
charge of $46.4 million in the third quarter of 1999, and a $6.0 million
reversal of the charge in the fourth quarter of 1999. Office Depot also disclosed
merger and restructuring charges as part of the reporting for its segments.43
To complete this review of selected financial statement notes, we discuss
one last item before illustrating the summarization of information on nonrecurring
items and the development of the sustainable earnings series. This
topic is the most recent standard-setting activity with a focus on the fundamental
structure and content of the income statement.
EARNINGS ANALYSIS AND OTHER
COMPREHENSIVE INCOME
The last section in the AK Steel Holdings income statement in Exhibit 2.9 is devoted
to the reporting of other comprehensive income. This is a relatively new
feature of the income statement and was introduced with the issuance by the
FASB of SFAS No. 130, Reporting Comprehensive Income.44 The goal of the
standard is to expand the concept of income to included selected items of nonrecurring
revenue, gain, expense and loss. Under the new standard, traditional
net income is combined with a new component, "other comprehensive income,"
to produce a new bottom line, "comprehensive income."
The principal elements of other comprehensive income are listed in the
other comprehensive income section of the AK Steel Holdings comprehensive
income statement (Exhibit 2.9). They include:
1. Foreign currency translation adjustments.45
2. Unrealized gains and losses on certain securities.
3. Minimum pension liability adjustments.
Each one of these items was already recognized prior to the issuance of SFAS
No. 130. However, they were reported not as part of net income but directly in
shareholders' equity. The items made their way into the income statement only
if they became realized gains or losses by, for example, selling securities. Notice
that the AK Steel disclosures in Exhibit 2.9 list the reclassification of gains
on securities that had previously been recognized in other comprehensive income.
When these gains were realized they were reported in net income. However,
since they had earlier been included in other comprehensive income,
avoiding double counting them requires an adjustment to other comprehensive
income in the year of sale.
SFAS No. 130 permitted other comprehensive income to be reported in
three different ways. The preferred alternative was the income statement format
of AK Steel, though reporting other comprehensive income in a separate
income statement was also permitted. The third option permitted other comprehensive
income to be reported directly in shareholders' equity. It should
72 Understanding the Numbers
come as no surprise that most firms have elected this third option. Firms have
an aversion to including items in the income statement that have the potential
to increase the volatility of earnings. Hence, given the option, firms can and
did choose to avoid the income statement.46
There is scant evidence at this time that statement users pay any attention
to other comprehensive income. Companies do not include other comprehensive
income in discussions of their earnings performance, nor does the financial press
comment on it when earnings are announced. Earnings per share statistics do
not incorporate other comprehensive income. Other comprehensive income is
not currently part of earnings analysis. Hence, we consider it no further. Attitudes
may change, however, about the usefulness of other comprehensive income
as analysts and others become more familiar with these relatively new
disclosures. It seems worthwhile to at least be made aware of these disclosures as
part of a thorough treatment of income statement structure and content.
With the structure of the income statement and relevant GAAP now reviewed,
the nature of nonrecurring items considered, and methods of locating
nonrecurring items outlined and illustrated, we can turn to the task of developing
the sustainable earnings series.
SUMMARIZING NONRECURRING ITEMS AND
DETERMINING SUSTAINABLE EARNINGS
The work to this point has laid out important background but is not complete.
Still required is a device to assist in summarizing information discovered on
nonrecurring items so that new measures of sustainable earnings can be developed.
We devote the balance of this chapter to introducing a worksheet
specially designed to summarize nonrecurring items and illustrating its development
and interpretation in a case study.47
THE SUSTAINABLE EARNINGS WORKSHEET
The sustainable earnings worksheet is shown in Exhibit 2.26. Detailed instructions
on completing the worksheet follow:
1. Net income or loss is recorded on the top line of the worksheet.
2. All identified items of nonrecurring expense or loss, which were included
in the income statement on a pretax basis, are recorded on the "add" lines
provided. Where a prelabeled line is not listed in the worksheet, a descriptive
phrase should be recorded on one of the "other" lines and the
amounts recorded there. In practice, the process of locating nonrecurring
items and recording them on the worksheet would take place at the same
time. However, effective use of the worksheet calls for the background
provided earlier in the chapter. This explains the separation of these steps
in this chapter.
Analyzing Business Earnings 73
EXHIBIT 2.26 Adjustment worksheet for sustainable earnings base.
Year Year Year
Reported net income or (loss)
Add
Pretax LIFO liquidation losses
Losses on sales of fixed assets
Losses on sales of investments
Losses on sales of other asset
Restructuring charges
Investment write-downs
Inventory write-downs
Other asset write-downs
Foreign currency losses
Litigation charges
Losses on patent infringement suits
Exceptional bad-debt provisions
Nonrecurring expense increases
Temporary revenue reductions
Other
Other
Other
Subtotal
Multiply by
(1-combined federal, state tax rates)
Tax-adjusted additions
Add
After-tax LIFO liquidation losses
Increases in deferred tax valuation allowances
Other nonrecurring tax charges
Losses on discontinued operations
Extraordinary losses
Losses/cumulative-effect accounting changes
Other
Other
Other
Subtotal
Total additions
Deduct
Pretax LIFO liquidation gains
Gains on fixed asset sales
Gains on sales of investments
Gains on sales of other assets
Reversals of restructuring accruals
Investment write-ups (trading account)
Foreign currency gains
Litigation revenues
(continued)
74 Understanding the Numbers
3. When all pretax nonrecurring expenses and losses have been recorded,
subtotals should be computed. These subtotals are then multiplied times 1
minus a representative combined federal, state, and foreign income-tax
rate. This puts these items on an after-tax basis so that they are stated on
the same basis as net income or net loss.
4. The results from step 3 should be recorded on the line titled "tax-adjusted
additions."
5. All after-tax nonrecurring expenses or losses are next added separately.
These items are either tax items or special income-statement items that
are disclosed on an after-tax basis under GAAP, such as discontinued operations,
extraordinary items, or the cumulative effect of accounting
changes. The effects of LIFO liquidations are sometimes presented pretax
and sometimes after-tax. Note that a line item is provided for the effect
of LIFO liquidations in both the pretax and after-tax additions
section of the worksheet.
EXHIBIT 2.26 (Continued)
Year Year Year
Gains on patent infringement suits
Temporary expense decreases
Temporary revenue increases
Reversals of bad-debt allowances
Other
Other
Other
Subtotal
Multiply by
Times (1-combined federal, state tax rate)
Tax-adjusted deductions
After-tax LIFO liquidation gains
Reductions in deferred tax valuation allowances
Loss carryforward benefits from prior years
Other nonrecurring tax benefits
Gains on discontinued operations
Extraordinary gains
Gains/cumulative-effect accounting changes
Other
Other
Other
Subtotal
Total deductions
Sustainable earnings base
Analyzing Business Earnings 75
6. Changes in deferred-tax-valuation allowances are recorded in the taxadjusted
additions (or deductions) section only if such changes affected
net income or net loss for the period. Evidence of an income-statement
impact will usually take the form of an entry in the income tax ratereconciliation
schedule.
7. The next step is to subtotal the entries for after-tax additions and then
combine this subtotal with the amount labeled "tax adjusted additions."
The result is then recorded on the "total additions" line at the bottom of
the first page of the worksheet.
8. Completion of page 2 of the worksheet, for nonrecurring revenues and
gains, follows exactly the same steps as those outlined for nonrecurring
expense and loss.
9. With the completion of page 2, the sustainable earnings base for each
year is computed by adding the "total additions" line item to net income
(loss) and then deducting the "total deductions" line item.
ROLE OF THE SUSTAINABLE EARNINGS BASE
The sustainable earnings base provides earnings information from which the
distorting effects of nonrecurring items have been removed. Some analysts
refer to such revised numbers as representing "core" or "underlying" earnings.
Sustainable is used here in the sense that earnings devoid of nonrecurring
items of revenue, gain, expense, and loss are much more likely to be maintained
in the future, other things equal. Base implies that sustainable earnings
provide the most reliable foundation or starting point for projections of future
results. The more reliable such forecasts become, the less the likelihood that
earnings surprises will result. Again, Phillips Petroleum captures the essence
of nonrecurring items in the following:
Net income is affected by transactions defined by management and termed
"special items," which are not representative of the company's ongoing operations.
These transactions can obscure the underlying operating results for a period
and affect comparability of operating results between periods.48
APPLICATION OF THE SUSTAINABLE EARNINGS BASE
WORKSHEET: BAKER HUGHES INC.
This case example of using the SEB worksheet is based on the 1997 annual report
of Baker Hughes Inc. and its results for 1995 to 1997. The income statement,
statement of cash flows, management's discussion and analysis of results
of operations (MD&A), and selected notes are in Exhibits 2.27 through 2.34.
Further, to reinforce the objective of efficiency in financial analysis, we adhere
to the search sequence outlined in Exhibit 2.3.
76 Understanding the Numbers
Most of the content of the Baker Hughes financial statements as well as
relevant footnote and other textual information is provided. This is designed to
make the exercise as realistic as possible.
THE BAKER HUGHES WORKSHEET ANALYSIS
The nonrecurring items located in the Baker Hughes annual report are enumerated
in the completed SEB worksheet in Exhibit 2.35. Each of the nonrecurring
items is recorded on the SEB worksheet. When an item is disclosed for the first,
second, third, or fourth time, it is designated by a corresponding superscript
EXHIBIT 2.27 Consolidated statements of operations: Baker Hughes
Inc., years ended September 30 (in millions).
1995 1996 1997
Revenues:
Sales $1,805.1 $2,046.8 $2,466.7
Services and rentals 832.4 980.9 1,218.7
Total $2,637.5 $3,027.7 $3,685.4
Costs and expenses:
Costs of sales $1,133.6 $1,278.1 $1,573.3
Costs of services and rentals 475.1 559.5 682.9
Selling, general, and administrative 743.0 814.2 966.9
Amortization of goodwill and other intangibles 29.9 29.6 32.3
Unusual charge 39.6 52.1
Acquired in-process research and development — — 118.0
Total $2,381.6 $2,721.0 $3,425.5
Operating income $ 255.9 $ 306.7 $ 259.9
Interest expense (55.6) (55.5) (48.6)
Interest income 4.8 3.4 1.8
Gain on sale of Varco stock — 44.3 —
Income before income taxes and cumulative effect
of accounting changes 205.1 298.9 213.1
Income taxes (85.1) (122.5) (104.0)
Income before cumulative effect of
accounting changes 120.0 176.4 109.1
Cumulative effect of accounting changes:
Impairment of long-lived assets to be disposed of
(net of $6.0 income tax benefit) (12.1)
Postemployment benefits (net of $7.9 income
tax benefit) (14.6) — —
Net income $ 105.4 $ 176.4 $ 97.0
SOURCE: Baker Hughes Inc., annual report, September 1997, 37.
Analyzing Business Earnings 77
in a summary of the search process provided in Exhibit 2.36. For purposes of
illustration, all nonrecurring items have been recorded on the SEB worksheet
without regard to their materiality. We have followed this procedure because a
materiality threshold would exclude a series of either immaterial gains or losses
that could, in combination, distort a firm's apparent profitability. An effort is
made to consider the possible effects of materiality in a report on the efficiency
of the search process presented in Exhibit 2.37.
Without adjustment, Baker Hughes's income statement reports net income
of $105.4 million in 1995, $176.4 million in 1996, and $97.0 million in
1997. The impression obtained is a company with a volatile earnings stream
and no apparent growth. However, the complete adjustment for nonrecurring
items conveys quite a different message. After restatement, sustainable earnings
amount to $97.4 million in 1995, $158.6 million in 1996, and $241.3 million
in 1997. This suggests that profits are in fact growing, though acquisitions
have contributed to this result.
It should be clear that the number and magnitude of nonrecurring items
identified in the Baker Hughes annual report caused its unanalyzed earnings
data to be unreliable indicators of profit performance. Without the comprehensive
identification of nonrecurring items and the development of the SEB
EXHIBIT 2.28 Consolidated statements of cash f lows (operating
activities only): Baker Hughes Inc., years ended
September 30 (in millions).
1995 1996 1997
Cash Flows from Operating Activities:
Net income $105.4 $176.4 $97.0
Adjustments to reconcile net income to net cash
f lows from operating activities:
Depreciation and amortization of:
Property $114.2 $115.9 $143.9
Other assets and debt discount 40.4 39.9 42.1
Deferred income taxes 44.8 30.2 (6.8)
Noncash portion of unusual charge 25.3 32.7
Acquired in-process research and development 118.0
Gain on sale of Varco stock (44.3)
Gain on disposal of assets (18.3) (31.7) (18.4)
Foreign currency translation (gain)/loss-net 1.9 8.9 (6.1)
Cumulative effect of accounting changes 14.6 12.1
Change in receivables (94.7) (84.1) (129.8)
Change in inventories (79.9) (73.8) (114.9)
Change in accounts payable 51.7 22.6 65.3
Changes in other assets and liabilities (52.9) 9.4 (35.6)
Net cash f lows from operating activities $127.2 $194.7 $199.5
SOURCE: Baker Hughes Inc., annual report, September 1997, 40.
78 Understanding the Numbers
EXHIBIT 2.29 Income tax note: Baker Hughes Inc., years ended
September 30 (in millions).
The geographical sources of income before income taxes and cumulative effect of accounting
changes are as follows:
1995 1996 1997
United States $128.3 $116.4 $ 20.6
Foreign 76.8 182.5 192.5
Total $205.1 $298.9 $213.1
The provision for income taxes is as follows:
1995 1996 1997
Current:
United States $ 3.7 $ 40.1 $ 46.5
Foreign 36.6 52.2 64.3
Total current 40.3 92.3 110.8
Deferred:
United States 42.1 20.7 (.2)
Foreign 2.7 9.5 (6.6)
Total deferred 44.8 30.2 (6.8)
Total provision for income taxes $ 85.1 $122.5 $104.0
The provision for income taxes differs from the amount computed by applying the U.S. statutory
income tax rate to income before income taxes and cumulative effect of accounting
changes for the reasons set forth below:
1995 1996 1997
Statutory income tax $ 71.8 $104.6 $ 74.6
Nondeductible acquired in-process research and
development charge 41.3
Incremental effect of foreign operations 24.8 12.5 (6.5)
1992 and 1993 IRS audit agreement (11.4)
Nondeductible goodwill amortization 4.2 5.4 4.5
State income taxes, net of U.S. tax benefit 1.0 2.1 2.9
Operating loss and credit carryforwards (13.1) (3.3) (4.2)
Other, net (3.6) 1.2 2.8
Total provision for income taxes $ 85.1 $122.5 $104.0
Deferred income taxes ref lect the net tax effects of temporary differences between the carrying
amounts of assets and liabilities for financial reporting purposes and the amounts used
for income tax purposes, and operating loss and tax credit carryforwards. The tax effects of
the Company's temporary differences and carryforwards are as follows:
Analyzing Business Earnings 79
EXHIBIT 2.29 (Continued)
1996 1997
Deferred tax liabilities:
Property $62.3 $ 90.6
Other assets 57.7 147.5
Excess costs arising from acquisitions 64.0 67.6
Undistributed earnings of foreign subsidiaries 41.3 41.3
Other 37.4 36.5
Total $262.7 $ 383.5
Deferred tax assets:
Receivables $4.1 $ 2.8
Inventory 72.4 72.4
Employee benefits 44.0 21.5
Other accrued expenses 20.2 40.6
Operating loss carryforwards 16.6 9.0
Tax credit carryforwards 30.8 15.9
Other 15.9 34.9
Subtotal $204.0 $ 197.1
Valuation allowance (13.1) (5.7)
Total 190.9 191.4
Net deferred tax liability $ 71.8 $ 192.1
A valuation allowance is recorded when it is more likely than not that some portion or all of
the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets
depends on the ability to generate sufficient taxable income of the appropriate character in
the future. The Company has reserved the operating loss carryforwards in certain non-U.S.
jurisdictions where its operations have decreased, currently ceased or the Company has withdrawn
entirely.
Provision has been made for U.S. and additional foreign taxes for the anticipated repatriation
of certain earnings of foreign subsidiaries of the Company. The Company considers
the undistributed earnings of its foreign subsidiaries above the amounts already provided for
to be permanently reinvested. These additional foreign earnings could become subject to additional
tax if remitted, or deemed remitted, as a dividend; however, the additional amount of
taxes payable is not practicable to estimate.
SOURCE: Baker Hughes Inc., annual report, September 1997, 48–49.
80 Understanding the Numbers
EXHIBIT 2.30 Management's discussion and analysis (excerpts from
results of operations section): Baker Hughes Inc., years
ended September 30 (in millions).
Revenues
1997 versus 1996
Consolidated revenues for 1997 were $3,685.4 million, an increase of 22% over 1996 revenues
of $3,027.7 million. Sales revenues were up $419.9 million, an increase of 21%, and services
and rental revenues were up $237.8 million, an increase of 24%. Approximately 64% of the
Company's 1997 consolidated revenues were derived from international activities. The three
1997 acquisitions contributed $192.1 million of the revenue improvement.
Oilfield Operations 1997 revenues were $2,862.6 million, an increase of 19.4% over 1996
revenues of $2,397.9 million. Excluding the Drilex acquisition, which accounted for $70.5
million of the revenue improvement, the revenue growth of 16.4% outpaced the 14.4% increase
in the worldwide rig count. In particular, revenues in Venezuela increased 37.6%, or
$58.6 million, as that country continues to work towards its stated goal of significantly increasing
oil production.
Chemical revenues were $417.2 million in 1997, an increase of 68.5% over 1996 revenues of
$247.6 million. The Petrolite acquisition was responsible for $91.6 million of the improvement.
Revenue growth excluding the acquisition was 31.5% driven by the strong oilfield market
and the impact of acquiring the remaining portion of a Venezuelan joint venture in 1997.
This investment was accounted for on the equity method in 1996.
Process Equipment revenues for 1997 were $386.1 million, an increase of 9.4% over 1996 revenues
of $352.8 million. Excluding revenues from 1997 acquisitions of $32.7 million, revenues
were f lat compared to the prior year due to weakness in the pulp and paper industry
combined with delays in customers' capital spending.
1996 versus 1995
Consolidated revenues for 1996 increased $390.2 million, or 14.8%, over 1995. Sales revenues
were up 13.4% and services and rentals revenues were up 17.8%. International revenues
accounted for approximately 65% of 1996 consolidated revenues.
Oilfield Operations revenues increased $325.7 million or 15.7% over 1995 revenues of
$2,072.2 million. Activity was particularly strong in several key oilfield regions of the world
including the North Sea, Gulf of Mexico and Nigeria where revenues were up $93.4 million,
$56.8 million and $30.1 million, respectively. Strong drilling activity drove a $35.5 million
increase in Venezuelan revenues.
Chemical revenues rose $23.9 million, or 10.7% over 1995 revenues as its oilfield business
benefited from increased production levels in the U.S.
Process Equipment revenues for 1996 increased 10.4% over 1995 revenues of $319.6 million.
Excluding revenues from 1996 acquisitions of $21.5 million, revenues increased 3.7%. The
growth in the minerals processing and pulp and paper industry slowed from the prior year.
Costs and Expenses Applicable to Revenues
Costs of sales and costs of services and rentals have increased in 1997 and 1996 from the
prior years in line with the related revenue increases. Gross margin percentages, excluding
the effect of a nonrecurring item in 1997, have increased from 39.0% in 1995 to 39.3% in
1996 and 39.4% in 1997. The nonrecurring item relates to finished goods inventory acquired
in the Petrolite acquisition that was increased by $21.9 million to its estimated selling price.
The Company sold the inventory in the fourth quarter of 1997 and, as such, the $21.9 million
is included in cost of sales in 1997.
Analyzing Business Earnings 81
EXHIBIT 2.30 (Continued)
Selling, General, and Administrative
Selling, general and administrative ("SG&A") expense increased $152.7 million in 1997 from
1996 and $71.2 million in 1996 from 1995. The three 1997 acquisitions were responsible for
$54.3 million of the 1997 increase. As a percent of consolidated revenues, SG&A was 26.2%,
26.9% and 28.2% in 1997, 1996 and 1995, respectively.
Excluding the impact of acquisitions, the Company added approximately 2,500 employees
during 1997 to keep pace with the increased activity levels. As a result, employee training
and development efforts increased in 1997 as compared to the previous two years. These increases
were partially offset by $4.1 million of foreign exchange gains in 1997 compared to foreign
exchange losses of $11.4 million in 1996 due to the devaluation of the Venezuelan Bolivar.
The three-year cumulative rate of inf lation in Mexico exceeded 100% for the year
ended December 31, 1996; therefore, Mexico is considered to be a highly inf lationary economy.
Effective December 31, 1996, the functional currency for the Company's investments in
Mexico was changed from the Mexican Peso to the U.S. Dollar.
Amortization Expense
Amortization expense in 1997 increased $2.7 million from 1996 due to the Petrolite acquisition.
Amortization expense in 1996 remained comparable to 1995 as no significant acquisitions
or dispositions were made during those two years.
Unusual Charge
1997: During the fourth quarter of 1997, the Company recorded an unusual charge of $52.1
million. In connection with the acquisitions of Petrolite, accounted for as a purchase, and
Drilex, accounted for as a pooling of interests, the Company recorded unusual charges of
$35.5 million and $7.1 million, respectively, to combine the acquired operations with those of
the Company. The charges include the cost of closing redundant facilities, eliminating or relocating
personnel and equipment and rationalizing inventories that require disposal at
amounts less than their cost. A $9.5 million charge was also recorded as a result of the decision
to discontinue a low margin, oilfield product line in Latin America and to sell the Tracor
Europa subsidiary, a computer peripherals operations, which resulted in a write-down of the
investment to its net realizable value. Cash provisions of the unusual charge totaled $19.4
million. The Company spent $5.5 million in 1997 and expects to spend substantially all of the
remaining $13.9 million in 1998. Such expenditures relate to specific plans and clearly defined
actions and will be funded from operations and available credit facilities.
1996: During the third quarter of 1996, the Company recorded an unusual charge of $39.6
million. The charge consisted primarily of the write-off of $8.5 million of Oilfield Operations
patents that no longer protected commercially significant technology, a $5.0 million impairment
of a Latin America joint venture due to changing market conditions in the region in
which it operates and restructuring charges totaling $24.1 million. The restructuring charges
include the downsizing of Baker Hughes INTEQ's Singapore and Paris operations, a reorganization
of EIMCO Process Equipment's Italian operations and the consolidation of certain
Baker Oil Tools manufacturing operations. Noncash provisions of the charge totaled $25.3
million and consist primarily of the write-down of assets to net realizable value. The remaining
$14.3 million of the charge represents future cash expenditures related to severance
under existing benefit arrangements, the relocation of people and equipment and abandoned
leases. The Company spent $4.2 million of the cash during 1996, $6.3 million in 1997 and expects
to spend the remaining $3.8 million in 1998.
(continued)
EXHIBIT 2.30 (Continued)
Acquired In-Process Research and Development
In the Petrolite acquisition, the Company allocated $118.0 million of the purchase price to
in-process research and development. In accordance with generally accepted accounting
principles, the Company recorded the acquired in-process research and development as a
charge to expense because its technological feasibility had not been established and it had no
alternative future use at the date of acquisition.
Interest Expense
Interest expense in 1997 decreased $6.9 million from 1996 due to lower average debt levels,
primarily as a result of the maturity of the 4.125% Swiss Franc Bonds in June 1996. Interest
expense in 1996 remained comparable to 1995 as slightly higher average debt balances were
offset by a slightly lower weighted average interest rate.
Gain on Sale of Varco Stock
In May 1996, the Company sold 6.3 million shares of Varco International, Inc. ("Varco") common
stock, representing its entire investment in Varco. The Company received net proceeds of
$95.5 million and recognized a pretax gain of $44.3 million. The Company's investment in
Varco was accounted for using the equity method. Equity income included in the Consolidated
Statements of Operations for 1996 and 1995 was $1.8 million and $3.2 million, respectively.
Income Taxes
During 1997, the Company reached an agreement with the Internal Revenue Service ("IRS")
regarding the audit of its 1992 and 1993 U.S. consolidated income tax returns. The principal
issue in the examination related to intercompany pricing on the transfer of goods and services
between U.S. and non-U.S. subsidiary companies. As a result of the agreement, the Company
recognized a tax benefit through the reversal of deferred income taxes previously provided of
$11.4 million ($.08 per share) in the quarter ended June 30, 1997.
The effective income tax rate for 1997 was 48.8% as compared to 41.0% in 1996 and
41.5% in 1995. The increase in the rate for 1997 is due in large part to the nondeductible
charge for the acquired in-process research and development related to the Petrolite acquisition
offset by the IRS agreement as explained above. The effective rates differ from the federal
statutory rate in all years due primarily to taxes on foreign operations and nondeductible
goodwill amortization. The Company expects the effective income tax rate in 1998 to be between
38% and 39%.
SOURCE: Baker Hughes Inc., annual report, September 1997, 30–32.
EXHIBIT 2.31 Summary of signif icant accounting policies note
(partial): Baker Hughes Inc., years ended September 30
(in millions).
Impairment of assets: The Company adopted Statement of Financial Accounting Standards
("SFAS") No. 121, Accounting for the Impairment of Long-lived Assets and for Long-lived
Assets to be Disposed Of, effective October 1, 1996. The statement sets forth guidance as to
when to recognize an impairment of long-lived assets, including goodwill, and how to measure
such an impairment. The methodology set forth in SFAS No. 121 is not significantly different
from the Company's prior policy and, therefore, the adoption of SFAS No. 121 did not
have a significant impact on the consolidated financial statements as it relates to impairment
of long-lived assets used in operations. However, SFAS No. 121 also addresses the accounting
for long-lived assets to be disposed of and requires these assets to be carried at the lower of
cost or fair market value, rather than the lower of cost or net realizable value, the method
that was previously used by the Company. The Company recognized a charge to income of
$12.1 million ($.08 per share), net of a tax benefit of $6.0 million, as the cumulative effect
of a change in accounting in the first quarter of 1997.
SOURCE: Baker Hughes Inc., annual report, September 1997, 41.
Analyzing Business Earnings 83
EXHIBIT 2.32 Acquisitions and dispositions note: Baker Hughes Inc.,
years ended September 30 (in millions).
1997
Petrolite
In July 1997, the Company acquired Petrolite Corporation ("Petrolite") and Wm. S. Barnickel
& Company ("Barnickel"), the holder of 47.1% of Petrolite's common stock, for 19.3 million
shares of the Company's common stock having a value of $730.2 million in a three-way business
combination accounted for using the purchase method of accounting. Additionally, the Company
assumed Petrolite's outstanding vested and unvested employee stock options that were
converted into the right to acquire 1.0 million shares of the Company's common stock. Such assumption
of Petrolite options by the Company had a fair market value of $21.0 million resulting
in total consideration in the acquisitions of $751.2 million. Petrolite, previously a publicly held
company, is a manufacturer and marketer of specialty chemicals used in the petroleum and
process industries. Barnickel was a privately held company that owned marketable securities,
which were sold after the acquisition, in addition to its investment in Petrolite.
The purchase price has been allocated to the assets purchased and the liabilities assumed
based on their estimated fair market values at the date of acquisition as follows (millions of
dollars):
Working capital $ 64.5
Property 170.1
Prepaid pension cost 80.3
Intangible assets 126.0
Other assets 89.6
In-process research and development 118.0
Goodwill 263.7
Debt (31.7)
Deferred income taxes (106.7)
Other liabilities (22.6)
Total $751.2
In accordance with generally accepted accounting principles, the amount allocated to inprocess
research and development, which was determined by an independent valuation, has been
recorded as a charge to expense in the fourth quarter of 1997 because its technological feasibility
had not been established and it had no alternative future use at the date of acquisition.
The Company incurred certain liabilities as part of the plan to combine the operations of
Petrolite with those of the Company. These liabilities relate to the Petrolite operations and include
severance of $13.8 million for redundant marketing, manufacturing and administrative
personnel, relocation of $5.8 million for moving equipment and transferring marketing and
technology personnel, primarily from St. Louis to Houston, and environmental remediation of
$16.5 million for redundant properties and facilities that will be sold. Cash spent during the
fourth quarter of 1997 totaled $7.7 million. The Company anticipates completing these activities
in 1998, except for some environmental remediation that will occur in 1998 and 1999.
The operating results of Petrolite and Barnickel are included in the 1997 consolidated
statement of operations from the acquisition date, July 2, 1997. The following unaudited pro
forma information combines the results of operations of the Company, Petrolite and Barnickel
assuming the acquisitions had occurred at the beginning of the periods presented. The pro
forma summary does not necessarily ref lect the results that would have occurred had the acquisitions
been completed for the periods presented, nor do they purport to be indicative of
the results that will be obtained in the future, and excludes certain nonrecurring charges related
to the acquisition which have an after tax impact of $155.2 million.
(continued)
84
EXHIBIT 2.32 (Continued)
(Millions of dollars,
except per share amounts)
1996 1997
Revenues $3,388.4 $3,944.0
Income before accounting change 189.3 283.9
Income per share before accounting change 1.16 1.69
In connection with the acquisition of Petrolite, the Company recorded an unusual
charge of $35.5 million. See Note 5 of Notes to Consolidated Financial Statements.
Environmental Technology Division of Deutz AG
In July 1997, the Company acquired the Environmental Technology Division, a decanter centrifuge
and dryer business, of Deutz AG ("ETD") for $53.0 million, subject to certain postclosing
adjustments. This acquisition is now part of Bird Machine Company and has been
accounted for using the purchase method of accounting. Accordingly, the cost of the acquisition
has been allocated to assets acquired and liabilities assumed based on their estimated
fair market values at the date of acquisition, July 7, 1997. The operating results of ETD are
included in the 1997 consolidated statement of operations from the acquisition date. Pro
forma results of the acquisition have not been presented as the pro forma revenue, income
before accounting change and earnings per share would not be materially different from the
Company's actual results. For its most recent fiscal year ended December 31, 1996, ETD had
revenues of $103.0 million.
Drilex
In July 1997, the Company acquired Drilex International Inc. ("Drilex") a provider of products
and services used in the directional and horizontal drilling and workover of oil and gas
wells for 2.7 million shares of the Company's common stock. The acquisition was accounted
for using the pooling of interests method of accounting. Under this method of accounting, the
historical cost basis of the assets and liabilities of the Company and Drilex are combined at
recorded amounts and the results of operations of the combined companies for 1997 are included
in the 1997 consolidated statement of operations. The historical results of the separate
companies for years prior to 1997 are not combined because the retained earnings and results
of operations of Drilex are not material to the consolidated financial statements of the Company.
In connection with the acquisition of Drilex, the Company recorded an unusual charge
of $7.1 million for transaction and other one time costs associated with the acquisition. See
Note 5 of Notes to Consolidated Financial Statements. For its fiscal year ended December 31,
1996 and 1995, Drilex had revenues of $76.1 million and $57.5 million, respectively.
1996
In April 1996, the Company purchased the assets and stock of a business operating as Vortoil
Separation Systems, and certain related oil /water separation technology, for $18.8 million. In
June 1996, the Company purchased the stock of KTM Process Equipment, Inc., a centrifuge
company, for $14.1 million. These acquisitions are part of Baker Hughes Process Equipment
Company and have been accounted for using the purchase method of accounting. Accordingly,
the costs of the acquisitions have been allocated to assets acquired and liabilities assumed
based on their estimated fair market values at the dates of acquisition. The operating results
are included in the consolidated statements of operations from the respective acquisition dates.
In April 1996, the Company exchanged the 100,000 shares of Tuboscope Inc. ("Tuboscope")
Series A convertible preferred stock held by the Company since October 1991, for 1.5
million shares of Tuboscope common stock and a warrant to purchase 1.25 million shares of
Tuboscope common stock. The warrants are exercisable at $10 per share and expire on December
31, 2000.
SOURCE: Baker Hughes Inc., annual report, September 1997, 43–45.
85
EXHIBIT 2.33 Unusual charges note: Baker Hughes Inc., years ended
September 30 (in millions).
1997
During the fourth quarter of 1997, the Company recognized a $52.1 million unusual charge
consisting of the following (millions of dollars):
Baker Petrolite:
Severance for 140 employees $ 2.2
Relocation of people and equipment 3.4
Environmental 5.0
Abandoned leases 1.5
Integration costs 2.8
Inventory write-down 11.3
Write-down of other assets 9.3
Drilex:
Write-down of property and other assets 4.1
Banking and legal fees 3.0
Discontinued product lines:
Severance for 50 employees 1.5
Write-down of inventory, property and other assets 8.0
Total $52.1
In connection with the acquisitions of Petrolite and Drilex, the Company recorded unusual
charges of $35.5 million and $7.1 million, respectively, to combine the acquired operations
with those of the Company. The charges include the cost of closing redundant facilities,
eliminating or relocating personnel and equipment and rationalizing inventories that require
disposal at amounts less than their cost. A $9.5 million charge was recorded as a result of the
decision to discontinue a low margin, oilfield product line in Latin America and to sell the
Tracor Europa subsidiary, a computer peripherals operation, which resulted in a write-down
of the investment to net realizable value. Cash provisions of the unusual charge totaled $19.4
million. The Company spent $5.5 million in 1997 and expects to spend substantially all of the
remaining $13.9 million in 1998.
1996
During the third quarter of 1996, the Company recognized a $39.6 million unusual charge
consisting of the following (millions of dollars):
Patent write-off $ 8.5
Impairment of joint venture 5.0
Restructurings:
Severance for 360 employees 7.1
Relocation of people and equipment 2.3
Abandoned leases 2.8
Inventory write-down 1.5
Write-down of assets 10.4
Other 2.0
Total $39.6
The Company has certain oilfield operations patents that no longer protect commercially
significant technology resulting in the write-off of $8.5 million. A $5.0 million impairment
of a Latin America joint venture was recorded due to changing market conditions in the
region in which it operates. The Company recorded a $24.1 million restructuring charge including
the downsizing of Baker Hughes INTEQ's Singapore and Paris operations, a reorganization
of EIMCO Process Equipment's Italian operations and the consolidation of certain
Baker Oil Tools manufacturing operations. Cash provisions of the charge totaled $14.3 million.
The Company spent $4.2 million in 1996, $6.3 million in 1997 and expects to spend the
remaining $3.8 million in 1998.
SOURCE: Baker Hughes Inc., annual report, September 1997, 45.
86 Understanding the Numbers
EXHIBIT 2.34 Segment and related information note: Baker Hughes
Inc., years ended September 30 (in millions).
NOTE 10
Segment and Related Information
The Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, in 1997 which changes the way the Company reports information about its
operating segments. The information for 1996 and 1995 has been restated from the prior
year 's presentation in order to conform to the 1997 presentation.
The Company's nine business units have separate management teams and infrastructures
that offer different products and services. The business units have been aggregated into three
reportable segments (oilfield, chemicals and process equipment) since the long-term financial
performance of these reportable segments is affected by similar economic conditions.
Oilfield: This segment consists of five business units—Baker Hughes INTEQ, Baker Oil
Tools, Baker Hughes Solutions, Centrilift and Hughes Christensen—that manufacture and
sell equipment and provide services and solutions used in the drilling, completion, production
and maintenance of oil and gas wells. The principle markets for this segment include all
major oil and gas producing regions of the world including North America, Latin America,
Europe, Africa and the Far East. Customers include major multinational, independent and
national or state-owned oil companies.
Chemicals: Baker Petrolite is the sole business unit reported in this segment. They manufacture
specialty chemicals for inclusion in the sale of integrated chemical technology solutions
for petroleum production, transportation and refining. The principle geographic markets for
this segment include all major oil and gas producing regions of the world. This segment also
provides chemical technology solutions to other industrial markets throughout the world including
petrochemicals, steel, fuel additives, plastics, imaging and adhesives. Customers include
major multinational, independent and national or state-owned oil companies as well as
other industrial manufacturers.
Process Equipment: This segment consists of three business units—EIMCO Process Equipment,
Bird Machine Company and Baker Hughes Process Systems—that manufacture and sell
process equipment for separating solids from liquids and liquids from liquids through filtration,
sedimentation, centrifugation and f loatation processes. The principle markets for this segment
include all regions of the world where there are significant industrial and municipal wastewater
applications and base metals activity. Customers include municipalities, contractors, engineering
companies and pulp and paper, minerals, industrial and oil and gas producers.
The accounting policies of the reportable segments are the same as those described in
Note 1 of Notes to Consolidated Financial Statements. The Company evaluates the performance
of its operating segments based on income before income taxes, accounting changes,
nonrecurring items and interest income and expense. Intersegment sales and transfers are not
significant.
Summarized financial information concerning the Company's reportable segments is
shown in the following table. The "Other" column includes corporate related items, results of
insignificant operations and, as it relates to segment profit (loss), income and expense not allocated
to reportable segments (millions of dollars).
1997
Revenues $2,862.6 $417.2 $386.1 $19.5 $3,685.4
Segment profit (loss) 416.8 41.9 36.3 (281.9) 213.1
Total assets 3,014.3 1,009.5 363.7 368.8 4,756.3
Capital expenditures 289.7 24.8 6.4 21.8 342.7
Depreciation and amortization 143.2 20.5 8.4 4.1 176.2
Analyzing Business Earnings 87
EXHIBIT 2.34 (Continued)
1996
Revenues $2,397.9 $247.6 $352.8 $29.4 $3,027.7
Segment profit (loss) 329.1 23.3 31.2 (84.7) 298.9
Total assets 2,464.6 270.3 258.9 303.6 3,297.4
Capital expenditures 157.5 16.6 6.6 1.5 182.2
Depreciation and amortization 123.6 12.2 6.7 3.0 145.5
1995
Revenues $2,072.2 $223.7 $319.6 $22.0 $2,637.5
Segment profit (loss) 249.6 17.8 29.7 (92.0) 205.1
Total assets 2,423.7 259.8 187.3 295.8 3,166.6
Capital expenditures 119.1 11.0 5.0 3.8 138.9
Depreciation and amortization 123.9 12.4 5.4 2.4 144.1
The following table presents the details of "Other" segment profit (loss).
1995 1996 1997
Corporate expenses $(39.7) $(40.2) $(44.3)
Interest expense-net (50.8) (52.1) (46.8)
Unusual charge (39.6) (52.1)
Acquired in-process research and development (118.0)
Nonrecurring charge to cost of sales for
Petrolite inventories (21.9)
Gain on sale of Varco stock 44.3
Other (1.5) 2.9 1.2
Total $(92.0) $(84.7) $(281.9)
The following table presents revenues by country based on the location of the use of the
product or service.
1995 1996 1997
United States $972.9 $1,047.2 $1,319.7
United Kingdom 207.6 277.9 288.0
Venezuela 122.7 160.0 244.2
Canada 157.5 165.1 204.5
Norway 104.2 145.6 175.0
Indonesia 54.5 92.7 128.0
Nigeria 33.5 64.1 83.5
Oman 45.7 56.8 77.2
Other (approximately 60 countries) 938.9 1,018.3 1,165.3
Total $2,637.5 $3,027.7 $3,685.4
The following table presents property by country based on the location of the asset.
1995 1996 1997
United States $353.0 $359.9 $593.3
United Kingdom 67.6 77.7 145.3
Venezuela 19.0 25.1 33.3
Germany 18.4 19.3 21.4
Norway 11.3 10.9 20.0
Canada 8.0 9.1 16.9
Singapore 25.0 17.7 11.7
Other countries 72.8 79.3 141.0
Total $575.1 $599.0 $982.9
SOURCE: Baker Hughes Inc., annual report, September 1997, 49–51.
88 Understanding the Numbers
EXHIBIT 2.35 Adjustment worksheet for sustainable earnings base:
Baker Hughes Inc., years ended September 30
(in millions).
1995 1996 1997
Reported net income or (loss) $105.4 $176.4 $97.0
Add
Pretax LIFO liquidation losses
Losses on sales of fixed assets
Losses on sales of investments
Losses on sales of "other" assets
Restructuring charges (unusual charge) 39.6 52.1
Investment write-downs
Inventory write-downs (included in cost of sales) 21.9
Other asset write-downs
Foreign currency losses 1.9 11.4
Litigation charges
Losses on patent infringement suits
Exceptional bad debt provisions
Temporary expense increases
Temporary revenue reductions
Other
Other
Other
Subtotal $1.9 $51.0 $74.0
Multiply by
(1 – Combined federal and state tax rates) 58% 58% 58%
Tax-adjusted additions $1.1 $29.6 $42.9
Add
After-tax LIFO liquidation losses
Increases in deferred tax valuation allowances
Other nonrecurring tax charges
Losses on discontinued operations
Extraordinary losses
Losses/cumulative-effect accounting changes 14.6 12.1
Other (acquired in-process R&D) 118.0
Other
Other
Subtotal $14.6 $130.1
Total additions $15.7 $29.6 $173.0
Analyzing Business Earnings 89
EXHIBIT 2.35 (Continued)
1995 1996 1997
Deduct
Pretax LIFO liquidation gains
Gains on sales of fixed assets (disposal of assets) 18.3 31.7 18.4
Gains on sales of investments (Varco stock) 44.3
Gains on sales of other assets
Reversals of restructuring charges
Investment write-ups (trading account)
Foreign currency gains 4.1
Litigation revenues
Gains on patent infringement suits
Temporary expense decreases
Temporary revenue increases
Reversals of bad-debt allowances
Other
Other
Other
Subtotal $18.3 $76.0 $22.5
Multiply by
(1 – Combined federal and state tax rate) 58% 58% 58%
Tax-adjusted deductions $10.6 $44.1 $13.1
Deduct
After-tax LIFO liquidation gains
Reductions in deferred tax valuation allowances
Loss carryforward benefits—from prior periods 13.1 3.3 4.2
Other nonrecurring tax benefits
(IRS audit agreement) 11.4
Gains on discontinued operations
Extraordinary gains
Gains/cumulative-effect accounting changes
Other
Other
Other
Subtotal $13.1 $3.3 $15.6
Total deductions $23.7 $47.4 $28.7
Sustainable earnings base $97.4 $158.6 $241.3
90 Understanding the Numbers
EXHIBIT 2.36 Summary of nonrecurring items search process: Baker
Hughes Inc.
Step and Search Location Nonrecurring Item Revealed
1. Income statement Unusual charge (1996-1997)1
Acquired in-process research and development (1997)1
Gain on sale of Varco stock (1996)1
Cumulative effect of accounting changes (1995, 1997)1
2. Statement of cash f lows Acquired in-process research and development (1997)2
Gain on sale of Varco stock (1996)2
Gain on disposal of assets (1995–1997)1
Foreign currency translation (gain)/loss, net
(1995–1997)1
Cumulative effect of accounting changes (1995, 1997)2
3. Inventory note No nonrecurring items located
4. Income tax note 1992 and 1993 IRS audit agreement (1997)1
Operating loss and credit carryforwards (1995–1997)1
5. Other income (expense) note No note provided
6. MD&A Petrolite inventory writedown in cost of sales (1997)1
Unusual charge (1996-1997)2
Acquired in-process research and development (1997)3
Gain on sale of Varco stock (1996)3
1992 and 1993 IRS audit agreement (1997)2
Foreign currency translation (gain)/loss, net
(1996–1997)2
7. Other notes revealing nonrecurring
items:
a. Significant accounting policies Cumulative effect of accounting changes (1995, 1997)3
b. Acquisitions and dispositions Acquired in-process research and development (1997)4
Unusual charges (1996-1997)3
Gain on sale of Varco stock (1996)4
c. Unusual charge Unusual charges (1996-1997)4
d. Segment information Unusual charges (1996-1997)5
Acquired in-process research and development (1997)5
Petrolite inventory writedown in cost of sales (1997)2
Gain on sale of Varco stock (1996)5
Note: The superscripts 1, 2, 3, and so on indicate the number of times the nonrecurring item was found.
For instance, "Gain on sale of Varco stock" was found in the income statement (first location); in the
statement of cash f lows (second location); in MD&A (third location); in the "Acquisitions and dispositions"
note (fourth location); and in the "Segment and related information" note (fifth location).
Analyzing Business Earnings 91
worksheet, the company's three-year operating performance is virtually impossible
to discern.
The efficient search sequence for identifying nonrecurring items in Exhibit
2.3 was based on the experience of the authors supported by a large-scale
study of nonrecurring items by H. Choi. While the recommended search sequence
may not be equally effective in all cases, Exhibit 2.37 demonstrates
that most of Baker Hughes's nonrecurring items could be located by employing
only steps 1 to 5, a sequence that is very cost-effective. In fact, 92% of all
material nonrecurring items were located through the first four steps of the
search sequence. Further, locating these items requires reading very little text,
and the nonrecurring items are generally set out prominently in either statements
or schedules.
Exhibit 2.37 presents information on the efficiency of the search process.
The meaning of each column in the exhibit is as follows:
Column 1: The number of nonrecurring items located at each step in
the search process. This is based on all 17 nonrecurring
items without regard to their materiality.
Column 2: The cumulative percentage of all nonrecurring items
located through each step of the search process. Ninety
four percent of the total nonrecurring items were located
through the first five steps of the search process. All
nonrecurring items were located by step 6.
EXHIBIT 2.37 Ef f iciency of nonrecurring items search process: Baker
Hughes Inc.
Incremental Nonrecurring Items Discovered
(1) (2) (3) (4)
All Non- All
recurring Cumulative Materiala Cumulative
Step and Search Location Items % Located Items % Located
1. Income statement 6 35% 6 50%
2. Statement of cash f lows 6 71 3 75
3. Inventory note 0 71 0 75
4. Income tax note 4 94 2 92
5. Other income (expense) note 0 94 0 92
6. MD&A 1 100 1 100
7a. Significant accounting
policies note 0 100 0 100
7b. Acquisitions and dispositions
note 0 100 0 100
7c. Unusual charge note 0 100 0 100
7d. Segment and related
information note 0 100 0 100
Total nonrecurring items 17 100% 12 100%
a Five percent or more of the amount of the net income or net loss, on a tax-adjusted basis.
92 Understanding the Numbers
Column 3: Same as column 1 except only material nonrecurring items
(those items exceeding 5% of net income on an after-tax
basis).
Column 4: Same as column 2 except that only material nonrecurring
items were considered.
SOME FURTHER POINTS ON THE
BAKER HUGHES WORKSHEET
The construction of an SEB worksheet always requires a judgment call. One
could, of course, avoid all materiality judgments by simply recording all nonrecurring
items without regard to their materiality. However, the classification
of items as nonrecurring, as well as on occasion their measurement, calls for
varying degrees of judgment. Some examples of Baker Hughes items that required
the exercise of judgment, either in terms of classification or measurement,
are discussed next.
The Petrolite Inventory Adjustment
A pretax addition was made in Exhibit 2.35 for the effect on 1997 earnings of
inventory obtained with the Petrolite acquisition (see Exhibits 2.30 and 2.34).
Accounting requirements for purchases call for adjusting acquired assets to
their fair values. This adjustment required a $21.9 million increase in Petrolite
inventories to change them from cost to selling price. This meant that there
was no profit margin on the subsequent sale of this inventory in the fourth
quarter of 1997. That is, cost of sales was equal to the sales amount. Baker
Hughes labeled this $21.9 million acquisition adjustment "nonrecurring
charge to cost of sales for Petrolite inventories" (see segment disclosures in
Exhibit 2.34).
This Petrolite inventory charge raised the level of cost of sales in relationship
to sales. However, this temporary increase in the cost-of-sales percentage
(cost of sales divided by sales) was not expected to persist in the future. We
concurred with the Baker Hughes judgment and treated this $21.9 million
cost-of-sales component as a nonrecurring item in developing sustainable
earnings.
Foreign Exchange Gains and Losses
Information on foreign exchange gains and losses was disclosed in the statement
of cash flows (Exhibit 2.28) and in the MD&A (Exhibit 2.30). The statement
of cash flows disclosed foreign-currency losses of $1.9 million in 1995
and $8.9 million in 1996. A $6.1 million gain was disclosed in 1997. However,
the MD&A disclosed a foreign-currency loss of $11.4 million for 1996 and a
gain of $4.1 million for 1997. The foreign-currency items in the statement of
Analyzing Business Earnings 93
cash f lows represent recognized but unrealized gains and losses. As such, there
are no associated cash inflows and outflows. However, the disclosures in the
MD&A represent all of the net foreign-exchange gains and losses, both realized
and unrealized. These are the totals that would have been added or deducted
in arriving at net income and also represent the nonrecurring foreign
currency gains and losses.
For 1996 and 1997, the Baker Hughes worksheet includes the foreign currency
gain and loss disclosed in the MD&A, a loss of $11.4 million for 1996 and
a gain of $4.1 million for 1997. In the absence of a disclosure of any foreign
currency gain or loss in the MD&A for 1995, the worksheet simply included
the $1.9 million loss disclosed in the statement of cash f lows. Adjusting the
foreign-currency gains and losses out of net income is based on a judgment that
comparative performance is better represented in the absence of these
irregular items.
The Tax Rate Assumption and Acquired R&D
The tax rate used in the Baker Hughes worksheet was a combined (state, federal,
and foreign) 42%. This is the three-year average effective tax rate for the
company once nonrecurring tax items were removed from the tax provision.
Two nonrecurring tax items stand out in the income tax disclosures in Exhibit
2.29. First is the increase in the tax provision because of the lack of tax
deductibility of the $118 million of acquired in-process research and development
in 1997.49 The tax effect of this nonrecurring item, $41.3 million, pushed
the effective rate up to 49% for 1997. Because of this lack of deductibility for
tax purposes, the pretax and after-tax amounts of this charge are the same,
$118 million. Therefore, we recorded the $118 million charge with the other
tax and after-tax items in the bottom section of the SEB worksheet. Because
this item is added back to net income on its after-tax basis, no additional adjustment
was needed for the $41.3 million tax increase resulting from the lack
of deductibility.
The second adjustment was for the $11.4 million nonrecurring tax reduction
that resulted from an IRS audit agreement. The tax rate scales the numbers
in the worksheet to their after-tax amounts. The goal should be a rate that
is a reasonable representation of this combined rate. It is usually not cost beneficial
to devote an inordinate amount of time to making this estimate.
Equity Earnings and Disposal of
the Varco Investment
The MD&A included discussion of the gain on the sale of the Varco investment.
This is a clear nonrecurring item, and it was adjusted from results in the Baker
Hughes SEB worksheet. Baker Hughes accounted for its investment in Varco by
using the equity method. This indicates that its ownership was sufficient to provide
it with the capacity to exercise significant inf luence over Varco. Baker
94 Understanding the Numbers
Hughes disclosed that it recognized equity income from Varco of $3.2 million in
1995 and $1.8 million in 1996. However, the disposal of the Varco investment
did not qualify as a discontinued operation. If it had been so classified, then the
Baker Hughes share of earnings would have been removed from income from
continuing operations of 1995 and 1996 and reported with discontinued operations—
along with the gain on the disposition of the investment.
Clearly, a case could be made for treating the 1995 and 1996 equity earnings
as nonrecurring and removing them from earnings in developing the SEB
worksheet. This would not alter the message conveyed by the SEB worksheet in
this particular case. However, if the effect were more material, then a judgment
to treat as nonrecurring the equity earnings from the Varco investment
would be in order.
Using the Summary Disclosures of Unusual Charges
In completing the worksheet, the summary totals from the unusual-charge disclosures
(Exhibit 2.33) were used. Alternatively, the detail on the charges
could have been recorded in appropriate lines in the worksheet. We saw this as
offering no advantage here.
Having the detail on the makeup of the unusual charges is helpful in determining
whether other additional nonrecurring items have already been included
in these totals. Recall that the 1997 Petrolite inventory adjustment of
$21.9 million was not included in the unusual charges total (it was included in
cost of sales). Summaries for unusual charges, it should be noted, usually do
not include all items that could reasonably be considered nonrecurring. In addition,
care should be taken not to duplicate the recording of items already included
in summary totals for unusual charges.
SUMMARY
An estimation of the sustainable portion of earnings should be the centerpiece
of analyzing business earnings. This task has become a far greater challenge
over the past decade as the number of nonrecurring items has increased dramatically.
This explosion has been driven by corporate reorganizations and
associated activities. Some of the labels attached to these producers of nonrecurring
items are restructuring, rightsizing, downsizing, reengineering, redeployment,
repositioning, reorganizing, rationalizing, and realignment. The
following are some key points for the reader to consider:
• An earnings series from which nonrecurring items have been purged is
essential in order to both evaluate current trends in operating performance
and make projections of future results.
• The identification and measurement of nonrecurring items will typically
require the exercise of judgment.
Analyzing Business Earnings 95
• There are no agreed-upon definitions of nonrecurring items as part of
GAAP. Moreover, a variety of labels are used beyond the term nonrecurring
and they include special, unusual, nonoperating, and noncore.
• It is common to treat items as nonrecurring even though they may appear
with some regularity in the income statement. However, these items are
usually very irregular in terms of their amount as well as whether they are
revenues/gains or expenses/losses.
• The key question to pose in making the nonrecurring judgment is: Will
underlying trends in operating performance be obscured if the item remains
in earnings?
• Many material nonrecurring items will be separately disclosed on the face
of the income statement. However, a substantial number will be disclosed
in other statements and locations. It is typically necessary to extend the
search for nonrecurring items well beyond the income statement.
• In response to reductions in the time available for a whole range of important
activities, an efficient and abbreviated search sequence is presented
in the chapter and illustrated with a comprehensive case example.
While a comprehensive review of all financial reporting is the gold standard,
reliable information on sustainable earnings can typically be developed
while employing only a subset of reported financial information.
FOR FURTHER READING
Bernstein, L., and J. Wild, Financial Statement Analysis: Theory, Application, and
Interpretation, 6th ed. (Homewood, IL: Irwin McGraw-Hill, 1998).
Comiskey, E., and C. Mulford, Guide to Financial Reporting and Analysis (New
York: John Wiley, 2000).
Comiskey, E., C. Mulford, and H. Choi, "Analyzing the Persistence of Earnings: A
Lender 's Guide," Commercial Lending Review (winter 1994–1995).
White, G., A. Sondhi, and D. Fried, The Analysis and Use of Financial Statements
(New York: John Wiley, 1997).
Mulford, C., and E. Comiskey, Financial Warnings (New York: John Wiley, 1996).
Special Committee on Financial Reporting of the American Institute of Certified
Public Accountants, Improving Business Reporting—A Customer Focus (New
York: AICPA, 1994).
INTERNET LINKS
www.fasb.org This site provides updates on the agenda of the FASB.
It also includes useful summaries of FASB statements
and other information related to standard setting.
www.freeedgar.com This site provides a very convenient alternative source
of SEC filings.
96 Understanding the Numbers
www.sec.gov A source for accessing company Securities and
Exchange Commission filings. This site also includes
Accounting and Auditing Enforcement Releases of the
SEC. These releases provide very useful examples of
the actions sometimes taken by companies to
misrepresent their financial performance or position.
ANNUAL REPORTS REFERENCED IN THE CHAPTER
Advanced Micro Devices Inc. (1999)
Air T Inc. (2000)
Akorn Inc. (1999)
AK Steel Holdings Corporation (1999)
Alberto-Culver Company (2000)
Amazon.Com Inc. (1999)
American Building Maintenance Inc. (1989)
American Standard Companies Inc. (1999)
AmSouth Bancorporation (1999)
Archer Daniels Midland Company (2000)
Argosy Gaming Company (1995)
Armco Inc. (1998)
Armstrong World Industries Inc. (1999)
Artistic Greetings Inc. (1995)
Atlantic American Corporation (1999)
Avado Brands Inc. (1999)
Avoca Inc. (1995)
Baker Hughes Inc. (1997)
Baltek Corporation (1997)
C.R. Bard Inc. (1999)
Baycorp Holdings Ltd. (1999)
Bestfoods Inc. (1999)
Biogen Inc. (1999)
BLC Financial Services Inc. (1998)
Brooktrout Technologies Inc. (1998)
Brush Wellman Inc. (1999)
Burlington Resources Inc. (1999)
Callon Petroleum Company (1999)
Champion Enterprises Inc. (1995)
Chiquita Brands International Inc. (1999)
Analyzing Business Earnings 97
Cisco Systems Inc. (1999)
Colonial Commercial Corporation (1999)
Corning Inc. (1999)
Cryomedical Sciences Inc. (1995)
Dal-Tile International Inc. (1999)
Dana Corporation (1999)
Dean Foods Company (1999)
Decorator Industries Inc. (1999)
Delta Air Lines Inc. (1996, 2000)
Detection Systems Inc. (2000)
Dibrell Brothers Inc. (1993)
Escalon Medical Corporation (2000)
Evans and Sutherland Computer Corporation (1998)
The Fairchild Corporation (2000)
First Aviation Services Inc. (1999)
Freeport-McMoRan Inc. (1991)
Galey & Lord Inc. (1998)
Geo. A. Hormel & Company (1993)
Gerber Scientific Inc. (2000)
Gleason Corporation (1995)
Goodyear Tire and Rubber Company (1995, 1998)
Handy and Harman Inc. (1997)
M.A. Hanna Company (1999)
Hercules Inc. (1999)
H.J. Heinz Company (1995)
Holly Corporation (2000)
Hollywood Casino Corporation (1992)
Imperial Holly Corporation (1994)
Imperial Sugar Company (1999)
JLG Industries Inc. (2000)
KeyCorp Ohio Inc. (1999)
Kulicke & Soffa Industries Inc. (1999)
Lufkin Industries Inc. (1999)
Mason Dixon Bancshares Inc. (1999)
Maxco Inc. (1996)
Meredith Corporation (1994)
Micron Technology Inc. (2000)
NACCO Industries Inc. (1995)
National Steel Corporation (1999)
98 Understanding the Numbers
New England Business Services Inc. (1996)
Noble Drilling Inc. (1991)
NS Group Inc. (1992)
Office Depot Inc. (1999)
Osmonics Inc. (1993)
Pall Corporation (2000)
Petroleum Helicopters Inc. (1999)
Phillips Petroleum Company (1990)
Pollo Tropical Inc. (1995)
Praxair Inc. (1999)
Raven Industries Inc. (2000)
Saucony Inc. (1999)
Schnitzer Steel Industries Inc. (1999)
Shaw Industries Inc. (1999)
The Sherwin-Williams Company (1999)
Silicon Valley Group Inc. (1999)
Southwest Airlines Inc. (1999)
Standard Register Company (1999)
SunTrust Banks Inc. (1999)
Synthetech Inc. (2000)
Textron Inc. (1999)
Toys "R" Us Inc. (1999)
Trimark Holdings Inc. (1995)
Tyco International Ltd. (2000)
Watts Industries Inc. (1999)
Wegener Corporation (1999)
NOTES
1. The American Institute of CPA's Special Committee on Financial Reporting,
Improving Business Reporting—A Customer Focus (New York: AICPA, November
1993), 4.
2. Donald Kieso and Jerry Weygandt, Intermediate Accounting, 9th ed. (New
York: John Wiley, 1998), 154–161.
3. Delta Air Lines, annual reports, June 1996, 50–51, and June 2000.
4. Some might also remove these gains because they do not represent operating
items. However, the ongoing disposition of f light equipment is an inherent feature of
being in the airline business. It is not what they are in the business to do, but it does
come with the territory.
5. Delta Air Lines does disclose some proceeds from the sale of f light equipment
in its 1998–2000 statements of cash flow. The gains and losses were probably too small
Analyzing Business Earnings 99
to receive separate disclosure. Delta Air Lines, annual report, June 2000, 36. Delta
does disclose balances for deferred gains on sale and leaseback transactions. These
balances declined by $50 million in 2000, suggesting that gains equal to this amount
were included in earnings for 2000. They are treated as a reduction in lease expense
and do not appear on a line item as gains on the disposition of f light equipment.
6. In fact, 1996 saw a loss of $7.4 million, followed by gains of $34.1 in 1997 and
$2.6 million in 1998. Goodyear Tire and Rubber Company, annual report on Form
10-K to the Securities and Exchange Commission, December 1998, 32.
7. George A. Hormel & Company, annual report, 1993, 58.
8. H. Choi, Analysis and Valuation Implications of Persistence and Cash-
Content Dimensions of Earnings Components Based on Extent of Analyst Following,
unpublished PhD thesis, Georgia Institute of Technology, October 1994, 80.
9. Ibid. The authors of this chapter served as committee member and committee
chair for Dr. Choi's thesis guidance committee.
10. AICPA, Accounting Trends and Techniques (New York: AICPA, 2000), 311.
11. AICPA's Special Committee on Financial Reporting, Improving Business Reporting—
A Customer Focus (New York: AICPA, November 1993), 4
12. SFAS 131, Disclosures about Segments of an Enterprise and Related Information
(Norwalk, CT: Financial Accounting Standards Board, June 1997), para. 10.
13. APB Opinion No. 30, Reporting the Results of Operations (New York: AICPA,
July 1973), para. 20.
14. SFAS 4, Reporting Gains and Losses from the Extinguishment of Debt (Stamford,
CT: FASB, March 1975).
15. SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings
(Stamford, CT: FASB, June 1977).
16. Exxon's accident took the form of a massive oil spill in Alaska, and Union
Carbide's was a release of toxic fumes in India.
17. Armco Inc. annual report, December 1998. Information obtained from Disclosure
Inc., Compact D/SEC: Corporate Information on Public Companies Filing
with the SEC (Bethesda, MD: Disclosure Inc., June 2000).
18. Securities and Exchange Commission, Staff Accounting Bulletin No. 101
(Washington, DC: SEC, 1999).
19. Southwest Airlines Inc., annual report, December 1999.
20. This statement needs some expansion. With the exception of barter transactions,
almost all expenses involve a cash outf low at some point in time. In the case of
depreciation, the cash outf low normally takes place when the depreciable assets are
acquired. At that time, the cash outf low is classified as an investing cash outf low in
the statement of cash f lows. If the depreciation were not added back to net income in
computing operating cash flow, then cash would appear to be reduced twice—once
when the assets were purchased and a second time when depreciation is recorded,
and with it net income is reduced.
21. To keep the books in balance, the recognition of the loss in the income statement
is matched by a reduction in the carrying value of the investment in the balance sheet.
22. SEC Reg. S-X, Rule 5-02.6 (Washington, DC: SEC, 2001).
23. SEC, Staff Accounting Bulletin No. 40 (Washington, DC: SEC, February 8,
1981).
100 Understanding the Numbers
24. Handy and Harman Inc., annual report, December 1997. Information obtained
from Disclosure Inc., Compact D/SEC: Corporate Information on Public
Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 1998.
25. Even with great improvements in supply chain management, it is still difficult
to get along without any inventories.
26. Reviews and compilations represent a level of outside accountant service well
below that of an audit. Compilations typically provide only an income statement and
balance sheet. Neither notes nor a statement of cash f lows are part of the standard
compilation disclosures.
27. Absent disclosures, the effect of a LIFO liquidation can be estimated. This
requires the assumption that the observed increase in the gross margin is due largely
to the LIFO liquidation. The pretax effect of the LIFO liquidation can then be approximated
by multiplying sales for the period of the liquidation times the increase in
the gross margin percentage.
28. Archer Daniels Midland Company, annual report, June 2000, 20.
29. Guidance in this area is found in SFAS No. 109, Accounting for Income Taxes
(Norwalk, CT: FASB, February 1992).
30. The offsetting of gains and losses in the 1998 other income and expense note
is swamped by a $329 million nonrecurring gain on the disposition of C.R. Bard's cardiology
business.
31. Reg. S-K, Subpart 229.300, Item 303(a)(3)(i) (Washington, DC: SEC, 2001).
32. Mason Dixon Bancshares might take issue with this characterization. Financial
firms tend to characterize these disclosures as designed to measure core earnings.
However, our experience is that the end product is very similar to sustainable earnings,
where the focus is on purging nonrecurring items from reported net income.
33. Phillips Petroleum, annual report, December 1999, 33.
34. Ibid., 33.
35. Other companies that have provided similar presentations in recent years include
Amoco Corp., Carpenter Technology, Chevron Corp., Deere & Company Inc.,
Halliburton Co. Inc., Maxus Energy Corp., and Raychem Corp.
36. C. R. Bard Inc., annual report, December 1999, 17.
37. A hedge of foreign-currency exposure is achieved by creating an offsetting
position to the financial statement exposure. The most common offsetting position is
established by the use of a foreign-currency derivative. These issues are discussed
more fully in Chapter 12.
38. These alternative translation methods are discussed and illustrated in Chapter
12.
39. Dibrell Brothers Inc., annual report, December 1993, 35.
40. Ibid., 14.
41. Arthur Levitt, The Numbers Game, speech given at the NYU Center for Law
and Business, September 28, 1998 (available at: www.sec.gov/news/speeches
/spch220.txt).
42. The earnings of a subsequent period are increased by reducing the previously
accrued restructuring charge on the basis that the accrual was too large. The amount
by which the liability is reduced is also included in the income statement as either an
item of income or an expense reduction.
Analyzing Business Earnings 101
43. Office Depot Inc., annual report, December 1999, 57, 56.
44. SFAS No. 130, Reporting Comprehensive Income (Norwalk, CT: FASB,
June 1997).
45. Translation (remeasurement) gains and losses that result from the application
of the temporal (remeasurement) method continue to be included in the income
statement as part of conventional net income. Only translation adjustments that result
from application of the all-current translation method are included in other comprehensive
income. Recent changes in the accounting for financial derivatives also
result in the inclusion of certain hedge gains and losses in other comprehensive income:
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities
(Norwalk, CT: FASB, November 1998).
46. An annual survey conducted by the AICPA reveals the following pattern of
adoption of the alternative reporting methods of SFAS No. 130 for 497 firms: (1) a
combined statement of income and comprehensive income, 26 firms; (2) a separate
statement of comprehensive income, 65 firms; and (3) reporting comprehensive income
directly in shareholders' equity, 406 firms. AICPA, Accounting Trends and
Techniques (New York: AICPA, 2000), 429.
47. An earlier version of the Baker Hughes case study also appeared in
E. Comiskey and C. Mulford, Guide to Financial Reporting and Analysis (New York:
John Wiley, 2000), chapter 3.
48. Phillips Petroleum, annual report, December 1999, 33.
49. Research and development costs must be written off immediately—even if
the in-process R&D is purchased from another firm. Whether this expense is deductible
for tax purposes turns on the manner in which the acquisition is structured.
Generally, the expense is deductible in transactions structured as asset acquisitions
but not in the case of stock acquisitions.
102
3 COST-VOLUMEPROFIT
ANALYSIS
William C. Lawler
Abigail Peabody was a very well-known nature photographer. Over the years
she had had a number of best-sellers, and her books adorned the coffee tables
of many households worldwide. On this particular day she was contemplating
her golden years, which were fast approaching. In particular she was reviewing
her year-end investment report and wondering why she was not better prepared.
After all, she had been featured in the Sunday New York Times book
section, had discussed her works with Martha Stewart, and had been the
keynote speaker at the Audubon Society's annual fund-raiser. She knew it was
not her investment advisers' fault. Their performance over the past years had
been better than many of the market indixes. She wondered if she was just a
poor businessperson.
The last thought struck a pleasant chord. She had a grandson who was a
junior at a well-known business school just outside Boston. It was time, anyway,
to catch up to his latest business idea. She dialed the number from memory.
He was as lively as usual. "Hi, Abbey, I was just going to call you.
How's the new bird book coming?" [Of her many grandchildren, he had the most
irresistible charm.] How she loved his ability to make her feel young—and his
ability to remember never to call her anything that began with Grand-.
"Actually, Stephen, that's why I'm calling. I was just reviewing my retirement
portfolio, and I think it's time for me to renegotiate my royalty structure
with my publisher. I could use some help from a bright business mind."
"Love to help you. What's wrong with the current contract? Haven't you
been with them since the beginning?"
"Yes I have, but things have changed. In the old days, they provided me
with many services. They brainstormed projects with me, suggested different
Cost-Volume-Profit Analysis 103
ideas such as the Baskets of Nantucket best-seller, and edited my work wordby-
word and frame-by-frame. They worked hard for me and earned every
penny they made on me. I was not the easiest artist to put up with."
Stephen was interested. "Go on."
"Well, now I barely talk with them. I am at the point where loyal readers
suggest many of my projects. I design them myself, edit them myself, and even
help my publisher prepare the promotion materials. They don't work so hard
anymore. I think I have paid my dues. I want a bigger piece of the pie."
"That could be a problem, Abbey. I just finished a case study on that industry,
and it is very competitive. There are many parts to the industry value
system that ultimately ends with someone buying a book (see Exhibit 3.1). It
starts with people like you who have the intellectual capital. The next piece of
the system is the publisher, who manages the creativity process, supplies the
editing, prints the book, and markets it. Wholesalers like Ingram add value to
this system by buying books in large quantity from publishers, warehousing
them, and selling in smaller quantities to bookstores. Of course, the last piece
is the bookstore, where in-store promotion and the final sales process takes
place. On, say, a $50 book, the bookstore buys it from the wholesaler for about
$35, netting about $15 to cover its costs such as rent and salespeople. The
wholesaler buys the book from the publisher in large lot sizes for about $30 a
book, giving the wholesaler about $5 to cover its logistics costs. Of the $30 the
publisher sells it for, 15% of the retail price, or $7.50 ($50 × 15%) is your royalty,
and the rest covers printing, client development, returned books, administrative
expenses, and a profit. The publisher really can't give you too much
more since its margin is already very slim. Sorry to disappoint you but that's
how it is."
Abbey was disappointed. "Stephen, for all that money your parents are
paying, doesn't that business school teach creativity? You have to look at the
world and think of what it could be, not what it is today."
Unembarrassed by Abbey's chastisement, Stephen, reacted positively.
"How much risk do you want to take on this new project, Abbey?"
EXHIBIT 3.1 Publishing industry value system.
Author Customer
Competency: Intellectual
Printing
Logistics Promotion
Capital Editing Warehousing Sales
Development
Revenue: $7.50 $30.00 $35.00 $50.00
Purchase cost: 30.00 35.00
Gross margin: $ 5.00 $15.00
Publisher Wholesaler Bookstore
104 Understanding the Numbers
"That's more like it. For now, let's 'roll the bones'—I mean, assume risk is
not an issue. What do you have in mind?"
"Well, this semester I have a Web-marketing course and I need a project.
Are you familiar with the World Wide Web?"
"I spend a good part of the day corresponding with friends on it."
"Good. What you just said to me is that you don't see too many pieces of
the publishing system adding value commensurate with the value they extract.
How about setting up your own Web site and selling your latest project yourself?
We would have to contract with others to provide the necessary parts of
the chain, but selling the book through our Web site is possible. It could fail,
and you would have one very unhappy publisher."
Abbey thought she was now getting somewhere. "As long as you are getting
credit for it, why don't you develop this idea further. See if it's possible
and what my risks would be. I might even give you a piece of the action."
COST STRUCTURE ANALYSIS
A month later Abbey met Stephen for lunch in Boston. He was excited.
"Abbey, this is what I have found so far. Setting up a Web site is very easy,
but maintaining it and keeping it fresh and exciting so that people want to revisit
it is the challenge. Neither you nor I want to do that, trust me. I have
talked with a number of companies who offer this type of service. Many of
them were excited when I showed them copies of your past books. To set up
and maintain the site, the offers ran anywhere from a low of $25,000 a year to
four times that. The high-end ones also charge a 5% fee on all revenues generated.
I think we want a high-end site that is creative, custom designed, and exciting
so I lean toward the more expensive ones. They are good."
Abbey liked how he used the word we. And being an artist, she too
thought that her Web site should be exciting, creative, and different. "Go on."
"I also found a number of printers who specialize in small run sizes, typically
less than 50 books in any one printing. Their technology is called printon-
demand, and they also work with photographs. I brought some samples of
printed photos."
Abbey was impressed with the quality. It looked no different than her
previous books. "What would they charge?"
"They said they could print your books on demand and guarantee the
quality for about $35 each. Now, this is much more than what traditional printers
charge, but they always run large volumes, a minimum of 5,000 copies in
one printing, and want to be paid for every one of them even before we could
sell them. Bottom line, we would be at risk if this doesn't work."
Abbey was disappointed that she was again making someone else rich, but
moved on. "How would we do all the promotion and sales?"
"Two ways. Once your readers learn of your site, they will visit it. If the
Web-design company delivers what they promise, we should be able to sell
Cost-Volume-Profit Analysis 105
directly to them. Until that traffic happens, the Web designers will develop
links with all the major sites that might be interested."
"How does that work?"
"Well, your newest project is a Florida bird book for all the retired baby
boomers down there, right? So we develop what is called a link with the
Audubon's Web site and maybe AARP and the Florida Tourism Bureau. When
people see your book on those sites, they click on a link and get transferred to
our site. If they buy the book, we pay the site a 10% royalty."
"Does that mean I spend all my days, assuming we are successful, mailing
books all over the world? That doesn't interest me."
"No. I also talked with logistics companies like UPS and FedEx. They will
do all of that. When we sell a book, we just notify them electronically. They
work with the printer to obtain the book and with the credit card company to
get paid, and they ship it. They even collect the money, pay everyone involved
with the sale, and electronically deposit the remainder in your account. They
would charge about $10 per book for all of this, assuming we can guarantee a
certain minimal volume."
"Now that sounds like your parents are getting their money's worth. Have
you summarized all of this?"
"Sure have. You're still thinking about a price of $80 for this book?"
"My others have sold for that, and I think the demand for this might even
be greater. So $80 is a good assumption."
"Okay. First, all business models have only two types of costs, variable
and fixed. Each is defined by the behavior of the total cost function. Variable
costs are those that increase proportionately with volume—basically, the more
books we sell the higher these total costs will be. They can be expressed either
on a per-unit basis or as a percentage of the selling price. Notice we have both
types. Our printing and logistics costs total $45 for each book sold—$35 printing
plus $10 logistics. Our Web-site sales referral cost of 10% and Web-design
cost of 5% for every dollar of revenue are examples of the latter kind of variable
cost. For the targeted price of $80, these costs come to $12 for each book
sold ($80 × 15%). Note this type of variable cost is a little more complicated
than the simple $45 per book—here if we change selling price, the variable
cost will change. Given the $80 selling price, the total variable cost per book is
then $57 per unit ($45 + $12). Unlike these costs, the Web-site design cost is a
mixed cost1 and has to be broken into a variable and a fixed component. We
have already treated the 5% variable cost component. There is also a fixed
charge per year of about $100,000 if we go high-end. Note the difference in
behavior of this cost. Here the total cost is not dependent on a volume factor
such as "books sold." Fixed costs are often called period costs since they are
time dependent. So in summary, we have a time-dependent fixed charge of
$100,000 per year, which remains the same regardless of the number of books
sold, and a variable cost, which is better understood on a per-unit or, in this
case, per-book rate of $57. I made a graph of this—what businesspeople call
cost structure (see Exhibit 3.2)."2
106 Understanding the Numbers
Abbey thought she understood. "So this structure will always be the same?"
"With one proviso," Stephen affirmed. "Although my chart looks the
same from zero volume to an infinite amount sold, we really should only be
talking about a smaller relevant range. Both the printer and the logistics company
are assuming an annual volume of between 10,000 and 25,000 books—essentially
what your past books sold. Outside this range, especially on the high
side, the costs probably will change. I don't think the printer can do much
more than 25,000 a year for us. Likewise, at greater than this volume, we would
probably have to redesign the Web site. So the cost structure could change if
we were to move outside the range."
"Okay. So now I think I do understand what the cost structure would be
given our plans for the Web site. All that you said makes sense, and I'm sure my
new book will sell in that range. So tell me why I shouldn't do this."
COST-VOLUME-PROFIT ANALYSIS
"If we add a revenue line to my first exhibit," said Stephen, "we will start to get
a better picture of the answer to this question (see Exhibit 3.3). First, you must
understand the concept of contribution margin. For us, it is simple. For every
$80 book we sell, there is a variable cost to print, sell, and deliver that book of
$57. This means that the net contribution of each book sold is $23. Does this
make sense?"
"Sure does," Abbey answered, delighted. "This is wonderful. I was only
making $12 with my publisher, and now I can make almost double that."
"Not quite. You forgot one thing. Contribution margin must first go toward
covering the fixed costs before we can realize any profit. Each year we
have to cover the Web-site designer's charge of $100,000. At a contribution
margin of $23 per book, it will take about 4,350 books sold to do this (see
EXHIBIT 3.2 Web site cost structure.
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
0 5,000 10,000 15,000 20,000 25,000
Dollars (thousands)
Units
Relevant range
Cost-Volume-Profit Analysis 107
Exhibit 3.4). On my graph, this is the point where the revenue line intersects
the total cost line and is called the break-even point. After that, you are correct.
For any additional book we sell, the $23 contribution per book is all profit.
So, as I see it, there is little risk since you are sure that we will sell at a minimum
10,000 copies per year."
Abbey became a bit uncomfortable. "Actually, I think this book will sell
about 20,000 copies per year at a minimum. But isn't my alternative to stay
with my publisher? And if so, shouldn't we be talking about whether I would be
better off with the Web site?"
Stephen was suddenly not so cocky. Abbey thought that maybe some remedial
work on those tuition dollars was needed. "I have some work to do. Why
don't you get back to me on that, Stephen?"
Two nights later, after faxing her two charts, Stephen phoned Abbey. "I
sent you a different type of chart, called a profit chart, which shows the two
EXHIBIT 3.3 Web site CVP analysis.
Dollars (thousands)
Units
Total revenue line
Total cost line
Fixed cost
Profit area
Break-even point
0
500
1,000
1,500
2,000
2,500
0 5,000 10,000 15,000 20,000 25,000
EXHIBIT 3.4 Break-even calculations.
Solving for x,
General Rule: Break-even point
Fixed Costs
Contribution Margin
=
$ $ $ ,
$ $ ,
$ ,
,
80 57 100 000
23 100 000
100 000
23
4 348
x x
x
x
− =
=
= = books
Sales Revenue = Fixed Costs +Variable Costs
$80 x = $100, 000 + $57x
108 Understanding the Numbers
alternatives (see Exhibit 3.5). 'Stay with the publisher' shows that you make
$12 for every book sold. 'Sell through the Web site' is a bit more involved in
that it shows that you first must cover your fixed cost before making any profit.
Note that they intersect at about 9,100 books sold, which means that you would
be indifferent to which business model you chose at this volume of books sold.3
But at less than the 9,100 you should stay with your publisher; at greater than
that volume, build your own Web site. At the 20,000 books-per-year level you
said you are sure this project will hit, you make $240,000 per year (20,000 ×
$12 royalty per book) if you stay with your publisher, and $360,000 with the
Web site (20,000 × [$80 − $57] − $100,000 fixed costs). Another way to think
about this is that if we set up our own Web site there is an additional variable
cost for each book we sell—the $12 we could have made from the publisher
(see Exhibit 3.6). This is called an opportunity cost. It is a relative measure—
EXHIBIT 3.5 Profit chart.
5,000 10,000 15,000 20,000 25,000
Dollars (thousands)
Units
Stay with publisher
Sell through Web site
–200
–100
0
100
200
300
400
500
600
EXHIBIT 3.6 Revised Web site CVP analysis.
0 5,000 10,000 15,000 20,000 25,000
Dollars (thousands)
Units
Total revenue line
Revised total cost line
$69x + $100,000
Break-even now
indifference point
0
500
1,000
1,500
2,000
2,500
Cost-Volume-Profit Analysis 109
what is sacrificed when we choose one alternative, selling through the Web
site, over the next best alternative, staying with the publisher. If we think this
way, our contribution margin is now only $11 ($80 selling price less $57 variable
costs less $12 royalty per book sacrificed). We do arrive at the same indifference
point using this method—using the general rule:
I think this is the better way to think about the Web-site alternative. Note,
using this method, at 20,000 books per year we make a total contribution of
$220,000 (20,000 × $11), which covers our fixed costs and yields the $120,000
incremental profit—same as ($360,000 − $240,000)."
Abbey was becoming very interested in this business opportunity. She
liked the 50% greater return ($120,000/$240,000). "How fast can we get this
Web site up and running?"
"Let's talk a bit more. I also presented today in class what we have done so
far. Many students liked the idea. The only criticism was that Web customers
expect lower prices since they know the middle person has been eliminated.
The class agreed that a 10% to 15% price decline would be very likely, resulting
in a price closer to $70. This is not so good for us. Even though our variable cost
will fall to $67.50 since part of it is price dependent ($35 printing + $10 logistics
+ $12 opportunity cost + [15% × $70]), our contribution margin would
now only be $2.50 per book. Just to match what you could make with your
publisher, we would have to sell about 40,000 books a year ($100,000/$2.50
per book). At the 20,000-book level, we would now be worse off by $50,000
([20,000 × $2.50] − $100,000). Well, you asked about the risks and here they
are. The price could even be lower, so there is a high probability we could wind
up worse off."
"So, you're my business partner, what do you suggest?" was Abbey's reply.
"That's a hard one," was all Stephen could say.
CVP for Decision Making
The next day Abbey called Stephen for more advice. "Public Broadcasting System
of Florida called me after our talk yesterday. They just began planning
their end-of-year membership drive and heard about my book project. They
want to offer a free copy of my book to any member who donates $250
or more."
Stephen thought that was great.
"Unfortunately, since they are a public company they have constraints on
their spending. They can give a gift equivalent to only 20% of the donation.
CVP Point
Fixed Costs
Contribution Margin
units
=
=
=
$ ,
$
,
100 000
11
9 091
110 Understanding the Numbers
Fifty dollars a book for 5,000 books was their offer to me. Since we just went
over the numbers, I said I couldn't possibly do this since our variable costs
alone were greater than $50 a unit. This analysis we did does help with decision
making. Last year I might have agreed to the deal. I am starting to feel like a
businessperson."
Stephen asked whether the PBS group accepted her decision. When
Abbey said that they were very persistent and would call back next week,
Stephen suggested he and Abbey meet again for lunch. He needed to review
some of his class notes on relevant cost analysis, specifically on something he
remembered as "special orders."
At lunch Stephen explained some analysis he had done. "Abbey, this is
called a special order situation. These types of business decisions are shortrun
decisions that have no long-term ramifications.4 Assuming that we have
the Web site up by that time, we have to be careful in identifying only those
costs that are relevant to the decision. For instance, the $100,000 we will
spend on our site per year is not relevant, since regardless of whether we accept
this special order, those costs will still be there. The rule that we use is:
A cost is relevant if and only if it will change due to the decision being analyzed,
in this case our special order. Let's review the relevant costs. First,
there's the $35 charge to print the books on demand. Since this is a 5,000-unit
order the printer's costs to prepare the run, called set-up costs, will be spread
over a much larger number of books. I talked with him, and he would be willing
to do this run for $30 per book. Likewise, UPS or FedEx will ship these
books all at once and not individually, so the $10 charge per book will be
avoided. A one-time fixed charge of $250 for shipment of the 5,000-book
order is closer to the correct number. Since this order was not sold through a
EXHIBIT 3.7 Relevant cost analysis of special order.
Accept the
Order, No Accept the
Adjustments Order, Reject the
to Costs Adjusted Costs Order Difference
Number of books sold 5,000 5,000 0 5,000
Revenue $250,000 $250,000 $ 0 $250,000
Relevant costs:
Printing $175,000 $150,000 $ 0 $150,000
Logistics 50,000 250 0 250
10% site referral 25,000 0 0 0
5% Web site expense 12,500 12,500 0 12,500
Total relevant costs $262,500 $162,750 $ 0 $162,750
Nonrelevant costs
Web site design $100,000 $100,000 $100,000 $ 0
Profit from order $ 87,250
Cost-Volume-Profit Analysis 111
site reference, the 10% commission can also be avoided. I looked into the
Web-site contract, and I do think we will have to pay this charge of $2.50 per
book (5% × $50). Summing up, the variable cost per book for this special
order will be only $32.50 ($30 printing charge plus $2.50 Web-site fee)—less
than the $50 PBS is willing to pay. The end result is a $17.50 contribution margin
per book for this special order. There is an incremental fixed charge of
$250 but we still will make just over $87,000 (5,000 × [$50 − $32.50] − $250
= $87,250). So we should think about reconsidering the offer" (see Exhibit 3.7).
Though Abbey was beginning to appreciate the complexity of this type of
analysis, all the numbers did make sense. She had only one question: "What
happens if customers I would have sold to anyway get their books this way?
Don't I lose money?"
Stephen had done that analysis. "In the business world, we call that cannibalization.
On every book sold through this special offer, you could potentially
lose the $23 contribution margin per book sold through the regular Web
site if these people would have bought anyway. To solve for the potential number
of regular customers that would have to be cannibalized in order for us to
lose money on this special order, follow this procedure:
Solving for x, we get
This means that if about 3,800 of the 5,000 books sold by PBS go to customers
that would have bought anyway, we are indifferent to accepting this order. If
more than 3,800 would have bought anyway, we lose on this special order. Do
you think 76% (3,800/ 5,000) of these people would buy from our Web site? I
don't think it is anywhere near that. And, on the positive side, these 5,000 people
would now be advertising our Web site with your book on their coffee tables
all over Florida."
Abbey was searching for the PBS phone number before Stephen had finished
the last sentence. She made a mental note to understand this "relevant
cost" analysis a bit more.
Price Discrimination
In the above special order situation, there was a legitimate reason to offer PBS
the lower price. As Exhibit 3.7 illustrates, the relevant cost analysis justified
the lower price. When offering different prices to different customers, one
must be aware of the laws regarding price discrimination. Under the federal
Robinson-Patman Act and many state laws, it is illegal to price discriminate
unless there are mitigating circumstances. One must be very careful to do a
x =
=
$ ,
$
,
87 250
23
3 793 customers
$23x = $87,250
112 Understanding the Numbers
relevant cost analysis before granting any price concessions to customers on a
selective basis.
CVP in a Multiple Product Situation
The special order was a great opportunity, but both Abbey and Stephen knew
that the success of the Web site ultimately would depend on the regular, dayto-
day business activity. The two of them were still worried about the potential
Web discount resulting in a $70 price point. As an artist Abbey understood risk
and had learned long ago to accept risk and figure a way to minimize it. She decided
to talk with some of her artist friends.
In two weeks she and Stephen met again. Stephen was desperate to finish
his project since semester end was right around the corner. Abbey walked in
wearing a rather stylish straw hat.
"I think I have the solution, Stephen. I do not want to drop my price from
$80. My other books sold at this price, and to drop the price on this one might
send the wrong message to my loyal following. This book will not be in any
manner inferior to my past works. But I do have an idea. We are going to expand
our product offerings. I have a dear friend who makes these hats, and I
think this would be a perfect complement to my bird book. After all, if you are
going out bird-watching in Florida you need both to look good and to have sun
protection. We are going to package the book with a hat and a Peterson's
Florida Bird Guide at a very reasonable price for those that are more price
conscious."
Stephen was stunned. "Whoa, do you want all this complexity in your
business, Abbey?"
She smiled. "I, too, can do some field research. My friend will package
the three items as orders come in. I don't have to do any more work than before.
She was happy to build demand for her hats."
"So, how about the costs?"
"This is how I see it. We sell the hats for $50 by themselves; the books for
$80 by themselves; and then offer the package for $140. A Peterson's Guide
typically sells for $20, so this package price is a deal—you could say I'm selling
my book for $70 as part of this package, although I would never admit to it. I
coerced my friend to give us her hats for $24 each, and the book costs when included
in this package will change a bit. I put your relevant cost technique to
work here. My friend and I think we can assemble the package for a variable
cost of about $100 (see Exhibit 3.8). Peterson will give us the guide for $10 to
get the exposure, and since we are still shipping only one item, I'm hoping that
the logistics charge will not change too much. I had some problems figuring out
what we have to sell since there were now multiple items—hats, books, and
packages. But I have faith in you."
As his laptop was booting Stephen began. "CVP analysis for multiple
products is very common since few companies sell just one item. Instead of
Cost-Volume-Profit Analysis 113
focusing on a contribution margin per unit, when we have multiple products
we must base our calculations on the percentage contribution margin for each
dollar of revenue."
"Sounds complicated."
"Not really, Abbey. It's probably easier, though, for me to show you how it
works than to explain it. All I need is your estimate of the sales mix. For every
book you sell individually, how many hats will you sell and how many packages
will you sell? These estimates do not have to be exact—businesspeople typically
talk about ballpark estimates."
"My friend and I did discuss this. We were not sure, so we came up with a
range. We think that for every 100 books we sell individually, we will sell 50
packages. A surprisingly large number of people are active in this regard. They
actually do enjoy seeking these birds out in the wild. And, of course, everyone
knows you need a wide-brimmed hat in Florida. We guessed that we might also
sell 20 hats individually for every 100 books sold. If things go really well, we
might sell as many as 70 packages and 30 hats for every 100 books. On the pessimistic
side, we could sell as few as 30 packages and 10 hats for the same 100
books. Is this okay?"
"Actually, that's even better. If you're sure of these ranges, then we can
do a sensitivity analysis to see how our profits will change as the mix changes.
We need to know how much our profit will vary with changes in the mix. Are
you comfortable with these ranges?"
"Yes."
"To do this analysis we must first build a product mix analysis. Here, I'll
show you."
Abbey was very impressed as Stephan built the analysis on his laptop (see
Exhibit 3.9). "Just as we analyzed the unit costs before, we build a similar cost
analysis. The only difference is that this time we build it for a composite unit
defined by the mix. For your expected mix, 100 books plus 50 packages plus 20
hats, we see that for every $16,000 in sales you will have $11,180 in variable
costs. This means that on a percentage basis your variable costs are 69.9%
of sales as long as you sell in that mix. Note that we now have a percentage definition
of contribution margin, not a unit definition—contribution margin
EXHIBIT 3.8 Variable package cost
estimates.
Hat $ 24
Book printing 35
10% site referral fee 14
5% Web site commission 7
Peterson Guide 10
Package logistics 10
$100
114 Understanding the Numbers
percentage of 30.1%. Our fixed costs are still $100,000 per year, so we now adjust
the general rule for CVP point as follows:5
Solving for x,
To test this model, assume that we have $332,226 in sales revenue and we did
sell the planned mix. Our contribution margin will be 30.1%, which yields the
$100,000 necessary to cover the fixed costs. We do, in fact, break even. The
key, of course, is to be able to forecast the correct mix and then to attain it."
Abbey was quick to correct Stephen. "Don't forget, I still want to be at
least as well off as if I chose to stay with my publisher—say the 20,000 books at
my $12 royalty."
"Easy enough. We just revise the equation by adding a necessary profit requirement—
this is why they call it cost-volume-profit analysis:
Sales − Variable Costs − Fixed Costs = Profit
x − (69.9%)x − $100, 000 = $240, 000
( . %) $ ,
$ ,
. %
$ ,
30 1 100 000
100 000
30 1
332 226
x
x
=
=
= in sales revenue
Sales − Variable Costs − Fixed Costs =
− − =
0
x (69.9%)x $100, 000 0
EXHIBIT 3.9 Mix contribution estimates.
Books Packages Hats Mix
Per Unit Total Per Unit Total Per Unit Total Total
Low Mix 100 30 10
Revenue $80 $8,000 $140 $4,200 $50 $ 500 $12,700
Variable Cost $57 $5,700 $100 $3,000 $24 $ 240 $ 8,940
Contribution 71.3% 71.4% 48.0% 70.4%
Expected Mix 100 50 20
Revenue $80 $8,000 $140 $7,000 $50 $1,000 $16,000
Variable Cost $57 $5,700 $100 $5,000 $24 $ 480 $11,180
Contribution 71.3% 71.4% 48.0% 69.9%
High Mix 100 70 30
Revenue $80 $8,000 $140 $9,800 $50 $1,500 $19,300
Variable Cost $57 $5,700 $100 $7,000 $24 $ 720 $13,420
Contribution 71.3% 71.4% 48.0% 69.5%
Cost-Volume-Profit Analysis 115
Solving for x,
We find that you must do about $1.130 million in sales to be as well-off."
"Hmm. I'm not sure what this means. So how much of what do I have to
sell? That's what I want to know."
"What we do is take the total required sales of $1.130 million and split it
by your revenue mix percentages. Given your expected mix estimates, half of
your revenues will come from sales of books, or $564,315; seven-sixteenths
from packages, or $493,776; and the other one-sixteenth from sales of hats, or
$70,539. Dividing by the selling price of each item, we can also compute the
necessary unit sales levels—7,054 books, 3,527 packages, and 1,411 hats. With
our variable cost estimates, if you meet these targets we will indeed meet the
targeted profit level (see Exhibit 3.10). In summary, we were worried that our
9,100-book target was too optimistic because price cuts were possible. With
this mix we will have to sell 10,581 books—7,054 individually and 3,527 in
packages—but one-third of them will essentially sell for around $70. This
seems more realistic if the packages are marketed correctly."
"What does the sensitivity analysis tell us?"
"Since the contribution percentage for the package is about equal to an
individual book, this solution is not very sensitive to variation in mix. If you
do meet your 'optimistic' mix projection, your contribution percentage increases
by less than 1%—30.1% to 30.5% (see Exhibit 3.11). As a result your
( . %) $ ,
$ ,
. %
$ , ,
30 1 340 000
340 000
30 1
1 128 631
x
x
=
=
= (with no rounding)
EXHIBIT 3.10 Required unit revenues and sales volumes expected mix.
Books Packages Hats Mix
Per Unit Total Per Unit Total Per Unit Total Total
Expected mix 100 50 20
Revenue $80 $ 8,000 $140 $ 7,000 $50 $ 1,000 $ 16,000
Percentage of
total 50.00% 43.75% 6.25% 100.00%
CVP target $1,128,631
Mix % allocation $564,315 $493,776 $70,539 $1,128,631
Variable cost 71.3% 402,075 71.4% 352,697 48.0% 33,859
Contribution
margin $162,241 $141,079 $36,680 $ 340,000
Divide by unit
price to find
unit sales
needed Books 7,054 Packages 3,527 Hats 1,411
116 Understanding the Numbers
sales revenue target to meet your profitability goal will drop only a small
amount—from about $1.130 million ($340,000/30.1%) to $1.120 million
($340,000/30.5%). Basically, we would have to sell only 9,830 books with 41%
at discount. This would mean, though, that we would have to sell substantially
more packages. All in all, our answer is not that sensitive to the mix."
Abbey now asked Stephen if he wanted to partner with her.
METHODS OF COST BEHAVIOR ESTIMATION
CVP analysis is a rough, first-pass analytic technique. Businesspeople use it to
make some initial profitability estimates of potential opportunities and to cull
those that show the most promise. More in-depth analysis would then follow.6
The key to CVP analysis is correctly identifying the cost structure of the
business opportunity being analyzed. Without a proper knowledge of the cost
behaviors—identification of the fixed period costs and the variable costs per
unit or as a percentage of sales revenue—business planning cannot be done
properly. There are four methods used to analyze cost behavior. Three are analytic
approaches that require historical data, and the other is more judgmental.
Abbey's Web-site example discussed above is an example of the latter.
Since the business was not yet operating, there was no database to study.
Rather, the cost structure was estimated by analyzing the processes on which
Abbey's business would be based. The data came from discussions with process
partners such as the Web-site designer and the logistics company and from
Abbey's firsthand knowledge of the book business. This procedure depends on
correctly identifying all the necessary business processes and the experience
EXHIBIT 3.11 Mix sensitivity analysis optimistic mix.
Books Packages Hats Mix
Per Unit Total Per Unit Total Per Unit Total Total
Expected mix 100 70 30
Revenue $80 $ 8,000 $140 $ 9,800 $50 $ 1,500 $ 19,300
Percentage of
total 41.45% 50.78% 7.77% 100.00%
CVP target $1,115,986
Mix % allocation $462,585 $566,667 $86,735 $1,115,986
Variable cost 71.3% 329,592 71.4% 404,762 48.0% 41,633
Contribution
margin $132,993 $161,905 $45,102 $ 340,000
Divide by unit
price to find
unit sales
needed Books 5,782 Packages 4,048 Hats 1,735
Cost-Volume-Profit Analysis 117
and ability of those who provide accurate process cost estimates. Since
Abbey's business model was relatively simple and many of the processes were
outsourced to experienced third-party providers, the resulting cost structure
estimates are probably relatively accurate. Given a more complex business opportunity
that might require many internal process steps that are not yet well
understood, this methodology might not yield such accurate results.
The three analytic approaches are techniques used when historical data is
available. Unfortunately, many firms first develop this analysis after they have
begun operations—an inopportune time. For instance, now that the bloom is
off the Internet rose, there are many such firms scrambling to do this analysis
after the fact. Investors are withholding later-round financing until these firms
can develop the analysis we illustrated above.
Assume that Books "R" Us is one of those firms. Since it has not yet broken
even, its investors want to better understand the cost structure and when,
if ever, they can expect a return. The company has been in business for two
years and over the past 12 months has shifted from building infrastructure to
its primary focus, selling books.7 All agree that these past 12 months would be
a good basis on which to develop the analysis.8 The relevant data are given in
Exhibit 3.12.
There are many ways to analyze this data. They all assume the following
first-order cost equation:
The first of the three databased techniques is simply to plot the data in an x-y
coordinate system with costs on the y-axis and sales revenues on the x-axis. It
Total Cost Variable Cost Fixed Cost
(Variable Cost Percentage Sales Revenue) Fixed Cost
= +
= × +
EXHIBIT 3.12 Books "R" Us data.
Revenue Total Costs Profit
$(000) $(000) $(000)
January $ 12,250 $ 13,500 $ (1,250)
February 14,500 16,000 (1,500)
March 15,000 16,500 (1,500)
April 16,250 17,250 (1,000)
May 15,250 16,500 (1,250)
June 13,750 15,500 (1,750)
July 11,500 13,000 (1,500)
August 17,500 18,250 (750)
September 23,750 25,000 (1,250)
October 15,500 16,500 (1,000)
November 16,000 17,250 (1,250)
December 22,500 22,000 500
Total $193,750 $207,250 $(13,500)
118 Understanding the Numbers
is called visual fit because one simply draws a straight line through the data
that "best fits" the pattern (see Exhibit 3.13). The point where this line intersects
the y-axis yields an estimate of the fixed cost component—those costs
that exist even without any sales activity. The slope of the line drawn is defined
mathematically as: rise over run or change in y-axis values divided by the
change in x-axis values. Using business rather than mathematical terminology,
how much the total costs change (the y-axis or rise) as the sales volume changes
(the x-axis or run). As was discussed above, this is simply the variable cost expressed
as a percentage of sales. For the Books "R" Us example, given the line
I've drawn subjectively, the result would be:
With today's computer software, this method is easy and time efficient. Unfortunately,
it lacks verifiability. If 20 people were to analyze this same data set,
you could end up with twenty different cost structure estimates.
The second method is called high-low analysis. It also is time efficient
and has the added advantage of verifiability. Since it is rule based, all twenty
people in this case would arrive at the same estimate. It has four steps:
1. On the x-axis, identify the high and the low points of the data set.
2. Identify the historical costs for each of those points.
3. Assume a straight line through these two points and calculate the variable
cost component using the traditional slope equation:
4. For either the high or the low set of data points, plug the values into the
cost equation and solve for the fixed cost component.
Slope
Change in - xis Values
Change in - xis Values
= y A
x A
Fixed Cost Estimate: line crosses -axis at about million dollars
Variable Cost Percentage of Sales Estimate Slope: about 85.2%9
y $4
=
EXHIBIT 3.13 Books "R" Us scatter plot.
0 5,000 10,000 15,000 20,000 25,000
Revenue ($)
Total Cost ($)
0
5,000
10,000
15,000
20,000
25,000
30,000
Cost-Volume-Profit Analysis 119
For the example and data set in Exhibit 3.12, the steps would be as
follows:
1. High and low points = September sales or $23.75 million and July sales of
$11.5 million.
2. Historical costs for each point = $25,000 (September) and $13,000 (July).
3. Slope = Rise/Run = ($25,000 − 13,000)/($23,750 − $11,500) = 98%.
4. Fixed component: Total Cost = Variable Cost + Fixed Cost.
For high data points:
For low data points:
This method has two weaknesses. First, the high and low data points chosen
are assumed to ref lect the pattern of all data points. Often, however, either or
both of these points may not be such, and the analysis is f lawed.10 The second
weakness is an extension of the first. We had 12 data points but chose to analyze
only two of them, ignoring the other 10. This method is data inefficient; if
you have 12 data points, all 12 should be considered for the analysis.
The third databased technique is called regression analysis. Here a function
is fit through all data points in a manner that minimizes the total squared
error between each data point and the fitted line. The mathematics underlying
this technique are beyond the scope of this chapter, but the method is widely
used and preferred when the data set has problems such as a stepped fixed cost
or variable costs based on multiple factors. All spreadsheet software packages
have a function that performs simple regression analysis.11 Exhibit 3.14 is an
example of what the output would look like for a least-squares regression analysis
using Excel. The estimate for the fixed cost is $2.73 million, and the variable
cost is 90% per sales dollar. The adjusted R2 of 98% means that 98% of
the variance of the Total Cost data is explained by this equation. The drawback
of this analysis is that it is not intuitive. One must trust the output from the statistical
package. If the user does not understand the statistical technique and
the assumptions of the software package, the output is often f lawed.12 This approach
needs a sound grounding in statistical analysis.
In summary, for the data set being analyzed, the three databased techniques
yield results that vary considerably (see Exhibit 3.15). The key to
correctly using databased techniques, however, is not choosing the right technique
but beginning with a data set that truly ref lects the cost structure being
$ , %($ , )
$ , %($ , )
$ .
13 000 98 11 500
13 000 98 11 500
1 725
= +
= −
=
Fixed Cost
Fixed Cost
million (rounded)
$ , %($ , )
$ , %($ , )
$ .
25 000 98 23 750
25 000 98 23 750
1 725
= +
= −
=
Fixed Cost
Fixed Cost
million (rounded)
120 Understanding the Numbers
analyzed. To emphasize this, the cost function, Total Cost = (76%)Revenue
+ $5 million, was used to generate the data set in Exhibit 3.12. A randomized
error term was then added to these data estimates, they were rounded to the
nearest quarter million, and then the high and low data points, July and September,
were purposely changed. For instance, assume September was a very
busy month for Books " " Us because of the many college-student book orders.
This rush caused overtime and other disruptive cost behavior. Without
the analyst first adjusting the data point for this aberrant behavior, the results
are skewed. For databased techniques such as these, the adage "Garbage in,
garbage out" holds true. Before employing any of these techniques first ensure
that your data does truly ref lect the cost structure being studied.
R
EXHIBIT 3.14 Least-squares regression output (Books "R" Us data).
SUMMARY OUTPUT
Regression Statistics
Multiple R 99.1%
R square 98.2%
Adjusted
R square 98.0%
Standard
error 471.36
Observations 12
ANOVA
df SS MS F Significance F
Regression 1 119,835,495 119835495 539.363 4.956E-10
Residual 10 2,221,797 222179.69
Total 11 122,057,292
Coefficients
Intercept $2,733
X variable 1 90%
EXHIBIT 3.15 Databased cost structure estimates.
Variable Cost Fixed Cost
Percentage (in millions)
Visual fit 85 $4.0
High-low 98 1.725
Least squares 90 2.733
Cost-Volume-Profit Analysis 121
THE ROLE OF PRICING IN CVP ANALYSIS
CVP analysis is often erroneously used to set prices. The P in CVP does not
stand for "price"; it stands for "profit." A rule to remember: There is no such
thing as "cost-based pricing." Prices are market driven. If a firm finds itself in
a competitive market where competition among rivals is based on delivering
comparable value to customers at the lowest cost, the market sets the price. As
Adam Smith wrote centuries ago, only the most efficient firms will survive. To
use CVP analysis in this situation, one starts with estimates of the marketdriven
price and then calculates the profitability given probable unit demand
and the current cost structure. If the forecasted profit is not sufficient to satisfy
investors, one must then focus on reducing costs, not raising prices.
Incumbent firm behavior in the U.S. health care industry after deregulation
in the 1980s is a perfect example of incorrect use of this technique. New
entrants into the lower, more profitable segments of this industry—for example,
the walk-in clinics that have sprung up in metropolitan areas—gave patients
(and insurance providers) a lower-cost option than traditional hospitals
for minor health-care procedures. Large hospitals responded to this loss of segment
revenue by spreading their costs (mostly fixed) over their remaining
health-care offerings and raising prices. With those higher prices, the clinics
were able to offer lower-priced alternatives for more complex procedures.
With the loss of these revenues, the hospitals responded in the same manner.
This is called the "doom loop," and it led to the closing of many such institutions.
The proper move for the hospitals should have been to pare expenses on
the noncompetitive offerings.
For firms that compete by differentiating themselves from rivals by offering
additional value to customers at comparable cost, pricing should be based
on value to the customer, not cost. Microsoft certainly does not price its products
on the costs to develop and deliver them. Bill Gates long ago understood
the value of an industry-standard PC operating system and has priced Microsoft's
offerings accordingly. The key here, of course, is that the additional value
must exceed the costs to create it. CVP analysis in this situation is basically no
different than previous examples. Only here, one starts with estimates of the
value-based price and then calculates the profitability given probable unit demand
and the current cost structure. If the forecasted profit is not sufficient to
satisfy investors, one must then focus not simply on raising prices but on reducing
costs or increasing the willingness of consumers to pay more.
Predatory Pricing
In recent years a legal battle raged between two of the nation's largest tobacco
companies.13 The Brooke Group Inc. (previously known as Liggett Group Inc.)
accused Brown & Williamson Tobacco Corporation of predatory pricing in the
wholesale cigarette market. At trial in federal court the jury decided that
Brown & Williamson had indeed engaged in predatory pricing against Brooke.
122 Understanding the Numbers
The jury awarded damages of $150 million to be paid to Brooke by Brown &
Williamson. However, the presiding judge threw out this verdict. Brooke then
filed an appeal, and the case continued.
Predatory pricing cases are not unusual, and damage awards as large as
$150 million are not unheard of. Predatory pricing, as the name implies, is a
tactic where the predator company slashes prices in order to force its competitors
to follow suit. The purpose is to wage a price war and inf lict upon the
competition losses of such severity that they will be driven out of business.
After destroying the competition, the predator company will be free to raise
prices so that it can recover the losses it sustained in the price war and also
rake in profits that will greatly exceed normal earnings at the competitive
level. This final result is harmful to competition, and predatory pricing has
therefore been made unlawful.
To determine whether a firm has engaged in predatory pricing, the courts
need a test that will supply the correct answer. One of the usual tests is
whether there is a sustained pattern of pricing below average variable cost. If
the answer is yes, this indicates predatory pricing. Let us examine the logic underlying
this widely used test.
First, recall that contribution is the margin between selling price and
variable cost. Contribution goes toward paying fixed costs and providing a
profit. If price is less than variable cost, contribution is negative. In that case,
the firm cannot fully cover its fixed costs, and certainly it will suffer losses.
Therefore, it makes no sense for the firm to charge a price that is below variable
cost unless the firm is engaging in predatory pricing in order to destroy
competing firms. That is why pricing below variable cost is considered to be
consistent with predatory pricing.
We should bear in mind that the variable cost used in the test is that of
the alleged predator, not of the alleged victim. The reason is that the alleged
predator may be an efficient low-cost producer, whereas the alleged victim
may be an inefficient high-cost producer. Therefore, a price below the alleged
victim's variable cost may be above that of the alleged predator, in which case
it could be a legitimate price and simply a ref lection of the superior efficiency
of the alleged predator. The antitrust laws are designed to protect competition,
but not competitors (especially those competitors who are inefficient).
Of course, this is only one indicator of predatory pricing, and all of the
relevant evidence must be considered. There should also be a pattern of sustained
pricing below variable cost. Prices that are slashed only sporadically or
occasionally are probably legitimate business tactics, such as loss-leader pricing
to attract customers or clearance sales to get rid of obsolete goods.
Predatory pricing is an important topic and has been the subject of major
lawsuits in a wide variety of industries. Because it is a common test for predatory
pricing, variable cost is also a very important topic that all successful businesspeople
will benefit from thoroughly understanding.
Predatory pricing is usually thought of in a regional sense, or perhaps on a
national scale. But it can also occur on an international basis. In that case, it is
known as dumping.
Cost-Volume-Profit Analysis 123
Dumping
If a foreign company is the predator, there is no inherent difference in the tactics
or the goal of predatory pricing. Pricing below variable cost would still remain
a valid test. However, U.S. law imposes a stricter test on foreign than on
domestic companies. The legal test for dumping does not involve variable cost.
Rather, it focuses on whether the foreign company is selling its product here at
a price less than the price in its home market.
Dumping is simply predatory pricing by a foreign company. So the logic
that supported using variable cost as a test for predatory pricing would also
support using the same test for dumping. But the test actually used is the
domestic selling price (usually higher than variable cost). This test makes it
easier to prove dumping than to prove predatory pricing. It favors the domestic
firms and is harder on the foreign company. This may be a matter of politics as
well as one of economics.
Perhaps the best-known cases of dumping have involved the textile and
steel industries. Another recent case of dumping concerned Japanese auto
companies accused by U.S. competitors of dumping minivans in this country.
Also, the Japanese makers of f lat screens for laptop computers (active matrix
liquid crystal displays) were alleged to have sold their products in the United
States at prices below those in the home market.
It is not always easy to ascertain the home market selling price. Even if
there are list prices or catalog prices in the home market, there may be discounts
or rebates that are difficult to detect. Therefore, instead of using the
home market selling price as the test, the production cost may be used instead.
This is reasonable, because the production cost is likely to be below the home
market selling price. Therefore a dumping price below production cost is virtually
certain to be also below the home market selling price. But production
cost includes both fixed and variable costs and is therefore above variable cost.
Also, it may be arguable as to what should be included in production cost. For
example, some may include interest expense on money borrowed to purchase
manufacturing material inventories. Others may believe that interest is not
part of production cost.
If it is determined that dumping has indeed taken place, then the U.S. International
Trade Commission (ITC) will impose an import duty on the foreign
product involved. This duty will be sufficiently high to boost the U.S. selling
price to the same level as the home market price.
Dumping has a large potential impact on businesses and industries in our
economy. By extension, production cost is also a subject that successful businesspeople
will find profitable to understand.
FOR FURTHER READING
Garrison, Ray, and Eric Noreen, Managerial Accounting, 8th ed. (New York: McGraw-
Hill, 1999).
Hilton, Ronald, Managerial Accounting, 4th ed. (New York: McGraw-Hill, 1998).
124 Understanding the Numbers
Horngren, Charles, Cost Accounting: A Managerial Emphasis, 9th ed. (Upper Saddle
River, NJ: Prentice-Hall, 1998).
Zimmerman, Jerold, Accounting for Decision Making and Control, 3rd ed. (New York:
McGraw-Hill, 1999).
NOTES
1. Mixed simply means that it has both a variable- and a fixed-cost component.
Mixed costs are very common—note your monthly phone bill or many car rental
contracts.
2. Economists argue that variable costs should not be represented by linear
functions, since economies and diseconomies of scale do exist. For instance, price
discounts are often given if one buys inputs such as paper for book printing in large
quantities. They are better represented by quadratic functions. Most agree, however,
that if we are analyzing a narrow enough range the assumption of linearity does not
lead to material error.
3. This can be expressed in an algebraic equation as follows. Since the indifference
point is where the two alternatives are equal:
Solving for x yields:
4. Defining the parameters of a "short-run" decision is often difficult. For this
special offer, if accepted, will PBS assume that this will be the price in the future?
Will other customers learn of this offer and expect the same terms? Short-run decisions
often have hidden long-run effects—they should always be scrutinized.
5. In this format, x represents required dollar sales volume, not required unit
sales volume.
6. ABC analysis, which is covered in the following chapter, is one such
technique.
7. When estimating cost structure from historical data the analyst must first
ascertain that the structure has not changed during the period being analyzed. If
Books " " Us made major additions to its infrastructure, it would make little sense to
aggregate the costs pre- and postaddition and consider them to be representative of a
single cost structure.
8. For this simple example we will assume that there are none of the seasonalities
in the fixed cost one would expect, say, for heating costs during the winter in New
England. Likewise, we will assume that the variable cost per dollar of revenue is the
same for all types of books.
R
$ $ ,
$ ,
$
,
11 100 000
100 000
11
9 091
x
x
=
=
= units
$12x = $23x − $100,000
Cost-Volume-Profit Analysis 125
9. To compute the slope, find a point that the line intersects and then measure
the "rise-over-run" using the y-axis intercept and that point. For this calculation my
line intersected the June data at point ($13,500, $15,500) so my rise was $11,500
($4,000 to $15,500 in Total Cost) and my run was $13,500 ($0 to $13,500 in Revenue).
The slope, therefore, was $11,500/$13,500 or 85.2%.
10. To avoid this shortcoming, many analysts first plot the data and then select
high and low data points that "best fit" the data set. This technique is a melding of
the first two databased techniques discussed.
11. For instance, Excel has a function that will perform a simple least-squares
regression on a given data set. Other regression techniques that relax the linear fit assumption
are also available on many statistical software packages.
12. For instance, infrastructure may have been expanded over the period
the data set covers. The regression software will assume a constant fixed cost rather
than some type of step function unless otherwise told. This can be treated using
dummy variables, but the user needs to have a working knowledge of the statistical
technique.
13. The final two sections of this chapter were written by John Leslie Livingstone
for earlier editions of this book. They are reproduced here in their entirety.
126
4 ACTIVITY-BASED
COSTING
William C. Lawler
Dave Roger, CEO of Electronic Transaction Network (ETN/W), sat stunned
in his office. He had just come out of a preliminary third-round financing
meeting with potential investors. Six months ago his CFO had assured him that
third-round financing would not be a problem. Much had happened since that
date. The Internet stocks had crashed. Money for the technology sector was
now tight. In the two rounds before the crash, ETN/W had so many prospective
investors, the company had to turn some away. Since then their business
model had not changed; ETN/W had a solid revenue stream, and the forecast
was for continued revenue growth—unlike many of the recently failed Internet
companies, ETN/W had real customers who were happy with its services.
Yet the meeting had concluded without closure on the third round for one simple
reason. When Dave started talking about their "proven" business model the
potential investors immediately asked for specific details—"Explain your business
model in terms of how you will create wealth for us, your investors."
As he fumbled to explain how ETN/W would create shareholder wealth,
they stopped him and suggested an approach with which they were all
comfortable.
If you were a manufacturer we would expect you to tell us how you will use our
investment—some goes to infrastructure such as plant and equipment and some
to working capital such as inventory and receivables. You would then tell us how
much it would cost you to build your product, how much to market it, how much
to service it, and what customers would be willing to pay for it. Our first two
rounds of investment would have given you sufficient experience to gather this
type of data. With this information, you could explain your business model—
how you would create enough wealth to pay back our principal plus our required
Activity-Based Costing 127
return. Now, since you are a service provider rather than a manufacturer, explain
your business model in like terms. What infrastructure is necessary for
your business? What does it cost you to provide your service? How much does it
cost to market these services? What are customers willing to pay for it?
As he sat there now, Dave wondered if the analogy the investors had used
was appropriate. In a manufacturing environment these questions were more
easily answered than in a service company like ETN/W. Yet after two rounds of
investment and eighteen months in business he had fumbled the most important
question in the meeting. In his hand he had the business card of a consultant
suggested by his investors. They said this person had worked with a
number of their clients and could help him develop the appropriate analysis. As
much as he disliked being pushed by anyone to make decisions, he knew that 25
employees were counting on him. He lifted the phone to call Denise Pizzi.
PREPARING FOR DENISE
Denise was very professional on the phone. She was awaiting his call and suggested
that he prepare some documentation for their first meeting: a brief history
of the company, their customer value proposition (she called it CVP), a
blueprint of the value system for their industry, and their strategy—what was
it that ETN/W could offer clients that was distinct and value producing? Much
of this had already been prepared.
ETN/W History
Three MBA classmates with extensive experience in electronic commerce had
founded ETN/W in Dallas, Texas, 18 months ago. Two came from a Houston
computer giant—Carol Kelly from the hardware side and Eric Rock, a senior
software applications manager. The third, Dave Roger, came from a well-known
Dallas IT consultancy, a company focused on the Internet and e-commerce. The
idea had come from Dave. Many of his clients were in e-commerce, and all had
the same problem—transaction processing. Although most people think online
commerce is a relatively simple process—point and click—it is actually
quite complicated (see Exhibit 4.1). Assume customer A buys an item
at Books " " Us. When the order comes in, the company must first ascertain
A's creditworthiness. This means a credit check with a payment processor. If
credit is okay, then Books " " Us has to contact the book wholesaler it partners
with to see if the book is in stock (this is called fulfillment). If the answer is in
the affirmative, Books " " Us gives the wholesaler the appropriate shipping
information, gets the tracking information from the shipper, and contacts the
payment processor once more to charge customer A. Books " " Us then relays
this information to A. This all has to be done in real time. Customer A does not
want to wait and will quickly move to a competitor if not satisfied. In addition,
R
R
R
R
128 Understanding the Numbers
Books " " Us will update Customer A's buying profile (or open a new one) in
order to better serve that person in the future. Books " " Us's focus is on retail
sales and Web-site design; this is the key to its success. The transaction processing
is a necessary evil. In order to do this, Web merchants typically, purchase
three to four software systems—one each for credit and payment processing, inventory
management and fulfillment, tracking, and customer-information storage
and mining. All these systems must talk to one another, which means that
interfaces must be maintained. This interfacing is a nightmare because updates
for each of these software systems are constantly being brought to market, requiring
all interfaces to be rewritten. IT personnel in this area are highly valued,
and retention is a major issue, especially for the smaller Web merchants.
This nightmare blossomed into a business opportunity during a golf
match. Carol was complaining about a new assignment—setting up a server
farm.1 She was given the task of transforming her company from a provider of
"boxes" (servers) to a provider of the services embedded in the box. This
meant that her company had to get closer to customers, understand their computing
needs, and meet those needs with a bundle of services delivered by the
"server farm" she would be running. Basically this was a hardware outsourcing
service similar to an offering of one of Dave's sister divisions. Although he
understood the move, and although servers were becoming commodified and
margins were falling, he doubted that Carol could change the culture of her
company. Maintaining customer relationships was expensive, much like the required
maintenance on any hardware system; but unlike hardware maintenance
they also required a unique set of people skills.
On the next hole it was Dave's turn to complain about his customers and
how he had to hold their hands every time one of their transaction processing
systems needed updating—every day the same thing only a different customer
and a different software system. Eric laughed at this since he had much the
same problems within his software applications group. Yet all three realized
R
R
EXHIBIT 4.1 E-Commerce transaction detail.
Customer A #1
#2
#3
#4
#5
#6
Web-merchant
Fulfiller
Shipper
Credit company
Credit company
Summary from ETN/W
to Web-merchant
Update customer profile Batch
process
ETN/W
Real-time
Activity-Based Costing 129
that this was how software companies made their money. Once they captured a
customer with an installed software system, that client was treated as an annuity.
Every update required an additional payment to move each installed customer
to the new system. They all agreed that this would never change.
The golf round continued, as did the complaining about both work and
golf. It was not until later, over libations in the 19th Hole, that they realized
this could be a real opportunity. Dave was convinced that his customers would
be more than willing to outsource their transaction-processing headaches. If a
company could provide an integrated service that would perform all the tasks,
it would be a winner. A customer value proposition (CVP) that said, "All your
e-commerce transactions will be processed with the latest technology, and you
will never have to worry about a customer waiting, updating your interfaces, or
hiring and training another IT person," would be music to their ears. Eric insisted
that most application service providers (ASPs), much like Carol's hardware
company, were focused on selling their software packages, not on service.
They were not capable of providing such a service. Carol agreed with both
Eric and Dave—although she would try her hardest, her new assignment was
like pushing a boulder uphill. All systems inside her company were focused on
selling product; engineers designed the latest bells and whistles into their hardware
and avoided customer contact whenever possible. All commission systems
were based on dollar revenues; the top salespeople only sold what made them
money, high priced items. They were not interested in selling low-commission
service contracts.
Within a month the threesome was working almost full-time on developing
the business model. Carol was focused on designing the necessary hardware
infrastructure—N/T and UNIX servers, hubs and routers, firewalls, disk
arrays, frame relays, and the like—and identifying the staffing requirements.
Eric was researching the software offering for payment, fulfillment, tracking,
and storage and attempting to identify which systems would likely become industry
standards. Dave was running focus groups with a number of potential
customers, trying to refine the CVP—exactly what should they offer these Web
merchants?—and measure their willingness to pay.
The business plan came together rather quickly. As expected, Dave
found that customers would highly value the ability to focus all their attention
on their primary activity, Web-based marketing and selling, rather than
transaction processes and the hiring and training of people involved in these
processes. In addition, the avoidance of investment in this type of infrastructure
was important since capital was becoming scarce for many Web-based
merchants and obsolescence was always a problem. An additional value that
potential customers asked about involved the nature of the charge: Was it to
be a variable per-transaction charge or a fixed fee? For this type of business,
scalability was always a problem. No one knew what size system to build, but
to have a system crash due to excess demand was fatal. As a result, idle infrastructure
charges were always a problem. Many customers were ready to sign
on immediately if the charge was on a per-transaction basis.
130 Understanding the Numbers
Carol found that the infrastructure build-out would not be cheap. She estimated
that it would cost approximately $8 million in the startup mode and
require about a dozen people. She estimated that this would give them the capacity
to process about 120,000 transactions per day, which would be about 10
average-sized customers in a peak demand period such as Christmas or Valentines
Day.
Eric found that the software system would be cheaper. He also found
some additional interesting information. Many ASPs such as Yantra, Oracle,
and Cybersource offered to work with them in an alliance if they could advertise
their applications, say, like the "Intel inside" model in the PC industry. He
estimated that to build a totally integrated software platform would cost
around $600,000 to $800,000.
In this manner ETN/W (Electronic Transaction Network) was started.
Angel investors and alliance partners contributed $20 million, and the doors
were open for business 18 months ago. Within a year they had nine customers
and added another three in the following six months. Various pricing schemes
were tried, but ETN/W seemed to be gravitating toward a market-based,
purely per-transaction charge between $0.10 and $0.15. Although transaction
volume had not met the projected 120,000-per-day level, they were currently
in the process of identifying potential new customers.
ETN/W CVP
The group provided Denise the following from one of their marketing
brochures:
Web merchants should spend the majority of their time on their primary mission,
creating value through innovative marketing and sales to customers and
clients.2 You should avoid spending both scarce managerial talent and investor
capital on any activity that could best be performed by third-party partners
such as ETN/W. Do investors see the value in your using their investment dollars
and your creative energy to build transaction-processing systems that are
suboptimal in scale and soon obsolete? In you spending your scarce time to hire
and train high-cost personnel to manage and run these inefficient systems? The
answer is clearly no.
Join our network and get all these services seamlessly provided with stateof-
the-art applications run by highly trained IT professionals. We will convert a
difficult-to-manage fixed infrastructure cost into a totally scaleable variable
cost that you pay only on a per-transaction basis. With us as your partner, you
can spend your creative energies on tasks of value to your investors.
ETN/W Value System & Strategy
This part of preparing for their meeting with Denise was an interesting task for
the threesome, one that they had not previously performed. After referring to
some of their old MBA notes, they prepared the following:
Activity-Based Costing 131
Value System. ETN/ W is an intermediary providing services to the Web merchant
and its fulfillment, payment, and shipping partners. Although ETN/W
charges the merchant for the service, who ultimately pays for the service could
be left to negotiation amongst the parties (see Exhibit 4.2).
This exercise did open some interesting discussion regarding our narrowly
defined CVP. We recalled Metcalf 's Law: The value of a network is equal to the
square of the number of nodes. Clearly, as our network expands, fulfillers such
as Ingram, a $2 billion wholesaler of books, PCs, and home electronics, would
see value in joining because it could provide fulfillment services to a number of
the network's Web merchants. Likewise, UPS and FedEx would want to join
ETN/ W to offer their services if there was enough commerce going over the
network. We did not have time to fully develop this thought, but discussion of
an expanded scope for our CVP and potential pricing schemes is on the agenda
for an upcoming meeting. This process might really be worth your fee.
Strategy. ETN/W will be the global cost leader in transaction processing for ecommerce
providers. Exactly what is it that ETN/W offers that others cannot
copy? A sustainable strategy is based on doing things differently or doing different
things, not simply doing the same thing as other competitors only better.
As noted above, it would be difficult for any of the hardware companies and
ASPs to copy our model, since their culture and internal systems are so geared
to selling hardware or software rather than servicing customers. Hewlett
Packard coined the term solution provider almost thirty years ago but still
struggles in making the requisite transition. We all feel that ETN/W can successfully
compete with hardware providers and ASPs. The problem is the low
barriers to entry: If all it takes is building an infrastructure with hardware and
software technology that are readily available, what is to stop others from imitating
our model? The only advantage we see is to be the first mover; once
someone joins our network, why join another? We understand the urgency of
building the network as quickly as possible to be recognized as the industry
standard for transaction processing.
EXHIBIT 4.2 ETN/W value system.
Customer ETN/W
Visa, AmExp,
MasterCard
Fulfiller
FedEx,
UPS
Transaction flow
Physical flow
Webmerchant
132 Understanding the Numbers
THE FIRST MEETING
Denise was very happy with the work they had done. She had reviewed the materials
and asked a few questions. Within an hour all felt comfortable that she
understood ETN/W in sufficient detail to aid them in preparing an answer for
the investment group. They then turned to this phase of the meeting.
Denise began.
The value system analysis you did is a map at an aggregate level of the many
firm-level value chains that together form this industry. It identifies all the
processes that create value for an end customer or set of end customers and
maps all the players and who adds what to the system. Our focus is on ETN/W,
but we cannot lose sight of how it interacts with other members of the system.
The next step is to add another layer of detail—what are the process steps that
ETN/ W performs, and do their values exceed the costs to perform them?
Dave, Carol, and Eric did not understand what she meant and asked for
clarification.
"Simply stated," Denise replied, "what is it that you do? Map the valueproducing
processes you add to the system."
Carol was quick to answer: "We already told you—we process e-commerce
transactions."
"Okay. So that is all you do? If I were to talk to any number of your people
spread throughout this building, they would say, 'I process transactions'?"
Dave jumped in this time: "Well, not really. While most of us are involved
in this in some form, we also have marketing and sales people."
"What do they do?"
This dialog went on for another hour, with Denise at a blackboard capturing
their discussion. After many edits the group arrived at the following. The
process map for ETN/W had three sequential steps:
1. Customer Capture.
2. Customer Loading onto the network.
3. Transaction Processing.
Denise then stated:
The next phase of this analysis is critical. Although most accounting systems
capture costs by function—for example, manufacturing costs such as direct material,
labor, and overhead and operating costs such as sales, marketing, R&D,
and administrative—we can understand and forecast them only if we identify
their causes. This analysis is called activity-based costing, or ABC. Not everyone
believes the cost of ABC is worth the benefit, but higher cost is, I believe,
more often due to how it is implemented rather than to the approach itself. Too
many firms have limited it to manufacturing situations, yet it is appropriate also
for service companies such as yours. ABC is also often too narrowly applied—
some now argue that ABC begins too late and ends too soon in many companies.
We have to analyze costs across the value system since causal factors for one
Activity-Based Costing 133
company's costs often are found within another company in the value system.
Although this may sound confusing, I will of course show you examples as we
analyze your costs.
Let's start with what I think will be the easiest process—customer capture.
Exactly what activities do you perform that result in a capture, which we
defined as a signed contract?
Again, the discussion went on for at least an hour. Denise nearly drove the
group crazy asking the most basic questions, "Why?" and "How?" By the end,
all three agreed that the first activity was customer identification. This was
accomplished either through cards filled out at trade shows or responses from
their advertising campaign. The next activity was customer qualification,
which entailed basic research on these companies to identify those with
enough size and creditworthiness to pursue. And the final one was customer
sale, where an inside salesperson first made contact with each customer to see
if there still was interest. Few were ready to sign contracts at this point, and
often multiple site visits were necessary before contracts were signed to assure
the customer that ETN/W understood their business.
Denise then gave them a template to be filled in for the next meeting (see
Exhibit 4.3).
What you have to do is reformat the way your costs are compiled. For external
reporting your financial statements are sufficient, but for decision making and
communicating your business model they are worthless. As I have drawn in the
template, we need to build the total costs for each activity we identified above.
To do this, some of my past clients estimated as best they could from historical
data, and others, if they perform the activity frequently enough, develop the
EXHIBIT 4.3 Activity-based costing process.
General Ledger Cost Format ABC Cost Format
Customer identification
Customer qualification
Customer sale
Activity n
Corporate costs
Labor costs
Marketing costs
Outside consultants
Sales costs
Travel costs
•
•
•
•
•
•
•
•
•
•
•
•
•
$XXX
$XXX
$XXX
$XXX
$XXX
$XXX
$XXX
•
•
$XXX
$XXX
$XXX
$XXX
134 Understanding the Numbers
activity costs by studying their processes real time. I suggest you recreate from
past data as best you can what you spent to capture the clients you already have
on your system, since you're currently selling to only a few—a sample size too
small to study real time. A detailed discussion with all those involved with the
process typically is sufficient to develop a crude analysis. I can meet next
week—Okay?
THE SECOND MEETING
Dave, Carol, and Eric did a lot of work that week. After many false starts they
agreed to use the financial statement data from the past 12 months for the
analysis. Discussions with a number of their employees resulted in some interesting
analyses. Although unsure of a few of their assumptions, they walked in
with deeper insight into customer identification, qualification, and sale.
The activities we initially agreed upon needed some refinement. The first, customer
identification, was correct. There are actually three subactivities, trade
show attendance, trade show preparation, and advertising, which lead to an
identified customer. These activities are not mutually exclusive; often people
respond to the advertising after seeing us at a trade show, or, vise versa, they
come to our booth because they remember one of our advertising pieces. Using
your template, we arrived at some interesting results. First, you were correct,
customer identification does draw on many resources within the company. People
from across ENT/ W attend the trade shows: our sales and marketing people
as you would expect; our corporate officers, who typically talk with the top
management of potential customers; and our operations people, who demonstrate
the system and answer the technical questions. In addition, for each show
there is quite a bit of preparation: Collateral materials such as brochures have
to be produced, booths have to be designed and built, and site contracts negotiated.
Aside from the trade shows, we also spend a large amount on advertising
in trade journals. In the last 12 months, we spent approximately $875,000 on
these three subactivities, which resulted in 1,200 customer leads (potential customers).
We arrived at this number by talking with just about everybody in the
organization, checking travel itineraries, expense reports, ad agency vouchers,
and the like. It's not an exact number, so we decided to round all our numbers
to the nearest $5,000; but we think it's close. This comes out to about $730 per
lead ($875,000/1,200, rounded). We think this is a reasonable number given
some industry benchmarks. Is that OKAY?
Denise was excited; these could be good clients. "Yes, ABC analysis does
sacrifice some accuracy for relevance. So, when you divided by the 1,200, you
implicitly assumed that each of these leads were the same. Is this true?"
Dave answered since he had done most of this analysis. "Yes, each lead is
about the same. When people show interest, either at a show or from answering
an ad, we do about the same thing: talk with them, take down their information,
and pass it on to the next step."
Denise thought it was now time to do a little process review. "Good, you
have just concluded your first activity-based cost analysis. Let me review the
Activity-Based Costing 135
steps. First, we drilled down from a high-level value system view to a process
map and then ultimately into an activity and subactivity analysis. I have only
one question: After identifying subactivities, why did you pool the costs together;
why not analyze them separately?"
"We initially did it separately but then found that there was no additional
value to this added work. Ultimately, we were concerned with what it cost us to
generate a lead, and, since we found that the subactivities were not mutually
exclusive, we think the $730 number is sufficient," Dave replied.
Let that be you first lesson. ABC involves pooling costs from various functions
within the company into homogeneous activity pools, as you have just done. The
$875,000 ref lects your best estimate of the total customer identification cost
pool for the last 12 months. ABC analysis is often done at too fine a level of detail.
You could have tried to identify the cost of identifying each customer by
having your people keep a log and entering the exact time they spent with each
customer—in essence, 1,200 cost pools. Would this additional level of accuracy
be worth the effort? Certainly not. The first key to ABC is to find the correct
level of disaggregation of cost information: too little and the system does not
provide relevant information; too much and the system becomes too complex
and hard to communicate. I once saw a system installed by a consulting group
with over 6,000 cost pools. No one understood it but the consultants that designed
it, and when they left no one was able to explain the information from it
or update it. It died in less than six months. Okay, what was your next step?
Carol had done the customer qualification analysis. "This was an easy
one. We outsource this function to a credit agency that gives us a report on
each lead—credit history, sales history, and any other relevant information. We
paid them about $210,000 for the 1,200 reports—about $175 per report, which
is about the contract rate."
Denise thought, "Can I do one more lesson without overreaching? Why
not try?"
Note the difference between these two cost pools. This pool is very much a
variable cost—the more customer reports, the greater the total cost pool. And
the manner in which we apply the total costs to the object we wish to cost—a
customer cost report—is obvious—the number of cost reports, since each is the
same. ABC is a two-step process. First we identify the appropriate level of disaggregation—
that is, the cost pools—and then we identify the appropriate "driver"
for each pool. A driver is the method we use to take the total cost pool and
trace it to the object we wish to cost. It's the causal factor for the cost pool. For
customer qualification, the total pool of $210,000 was spread over its causal factor,
the 1,200 cost reports, to arrive at the $175 per cost report. This is what it
costs to qualify a customer, the cost object. ABC is nothing more than pools and
drivers. Are you totally comfortable with our first two analyses?"
Dave answered: "We did argue about this. Now I think we are beginning
to understand. The first activity we discussed, customer identification, is more
a fixed cost pool—it doesn't vary with the number of customer leads. Once we
agree on how many trade shows we will present at and what our budget is with
the ad agency, this cost is relatively fixed. Maybe one person more or less might
136 Understanding the Numbers
travel to the show, but the cost is budgeted. As a result, the cost per lead decreases
as we become more successful in generating leads. We have already
talked about ways of being more effective in this regard."
"Exactly," said Denise. "We will no doubt go more deeply into proper
identification of drivers for fixed and variable cost pools. What you should understand,
though, is that ABC is just a first stage in a long journey. Most people,
as you did, move quickly into ABM—activity-based management. Once you
make your cost system transparent, you then naturally seek to optimize it as
you are doing with customer identification. So, our end objective of this 'long
journey' is simply that, transparency of the cost system. And the final piece?"
Eric had this one.
This was my responsibility and it was a lot more difficult than Carol's piece.
The final activity, customer sale, also has subactivities. We review the consultant
reports and identify those we want to pursue. Of the 1,200, we identified
eighty as "high potential" and tried to sell to them. Although all the effort did
not fall neatly into the 12-month window, essentially we went through the full
process to a signed contract for the equivalent of 10 customers. The process included
phone conversations and site visits. In total, we spent $410,000 to bring
to contract these 10—many of the others went through part of the process before
either they or we lost interest. As with the other two activities, the costs
that loaded into this pool came from across the company. Often we had to f ly
out technicians to explain how the system works as well as salespeople. For
larger clients, they expected a visit from a corporate officer for the formal signing.
So in the end it cost us about $41,000 each to sign them to contracts."
Denise asked only one question: "Would you say this is a variable- or a
fixed-cost pool?"
After a lengthy discussion, the consensus was that it clearly was both a variable
and a fixed cost since more high-potential leads meant more resources dedicated
to pursuing them. But it was not a pure variable cost since once you hire
someone to do this work, they can handle a certain number of leads rather than
just one. At the end, they agreed on the following: Unlike setting a budget for a
year, this cost was a step function. Within certain steps, defined as the number
of high potentials a sales person could pursue—say, eight at a time—the cost was
fixed. In essence, the cost was step fixed in units of eight. They also agreed that
this thinking should also be applied to the customer-identification cost analysis,
but left that for later.
Denise then asked, "Is the $41,000 roughly the same for each potential
customer sale?"
Eric was quick to respond, "Absolutely not. Some require a lot more work
than others."
They were at the end of the agreed meeting time but Denise thought one
more lesson would not hurt.
When this happens, it is an indication that you have improperly identified the
driver for the pool. You must drill down to a more detailed driver definition. As
Activity-Based Costing 137
we discussed last meeting, on one hand, you could keep an individual log on each
customer to identify the cost to sell them, but this would be time-consuming and
few people take the time to accurately enter this information. On the other
hand, you could aggregate the cost and average it over the 10 customers sold. But
it seems that this is also not appropriate. A reasonable midpoint is to identify a
separate driver defined as your best-case and worst-case customer and see if this
gives you the required amount of detail. Why don't you do that for next time and
also develop a summary of the total cost to capture a customer.
THE THIRD MEETING
Denise watched as the group approached the room. They were arguing something
in a manner that indicated they were enjoying themselves. This was a
good sign.
Dave began:
It's amazing to us as an organization how much we didn't know we knew about
our business. When we relayed your first assignment for this meeting to those
that work with potential customers, they immediately began identifying characteristics
that made some more expensive to sell than others. Large ones expect
to meet our management team before signing a contract, whereas smaller ones
do not. Flying one of us to these customers is expensive given our larger salaries
and what it takes to backfill in our absence. Also, customers who do not really
understand e-commerce and the complexity of transaction processing require
on average twice as many trips as those who do. They want us to demonstrate
what is wrong with their systems and to see how ours works better. Since we are
not familiar with their systems, this takes a while. For the selling process, the
best-case customer is a midsized company familiar with e-commerce and the
headaches caused by transaction processing. We can sell them on the first trip.
Unfortunately, of the 10 we signed to a contract in our sample, only 3 were of
this type. The other 7 were worst-case customers—larger with less knowledge
of the intricacies of e-commerce. In summary, when we trace the $410,000
using these driver definitions we estimate that the best-case customers cost
about $18,300 each and the worst-case about $50,700 ($18,300 × 3 + $50,700 ×
7 ≈ $410,000). What amazed us is that, once we asked these questions, our people
had a number of good suggestions on how to reengineer this process. They
knew these worst-case people were a problem, but never saw how much more
they cost. Transparency does help.
The answer to your second assignment, to calculate the total cost to capture
a customer, is also amazing. This customer capture process is like a funnel.
Last time we said that the activity cost per lead of $730 was reasonable, as was
the $175 for each research report. But when you recognize that the process
ended with only 10 signed contracts, you get a different picture. The overall
process cost us a total of $1.495 million ($875 for identification, $210 for qualification,
and $410 for selling) or about $150,000 per signed contract ($1.495/10,
rounded)—quite a bit less for best case and a bit more for worst case. Some of
these costs are variable, some fixed, and some step fixed, but all of them can be
138 Understanding the Numbers
better managed. Although our accountant classified these costs as expenses,
they are really an investment, and, at this amount, we would have to do a lot of
transactions just to recoup our investment in each customer. The key for us is to
identify better-qualified customers in the first stage and then to convert a
greater number of these to signed contracts.
Denise had only one question: "Why did you charge the costs of the 70
customers you failed to convert to the 10 that you sold?"
Dave answered, "Actually, initially we broke out the cost of the 70, but we
felt that, as with any business process, you spoil some units in order to get good
ones (see Exhibit 4.4). It really cost us only about $8,000 to sell each best-case
customer and almost three times that for the worst-case one. But when you allocated
the cost of the 70 customers dropped during the process, these costs
increase dramatically. Don't you agree?"
The depth of the analysis impressed Denise. She thought she might even
invest in this company. It was time for another summary.
There is no right answer, since we could argue over the correct way to allocate
the dropped-customer costs. But that is not what is important here. You have to
be careful with any reallocation procedure since this is a strategic analysis. You
have already noted that your only advantage was being first to enter. By your actions,
I am not sure you know what that means. Since all of your technology
comes from third-party suppliers, the only way you will win in this industry is
to become the low-cost provider. Your first-mover advantage means simply that
you are first down the experience curve. Research has shown that as one repeats
an activity, one can become more efficient and thus lower the cost of the
activity. This, however, does not happen automatically; one must manage the
learning process. Until we began the ABC analysis it seems that you had not
leveraged your first-mover advantage. Do you agree? Remember saying, "As an
organization, we were amazed at how much we didn't know we knew"?
None of the three were willing to argue with her.
The key number in your exhibit is the $8,000 cost to sell a best-case customer. If
you were able to identify only those that understood your CVP and wanted to
EXHIBIT 4.4 Customer-sale activity analysis.
Best-Case Worst-Case Dropped Total
Number of customers 3 7 70 80
Estimated cost pool $24,000 $154,000 $ 232,000 $410,000
Cost /customer $ 8,000 $ 22,000 N/A N/A
Reallocation* $31,000 $201,000 $(232,000)
Adjusted cost pool $55,000 $355,000 — $410,000
Full cost /customer $18,300 $ 50,700
* Dropped Cost total was allocated based on relative total cost /customer ratios:
3
8 000
7
22 000
24 000
154 000
31 000
201 000
× × = ≅ $ ,
$ ,
$ ,
$ ,
$ ,
$ ,
Activity-Based Costing 139
buy, this would be the cost, not the average of $41,000 or the higher one for
worst-case. Are you getting better? Is your cost of this activity decreasing? The
research from the Chasm Group seems relevant here.3 They found that newtechnology
buyers over the product life cycle fall into four segments. Each responds
to a different CVP and requires a different selling approach. The first
product life-cycle segment, called early adopters, is the smallest but the most
important. They seek new technology, are risk takers, and are probably much
like your three best-case customers. This customer group is important because
you can use their results as validation of your new offering. The later life-cycle
segments are larger, less technologically savvy, and more risk averse. They are
skeptics and need to see validation before they buy. If you studied your seven
worst-case data points they probably fall into this segment. If you learn to use
the experiences of your first customers to sell to these more risk-averse segments,
your cost should approach the $8,000, and you would have a true firstmover
advantage.
Denise didn't like to further dampen their spirits but knew she had to.
"We haven't finished yet. Don't forget you also have to load the customers on
the network. What does this process cost?"
After a collective groan, the group got to work. The customer loading
process involves the activities necessary to enter a Web merchant and its fulfiller(
s) onto the ETN/W network. Although the activities are much different
than for customer capture, the analysis is similar. The activities in this process
are customer business operations review, system design, and implementation
and certification. Over the past 12 months seven customers had been loaded.
The analysis was a bit easier since there was no funnel effect; seven went
through each activity.4
Business operations review was outsourced to a number of subcontractors
that ETN/W used. Their report detailed the customer's IT systems and how
transactions were treated. While most handled them real time, some batched
the orders and dealt with these at the end of the business day, sending confirmation
to customers on the next business day. For the seven customers loaded,
ETN/W paid $25,000, or about $3,600 each. System design—writing the necessary
software interfaces and configuring hardware linkages for the payment
processing, fulfillment, and shipping systems—was done by ETN/W technical
staff, as was implementation and certification. System design cost $35,000, and
implementation and design, $160,000. Both the business operations review and
system design activities were relatively homogeneous—they did not vary from
customer to customer. The final activity, however, implementation and certification,
was much like the customer sale activity. Depending upon the customer,
the cost could vary greatly. From discussions with those involved with these activities,
the threesome recognized this variability and did the necessary analysis.
A best-case customer was one that understood the process, had compiled
the necessary documentation, had their IT group prepared, and had only one or
two fulfillers. As before, the worst-case was unprepared, unresponsive, and had
numerous fulfillment agreements. Of the seven studied, three fell in the former
140 Understanding the Numbers
group and four in the latter with the following result: best-case cost to load onto
network approximately $13,000, and worst-case a bit, under $30,000 ($13,000 ×
3 + $30,000 × 4 ≈ $160,000). Dave reported that this result necessitated
adding a penalty clause to their standard contract to emphasize the importance
of the customer prework for the implementation team.
Denise thought there was time for a quick summary. She went to the
board and drew the following chart (see Exhibit 4.5). "As I see it there is a lot
of room for improvement. Granted, you will never reach the ideal cost of
$30,500, which is the total of the activity costs to capture and load a customer.
But the transparency you now have given these activities means that, as an organization,
you should make steady progress down the experience curve. Next
time, let's tackle transaction processing."
TRANSACTION PROCESSING—MEETING 1
Since Carol was the hardware guru, she had taken the lead in this analysis.
Our transaction-processing system has three front-end N/T systems that do the
order entry, transaction-processing, and fulfillment inventory management.
They sit on a UNIX backbone system that also runs the database. It made little
sense to go back and compile the costs for these systems over the past 12
months, since we were expanding them continually. What we did was take the
costs of the system for the last month and annualize it. The costs fall into two
groupings—people and system depreciation.
I have one systems manager and three shifts of two people—don't forget,
we do provide service on a 365-by-24-by-7 basis. One person monitors the system
and troubleshoots any transaction-related problems, and the other handles
all hardware-related problems. Fully loaded, these seven people cost us approximately
$750,000 per year.
Ideally, we would have cost the N/ T systems independently of the UNIX
backbone. We didn't have that fine a separation of costs in this area, however,
and we ultimately grouped all of them together. Since the UNIX system
EXHIBIT 4.5 Customer-capture and customer-loading
cost summary.
Activity Average Cost Ideal Cost
Customer identification $ 87,500 [$875,000/10] $00,730
Customer qualification 21,000 [$210,000/10] 175
Customer sale 41,000 [$410,000/10] 8,000
Business process review 3,600 [$ 25,000/7] 3,600
System design 5,000 [$ 35,000/7] 5,000
Implementation & certification 23,000 [$160,000/7] 13,000
Total (rounded) $181,000 $30,500
Activity-Based Costing 141
represents the large majority of the cost, this probably doesn't cause us any
material error. In total we estimate that at the current level our systems cost us
about $1.35 million a year in depreciation of hardware and amortization of
software. We are writing off the technology over a three-year life, which is
reasonable. So we estimate that it will cost us in total about $2.1 million a year
($1.35 million in systems and 0.75 million in personnel) at our current level of
operations. This pool is a fixed pool since both the people and systems costs
are independent of volume—our people now are nowhere near capacity but
you can't hire a half-person.
The driver for this cost pool is clearly the number of transactions
processed, but arriving at the proper measure was difficult. For the order-entry
and payment-processing systems a transaction is measured at the order level.
But for the fulfillment and database systems, transactions are dependent on the
line items in the order. Once that was understood we found that we were currently
handling about 20,000 transactions per day on average, which annualizes
to about 7.3 million per year (20,000 × 365). Dividing this total into the cost to
run the system—people and systems—we estimate that it costs us just under
$0.30 for each transaction that is processed by our system ([$750 + 1,350]/7,300
≈ $0.29). This cost is far above our target price of between $0.10 and $0.15 per
transaction.
"How do you plan to become more competitive?" Denise asked.
"We were hoping you could help us," was the answer.
Denise had a number of questions. "Okay, first, a lesson. Driver identification
is different for variable- and fixed-cost pools. For variable pools, drivers
are usage based—for ETN/W, the customer-qualification cost pool driver was
the number of reports outsourced; for materials cost pools in car manufacturing,
it is cars produced; and for fuel cost pools in freight hauling, it is miles driven.
But for fixed-cost pools, the causal factor is capacity, not usage—the $2.1
million gives you the capacity to handle a given number of transactions; the
number that you do deal with is not meaningful other than as an indication of
the capacity utilized. And when we talk about capacity, we have to be aware of
the distinction between used and useful. You said that you are processing about
20,000 transactions per day. Is every day the same?
"Absolutely not," Dave shot back. "Christmas and special holidays such as
Mother's Day are our busy time."
Denise then asked Carol, "How does this impact your area?"
Carol thought she understood. "When I planned the system, I had to use
our peak demand forecasts as the long-run target for the capacity. Unfortunately,
just as you can't build an apartment complex apartment by apartment to
meet demand, you cannot build a system such as ours in small increments.
Right now our system is larger than what is needed, and it is built to meet a
projected peak demand, not today's average demand."
Denise asked, "Do you have that data?"
"No, but I can get it within the week. Why don't you let us build this into
our model, and we will have a "version 2.0" transaction processing cost for you
next week?"
142 Understanding the Numbers
Denise said she could meet then and added one more piece of advice.
"When you do your cost estimates, do them from the customer's viewpoint.
Assume that your system is fully transparent to your customer and that they
must see the value of anything you charge to them."
TRANSACTION PROCESSING—MEETING 2
The group started by explaining their transaction-processing chart (see Exhibit
4.6).
"Right now," said Carol, "the data discussed last time, 20,000 transactions
per day on average, is correct, but our current peak demand is closer to 80,000.
Our system today can process close to 120,000 transactions per day, so we do
have excess capacity because of the cost of acquiring technology in certain
sizes. Likewise, the 80,000 peak demand represents about 50% of the capacity
of our personnel because of the decision we made in hiring and training the six
people in anticipation of future demand. As we said last week, using part-time
people may have been cheaper in the short run, but we decided to fully staff
for the future.
"So, we have developed the following analysis (see Exhibit 4.7). For the
personnel costs, we took 50% of them and charged it to an idle-capacity account.
Clearly, the other $375,000 is, to our customers, value added.
"Likewise, we have some idle capacity in our hardware and software systems.
From a customer point of view, we feel that the amount they should see
as value added is our peak capacity of 80,000. Although they only average
20,000 transactions per day, when they have their peaks they need us to be
ready, so this is value added and not excess. Only 40,000 currently is idle
(120,000 capacity less the 80,000 peak). This means that $450,000 of the systems
costs ($1.35 million × [40,000/120,000]) is not adding value to our current
customers. So we feel that currently about $825,000 ($375,000 personnel and
$450,000 systems) is idle and not chargeable to our customers. The other
EXHIBIT 4.6 Transaction-processing volume.
Time
Average per day
20,000 transactions
Peak demand per day
80,000 transactions
System capacity per day
120,000 transactions
Activity-Based Costing 143
$1.275 million ($375,000 in personnel and $900,000 in systems) is of value to
our customers, and they should be willing to pay for this. Unfortunately, if we
charge these costs to the current annual level of transactions, 7.2 million, we
arrive at a cost per transaction of about $0.175 ($1.275 million/7.2 million
transactions). Our research shows that the maximum we can charge is $0.15.
The peak demand problem is killing us."
Denise agreed. "Your work is well thought out and your results seem
correct. Your problem is a classic one for all systems operators. Electric utilities
have studied this peak load problem for decades and have developed
demand-management solutions such as off-peak discounts. Can you do anything
like this?"
Dave answered this one. "Some of our current customers do not need
their transactions dealt with on a real-time basis. They send us their orders at
end of day in batches, and we treat them by the next business day. I'm sure that
others would do this if given some type of incentive."
Denise asserted that this could be the key to their profitability. "If you
were able to decrease the peak demands, your costs per transactions would decrease.
In the extreme, assume that there was no peak loads and the 80,000 was
utilized every day. Your analysis shows that when your $1.275 million system
costs are spread over useful capacity of 29.2 transactions per year, this results
in an ideal systems cost under $0.05 per transaction."
Eric then summarized: "This would mean that if we could sell it for
$0.15, we could be very profitable. And given the growth rate forecasts for
e-commerce, we could get rich."
Denise then tied it all together. "Let's see. Assume that with some management
focus, you could get your costs to acquire and load a customer onto
your network down to about, say, $35,000. If you make a nickel profit on a
transaction, you would need 700,000 transactions to recoup your investment.
Given that your average customer now does about 3,000 transactions per day
(average demand of 20,000 per day/7 customers current on network), this
means that you cover your investment in about 240 days (700,000/3,000) or
eight months. After that, it's pure profit. For larger customers, this payback
happens sooner, meaning you become profitable more quickly."
EXHIBIT 4.7 Transaction-processing cost summary.
Value Add Idle Value Add
Portion Portion Total Portion
Personnel $0,375,000 $375,000 $0,750,000 $0.051 [$375/7,300]
H/ W & S/W 900,000 450,000 1,350,000 0.123 [$900/7,300]
$1,275,000 $825,000 $2,100,000 $0.174 [$1,275/7,300]
System usage 20,000 × 365 days 7,300,000 transactions/day
Useful capacity 80,000 × 365 days 29,200,000 transactions/day $0.044 [$1,275/29,200]
144 Understanding the Numbers
Denise concluded: "So, it looks like the keys to success for ETN/W are
threefold. First, study your customer capture and customer loading processes
and make them more efficient. Second, figure out a way to minimize your peak
periods such that you run your transaction processing systems at capacity most
of the time. And last, focus your business model on large-volume e-commerce
retailers such that you recoup your front-end investment sooner. If you can address
these three issues, your investors should grant your third-round request.
Of course, we could not have come to these action steps until we achieved
transparency of your cost systems through ABC analysis. Good luck.
A REVIEW OF THE ABC METHODOLOGY
There are a number of lessons to be taken from the ETN/W example.
ABC is a strategic model. The strategy literature states in various ways
that a company will achieve a strategic advantage over rivals if it can deliver
(1) additional value to customers at a cost comparable to rivals or (2)
comparable value at a cost lower than rivals. This advantage is sustainable
if and only if the company does this in a manner different than its rivals.
The myth that all companies have a strategic cost model that provides the
necessary information unfortunately, in today's world, does not hold true.
Most cost systems mainly provide aggregated cost information for estimating
inventory valuation and cost of goods sold—they focus on external
financial reporting. ABC, if done correctly, can provide the necessary
strategic information.
The earlier ABC is done in the strategic planning process, the
more value it creates. In the mid-1980s, when ABC analysis was being
touted as the key tool in making the United States more competitive on a
global basis, some researchers focused their studies on Japanese companies.
Their hypothesis was that, since the Japanese have dominated
many key industries over the last two decades, they must have some type
of ABC methodologies. These researchers found exactly the opposite;
costing systems for Japanese companies had even more arbitrary cost allocations
than their U.S. rivals. Further research, however, unveiled a key
competitive advantage.5 Japanese product development was very cost
based. They employed a technique, called target costing, in which prices
were first set for new products through extensive market research, then
profitability targets based upon investor capital requirements for the
new product were estimated, yielding cost targets which were set at the
design stage. Techniques such as value engineering and experiencecurve
analysis were employed to ensure that when the production began,
the product would meet its target cost. The Japanese understood that
this type of activity-cost analysis was best done very early in the product
development stage. An interesting additional insight was that these
Activity-Based Costing 145
strategic cost systems were more often under the responsibility of the engineering
rather than the finance department in Japanese companies.
When done after the strategy implementation stage, ABC becomes
ABM. Much research has demonstrated that about 85% of costs
for a new product are committed in the design stage. As a result, it can be
argued that performing an ABC analysis after this point is of little
value—once a system is in place, operational efficiency should be the
goal.6 The challenge is to maximize output given the constraints of the
system.7 Note that by optimizing output, the fixed costs are minimized on
a per-unit basis leading to the lowest-cost situation and the best possible
shareholder value position. Since pricing is not cost dependant, detailed
cost information is not really necessary.8 This is not quite correct since
no business situation is static. Note in the ETN/W example, we did do an
ABC analysis after the fact. But also note that the final result of the
analysis was not an ABC model. The key to the analysis was the managerial
decisions that were implemented to make ETN/W more competitive.
When done after the fact, the focus of ABC is not costing—it is to gain
transparency of the business model so that it can be reengineered to create
additional shareholder value. When done after the fact ABC necessarily
leads to ABM, activity-based management.
The value of ABC analysis is the "journey" rather than the final
result. As was stated in the ETN/W example, the purpose of ABC is ultimately
to gain business-wide transparency of your business model. It is
important that every function within the organization understand the
strategic logic of how your company is going to create shareholder value.
This includes how it is positioned in the industry-level value system, how
its processes link to those of upstream and downstream partners, as well
as a detailed activity-by-activity understanding of internal processes. The
steps are as follows.
1. Develop a cross-functional team to do the analysis and assign ownership
of the final ABC system to one function within your organization.
If an outside consulting group is used, its role should be facilitator
rather than designer of the system. It is important that ownership of
the ABC model be internal since it will have to be updated on a regular
basis. Because this is a strategic tool, ownership need not reside in
the finance function. Many companies have found that, since this
analysis requires business-wide vision, the strategy function is a more
appropriate owner.
2. Begin with a map of the industry-level value system that shows all
participants in the value creation process. Before moving to the next
step, ensure that each member of the team understands and agrees
with the strategic positioning logic for your company. This is necessary
because all members must agree upon the strategic underpinnings
of the analysis. In addition, cost drivers for one company often
146 Understanding the Numbers
reside within another in the chain. For instance, the driver for the
ETN/W customer sale cost pool was the technical sophistication of
the potential customer. Those that did not understand the costs of
transaction processing and what ETN/W could provide were much
more difficult to sell, and more costly. Once ETN/W understood this,
it developed a short video that explained the transaction processing
side of e-commerce and the cost and complexity of performing this
function internally. This video made the selling process much easier
for those customers—and less costly.
3. Once the industry-level value system is understood, prepare a process
map for your company. Identify what value pieces of the overall system
your company contributes. Although most people assume that everyone
"knows what we do," this is most often not the case. Like the
Hindu parable of the blind men trying to describe an elephant by feeling
only one piece—trunk, ear, leg—few managers within an organization
truly understand how all processes are integrated across the firm.
4. Prepare a detailed activity analysis for each internal process—exactly
what steps are taken, who does them, and with what resources. Since
this will be the basis for determining your cost pools, activities must
first be identified at a granular level—if you are too fine you always can
aggregate them later.9 Activity identification can be done from a historical
perspective or by studying the activity real time. In either case
this stage will require discussion with those people responsible for the
process to identify the activity steps. Since these steps often are performed
by many functions within an organization, it is sometimes
necessary to gather all participants such that a true cross-functional activity
map be drawn and agreed upon.
5. Estimate the cost pools for each activity and identify their behavior—
variable or fixed. If an activity has both fixed and variable costs, use
two pools for that activity. Often secondary support functions such as
payroll and human resources are first "allocated" to primary ledger accounts
such as manufacturing labor or sales salaries accounts before
being traced to activities.10 At the end of this step a reconciliation
should be performed. All of the costs from the general ledger should be
traced to activity pools using the activity map. Typically some costs
such as corporate administration and R&D do not get traced to activity
pools since they have little to do with current operations. This is acceptable,
and the key parameter one looks at is what percentage of overall
costs is ultimately charged to activity pools. Rather than being
discouraged by the 10% to 20% of costs not traced to any activity pool,
focus on the 80% to 90% of which you now have a better understanding.
To reiterate, this analysis is a strategic one; the acceptable percentage of
unknowns is dependent on how good your rivals' cost systems are.
6. Select drivers for each pool—that is, the method to be used to transfer
the costs from the pool to the object we wish to cost. Note the different
Activity-Based Costing 147
"objects" we developed costs for in the ETN/W example—capturing
and loading a customer onto the network and processing a transaction.
• For variable cost pools, drivers should be usage based since this is
the causal factor for a variable cost. Note how we used Outsourced
Credit Reports as a driver for the customer-qualification cost pool.
• For fixed-cost pools, the driver should be capacity based since this
is the causal factor for a fixed cost. Capacity drivers are often more
complex than usage drivers. Since fixed-cost pools are "chunkier"
than variable ones that increase in a proportionate fashion,11 idle
costs are often a problem. Only that portion of the fixed cost pool
that is "useful" to a cost object should be charged to it—note how
peak demand was used to define that portion of the transactionprocessing
system that was deemed idle in the ETN/W example.
7. Develop the final cost estimates for your system. Understand that
there are no right answers. Since this is a strategic analysis, the longrun
value of your results is dependent upon actions of rivals. For
ETN/W we found that the current cost for each transaction processed
was $0.175. Can it make any money at this cost level? Probably there
are a few customers who understand that their costs are higher than
this and would be willing to pay ETN/W a price today that is in excess
of the $0.175. But in the long run, rivals could enter and provide services
at a lower price. Given that ETN/W set its pricing target in the
$0.10 to $0.15 range, it understands that it currently has no sustainable
advantage. By figuring out how to better manage the peak problem, it
thinks it can attain that advantage. The main goal of an ABC analysis
is a set of activity-based target costs that everyone in the organization
may see. The message should be: "If we as an organization achieve
these, we will be successful." Progress towards these goals is the key
strategic performance indicator.
FOR FURTHER READING
Brimson, James, Activity Accounting: An Activity-Based Costing Approach (New
York: John Wiley, 1997).
Cokins, Gary, Activity-Based Cost Management: Making It Work: A Manager's Guide
to Implementing and Sustaining an Effective ABC System (Chicago: Irwin,
1996).
Forrest, Edward, Activity-Based Management: A Comprehensive Implementation
Guide (New York: McGraw-Hill, 1996).
Kaplan, Robert, and Robin Cooper, Cost and Effect: Using Integrated Cost Systems to
Drive Profitability and Performance (Cambridge, MA: Harvard Business
School Press, 1997).
Player, Steve, and David Keys, Activity-Based Management: Arthur Andersen's
Lessons From the ABM Battlefield, 2nd ed. (New York: John Wiley, 1999).
148 Understanding the Numbers
NOTES
1. A server farm is a new service-offering concept in the IT industry enabled by
advances in optic fiber connectivity. NT- and UNIX-based IT computer systems (i.e.,
servers) are housed in a service facility, and customers are given the option of buying
the service on a usage basis rather than buying the computer itself. Customers are
then supplied this service through a fiber-optic telecommunication network.
2. Clients are also called fulfillers. An apt analogy in the non-ebusiness world is
the role played by Wal-Mart for its suppliers ("fulfillers" in the e-commerce world),
such as a Procter & Gamble.
3. See Geoffrey Moore, Crossing the Chasm (New York: HarperCollins, 1990)
and Inside the Tornado (New York: HarperCollins, 1995).
4. As discussed previously, some of these had been started but not finished at
the beginning of the period, and at the end some were still in process; but on average
they estimated that the equivalent of seven customers were loaded onto the network
during this period.
5. See Womack et al., The Machine That Changed the World (New York:
Macmillan, 1990), chapter 5 particularly.
6. See Eli Goldratt, Theory of Constraints (Croton on Hudson: North River Press,
1990).
7. Where output is defined by any parameter—units produced for a manufacturing
system, units sold for a sales infrastructure, customers serviced for a service
infrastructure, and so on.
8. Economists argue that in a competitive market prices are set by the marketplace,
and in a market where there is product differentiation, prices are value based—
i.e., dependent on the perceived value to the customer, not on cost to produce.
9. Many companies today do not limit their analysis to within company walls.
This type of activity analysis is often done across the value system to understand
how much value is being developed as a whole and who is capturing the majority of it.
This understanding can be very valuable when negotiating with partners. See
Gadlesh & Gilbert, "How to Map Your Industry's Profit Pool," Harvard Business Review,
May–June 1998, pp. 149–162.
10. Quotation marks are used here to emphasize that this analysis needs to have
causal underpinnings. The key here is to allocate these costs using some type of a logical
procedure; avoid doing it in an arbitrary manner. The simple rule is: If there is no
logical manner in which to trace the cost, don't!
11. Note in the ETN/W example, the customer-qualification activity pool
increased with each additional outsourced report while the customer-sale pool increased
with each additional person hired. It increased in larger increments, thus the
descriptor chunky is often used.
149
5
INFORMATION
TECHNOLOGY
AND YOU
Edward G. Cale Jr.
Amazing though it may seem, the personal computer has only been around for
about 20 years. Before 1980 the world of computing belonged to highly trained
technical people who worked their wizardry wearing white coats in hermetically
sealed rooms. Today kindergarten students use personal computers to
learn the alphabet, grade school students use the Internet to research term
papers, and on-the-go executives are always in touch with their beepers, Webenabled
cell phones, cellular personal digital assistants (PDAs), and laptop
computers. However, many people are not yet comfortable with these technologies.
The range of people's acceptance and knowledge of information technology
is wide, with the technical novice at one end of the continuum and the
"techie" at the other end. Where you fall in this range will dictate what you
gain from this chapter. If you are fortunate to fall near the techie side, skim
this chapter for ideas which you might find interesting.
Technology has changed the way people conduct business. Computers
have replaced pencil and paper in contemporary business life. In the past,
when a new employee was hired, he or she was shown to a desk and given pen,
pencil, paper, and a telephone. Today, the new hire is given a computer, usually
attached to a network; a cellular phone; a beeper; and possibly a laptop computer
for portable use. People's lives have been turned upside down as they
learn to manage the latest technology. E-mail is replacing U.S. Mail. Secretaries
are being replaced by personal productivity technology such as voice
150 Understanding the Numbers
mail and Internet-based calendaring. People question how much more productive
they as workers can be. Technology will allow managers' and workers' productivity
to reach the next plateau and enable them to find better and
alternative modes for working and succeeding.
Information technology has changed not only the way people work but
also in some cases the venue from which they perform their work. No longer
are workers chained to their desks. The number of telecommuters—people
who work from home via computer and telephone communications—is increasing
dramatically. Business people who travel with their portable computers
have become so prevalent that hotels have installed special hardware on their
hotel room telephones that allows guests to plug their computers into the telephone
system and communicate with their home offices. Sometimes people
even connect their laptop computer modems to the airline telephones at their
seats!
How much do you need to understand about the technology to become
technologically enabled? The answer to this question will depend in part on the
job you hold and the organization for which you work. However, at this time,
when information technology is having a dramatic impact on the very definition
of many industries, the material covered in this chapter and in Chapter 16 has
to be considered essential.
HARDWARE
Computer hardware comes in several shapes and sizes. This chapter concentrates
on personal computers (PCs). Over the past 15 years, Microsoft and Intel
have become so dominant in the software and hardware ends of the PC business
that they have, de facto, set the worldwide standard for PCs, which is referred
to as the Wintel standard, short for Microsoft Windows and the Intel
CPU chip. More than 90% of all personal computers use the Wintel standard,
affecting both the hardware marketplace and the applications software that is
developed. Currently, Dell and Compaq are the largest producers of personal
computers, with Gateway, Hewlett-Packard, and IBM following closely.
Personal computers come in two basic shapes: desktop and laptop. Regardless
of their shape, all PCs have the same basic components. When you
buy a computer, you usually have a choice on the size, speed, or amount of any
given component that will be a part of your system. The basic components
with which users must concern themselves are the CPU, RAM, hard disk, CD
ROM/DVD ROM, modem, various adapters, and the monitor. Most of the rest
of this section deals with the basic options you will have to choose in selecting
these components.
However, beyond personal computers, we are also seeing the emergence
of a whole range of small digital products for supporting effective managers.
These products as a group are called personal digital assistants, or PDAs, and
will be discussed brief ly.
Information Technology and You 151
Desktop Computers
Underneath their covers, most desktop computers are very similar. Many of
the various manufacturers of desktop machines use parts from the same suppliers
because there are only a handful of companies that manufacture hard
disk drives and many other desktop components. Before buying a machine,
compare the attributes and capabilities of many different ones. Also, check the
warranty offered by the different manufacturers. Though one-year warranties
are fairly typical, some computers come with two- or three-year warranties.
Beware of hype advertising and read the fine print. Most advertised specials
do not include the monitor, which will cost upward of $200 depending on the
size and quality.
Laptop Computers
The laptop has become a mainstay for the traveling worker. It provides all the
functionality and most of the power of most desktop units, in a package that
weighs approximately six pounds. Laptops are powered by standard electricity
or, for about two hours, by their self-contained batteries. Unlike desktop units,
under the covers all laptops are not the same. While they all utilize either an
Intel or Intel clone chip, the majority of the electronics are frequently custom
designed. Consequently, servicing laptops is more complicated and more expensive,
and laptop parts are not necessarily interchangeable.
The display screen is one of the most important features of the laptop
computer. Display quality and size are rapidly approaching that of desktop
machines.
Although laptops provide the luxury of portability, that is their only advantage
over desktop machines. Desktops offer better displays, more memory,
and higher speed—higher performance for far less money. A laptop computer
will cost between twice and three times as much as a comparable desktop unit.
Personal Digital Assistants (PDAs)
PDAs are small digital devices that can be used to take notes, to manage tasks,
to keep track of appointments and addresses, and even to send and receive email.
Similar to PCs, PDAs have CPUs, RAM, displays, and keyboards of sorts,
and some even have modems. However, a PDA can typically fit easily into a
pocket or purse. Today, the most popular PDA is made by Palm Inc. and has
its own proprietary software. However, there are a number of competing
PDAs, some of which use a stripped-down version of Windows software called
Windows CE. As miniaturization continues to develop and as cellular and computer
technologies continue to be woven together, we can expect a further
blurring of the line between PDAs and PCs.
Probably the two most popular capabilities of PDAs are their ability to
keep track of appointments and to store and retrieve contact information such
152 Understanding the Numbers
as phone numbers and addresses. These same capabilities are also available on
PCs, most typically in software products such as Microsoft Outlook, which also
includes e-mail. Most PDAs come with the ability to transfer appointments and
contact information bidirectionally between the PDA and a PC.
Computer Components
Exhibit 5.1 shows a schematic rendition of the components in a computer system.
This section of Chapter 5 will explain the basic functioning of these components
and present some of the tradeoffs that you will face in making an
intelligent decision to buy a computer system.
CPU
All basic computers have a central processing unit (CPU). The CPU is the basic
logical unit that is the computer's "brain." As mentioned earlier, it is usually
provided by Intel Corporation or one of the clone-chip manufacturers such as
AMD. While Intel enjoys the lion's share of the market, the clones have
recently made significant inroads by offering lower prices for comparable
products. State-of-the-art CPUs manage to integrate onto one thumbnail sized
silicon chip tens of millions of electronic components. CPUs such as the Pentium
come in different speeds, expressed in megahertz or gigahertz (millions
or billions of cycles per second). Speed represents how fast the CPU is capable
of performing its various calculations and data manipulations. A typical CPU
today operates at between 800 MHz and 1.5 GHz.
EXHIBIT 5.1 Layout of a personal computer.
CPU
RAM
Hard
drive
CD ROM/
DVD drive
Monitor
Phone
jack
Keyboard Mouse
Disk controller
Display adapter
Modem
Sound card
Speaker Speaker
Network adapter Network
jack
Information Technology and You 153
RAM
Random access memory (RAM) is the space that the computer uses to execute
programs. The amount of RAM required is dictated by the number of applications
that the computer is asked to run simultaneously as well as by the systems
software in use (e.g., Windows 98, Windows XP). For most average users, 128
megabytes of RAM is an appropriate amount (a megabyte is 1,048,576 bytes of
data). You can never have too much RAM, though, so the more, the better.
While RAM prices f luctuate widely with supply and demand, you should plan
on spending about a dollar per megabyte.
Hard Disk
All programs and data are stored on the hard disk. Disk technology has advanced
greatly in the past five years. Recording density has enabled disk capacity
to approach numbers previously unheard of except in large mainframe
commercial systems. In 1992 the typical disk stored 80 megabytes. Today typical
disk capacity on desktop machines ranges from 10 to 20 gigabytes. Although
it seems unimaginable to fill up an entire 10-gigabyte disk, it happens
faster than one might think. Typical office applications require 100 megabytes
of storage for the application alone, not including any associated data. Multimedia
applications (sound and video) are very data intensive and quickly consume
disk space. For example, CD-quality music recordings consume roughly
10 megabytes per minute! Again, the more storage the better.
Reminder: Hard disk failures do occur. Always back up your data onto a
removable disk or tape!
CD ROM/DVD ROM
Today an increasing amount of data and number of applications are being supplied
on digital, compact disk (CD) technology. Using this technology, large
amounts of data can be stored inexpensively. CD ROMs, which have the storage
capacity for approximately 700 megabytes of data, are usually sold as "read
only." Recently, however, inexpensive recordable CD drives have become popular,
allowing people to store massive databases or record music on their own.
Other than the speed at which they access and transfer data, all CD ROMs are
very similar. Speed is expressed as a multiple of the speed of the original CD
ROMs, which were produced in the early 1990s. Today, typical CD ROMs
transfer data 32 or 48 times faster than the original CD ROMs and are referred
to as 32X or 48X CD ROMs. Again, the faster, the better.
There are numerous information databases available on CD that would
interest the accountant or finance executive. For example, most census data is
available on CD. Also, historical data on stock and bond prices, copies of most
trade articles, IRS regulations, state tax regulations, tax forms, recent court
154 Understanding the Numbers
decisions, tax services, accounting standards (GAAP and GAAS), continuing
education courses, and many other topics are available on CD.
Today, DVD ROMs, which have roughly ten times the capacity of CD
ROMs, are becoming popular and in many cases replacing CD ROMs. DVD
popularity is being driven at least in part by the fact that a single DVD can accommodate
the massive amount of data necessary to digitally store the sound
and pictures of a full-length feature movie. Recordable DVD drives are now
becoming reasonably priced. With their ability to read both CDs and DVDs
and their ability to record DVDs, one would expect that recordable DVD
drives will soon replace CD drives in new computer systems.
Modems
Modems are devices that allow computers to communicate with each other
using standard telephone lines. In the past few years, modem technology has
increased the speed of data communications over standard telephone lines to
speeds more than 10 times higher than in 1990. However, there is a practical
limit to how fast computers can transmit data over ordinary telephone lines—
currently about 56 KB (kilobit—a thousand bits) per second.
Because of the limitations of telephone lines, alternatives have been and
are being developed. Cable modems, which use cable television wires, and
DSL connections, which use regular telephone wires but with a new technology,
both have the capability of transmitting data at rates higher than 1 MB
(megabit) per second. While both technologies are spreading quickly, neither is
yet available in all geographic locations. In addition, satellite data service, similar
to satellite television service, is an available high-speed possibility for data
communications.
Network Adapter
Whereas modems connect computers using phone lines, network adapters
allow computers to directly communicate with each other over wires or cables
that physically connect the computers. In most office environments, the various
computers are interconnected through a local area network (LAN) so that
they can share printers, data, access to the Internet, and other capabilities.
Today, the dominant type of LAN is called an Ethernet network, and most network
adapters are Ethernet adapters. In addition, Ethernet adapters are the
most common form of hardware connection between PCs and cable modems
or DSL connections. An Ethernet network adapter typically costs between
$30 and $50.
Multimedia
By the latter half of the 1990s, most new personal computers came equipped
for multimedia, the ability to seamlessly display text, audio, and full-motion
Information Technology and You 155
video. To be capable of multimedia, a computer must be equipped with a
high-resolution monitor and a CD or DVD drive and have audio capabilities.
Because of the amount of storage that video requires, full-motion video is
somewhat difficult to accomplish on a personal computer. For it to look
smooth, video requires roughly 30 frames (pictures) per second, and each
frame requires about 500,000 characters of information. In other words, one
minute of smooth video could require as much as 900,000,000 characters of
storage. In order to manage the large amount of storage that video processing
requires, the video data is compressed. Data compression examines the data
and, using an algorithm or formula, reduces the amount of storage space
needed by eliminating redundancies in the data. Then, before the data is displayed,
it is inf lated back to its original form with little or no loss of picture
quality.
Printers
Printer technology has stabilized in recent years, with two standards having
emerged, laser printers and inkjet printers. Laser printers offer the best quality
and speed. They are, for the most part, black-and-white and offer high print
resolution. There are several speed and memory options, and models range in
price from $400 for the individual user to several thousand dollars for a fast
unit that offers printer sharing and color. Inkjet printers offer the lowest price.
Models cost as little as $100. In higher-priced inkjet printers, print quality is
excellent in black-and-white and color. Today many people are using high-end
inkjet printers to print pictures taken with digital cameras. With high-end
inkjet printers and digital cameras, the results can be virtually indistinguishable
from prints produced from film cameras.
Laser printers are the clear choice for network sharing, whereas inkjets
have become the mainstay of the individual user. In either case Hewlett-
Packard is the market leader in the development of printers.
Monitors
The most common type of computer monitor is a cathode ray tube, or CRT,
which physically resembles a television. In recent years, however, f lat-panel or
LCD (Liquid Crystal Display) have emerged. The major advantage of the f latpanel
display is that it takes up much less space on a desktop than does the
CRT. This advantage comes at a cost roughly three times as much as a comparably
sized CRT. Whether CRT or f lat panel, there are significant advantages
to having a display that is as large as space and budget allow. Some of the real
power of windowing software is the ability to view several windows of data at
the same time. Small displays make such windowing much more difficult. A
17-inch display (the screen measured diagonally) is about the minimum acceptable
size.
156 Understanding the Numbers
OPERATING SYSTEMS
The operating system is the basic software that makes the computer run. Applications
software is the software that runs a particular user function. Some
say that the operating system is the software closest to the machine, while the
applications software is the software closest to the user.
Microsoft Windows is the predominant operating-system software for
the personal computer. In the past 10 years, Microsoft has become the acknowledged
leader in the development of both operating-system and officeautomation
software. The Windows operating system provides a graphical
format for communicating between the computer and the user, while a pointing
device, such as a mouse, is used to point to the icon of the folder or application
that the user wishes to open.
APPLICATIONS SOFTWARE
Applications software is the personal computer's raison d'etre. Although there
are a multitude of applications available for the PC, this chapter focuses on the
following personal-productivity programs:
• Word processing.
• Spreadsheets.
• Presentation graphics.
• Databases.
• Personal finance.
• Project management.
Most of the popular packages are available as application suites that include
word processing, spreadsheets, graphics, and sometimes database management
systems. Microsoft Office is one of the most widely used suites; it
includes Word for Windows (word processing), Excel (spreadsheet), PowerPoint
(presentation graphics), Access (database), as well as several other applications.
The original spreadsheet application was developed at the very beginning
of the PC revolution and was called VisiCalc. It was later replaced by Lotus
1-2-3, which became the standard until the tremendous success of Microsoft
Office and Excel.
Word Processing
One of the two most popular applications, word processing and spreadsheets,
word processing has increased people's ability to communicate more effectively.
With word processing software, the user can create, edit, and produce a
high-quality document that appears as professional as that of any large organization.
Thus, word processing has become the great business equalizer, making
Information Technology and You 157
it difficult to decipher a small company or single practitioner from the large,
Fortune 500 company with a dedicated media department.
Today's word processing is as powerful as most desktop publishing software,
and it is so simple to use that any novice equipped with simple instructions
can master the software. Not only can documents include text, but they
can also contain spreadsheet tables, drawings, and pictures; be specially formatted;
and be black-and-white or color. Most word processing applications
come with clip art, which consists of drawings, cartoons, symbols, and/or caricatures
that can be incorporated into the document for emphasis.
Spreadsheet Software
For the accounting and finance executive, spreadsheet software has had the
greatest impact on productivity. Imagine a company controller who has been
asked to prepare the budget for the coming year. The company manufactures in
over a thousand products with special pricing depending on volume. The controller
not only has to make assumptions about material costs, which might
change over time, but also has a history of expense levels that must be factored
into the analysis. Using pencil and paper (usually a columnar pad), the controller
calculates and prepares all of the schedules necessary to produce the
final page of the report, which contains the income statement and cash flow.
Confident that all calculations are complete, the controller presents the findings
to management, only to be asked to modify some of the underlying assumptions
to ref lect an unexpected change in the business. As a result, the
controller must go back over all of the sheets, erasing and recalculating, then
erasing and recalculating some more.
Computer spreadsheets rendered this painful process unnecessary. Spreadsheets
allow the user to create the equivalent of those columnar sheets, but with
embedded formulas. Consequently, any financial executive can create a financial
simulation of a business. Thus, merely by changing any of a multitude of assumptions
(formulas), one can immediately see the ramifications of those changes.
Spreadsheets allow for quick and easy what-if analyses. What if the bank
changes the interest rate on my loan by 1%? What impact will that have on my
cash flow and income? In addition, most of the packages provide utilities for
graphing results, which can be used independently or integrated into a word
processing report or graphics presentation.
A spreadsheet is composed of a series of columns and rows. The intersection
of a row and column is referred to as a cell. Columns have alphabetic
letters, while rows have numbers. Cell reference "B23" indicates the cell in
column B and row 23.
Exhibit 5.2 provides an example of a simple spreadsheet application. A
company's pro forma income statement, the sample spreadsheet is a plan for
what the company expects its performance to ref lect. In this example, the
company expects to earn $275,475 (cell H18) after tax on $774,000 (cell H3) of
sales revenues. At the bottom of the exhibit, there is a series of assumptions
158 Understanding the Numbers
that govern the way the calculations are performed in this spreadsheet. For example,
cost of goods sold is always equal to 32.75% of sales, and advertising is
always equal to 12% of sales. Likewise, the income tax rate for this company
is set at 25%.
Looking behind the cells (Exhibit 5.3), you can see the spreadsheet's formula
infrastructure. For example, cell B4, which calculates the cost of goods
sold for the month of January, contains the formula that requires the spreadsheet
to multiply the cost-of-goods-sold percentage that is shown in cell B21
by the sales shown in cell B3; the formula in cell B5, which calculates the
gross profit, subtracts the cost of goods sold in cell B4 from the sales in cell
B3; and cell H5, which calculates the total gross profit for the six months of
January through June, contains the formula that adds the contents of cells B5
through G5.
The spreadsheet is set up so that, should the user wish to change any of
the assumptions, such as the cost-of-goods-sold-percentage, the contents of
cell B21 would be changed to a new desired value, and any other cell that was
affected by this change would immediately assume its new value. As mentioned
earlier, most spreadsheet packages provide excellent facilities for displaying
EXHIBIT 5.2 Pro forma income statement (in dollars).
Pro Forma Income Statement
Year
January February March April May June to Date
Sales 100,000 125,000 135,000 127,000 132,000 155,000 774,000
Cost of goods sold 32,750 40,938 44,213 41,593 43,230 50,763 253,485
Gross profit 67,250 84,063 90,788 85,408 88,770 104,238 520,515
Operating Expenses
Salaries 22,800 28,500 30,780 28,956 30,096 35,340 176,472
Benefits 11,200 14,000 15,120 14,224 14,784 17,360 86,688
Rent 3,200 3,200 3,200 3,200 3,200 3,200 19,200
Utilities 4,300 4,750 3,790 4,100 3,100 2,800 22,840
Advertising 12,000 15,000 16,200 15,240 15,840 18,600 92,880
Supplies 1,300 1,400 1,270 1,500 1,550 1,600 8,620
Total operating expenses 54,800 66,850 70,360 67,220 68,570 78,900 406,700
Net profit before taxes 45,200 58,150 64,640 59,780 63,430 76,100 367,300
Income taxes 11,300 14,538 16,160 14,945 15,858 19,025 91,825
Net profit after taxes 33,900 43,613 48,480 44,835 47,573 57,075 275,475
Assumptions
Costs of goods sold % 0.3275
Salaries (% sales) 0.228
Benefits (% sales) 0.112
Advertising (% sales) 0.12
Income taxes % 0.25
159
EXHIBIT 5.3 Spreadsheet formula infrastructure.
Pro Forma Income Statement
January February March April May June Year to Date
Sales 100,000 125,000 135,000 127,000 132,000 155,000 =SUM(B3:G3)
Cost of goods sold =$B21*B3 =$B21*C3 =$B21*D3 =$B21*E3 =$B21*F3 =$B21*G3 =SUM(B4:G4)
Gross profit =B3-B4 =C3-C4 =D3-D4 =E3-E4 =F3-F4 =G3-G4 =SUM(B5:G5)
Operating Expenses
Salaries =$B22*B3 =$B22*C3 =$B22*D3 =$B22*E3 =$B22*F3 =$B22*G3 =SUM(B8:G8)
Benefits =$B23*B3 =$B23*C3 =$B23*D3 =$B23*E3 =$B23*F3 =$B23*G3 =SUM(B9:G9)
Rent =3,200 =3,200 =3,200 =3,200 =3,200 =3,200 =SUM(B10:G10)
Utilities 4,300 4,750 3,790 4,100 3,100 2,800 =SUM(B11:G11)
Advertising =$B24*B3 =$B24*C3 =$B24*D3 =$B24*E3 =$B24*F3 =$B24*G3 =SUM(B12:G12)
Supplies 1,300 1,400 1,270 1,500 1,550 1,600 =SUM(B13:G13)
Total operating expenses =SUM(B8:B13) =SUM(C8:C13) =SUM(D8:D13) =SUM(E8:E13) =SUM(F8:F13) =SUM(G8:G13) =SUM(B14:G14)
Net profit before taxes =B3-B14 =C3-C14 =D3-D14 =E3-E14 =F3-F14 =G3-G14 =SUM(B16:G16)
Income taxes =$B25*B16 =$B25*C16 =$B25*D16 =$B25*E16 =$B25*F16 =$B25*G16 =SUM(B17:G17)
Net profit after taxes =B16-B17 =C16-C17 =D16-D17 =E16-E17 =F16-F17 =G16-G17 =SUM(B18:G18)
Assumptions
Costs of goods sold % 0.3275
Salaries (% sales) 0.228
Benefits (% sales) 0.112
Advertising (% sales) 0.12
Income taxes % 0.25
160 Understanding the Numbers
data in a graphical format. Exhibit 5.4 presents a graph of the information in
our demonstration spreadsheet. It contrasts sales and net profit over the six
months.
Presentation Graphics Software
Presentation graphics software is used to create slide presentations. These presentations
can include a variety of media through which information can be
presented to an audience, such as text, graphs, pictures, video, and sound. Special
effects are also available, meaning animation can be incorporated as the
system transitions from one slide to the next. Slides can be printed, in blackand-
white and color, for use on overhead projectors. Alternatively, the computer
can be directly connected to a system for projection onto a screen or a
television monitor, allowing the presenter to utilize the software's animation
and sound features. Most of the software comes equipped with various predeveloped
background formats and clip art to help simplify the process of creating
the presentation. Also, these software packages allow the user to import
both graphs and text from other software packages, such as word processing
and spreadsheets.
EXHIBIT 5.4 Pro forma sales and income.
January February March April May June
Sales
Net profit
after taxes
0
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000
Months
Dollars
Information Technology and You 161
Database Software
A database is a collection of data stored in such a way that the user may create
and identify relationships among data. For example, a mailing list of one's customers
might contain information about each customer's purchases and everything
about the sales transactions, including the prices the customer paid, who
sold it to him, how she paid, and so forth. This information can be retrieved in
a variety of ways usually specified by the user at the time of execution. The
user might want a list of all customers that purchased a specific product between
January and May or perhaps an aggregate list of all products a customer
has ordered and purchased from a particular salesperson. The number of possible
combinations and permutations and ways one may view the data is limited
only by the collection of the data and the imagination of the user. Databases
are discussed in more detail in Chapter 16, Information Technology and
the Firm.
Personal Finance Software
There are several software packages that allow individuals or small businesses
to manage finances, such as paying bills either electronically or by check, and
monitor investments. The packages are fairly sophisticated in that they provide
for secure communications for electronic bill paying and other online banking
services such as account reconciliation, as well as the importing of current
stock-market quotes. The most widely used package is Quicken and, for small
businesses, Quickbooks. Microsoft Money is also a comparable and popular
package.
Exhibit 5.5 displays a sample screen that is used to enter bills to be paid.
As you can see, the user input metaphor is a check, the very same document the
user would use if he or she were paying the bill manually. The difference using
Quicken is that data is collected for a host of other purposes such as:
• Paying bills.
• Tracking paid bills by category for budgeting purposes.
• Tracking payments for tax purposes.
• Reconciling the checking account.
The system has the capability to keep track of more than one account and to
make interaccount transfers.
Project Management Software
Often a manager or entrepreneur is faced with the challenge of managing the
many details concerned with a project, be it constructing a building or pulling
together a financial plan. With fairly simple projects, paper and pencil or a
simple spreadsheet might be an adequate tool for coordinating the people and
steps involved in a project. But, as the project gets complex, involving, say,
162
EXHIBIT 5.5 Personal f inancial sof tware check-writing screen.
Screen shot printed with permission of Intuit.
163
EXHIBIT 5.6 Project management software screen.
164 Understanding the Numbers
more than a few people and more than a few dozen steps, one should consider
using project management software to help with the planning and control of
the activities.
Project management software allows a manager to plan for and then control
the steps in a project with an eye toward managing the people working and
resources being spent on the project. Good project-management software can
help a manager foresee bottlenecks or constraints in a plan and can help the
manager bring the project to completion in the shortest possible time.
One popular tool for managing projects is Microsoft Project. Exhibit 5.6
shows a typical screen from Microsoft Project, which shows the steps in a project
along with a graphical representation of those steps called a GAANT chart.
NETWORKING
Another electronic advent of the 1990s was extensive networking, or interconnecting,
of computers, which has facilitated the sharing and exchanging of information.
The interconnecting may be done through wires within a building;
via the telephone system using modems; or through radio frequency transmissions
between the computers using wireless modems. There are several different
approaches, or types of architecture, for computer networks. In a small
office environment with only a few computers, the computers might be connecting
in what is referred to as a peer-to-peer network. Here all the computers
function on the same level as peers or equals to each other. Peer-to-peer networking
software comes built into Windows 98 and Windows Millennium Edition
(ME), making it relatively easy to set up a peer-to-peer network between
two or more PCs. All one needs is a network adapter card in each computer,
the cables for connecting the computers, and a connecting piece of hardware
called a hub.
However, in a larger networking environment (dozens, hundreds, or even
thousands of computers hooked together), the situation is more complex. In
this case, the most common network architecture is called a client-server network.
To deal with the added complexity, in a client-server network there is a
hierarchy of computers with a host or file server acting as the traffic policeman,
storing common data and directing the network traffic. In this architecture,
the user computer is frequently referred to as the client in the network. A
picture of a typical client-server network appears in Exhibit 5.7.
As mentioned earlier, the file server is the centerpiece of the network,
and the software that makes the network operate is called the network operating
system. Novell's NetWare and Microsoft's Windows 2000 (formerly Windows
NT) are two popular network operating systems. Within a business the
typical network is called a local area network, or LAN. Clients are connected
to the server, using wires or fiber-optic cables. Transmission speeds are generally
either 10 or 100 megabytes per second. As with the peer-to-peer network,
there is a hub that acts as a concentrator for all of the cabling. Again, each PC
Information Technology and You 165
on the network must have a network interface card if it is connected to a LAN,
or a modem if it is connected through telephone lines. When a series of LANs
in different cities are interconnected, they form a wide area network, or
WAN. Large businesses with facilities around the country or world network
their users' personal computers together in a series of LANs that are further
interconnected into a large WAN. The largest WAN, the Internet, connects together
millions of computers of commercial companies, government agencies,
schools, colleges and universities, and nonprofit agencies around the world.
Preventing unauthorized people from accessing confidential information
is one of the biggest challenges posed by networks. To do so, people and organizations
use special security software. One technique, a fire wall, allows outside
users to obtain only that data which is outside the "fire wall" of the file
server; subsequently, only people inside the company may access information
inside the fire wall.
Electronic Mail (E-mail)
E-mail is the most popular network application because it has become the
method of choice for communicating over both short distances (interoffice)
and long distances. It allows you to send communications to any other person
EXHIBIT 5.7 Diagram of client-server network.
Ethernet/WinNT Network
User PC User PC User PC
File server Print server Internet/mail server
Laptop
Laptop
Printers
Internet
Files
Files
166 Understanding the Numbers
on your local network as well as to any other network within your WAN,
including the Internet. E-mail has become so popular that U.S. Mail and
overnight delivery services such as FedEx are being rendered obsolete for
some types of communication.
Most e-mail software packages include a basic word-processing application
with which you can generate your letters. In addition, these packages allow
you to keep mailing lists and send a document to numerous people simultaneously.
Once sent, a document can be received within seconds by people thousands
of miles away. One of the more advantageous features of e-mail is that it
allows you to attach another document—a spreadsheet, graphic presentation,
another word processing report, a picture, or even a database—to your letter,
much as you would do with a paper clip.
Imagine that you have used a spreadsheet package to prepare a budget for
your division in Boston. You print out your letter and spreadsheet and mail or
ship it overnight to the main office in Chicago. You may even include an electronic
copy of your spreadsheet on a f loppy disk, in case the individual in
Chicago needs to further modify the numbers. Sometime within the next day
or two, the recipient will receive the package. He or she will then read the
information and may even use the f loppy disk for additional reporting. Alternatively,
using e-mail, you could draft your letter, electronically attach the
spreadsheet file, and send it via e-mail to your recipient in Chicago. Within a
matter of seconds or minutes, she or he will receive the electronic package,
read your letter, and be able to extract your attachment and load it directly into
a spreadsheet software package for any necessary additional processing.
Since colleges and universities have sites on the Internet, many college
students use e-mail regularly to keep in contact with their friends both in the
United States and around the world. Likewise, parents of college students have
picked up the e-mail bug and use it to correspond with their children.
The Internet
The Internet is the worldwide WAN that has become the major growth area in
technology and the business community. While the Internet has been around
for decades, its popularity exploded with the development of the World Wide
Web and the necessary software programs that made the "Web" very userfriendly
to explore.
Accessing the Internet requires that the user establish a connection to it
called a node. Large organizations have a dedicated data link to the Internet
using very fast data telephone lines. Individual users connect to the Internet
using third-party companies called Internet Service Providers (ISPs), such as
America Online (AOL) and Microsoft Network (MSN). These ISPs allow users
to dial into their computers, which are connected directly to the Internet. Recently,
a number of ISPs have started providing high-speed or broadband
connectivity between users and the Internet with the use of cable modems or
DSL technology (as discussed previously). High-speed connectivity will
Information Technology and You 167
typically cost $20 to $30 more than the normal $20 per month for modem
speed (56K) access.
World Wide Web
Though the terms Internet, World Wide Web, the Web, and the Net have become
synonymous, the Web is actually a subsystem of the Internet. One of the
major attractions of the Web is that it is quite easy for the average person to access
any of the millions of sites on the Web. All you need is a Web browser and
a connection to the Internet. Web browsers are merely software programs that
allow users to navigate the Web. The two most common browsers are Microsoft
Explorer and Netscape Navigator. Internet Explorer comes free with Windows,
and Netscape Navigator can be downloaded for free from Netscape's
Web site.
Every site that appears on the Internet has an address composed of a
company or organization name, called a domain name, and a domain type. For
example, "www.GenRad.com" refers to the Web site of a commercial company
named GenRad. These addresses are referred to as universal resource locators,
or URLs. Some of the more common domain types are as follows:
.com commercial organization
.org not-for-profit organization
.gov government organization
.mil military group
.edu educational institution
Each Web site displays its information using a series of Web pages. A Web
page may contain text, drawings, pictures, even audio and video, as well as blue
text called hypertext. Position your mouse pointer over one of these words, and
the arrow changes to a drawing of a hand. Click the mouse, and the computer
will automatically move to a new Web page. This move is called a hypertext
link. Using these hypertext links, a user can move around the Internet, from
page to page, company to company, state to state, country to country.
Internet e-mail addresses often consist of a username followed by the
symbol "@," followed by the domain name, followed by the domain type. Thus,
Bill Smith's e-mail address at GenRad might well be bsmith@genrad.com.
Many companies have put much of their literature on the Web, thereby
using the Web as an electronic catalogue. Home pages are the first page of information
that you encounter when you reach an organization's Web site. Companies
use their Web sites for marketing and distributing information about
their products. Instead of waiting on a telephone line for customer service, the
user can go online to get expert help about frequently asked questions (FAQs),
at any time of day, unattended. For example, the AICPA (American Institute of
CPAs) has a Web site at www.aicpa.org. Available at that Web site are many of
the AICPA services, including information on their membership, conferences,
168 Understanding the Numbers
continuing education, publications, and IRS forms. The home page for the
Financial Management Association, located at www.fma.org, is another interesting
site for financial executives. This site provides information on all of the
association's services with links to other pages.
Computer hardware and software companies use the Web as a device for
distributing software to users. As software device drivers change, users can
download the new software over the Net. The Net also provides a venue for
people with common interests to "chat" electronically in "chat rooms."
Internet Search Engines
The Web has become so extensive with so much information available to the
user that often one literally does not know where to look. Consequently, search
engines were created to help users navigate the Web. Search engines like
Yahoo, Alta Vista, Lycos, Google, and Northernlight constantly explore the
Web, indexing each site. When presented with key words or a topic to be
searched, they provide the user with a list and description of each site that
contains the information requested in the search. The search results also display
the hypertext links to the sites found, enabling the user to click on and immediately
go to those sites that seem most promising.
Electronic Commerce
Electronic commerce, the ability to purchase goods and services over the Net,
has grown geometrically in recent years. Before e-commerce can achieve its
full potential, however, there are a number of hurdles that must be overcome
successfully. First, as will be discussed in more detail in the following section,
there are strong concerns over the security of credit card and other confidential
data concerning sales transactions. Until consumers can be assured that
their personal data are confidential and their financial transactions are secure,
e-commerce will be under a cloud of suspicion. Second, shopping in cyberspace
is different from shopping in physical space. When shopping in physical
space, consumers see, touch, try on, test-drive, and buy physical products. In
cyberspace, consumers shop on the Net by referring only to metaphors, twodimensional
representations of what they see when shopping in stores. Essentially,
cyberspace consumers are supplied only secondhand information about
products.
For electronic commerce to be successful, therefore, the mode and the
metaphor for the cyberspace shopping experience must be improved. New
mechanisms for Internet shopping will be developed, many of which will include
experiments in virtual reality and the appearance of three-dimensional
venues. Also, the shopping experience will be custom-tailored to you, the individual
consumer. Many Internet sites already keep a profile on you when you
visit their site. These profiles include information on what products you buy
and what products you tend to look at, allowing the Internet sites to create
shopping experiences specific to your needs. Along these lines, the mail-order
Information Technology and You 169
and online shopping company Lands End now provides their customers with
the opportunity to have a three-dimensional computer model built from laser
scans of the customer's body. Once this model is built, the customer can "try
on" clothing on their computer screen to see how the actual clothes will look
on their computer-based body.
As electronic shopping becomes more effective, virtual malls, or groupings
of stores that share the same electronic Internet address, will spring up on
the Internet, creating the feel of a physical mall. Both consumers and retailers
will be able to benefit from one-stop shopping in cyberspace.
Privacy on the Internet
When using the Internet for e-mail, e-commerce, or other applications, you
must remember that, like the radio spectrum, the Internet is a public network.
With the right skill, anyone on the Internet has the ability to "listen in" on your
electronic transaction. While the transaction will appear to be processed normally,
its confidentiality might well be compromised. Beware! Never send
across the Net any confidential information that you would not want any other
person or company to know.
However, Web browsers usually have the ability to encrypt data that is
transmitted between a user and a Web site. Most organizations conducting
business on the Web will, therefore, only send and receive confidential information
using encryption technology, which should provide you with adequate
protection. Generally, Web sites will notify you that they are using such a secure
connection. In addition, whenever you are connected to a secure site, your
Web browser will show a little icon of a closed padlock on the status bar at the
bottom of your screen.
Beyond protecting data as it is transmitted, there is a significant privacy
issue surrounding the use of data in your Internet activities. Whenever you sign
onto a Web site, those sites can collect information about your activities, such as
purchases, credit card number, address, and so on. At the moment, there is very
little legislation either at the federal or state level preventing Internet sites from
selling or sharing information about you with third parties. Various industry
groups are trying to encourage self-regulation in the e-commerce industry, and
many Web sites will post their privacy policy, usually as a link on the home
page. However, at the moment there is little consistency or enforcement of privacy
policy. We can expect that there will be significant legislation on privacy
issues in the future, but until such legislation is in place, beware!
In addition, some Internet sites place small files, called cookies, on your
hard drive when you are in contact with the site. In most cases, these cookies
are innocuous, allowing you to access the site without having to remember a
password or providing you with your favorite screen. However, cookies can also
be used to help track your Web actions and build a profile of you and your activities.
Inexpensive or free software is available to help you manage or prevent
cookies being placed on your computer, but blocking cookies may prevent you
from being able to use certain Web sites.
170 Understanding the Numbers
Internet Multimedia
The Internet provides an amazing plethora of information, and not just in text
or still-picture format. Video and audio streaming media is becoming increasingly
available on the Internet. There are several sites on the Net where one
can obtain audio clips, listen to music, or listen to radio shows. For example,
NFL football games and commentaries are available on the National Football
League's or National Public Radio's Web pages. In addition, many music companies
are allowing consumers to listen to music in the comfort of their homes
before buying the CDs. In addition, sites such as Napster have been created to
allow users to share or swap music and other files. Some of this sharing comes
dangerously close to violating copyright legislation. We have seen and can expect
to continue to see the courts play a significant role in defining the boundary
of propriety.
THE FUTURE—TODAY, TOMORROW, AND NEXT WEEK
Although the industrial revolution began in the United States toward the beginning
of the nineteenth century, we are still feeling its effects today. Consider
for a moment how our everyday lives have changed as a result of those
innovations. The computer revolution began about 1950, and the microprocessor—
the heart of the PC revolution—has been exploited only for the last 20
years. Now think about how our everyday lives have changed as a result of
these innovations. Remember, the microprocessor is part of so many of our appliances,
computers, automobiles, watches, and so forth. The impact of the
computer revolution is just as large if not larger than its precursor, the industrial
revolution, and has taken far less time. Moreover, the acceleration of
change in our lives that results from the use of computer technology has been
rapidly increasing. Technologists speak about the rapid changes in the development
of the Internet and its allied products. They even joke that things are
happening so fast that three months is equivalent to an "Internet year." Funny,
but true.
One of the biggest trends in the last several years has been the merging of
heretofore separate technologies. As we mix computer technology with communication
technology and throw in a good measure of miniaturization, it is
difficult to imagine the products we may soon see.
Mix together a PDA, a cell phone, and a global positioning satellite (GPS)
receiver, miniaturize the result, and you have a product that will remind you as
you drive past the supermarket where you were supposed to pick up a quart of
milk on the way home! Walk in the door to the market, and your pocket wonder
may tell you, based on your past love of Snickers candy bars, that they are on
sale for half-price on aisle 5. As you move towards the checkout line, the clerk,
who has never met you, may greet you by name because your pocket wonder
has announced your arrival to her cash register. While this scenario may
sound fanciful, all of the technologies exist today that could make this fancy
Information Technology and You 171
real. How these technologies will be used in the future, and the tremendous
entrepreneurial potential for new products and services, is wide open for the
resourceful.
This section is titled "The Future—Today, Tomorrow, and Next Week,"
because the horizon for change in the world of technology is very short. Each
year, major enhancements to both hardware and technology are released, rendering
previous technology obsolete. Some people are paralyzed from buying
computers because they are concerned that the technology will change very
soon. How right they are! The promise of technology is that it is constantly
changing. Today's worker must recognize that fact and learn to adapt to the
changing methods. Those who are technologically comfortable will be the first
to gain strategic advantage in the work environment and succeed. A word to
the wise: Hold on to your hat, and enjoy the ride. Adapt and go with it.
FOR FURTHER READING
There are many excellent books on the personal use of computer systems. Topics
run the spectrum from books about individual software packages to those
that explain how to program a computer. Many of these books come equipped
with a f loppy disk or CD and include step-by-step examples and exercises.
There are several popular series of these books. The following are but a few of
the books you might consider. You would probably find it worth your while to
browse through a number of books at your local store, searching for those that
meet your needs for detail and appear to be aimed at your current level of
understanding.
SYBEX has a series of books on Microsoft's Office software, including
Microsoft Office 2000: No Experience Required by Courter and Marquis.
QUE has published many books on various software applications, including
Microsoft Office 2000 User Manual.
Hungry Minds Inc. has a series of very noteworthy books, the for Dummies
series, one book for nearly every software package (e.g., Excel: Excel for
Dummies). See books on Office 2000, the Internet, and so on.
Microsoft Press also publishes numerous titles for users on both its operating-
system and application software.
USEFUL WEB SITES
Search Engines
www.yahoo.com A good search site which organizes the Web into
a hierarchy of categories
www.northernlight.com A very extensive search engine that organizes
search findings by subject matter
www.google.com A very extensive search site
172 Understanding the Numbers
Computer Information Sites
www.cnet.com A site that provides product reviews and prices
on a broad range of technology products
www.zdnet.com Web site of a large technology publisher, with
product reviews, software downloads, useful
articles, and price comparisons
Accounting Sites
www.aicpa.org Homepage of the American Institute of
Certified Public Accountants, with lots of useful
information and many links to other Web sites of
interest to accountants
www.rutgers.edu Homepage of the American Accounting
/Accounting/raw/aaa Association
Financial Management Site
www.fma.org Homepage of the Financial Management
Association International, with lots of useful
information and many links to other Web sites of
interest to financial managers
finance.yahoo.com Very useful homepage for personal financial
management, with many links to other personal
finance Web sites
173
6 FORECASTS
AND BUDGETS
Robert Halsey
THE CONCEPT OF BUDGETING
Budgets serve a critical role in managing any business, from the smallest sole
proprietor to the largest multinational corporation. Businesses cannot operate
effectively without estimating the financial implications of their strategic plans
and monitoring their progress throughout the year. During preparation, budgets
require managers to make resource allocation decisions and, as a result, to
reaffirm their core operating strategy by requiring each business unit to justify
its part of the overall business plan. During the subsequent year, variances of
actual results from expectations serve to direct management to the areas that
may deserve a greater allocation of capital and those that may need adjustments
to retain their viability.
A budget is a comprehensive formal plan, expressed in quantitative terms,
describing the expected operations of an organization over some future time
period. Thus, the characteristics of a budget are that it deals with a specific entity,
covers a specific future time period, and is expressed in quantitative terms.
This chapter describes the essential features of a budget and includes a
comprehensive example of the preparation of a monthly budget for a small
business. Although the focus of this chapter is on budgeting from a business
perspective, many of the principles are also applicable to individuals in the
planning of their personal finances.
174 Understanding the Numbers
FUNCTIONS OF BUDGETING
The two basic functions of budgeting are planning and control. Planning encompasses
the entire process of preparing the budget, from initial strategic direction
through preparation of expected financial results. Planning is the
process that most people think of when the term budgeting is mentioned. Most
of the time and effort devoted to budgeting is expended in the planning stage.
Careful planning provides the framework for the second function of budgeting,
control.
Control involves comparing actual results with budgeted data, evaluating
the differences, and taking corrective actions when necessary. The comparison
of budget and actual data can occur only after the period is over and actual accounting
data are available. For example, April manufacturing cost data are
necessary to compare with the April production budget to measure the difference
between planned and actual results for the month of April. The comparison
of actual results with budget expectations is called performance reporting.
The budget acts as a gauge against which managers compare actual financial
results.
REASONS FOR BUDGETING
Budgeting is a time-consuming and costly process. Managers and employees are
asked to contribute information and time in preparing the budget and in responding
to performance reports and other control-phase budgeting activities.
Is it all worth it? Do firms get their money's worth from their budgeting
systems?
The answer to those questions cannot be generalized for all firms. Some
firms receive far more value than other firms for the dollars they spend on
budgeting. Budgets do, however, provide a wealth of value for many firms who
effectively operate their budgeting systems. I now discuss some of the reasons
for investing in formal budgeting systems. In the next section of this chapter I
discuss issues that contribute to effective budgeting.
Budgets offer a variety of benefits to organizations. Some common benefits
of budgeting include the following:
1. Requires periodic planning.
2. Fosters coordination, cooperation, and communication.
3. Forces quantification of proposals.
4. Provides a framework for performance evaluation.
5. Creates an awareness of business costs.
6. Satisfies legal and contractual requirements.
7. Orients a firm's activities toward organizational goals.
Forecasts and Budgets 175
Periodic Planning
Virtually all organizations require some planning to ensure efficient and effective
use of scarce resources. Some managers are compulsive planners who continuously
update plans that have already been made and plan for new activities
and functions. At the other extreme are people who do not like to plan at all
and, therefore, find little or no time to get involved in the planning process.
The budgeting process closes the gap between these two extremes by creating
a formal planning framework that provides specific, uniform periodic deadlines
for each phase of the planning process. People who are not attuned to this
process must still meet budget deadlines. Of course, planning does not guarantee
success. People must still execute the plans, but budgeting is an important
prerequisite to the accomplishment of many activities.
Coordination, Cooperation, and Communication
Planning by individual managers does not ensure an optimum plan for the entire
organization. The budgeting process, however, provides a vehicle for the
exchange of ideas and objectives among people in an organization's various segments.
The budget review process and other budget communication networks
should minimize redundant and counterproductive programs by the time the
final budget is approved.
Quantification
Because we live in a world of limited resources, virtually all individuals and organizations
must ration their resources. The rationing process is easier for some
than for others. Each person and each organization must compare the costs and
benefits of each potential project or activity and choose those that result in the
most efficient resource allocation.
Measuring costs and benefits requires some degree of quantification.
Profit-oriented firms make dollar measurements for both costs and benefits.
This is not always an easy task. For example, the benefits of an advertising campaign
are increased sales and a better company image, but it is difficult to estimate
precisely the additional sales revenue caused by a particular advertising
campaign, and it is even more difficult to quantify the improvements in the company
image. In nonprofit organizations such as government agencies, quantification
of benefits can be even more difficult. For example, how does one quantify
the benefits of better police protection, more music programs at the city park,
or better fire protection, and how should the benefits be evaluated in allocating
resources to each activity? Despite the difficulties, resource-allocation decisions
necessitate some reasonable quantification of the costs and benefits of the various
projects under consideration.
176 Understanding the Numbers
Performance Evaluation
Budgets serve as estimates of acceptable performance. Managerial effectiveness
in each budgeting entity is appraised by comparing actual performance
with budgeted projections. Most managers want to know what is expected of
them so that they can monitor their own performance. Budgets help to provide
that information. Of course, managers can also be evaluated on other criteria,
but it is valuable to have some quantifiable measure of performance.
Cost Awareness
Accountants and financial managers are concerned daily about the cost implications
of decisions and activities, but many other managers are not. Production
supervisors focus on output, marketing managers on sales, and so forth. It
is easy for people to overlook costs and cost-benefit relationships. At budgeting
time, however, all managers with budget responsibility must convert their
plans for projects and activities to costs and benefits. This cost awareness provides
a common ground for communication among the various functional areas
of the organization.
Legal and Contractual Requirements
Some organizations are required to budget. Local police departments, for example,
cannot ignore budgeting even if it seems too much trouble, and the National
Park Service would soon be out of funds if its management decided not
to submit a budget this year. Some firms commit themselves to budgeting requirements
when signing loan agreements or other operating agreements. For
example, a bank may require a firm to submit an annual operating budget and
monthly cash budgets throughout the life of a bank loan.
Goal Orientation
Resources should be allocated to projects and activities according to organizational
goals and objectives. Logical as this may sound, relating general organizational
goals to specific projects or activities is sometimes difficult. Many
general goals are not operational, meaning that determining the impact of specific
projects on the organization's general goals is difficult. For example, organizational
goals may be stated as follows:
1. Earn a satisfactory profit.
2. Maintain sufficient funds for liquidity.
3. Provide high-quality products for customers.
These goals, which use terms such as satisfactory, sufficient, and highquality,
are not operational: the terms may be interpreted differently by each
manager. To be effective, goals must be more specific and provide clear direction
for managers. The previous goals can be made operational as follows:
Forecasts and Budgets 177
1. Provide a minimum return on gross assets invested of 18%.
2. Maintain a minimum current ratio of 2 to 1 and a minimum quick ratio of
1.2 to 1.
3. Products must receive at least an 80% approval rating on customer satisfaction
surveys.
EFFECTIVE BUDGETING
There are many reasons why some firms use budgeting more effectively than
others, including the following:
1. Budgets should be oriented to help a firm accomplish its goals and
objectives.
2. Budgets must be realistic plans of action rather than wishful thinking.
3. The control phase of budgeting must be used effectively to provide a
framework for evaluating performance and improving budget planning.
4. Participative budgeting should be utilized to instill a sense of cooperation
and team play.
5. Budgets should not be used as an excuse for denying appropriate employee
resource requests.
6. Management should use the budgeting process as a vehicle for modifying
the behavior of employees to achieve company goals.
Goal Orientation
Some firms have more resources than others, but it seems no firm has all the
resources it needs to accomplish all its goals. Consequently, budgets should
provide a means by which resources are allocated among projects, activities,
and business units in accordance with the goals and objectives of the organization.
As logical as this may sound, it is sometimes difficult to relate general,
organization-wide goals to specific projects or activities. Many general goals
are not operational, meaning the impact of specific projects on the achievement
of the general goals of the organization is not readily measurable.
A prerequisite to goal-oriented budgeting is the development of a formal
set of operational goals. Some organizations have no formally defined goals,
and even those that do often have only general goals for the entire organization.
Major operating units may function without written or clearly defined
goals or objectives. A logical first step toward effective budgeting is to formalize
the goals of the organization. Starting at the top, general organizational
goals should be as specific as possible, and written. Next, each major unit of
the organization should develop more specific operational goals. The process
should continue down the organizational structure to the lowest level of budget
responsibility. This goal development process requires management at all levels
178 Understanding the Numbers
to resolve difficult issues, but it results in a budgeting framework that is much
more likely to be effective since all business units proceed in a coordinated
manner toward the achievement of a common objective. Even individuals need
to understand their goals and objectives as they prepare budgets for their own
activities.
Realistic Plan
Budgeting is not wishful thinking; it is a process designed to optimize the use of
scarce resources in accordance with the goals of the company. Many firms have
budgets that call for sales growth, higher profits, and improved market share,
but to be effective such plans must be based on specific executable plans and
on available resources and management talent that the company can bring to
bear in meeting the budget. If the management of a firm wants to improve its
level of operations, there must be a clearly defined path between the present
and the future that the firm can travel.
The process begins with an analysis of the market and preparation of a
SWOT (strengths, weaknesses, opportunities, and threats) analysis. Utilizing
this background information, the company develops an overall strategy together
with the operational tactics required to achieve it (the development of a
business plan is discussed further in Chapter 9). The financial impact of this
strategy is then assessed in the preparation of the budget. If the financial results
are unfavorable, strategies and tactics must be revised until an acceptable
outcome is achieved. Once the budget is finalized, strategies are implemented
and the company's operations are subsequently monitored throughout the year
in the control phase, as discussed next. Exhibit 6.1 presents an iterative model
that embodies these concepts.
Participative Budgeting
Most behavioral experts believe that individuals work harder to achieve objectives
that they have had a part in creating. Applied to budgeting, this concept
states that employees will strive harder to achieve performance levels defined
by budgets if the employees have had a part in creating the budget. Budgets
imposed by top-level management, in contrast, may get little support from
employees. The concept of building budgets from the bottom up with input
from all employees and managers affected by the budget is called participative
budgeting.
The Control Phase of Budgeting
The first and most time-consuming phase of budgeting is the planning process.
The control phase of budgeting, however, may be the time when firms get the
most value from their budgeting activities. Exhibit 6.2 is a budget-performance
report for the first quarter of 2001. The difference between budgeted and
Forecasts and Budgets 179
actual amount is called a budget variance. Budget variances are reported for
both revenues and costs separately. In this case, revenues were $20,000 under
budget and are, therefore, considered as an unfavorable budget variance (U).
Expenses, though, were $30,000 less than expected, a favorable budget variance
(F). The net result is a favorable, profit budget variance of $10,000.
Each category is then separately analyzed to uncover the source of the
variance. Although total revenues are lower than expected, management is interested
in the actual product lines causing this variance. Further analysis
might reveal, for example, that all of the product lines are performing satisfactorily
except for one that is performing more poorly than expected. On the
expense side, a favorable budget variance may be due to positive effects of management
actions to operate the company more efficiently. Or, positive variances
may have occurred because costs necessary for long-term performance—such as
maintenance of machinery, research and development, or advertising—were
deferred to achieve short-term gains.
Management must thoroughly investigate the causes for budget discrepancies
so that corrective action can be taken. Are markets as a whole performing
EXHIBIT 6.1 Comprehensive budgeting process.
Strategic planning
Market/SWOT analysis
Strategic
development
Budgeting
Implementation
Control
EXHIBIT 6.2 Budget variance report.
Budgeted Actual Variance
Revenues $800,000 $780,000 $(20,000)U
Expenses (500,000) (470,00) 30,000 F
Profit 300,000 310,000 10,000 F
180 Understanding the Numbers
better or worse than expected? Is the company's marketing support adequate?
Has the competitive landscape changed? Are cost variances the result of management
actions in response to competitive pressures or due to inadequate
control? The answers to these questions may suggest changes in the company's
strategic and tactical plans to compensate for the variances.
When actual prices and quantities are compared with expected prices
and quantities, an additional level of analysis can be conducted. Exhibit 6.3 illustrates
a more in-depth analysis of price and quantity variance. During the
month, the firm realizes a positive variance of $6,000 relating to the cost of
aluminum, one of its production inputs.
This $6,000 variance can then be further decomposed into a price variance
and a quantity variance. The price variance is $21,000 favorable because
of the lower than expected purchase price for aluminum. It is computed by
multiplying the price variance per unit ($3 to $2.80) by the actual pounds utilized
(105,000). The quantity variance is $15,000 unfavorable as a result of
lower efficiency in the production process that led to more material usage than
had been expected. This is computed by multiplying the quantity variance
(105,000 to 100,000) by the expected price ($3). This analysis reveals that the
manufacturing process was less efficient than planned in that it utilized more
material to produce its products. This inefficiency was more than offset, however,
by lower prices for direct materials than had been forecasted. The price
variance, therefore, masks the production inefficiency, which would not be revealed
without the additional level of analysis.
Comparing actual results with the budget, adjusting plans when necessary,
and evaluating the performance of managers are essential elements of
budget control. Many people, however, find the control phase difficult. When
business results are less than expected it may be painful to evaluate the results.
For some it is much easier to look ahead to future periods when things hopefully
will be better. But frequently, realistic plans for future success can be
made only when management learns from its past mistakes. The control phase
of budgeting provides much of that learning process. Firms must be willing to
evaluate performance carefully, adjusting plans and performance to stay on
track toward achieving goals and objectives.
EXHIBIT 6.3 Price and quantity variance analysis.
Budgeted Actual Variance
Production level in units 20,000 20,000 0
Lbs aluminum/unit 5.00 5.25 0.25U
Aluminum cost /lb $ 3.00 $ 2.80 $ 0.20F
Total lbs aluminum 100,000 105,000 5,000U
Total material cost $300,000 $294,000 $ 6,000F
Price variance ($3.00 − $2.80) × 105,000 = $21,000F
Quantity variance (105,000 − 100,000) × $3.00 = $15,000U
Total net variance $ 6,000F
Forecasts and Budgets 181
Many companies have intricate budget performance reporting systems in
place, but the firms achieve little control from their use. In order to provide
effective control, a business must use the budget as an integral part of the company's
reward system. That is, employees must understand that budget performance
reports are a component of their performance evaluation. Rewards such
as pay raises, bonuses, and promotions should be tied to budget performance.
Generally it is easy to determine if a company's budget performance reporting
system is working effectively. If, on one hand, discussions with managers
yield comments such as, "If we fail to achieve the budget, we just add
more to it next period," the budget-control process is likely ineffective. If, on
the other hand, employees say, "If we are over our budget by more than 2%, we
will be called on the carpet and forced to explain the problem," then one
knows the control process is having an effect.
Improper Use of Budgets
Sometimes managers use budgets as scapegoats for unpopular decisions. For
example, rather than telling a department head that his or her budget request
for three additional employees is not convincing when compared with all of the
other budget requests, the vice president says, "The budget just would not
allow any new employees this year." In another case, the director of the marketing
department requests travel funds to send all of his staff to an overseas
education program. The vice president believes the program is a waste of
money. Instead of giving the marketing director his opinion, the vice president
says, "We would really like to send your staff to the program, but the budget is
just too tight this year." Of course, the truth in this situation is that the trip is
not a good use of business resources, regardless of the condition of the budget.
The marketing director is left with the impression that the real problem is the
state of the budget, when in fact the benefits of his travel proposal did not outweigh
the cost. Management should be careful not to undermine the budgeting
process by assigning to it adverse characteristics.
Behavioral Issues in Budgeting
Many of the internal accounting reports firms prepare are intended to inf luence
managers and employees to behave in a particular way. For example, many
manufacturing cost reports are intended to enable and motivate employees to
reduce costs or keep them at an acceptable level. Similarly, reports that compare
the performance of one division with those of other divisions are used to
evaluate the performance of division managers and encourage better results
for each division.
Budgets and budget performance reports are among the more useful internal
accounting reports businesses use to inf luence employee performance in
a positive manner. Budget control is based on the principle that managers be
held responsible for activities they manage. Performance reports ref lect the
182 Understanding the Numbers
degree of achievement of plans embodied in the budget. To minimize adverse
behavioral problems, managers should take care to develop and administer budgets
appropriately. Budgets should not be used as a hammer to demand unattainable
performance from employees. The best safeguard against unrealistic
budgets is participative budgeting.
DEVELOPING A BUDGET
Budgets are useful, and in most cases essential, to the success of virtually all
organizations whether they are for-profit or not-for-profit organizations. The
larger and more complex the organization, the more time, energy, and resources
are needed to prepare and implement the budget.
The Structure of Budgets
Regardless of the size or type of organization, most budgets can be divided
into two categories: the operating budget and the financial budget. The operating
budget consists of plans for all those activities that make up the normal operations
of the firm. For a manufacturing business, the operating budget
includes plans for sales, production, marketing, distribution, administration,
and any other activities that the firm carries on in its normal course of business.
For a merchandising firm, the operating budget includes plans for sales,
merchandise purchases, marketing, distribution, advertising, personnel, administration,
and any other normal activities of the merchandising firm. The
financial budget includes all of the plans for financing the activities described
in the operating budget plus any plans for major new projects, such as a new
production plant or plant expansion. Both the operating and financial budgets
are described later in more detail.
The Master Budget
The master budget is the total budget package for an organization; it is the end
product of the budget preparation process. The master budget consists of all the
individual budgets for each part of the organization combined into one overall
budget for the entire organization. The exact composition of the master budget
depends on the type and size of the business. However, all master budgets represent
the organization's overall plan for a specific budget period. Exhibit 6.4
lists the common components of a master budget for a manufacturing business.
The components of the master budget form the firm's detailed operating
plan for the coming year. As noted earlier, the master budget is divided into the
operating budget and the financial budget. The operating budget includes revenues,
product costs, operating expenses, and other components of the income
statement. The financial budget includes the budgeted balance sheet, capital
expenditure budget, and other budgets used in financial management. A large
part of the financial budget is determined by the operating budget and the beginning
balance sheet.
Forecasts and Budgets 183
Exhibit 6.5 is a simplified budget for C&G's Gift Shop. It is prepared on a
monthly basis. The number preceding each heading refers to the applicable
line in the budget.
Sales Budget (1–3)
The sales budget, or revenue budget, is the first to be prepared. It is usually the
most important budget because so many other budgets are directly related to
sales and therefore largely derived from the sales budget. Inventory budgets,
production budgets, personnel budgets, marketing budgets, administrative
budgets, and other budget areas are all affected significantly by the overall
sales volume expected.
For C&G's Gift Shop, expected sales in units are reported on line 1. Note
that the business is highly seasonal, with most of the sales and profits realized
during the months of November and December. To keep the budget simple, we
assume an average sales price of $100 per unit. In practice, the business would
forecast unit sales by individual product lines.
Budgeted Cost of Goods Sold (4)
C&G assumes a cost of goods sold of 65% of sales revenues. This results in a
gross profit of 35%. For a retailing company, cost of goods sold represents the
purchase cost of inventories sold during the period. It is computed as
where all inventories and purchases are computed at the purchase price to the
company.
Cost of Goods Sold Beginning Inventory Purchases during the Period
Ending Inventory
= +
−
EXHIBIT 6.4 A manufacturing firm's
master budget.
Operating Budget
Sales budget
Budget of ending inventories
Production budget
Materials budget
Direct labor budget
Manufacturing overhead budget
Administrative expense budget
Budgeted non-operating items
Budgeted net income
Financial Budget
Capital expenditure budget
Budgeted statement of financial position (balance sheet)
Budgeted statement of cash f lows
184 Understanding the Numbers
EXHIBIT 6.5 C&G's Gift Shop: 2000 cash budget.
Line Assumptions Nov-99 Dec-99 Jan Feb Mar
1 Total sales—units 5000 6430 3680 3530 2760
2 Selling price 100 100 100 100 100
3 TOTAL GROSS SALES 500000 643000 368000 353000 276000
4 TOTAL COST OF SALES 65% 325000 417950 239200 229450 179400
5 GROSS MARGIN 35% 175000 225050 128800 123550 96600
6
7 Selling expense 15% 75000 96450 55200 52950 41400
8 Administration (fixed) 23000 23000 23000 23000 23000
9 Administration (variable) 10% 50000 64300 36800 35300 27600
10 Depreciation expense 15yr sl amort 3472 3472 3472 3472 3472
11 TOTAL OPERATING EXPENSE 151472 187222 118472 114722 95472
12
13 OPERATING PROFIT 23528 37828 10328 8828 1128
14 Interest income 0 0 0 0 354
15 Interest expense −1956 −2872 −1989 −441 0
16 PROFIT BEFORE TAX 21572 34956 8339 8387 1482
17 Taxes at 35% 7550 12235 2918 2936 519
18 PROFIT AFTER TAX 14022 22721 5420 5452 963
19 Cumulative profit 5420 10872 11835
20 BALANCE SHEET
21 Cash 25000 25000 95836 160060
22 Accounts and interest receivable 65%,30/35%,60 637000 412050 300800 218904
23 Inventory Next month sales 239200 229450 179400 170950
24 TOTAL CURRENT ASSETS 901200 666500 576036 549914
25
26 Property, plant, & equipment (gross) 625000 625000 625000 625000
27 Accumulated depreciation 15yr sl amort −41667 −45139 −48611 −52083
28 Property, plant, & equipment (net) 583333 579861 576389 572917
29
30 TOTAL ASSETS 1484533 1246361 1152425 1122831
31
32 Bank loan (line of credit) 198949 44056 0 0
33 Accounts payable 239200 229450 179400 170950
34 Accrued expenses 198857 119908 114626 92519
35 TOTAL CURRENT LIABILITIES 637006 393414 294026 263469
36
37 Common stock 800000 800000 800000 800000
38 Retained earnings 47527 52947 58399 59362
39 TOTAL SHAREHOLDERS' EQUITY 847527 852947 858399 859362
40
41 TOTAL LIAB. + S/H EQUITY 1484533 1246361 1152425 1122831
42 STATEMENT OF CASH FLOWS (INDIRECT METHOD)
43 Net income 5420 5452 963
44 Depreciation 3472 3472 3472
45 Change in current assets (other than cash) 234700 161300 90346
46 Change in current liabilities (other than notes payable) −88699 −55332 −30557
47 Net cash f low from operations 154893 114892 64224
48
49 Net cash f low from investing activities 0 0 0
50
51 Net cash f low from financing activities −154893 −44056 0
52
53 Net change in cash 0 70836 64224
54 Beginning cash 25000 95836
55 Ending cash 95836 160060
Forecasts and Budgets 185
Apr May Jun Jul Aug Sep Oct Nov Dec Jan
2630 2580 2600 2650 2780 2990 4370 5220 7200 4220
100 100 100 100 100 100 100 100 100 100
263000 258000 260000 265000 278000 299000 437000 522000 720000 422000
170950 167700 169000 172250 180700 194350 284050 339300 468000 274300
92050 90300 91000 92750 97300 104650 152950 182700 252000
39450 38700 39000 39750 41700 44850 65550 78300 108000
23000 23000 23000 23000 23000 23000 23000 23000 23000
26300 25800 26000 26500 27800 29900 43700 52200 72000
3472 3472 3472 3472 3472 3472 3472 3472 3472
92222 90972 91472 92722 95972 101222 135722 156972 206472
−172 −672 −472 28 1328 3428 17228 25728 45528
675 874 932 953 952 921 855 401 0
0 0 0 0 0 0 0 0 −80
503 202 460 981 2280 4349 18083 26129 45448
176 71 161 343 798 1522 6329 9145 15907
327 132 299 637 1482 2827 11754 16984 29541
12162 12294 12593 13231 14713 17540 29294 46278 75819
199895 211494 215548 215369 209279 196033 105282 25000 25000
179275 169924 170232 175953 190702 216221 361505 494351 721700
167700 169000 172250 180700 194350 284050 339300 468000 274300
546871 550419 558031 572022 594331 696304 806087 987351 1021000
625000 625000 625000 625000 625000 625000 625000 625000 625000
−55555 −59027 −62499 −65971 −69443 −72915 −76387 −79859 −83331
569445 565973 562501 559029 555557 552085 548613 545141 541669
1116316 1116392 1120532 1131051 1149888 1248389 1354700 1532492 1562669
0 0 0 0 0 0 0 8042 146036
167700 169000 172250 180700 194350 284050 339300 468000 274300
88926 87571 88161 89593 93298 99272 138579 162645 218987
256626 256571 260411 270293 287648 383322 477879 638687 639323
800000 800000 800000 800000 800000 800000 800000 800000 800000
59689 59821 60120 60758 62240 65067 76821 93805 123346
859689 859821 860120 860758 862240 865067 876821 893805 923346
1116316 1116392 1120532 1131051 1149888 1248389 1354700 1532492 1562669
327 132 299 637 1482 2827 11754 16984 29541
3472 3472 3472 3472 3472 3472 3472 3472 3472
42879 8051 −3558 −14170 −28399 −115220 −200534 −261546 −33649
−6843 −55 3840 9882 17355 95674 94557 152766 −137358
39835 11599 4054 −179 −6091 −13246 −90751 −88324 −137994
0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 8042 137994
39835 11599 4054 −179 −6091 −13246 −90751 −80282 0
160060 199895 211494 215548 215369 209279 196033 105282 25000
199895 211494 215548 215369 209279 196033 105282 25000 25000
186 Understanding the Numbers
For a manufacturing company, cost of goods sold is computed similarly, but
in place of purchases we have the cost of the raw materials together with the
labor and overhead incurred in the manufacturing process. Beginning and ending
inventories consist of raw materials, work-in-process, and finished goods.
Administrative Expense Budget (7–10)
The expected administrative costs for an organization are presented in the administrative
expense budget. This budget may contain many fixed costs, some
of which may be avoidable if subsequent operations indicate some cost cuts are
necessary. These avoidable costs, sometimes called discretionary fixed costs,
include such items as research and development, employee education and
training programs, and portions of the personnel budget. Fixed costs that cannot
be avoided during the period are called committed fixed costs. Mortgage
payments, bond interest payments, and property taxes are classified as committed
costs. Variable administrative costs may include some personnel costs, a
portion of the utility costs, computer service bureau costs, and supplies costs.
Fixed and variable costs and the application of these concepts to the budget
process is discussed in detail in Chapters 3 and 7.
C&G's Gift Shop budgets selling expenses at 15% of sales. These are variable
costs since they change in proportion to changes in sales. You might think
of these as commissions paid to the sales personnel as a percent of the sales
made during the period. The fixed portion of administration expense is budgeted
as $23,000 per month. These expenses might be rent, salaries of administrative
personnel, and so forth. The administrative expense also contains a
variable component, budgeted at 10% of sales. Finally, depreciation is computed
on a straight-line basis over 15 years and is a fixed expense budgeted at
$3,472 per month.
Budgeted Income Statement (3 –18)
The budgeted income statement shows the expected revenues and expenses
from operations during the budget period. Budgeted income is a key figure in
the firm's profit plan and ref lects a commitment of most of the firm's talent,
time, and resources for the period.
A firm may have budgeted nonoperating items such as interest on investments
or gains or losses on the sale of fixed assets. Usually they are relatively
small, although in large firms the dollar amounts can be sizable. If nonoperating
items are expected, they should be included in the firm's budgeted income
statement. Income taxes are levied on actual, not budgeted, net income, but
the budget should include expected taxes; therefore, the last figure in the budgeted
income statement is budgeted after-tax net income.
Nonoperating items in C&G's income statement include interest income
and interest expense. Amounts borrowed carry an interest rate of 12% (1% per
month), and cash in excess of the $25,000 required for daily transactions is inForecasts
and Budgets 187
vested in marketable securities earning an investment return of 6% per annum
(0.5% per month). Finally, taxes are levied at the rate of 35% on pre-tax income.
The Financial Budget
The financial budget presents the plans for financing the operating activities
of the firm. The financial budget is made up of the budgeted balance sheet
and the budgeted statement of cash f lows, each providing essential financial
information.
Budgeted Balance Sheet (20 –41)
The budgeted balance sheet for the coming accounting period is derived
from the actual balance sheet at the beginning of the current budget period
and the expected changes in the account balances of the operating, capitalexpenditure,
and cash budgets.
The budgeted balance sheet is more than a collection of residual balances
resulting from other budget estimates. Undesirable projected balances and account
relationships may cause management to change the operating plan. For
instance, if a lending institution requires a firm to maintain a certain relationship
between current assets and current liabilities, the budget must ref lect
these requirements. If it does not, the operating plan must be changed until
the agreed requirements are met.
Budgeted Accounts Receivable (22)
Budgeted accounts receivable are a function of expected sales on open account
and the period of time that the receivables are expected to be outstanding. For
C&G's Gift Shop, all sales are assumed to be on open account to other businesses.
The company expects that 65% of the sales during the period will be
collected in the following month, and 35% will be collected in the next month.
For this exercise, we have assumed that all of the accounts are collectible. If
not, the company would have to build in a provision for uncollectible accounts
that would reduce expected collections and be ref lected in the income statement
as bad debt expense.
Budget of Ending Inventories (23)
Inventories comprise a major portion of the current assets of many manufacturing
firms. Separate decisions about inventory levels must be made for raw
materials, work-in-process, and finished goods. Raw material scarcities, management's
attitude about inventory levels, inventory carrying costs, inventory
ordering costs, and other variables may all affect inventory-level decisions.
C&G's Gift Shop has a policy to maintain inventory on hand equal to the
next month's expected cost of goods sold.
188 Understanding the Numbers
Capital Expenditure Budget (26)
The capital expenditure budget is one of the components of the financial budget.
Each of the components has its own unique contribution to make toward
the effective planning and control of business operations. Some components,
however, are particularly crucial in the effective management of businesses,
such as the cash and capital expenditure budgets.
Capital budgeting is the process of identifying, evaluating, planning, and
financing an organization's major investment projects. Decisions to expand
production facilities, acquire new production machinery, buy a new computer,
or remodel the office building are all examples of capital-expenditure decisions.
Capital-budgeting decisions made now determine to a large degree how
successful an organization will be in achieving its goals and objectives in the
years ahead. Capital budgeting plays an important role in the long-range success
of many organizations because of several characteristics that differentiate
it from most other elements of the master budget.
First, most capital budgeting projects require relatively large commitments
of resources. Major projects, such as plant expansion or equipment replacement,
may involve resource outlays in excess of annual net income.
Relatively insignificant purchases are not treated as capital budgeting projects
even if the items purchased have long lives. For example, the purchase of 100
calculators at $15 each for use in the office would be treated as a period expense
by most firms, even though the calculators may have a useful life of several
years.
Second, most capital expenditure decisions are long-term commitments.
The projects last more than 1 year, with many extending over 5, 10, or even 20
years. The longer the life of the project, the more difficult it is to predict revenues,
expenses, and cost savings. Capital-budgeting decisions are long-term
policy decisions and should ref lect clearly an organization's policies on growth,
marketing, industry share, social responsibility, and other goals. This is discussed
in greater depth in Chapter 10.
For purposes of this exercise, we have assumed that C&G's Gift Shop will
not be making any capital expenditures in the upcoming year. As a result, property,
plant, and equipment (PP&E; line 26) remains constant. Net PP&E (line
28), however, is reduced each period by the addition of depreciation expense
to accumulated depreciation.
Budgeted Accounts Payable (33)
Accounts payable represent amounts owed to other businesses for the purchase
of goods and services. These are usually non-interest bearing. We have assumed
that all the inventories are purchased on open account and that the
terms of credit require payment in full in the following month. As a result, accounts
payable are equal to the cost of inventories in this example.
Forecasts and Budgets 189
Budgeted Accrued Expenses (34)
Expenses are recognized in the income statement when incurred, regardless of
the period in which they are paid. For this example, we assume that all of the
operating expenses incurred and recognized during the month are paid in the
following month. These expenses include selling expenses, administrative expenses
other than depreciation, interest expense, and taxes.
Bank Loan (Line of Credit) (32)
Businesses require cash to cover the portion of inventories and accounts receivable
that are not financed by trade accounts payable and accrued expenses.
This is very pronounced in seasonable businesses. For example, C&G's Gift
Shop must purchase inventories one month in advance of sales. And when
these inventories are sold, 65% of the proceeds are collected in the subsequent
month and 35% in the month thereafter. As a result, C&G has a considerable
amount of cash invested in the business that is not recouped for at least two
months.
Typically, short-term cash needs such as the needs of seasonal businesses
are met with a bank line of credit that allows the company to borrow funds up
to a predetermined maximum and to repay those loans at a later date. In this
case, funds are borrowed to finance the purchase of inventories and these
amounts are repaid when the receivables are collected.
Stockholders' Equity (37–39)
No sales of common stock are budgeted. Since no dividends are projected, retained
earnings (38) increase by the amount of profit for the month.
Cash Budget
Of all the components of the master budget, none is more important than the
cash budget. Of the two major goals of most profit-seeking firms—to earn a
satisfactory profit and to remain liquid—liquidity is more important. Many
companies lose money for many years, but with adequate financing they are
able to remain in business until they can become profitable. Firms that cannot
remain liquid, in contrast, are unable to pay their bills as they come due. In
such cases, creditors can and often do force firms out of business. Even government
and nonprofit organizations such as churches and charities must pay
their bills and other obligations on time.
Meeting cash obligations as they come due is not as simple as it may appear.
Profitability and liquidity do not necessarily go hand-in-hand. Some firms
experience their most critical liquidity problems when they go from a breakeven
position to profitability. At that time growing receivables, increased inventories,
and growing capacity requirements may create cash shortages.
190 Understanding the Numbers
The cash budget is a very useful tool in cash management. Managers estimate
all expected cash f lows for the budget period. The typical starting point
is cash from operations, which is net income adjusted for non-cash items, such
as depreciation, and required investment in net working capital (accounts receivable
and inventories less accounts payable). All nonoperating cash items are
also included. Purchase of land and equipment, sales of bonds and common
stock, and the acquisition of treasury stock are a few examples of nonoperating
items affecting the cash budget. The net income figure for an accounting period
usually is very different from the cash f low for the period because of nonoperating
cash f low items or changes in working capital.
Often, cash budgets are prepared much more frequently than other budgets.
For example, a company may prepare quarterly budgets for all of its operating
budget components such as sales and production and also for its other
financial budget components such as capital expenditures. For its cash budget,
however, the firm prepares weekly budgets to ensure that it has cash available
to meet its obligations each week and that any excess cash is properly invested.
In companies with very critical cash problems, even daily cash budgets may
be necessary to meet management's information requirements. The frequency
of cash budgets depends on management's planning needs and the potential for
cash management problems.
Cash management is intended to optimize cash balances; this means having
enough cash to meet liquidity needs but not so much that profitability is
sacrificed. Excess cash should be invested in earning assets and should not be
allowed to lie idly in the cash account. Cash budgeting is useful in dealing with
both types of cash problems.
Budgeted Statement of Cash Flows—
Indirect Method (42–55)
The final element of the master budget package is the statement of cash f lows.
The increased emphasis by management in recent years on cash and the
sources and uses of cash has made this an ever more useful management tool.
This statement is usually prepared from data in the budgeted income statement
and changes between the estimated balance sheet at the beginning of the budget
period and that at the end of the budget period.
The statement of cash f lows consists of three sections, net cash flows
from operations, net cash f lows from investing activities, and net cash flows
from financing activities. Net cash f lows from operations are equal to net income
plus depreciation expense plus or minus changes in current assets (other
than cash) and current liabilities (other than bank loans). Increases (decreases)
in current assets are treated as cash outf lows (inf lows), and increases (decreases)
in current liabilities are treated as cash inf lows (outf lows).
Net cash f lows from investing activities consist of changes in long-term
assets. Since we do not project any capital expenditures, net cash f lows from
investing activities are equal to zero in all months.
Forecasts and Budgets 191
Net cash f lows from financing activities consist of changes in borrowed
funds (short and long term), changes in other long-term liabilities, changes in
common stock, and dividends paid. The only financing activities in this example
are increases (decreases) in bank loans outstanding. The bank line of credit
is the buffer that keeps assets equal to liabilities and stockholders' equity. As
assets grow with increases in inventories and accounts receivable, bank loans
increase as well to finance this growth. And as the inventories are sold and the
receivables collected during slower periods, the excess cash is used to repay
the amounts borrowed. Banks typically require that the line of credit be paid
in full at some point during the year. Any excess funds generated after repayment
of the bank loans are invested in short-term marketable securities until
required again to finance seasonal growth in assets.
FORECASTING
Sales budgets are inf luenced by a wide variety of factors, including general
economic conditions, pricing decisions, competitor actions, industry conditions,
and marketing programs. Often the sales budget starts with individual sales
representatives or sales managers predicting sales in their particular areas. The
basic sales data are aggregated to arrive at a raw sales forecast that is then
modified to ref lect many of the variables mentioned previously. The resulting
sales budget is expressed in dollars and must include sufficient detail on product
mix and sales patterns to support decisions about changes in inventory levels
and production quantities.
In addition to the input from sales personnel, companies frequently utilize
a number of statistical techniques to estimate future sales. For example,
Exhibit 6.6 is a graph of the quarterly sales of Kellogg Company from 1990 to
2000.
The sales appear to demonstrate some variation around an upward trend.
How would one forecast sales for the next 12 quarters? Projecting from the
most recent sales level might overstate the estimates if the last quarter was
unusually high because of, say, the effects of a major advertising campaign or
new-product introduction, or seasonal increases. An alternative is to estimate
the underlying trend in quarterly sales. Exhibit 6.7 presents such a graph.
In Exhibit 6.7, I have estimated a trend line for Kellogg's quarterly sales
using a statistical technique called regression analysis. This line was estimated
with a statistical software package called Minitab, but the analysis is also available
in Microsoft Excel and many other software programs. The equation for
the trend line is
where Salest is the sales for time t (t = 41 for the first quarter estimated, since
our data ended at quarter number 40). Our forecasts for the next 12 quarters
Salest = $1,475, 002 + $8, 357.73 × t
192 Understanding the Numbers
extend linearly with a continuation of the same slope that was estimated in the
trend line fit through the data.
A potential problem with fitting a trend line through the data with regression
analysis is that each observation is treated the same way. That is, we
are not weighting the information contained in the latest set of observations
more heavily than those that occurred 30 quarters ago. Other statistical techniques
are available to address this concern. One of these is exponential
smoothing. Exhibit 6.8 presents the same quarterly sales data with a trend line
that has been exponentially smoothed.
EXHIBIT 6.6 Kellogg company's quarterly sales (1990 –2000).
Index 10 20 30 40
Sales ($)
Quarters
1,900,000
1,800,000
1,700,000
1,600,000
1,500,000
1,400,000
EXHIBIT 6.7 Trend analysis for Kellogg company's quarterly sales
(1990 –2000).
Actual
Fits
Forecasts
0 10 20 30 40 50
Quarters
Sales t = $1,475,002 + $8,357.73 × t
MAPE:
MAD:
MSD:
Linear Trend Model
Sales ($)
1,900,000
1,800,000
1,700,000
1,600,000
1,500,000
1,400,000 4
67,504
7.65E+09
Forecasts and Budgets 193
Notice how the estimated trend line reacts to changes in quarterly sales.
This technique weights recent observations more heavily than those in the distant
past. The result is a trend line whose slope changes over time to ref lect
changes in sales growth. Our projections for the next 12 quarters, then, begin
from the last estimate of the underlying trend and at the most recent slope indicated
by the data.
Many other statistical techniques can also be brought to bear on this
problem. These provide an objective estimate of future sales from the data itself.
Their advantage is that they are not prone to biases from wishful thinking
or undue pessimism. Their drawback is that they cannot take into account all
of the variables witnessed by our sales personnel and therefore, do not have as
much of a "feel" for the market. Companies must utilize a variety of inputs
into the projection process, and they derive some level of comfort when several
different approaches yield similar results.
Projection is a critical part of the budgeting process. It follows from our
SWOT analysis and the resulting strategic and tactical plan. Once these are
formulated, sales projections and the subsequent budgeting process outlined
above provide an evaluation of the effectiveness of the business plan.
FIXED VERSUS FLEXIBLE BUDGETS
Many organizations operate in an environment where they can predict with
great accuracy the volume of business they will experience during the upcoming
budget period. In such cases, budgets prepared for a single level of activity
typically are very useful in planning and controlling business activities. Budgets
prepared for a single level of activity are called fixed budgets.
EXHIBIT 6.8 Double exponential smoothing of Kellogg company's
quarterly sales (1990 –2000).
0 10 20 30 40 50
Quarters
Gamma (trend):
Alpha (level):
Smoothing Constants
Double Exponential Smoothing
Sales ($)
2,150,000
1,900,000
1,650,000
1,400,000
Actual
Predicted
Forecasts
MAPE:
MAD:
MSD:
5
79,481
0.200
9.08E+09
0.200
194 Understanding the Numbers
Organizations that have trouble predicting accurately the volume of activity
they will experience during the budget period often find that a budget
prepared for only one level of activity is not very helpful in planning and controlling
their business activities. These organizations can operate better with a
budget prepared for several levels of activity covering a range of possible levels
of activity. This type of budget is called a f lexible budget.
Fixed Budgets
A fixed budget, or static budget, contains budget data for only one specific volume
of activity. Because fixed budgets use only one volume of activity in determining
all budgeted data, the fact that some costs are fixed and some costs
are variable has no impact on the budgeted figures. The budget data used in
preparing the budget for the planning phase of the process are also used in
budget performance reports during the control phase of the budget process regardless
of whether the volume of activity is actually achieved.
The planning and control framework provided by a budgeting system is an
essential element of effective management. In many organizations, fixed budgets
are tools that offer managers the ability to plan and control operations and
to evaluate performance. If, however, the actual volume of activity achieved
by a firm is sufficiently different from the volume planned in the fixed budget,
the fixed budget may be a very poor measure on which to base the performance
of employees.
Flexible Budgets
A f lexible budget, also called a dynamic budget, is prepared for more than one
level of activity. For example, a firm may prepare budgets for 10,000, 11,000,
and 12,000 units produced. The purpose of preparing budgets for multiple activity
levels is to provide managers with information about a range of activity
in case the actual volume of activity differs from the expected level. For planning
material acquisitions, labor needs, and other resource requirements, managers
continue to rely heavily on the budget based on the expected level of
activity, but the f lexible budget provides additional information useful in modifying
plans if operating data indicate that some other level of activity will
occur. When performance reports are prepared, actual results are compared
with a budget based specifically on the level of activity actually achieved.
Actual activity may differ significantly from budgeted activity because of
an unexpected strike, cancellation of a large order, an unexpected new contract,
or other factors. In a business that frequently experiences variations in
its volume of activity, a f lexible budget may be more useful than a fixed budget.
Flexible budgets provide managers with more useful information for planning
and a better basis for comparing performance when activity levels
f luctuate than is available from a fixed budget. Flexible budgets are discussed
in more detail in Chapter 7.
Forecasts and Budgets 195
The Profit Plan
Though the term profit plan is sometimes used to refer to a master budget, it
probably best describes the operating part of the master budget of a forprofit
firm. It can be argued, however, that the entire master budget of such
firms is the total profit plan for the firm. The operating budget shows details
of budgeted net income, but the financial budgets, such as cash and capital
expenditure budgets, are also an integral part of the overall profit planning of
the firm.
Naturally, the term profit plan is not suitable for public-sector firms. Organizations
such as a fire department do not generate a net income. For publicsector
organizations, master budget is the more logical term for the total
budget package. Because we are concerned with both public- and privatesector
organizations, we use master budget predominantly. However, be aware
of profit plan because it is used occasionally in practice.
THE BUDGET REVIEW PROCESS
The budget plan determines the allocation of resources within the organization.
Typically, the resources available are less than the demand for the resources.
Consequently, there should be some systematic process for evaluating
all proposals relating to the budget. The process of systematically evaluating
budget proposals is referred to as the budget review process.
In the early planning stages, budget review may not be a formal process.
Sometimes a few people (or even a single individual) make the budgeting decisions.
For example, production-line supervisors may determine resource allocations
within their department. Next, a plant budget committee may evaluate
budget proposals for all production supervisors. The budget proposals for the
entire plant go to a division budget committee, and the final budget review is
made by a budget committee of the controller and corporate vice presidents.
The budget review process varies among organizations. Even within a single
firm, different budget review processes may be used in various segments of
the firm, and at various levels of responsibility. However, the basic review process
is fairly standard.
Accountants and financial managers participate in the preparation and
implementation of the budget, but all business managers, including marketing
managers, production supervisors, purchasing officers, and other nonfinancial
managers are interested in developing budgets for their particular part of the
business. In addition, each functional manager must be keenly interested in
selling her or his budget to higher-level management. Selling the budget means
convincing the budget review committee that a particular budget proposal
should be accepted. For some managers, selling the budget is the single most
important activity in their job, because if they fail at this task, even a tremendous
management effort cannot obtain desired results.
196 Understanding the Numbers
With such an awesome description of the importance of selling the budget,
one might conclude that it is an exceedingly difficult process. Not so. Actually,
the process requires a mixture of logic and diligence. There is no precise
formula for success, but some common suggestions are:
1. Know your audience.
2. Make a professional presentation.
3. Quantify the material.
4. Avoid surprises.
5. Set priorities.
Know Your Audience
A large part of a budget-selling strategy may depend on the budget review audience,
whether it is one person or a group of people. Information that may
prove essential to the successful budget approval effort includes: Strategies
that have succeeded or failed in the past; pet peeves or special likes of review
members; and a variety of other committee characteristics.
Make a Professional Presentation
A professional presentation is critical to gaining acceptance of the proposal.
This typically includes:
• An enthusiastic and polished presentation.
• A neat, concise, and understandable budget proposal.
• Ample supporting documentation.
• A willingness and ability to answer relevant questions.
Quantify the Material
Because most resource allocation decisions are in some way affected by their
cost-benefit relationships, it is necessary to quantify both the costs and benefits
of virtually all budget proposals. Cost estimation is seldom easy, but it is usually
far easier than the measurement of benefits. Even in the private sector, benefits
are not always easy to measure in terms of the corporate goals of profitability
and liquidity. In the nonprofit sector, benefit measurement is even more
difficult. For example, how does one measure the benefits of 20 new park
rangers, 10 new police cars, or a decorative fountain in the city park? Obviously
the quantification process would be different for each of these, and direct comparisons
could be inconclusive. Yet, such comparisons may be necessary in arriving
at final budget allocations.
It is easy to dismiss the value of quantification when the resulting numbers
are hard to compare with other budget proposals or the numbers are hard
to verify. Nevertheless, some quantitative support typically is better than just
Forecasts and Budgets 197
general statements about the desirability of the budget proposal. Budget salesmanship
should be approached with the same ingenuity that is found in the external
marketing effort. If certain budget proposals have benefits that are
difficult to quantify directly, various types of statistics might support the projects
in an indirect way. For example, if a police department wants to justify 10
new police officers, it might offer supporting statistics on rising population
in the community, rising crime rates, or relatively low per-capita police cost
ratios. Although none of the suggested statistics measures direct benefits, they
may be more useful in swaying a budget review committee than some vague
statement about the value of more officers. Statistics that are not direct measures
of benefits are used widely in both the public and private sectors when
supporting budget proposals.
Avoid Surprises
Avoid surprising either review committee or those who present the budget.
New proposals and information are hard to sell to a budget review committee
and should be introduced and developed long before the final review process.
Surprises to managers presenting the budgets most often occur during
the questioning process or when a budget proposal is more detailed than prior
budgets. To minimize this problem, budget presentations should be carefully
rehearsed. The rehearsal might include a realistic or even pessimistic mock review
committee. The mock review should ask pointed and difficult questions.
Sometimes knowing the answer to a relatively immaterial question is enough
to secure a favorable opinion.
Set Priorities
Few managers receive a totally favorable response to all budget requests. In a
world of limited resources, wants exceed available resources, and managers
should be prepared for a budget allocation that is somewhat different from the
initial request. Typically, all proposed budget items are not equally desirable.
Some projects and activities are essential; others are highly desirable. Some
would be nice but are really not essential.
Priority systems established by the managers of each budgeting entity
before the review process starts aid in structuring the budget proposal so that
important items are funded first. Setting priorities avoids embarrassing questions
and last-minute decision crises that affect the quality of a professional
presentation.
FOR FURTHER READING
Brownell, P., "Participation in Budgeting, Locus of Control, and Organizational Effectiveness,"
The Accounting Review, 56, no. 4 (Oct. 1981): 844–861.
198 Understanding the Numbers
Carruth, Paul J., and Thurrel 0. McClendon, "How Supervisors React to Meeting the
Budget Pressure," Management Accounting, 66 (Nov. 1984): 50.
Chandler, John S., and Thomas N. Trone, "Bottom Up Budgeting and Control," Management
Accounting, 63 (Feb. 1982): 37.
Chandler, Susan, "Land's End Looks for Terra Firma," Business Week, July 8, 1996,
130–131.
Collins, Frank, Paul Munter, and Don W. Finn, "The Budgeting Games People Play,"
The Accounting Review, 62 (Jan. 1987): 29.
Leitch, Robert A., John B. Barrack, and Sue H. McKinley, "Controlling Your Cash Resources,"
Management Accounting, 62 (Oct. 1980): 58.
Merchant, Kenneth A., "The Design of the Corporate Budgeting System: Inf luences
on Managerial Behavior and Performance," The Accounting Review, 56 (Oct.
1981): 813.
and J. Manzoni, "The Achievability of Budget Targets in Profit Centers: A
Field Study," The Accounting Review, 64, no. 3 (July 1989): 539–558.
Merewitz, Leonard, and Stephen H. Sosnick, The Budget's New Clothes (Chicago:
Markham Publishing Company, 1973).
Penne, Mark, "Accounting Systems, Participation in Budgeting, and Performance
Evaluation," The Accounting Review, 65, no. 2 (April 1990): 303–314.
"Tenneco CEO Mike Walsh's Fight of His Life," Business Week, September 20,
1993, 62.
Trapani, Cosmo S., "Six Critical Areas in the Budgeting Process," Management Accounting,
64 (Nov. 1982): 52.
Wildavsky, Aaron, The Politics of the Budgetary Process, 2nd ed. (Boston: Little,
Brown, 1974).
199
7 MEASURING
PRODUCTIVITY
Michael F. van Breda
"Control is what we need. Cost control. And urgently," said owner-manager
Dana Jackson emphatically to her management team. "Just a glance at these
reports tells me that our costs are going up faster than our revenues. We won't
survive much longer on that basis."
"Well, we could try using cheaper inks and lower quality paper," said Tom
Dodge, production manager of Jackson Printing, half-facetiously.
"That's not the answer," exclaimed marketing manager Ahmad Grande.
"We're having a hard enough time as it is selling in this competitive market. If
we start to produce an inferior product, our sales will tumble even further. Nobody
is going to pay our prices and take cheaper quality."
"Ahmad's right," said Dana. "Our aim should not be to reduce costs so
much as to control them. Remember that we have a goal to meet in this organization—
to produce the best-quality products that we can. If we don't keep our
eyes on that goal we won't be effective as an organization.
"What I'm really after is efficiency. I want to see us produce quality
products as cheaply as possible—but I don't want us to produce cheap products.
We must improve productivity.
"To get the ball rolling, I want Tom to draw up a set of standards for production.
Our attorney has been explaining the new system they have installed
in their office to control their billable hours. We could do something similar in
our business."
As eyes rolled, Dana explained what their law firm had done. "I was
telling their senior partner about our concerns and he related to me his own
200 Understanding the Numbers
conversation with one of his associates. She was expected to bill approximately
500 hours each quarter to clients. She had actually reported 570 hours, which
pleased him, but she had only brought in $70,500 when he would have expected
$85,500 based on her standard billing rate of $150 per billable hour.
That was $15,000 below his expectations.
"She explained to him that on the Prescot case the partner that she was
assisting had asked her to do some library research on an alternative theory of
liability. She spent 80 hours working on this research, but in the end the partner
decided not to adopt that alternative theory. The partner instructed her
not to charge those 80 hours out, so, at her hourly billing rate of $150, that was
$12,000 of the total shortfall.
"As for the other $3,000, she explained that on the Klinger case the client
felt that the $150 per hour was an excessive rate to charge for an inexperienced
lawyer like her. The partner in charge of this case agreed to cut her hourly rate
to $125. She spent 120 hours on that case, so, at $25 per hour not billed, there
was the other $3,000. He summarized her results for me like this:
"In other words, as he explained it, she actually put in only 490 billable hours,
even though she worked 570 hours, as opposed to the expected 500 hours. She
charged an average $143.88 instead of the expected $150. They use these numbers
to break their total variance into two parts: a volume variance and a rate
variance computed as follows:
"They like to do this in percentage or index terms, too.
"So they know not only the total amount that their actual costs differed from
the budget but also causes of this difference, namely the drop in 10 hours and
the drop in the rate of $6.12, and they can identify the effect of each cause on
their costs in dollars and percentage terms. That way they can pinpoint the
areas that need particular investigation. Things that don't need attention can
be safely neglected, leaving time to more carefully manage the exceptions.
"The percentage approach also enables them to introduce two other
indices, that of the hours billed to the hours actually worked, namely 490/570
or 86%, and the hours actually worked to those budgeted, 570/500 or 114%. In
other words, this associate worked 14% more than she should have but actually
Volume Index or a 2% drop
Rate Index or a 4% drop
= =
= =
.
.
.
490
500
0 98
143 88
150
0 96
Volume Variance hours $150.00 =$1, 500
Rate Variance 490 hours =$3, 000
= − ×
= − ×
( )
$( . . )
500 490
150 00 143 88
Actual Billings billable hours per hour
Budgeted Billings billable hours per hour
Total Variance billable hours unfavorable
= = ×
= = ×
= − =
$ , $ .
$ , $ .
$ , $ , $ ,
70 500 490 143 88
75 000 500 150 00
70 500 75 000 4 500
Measuring Productivity 201
billed only 86% of those hours. As he noted, that suggests a serious problem,
especially when one compares her with the firm average.
"Their firm," continued Dana, "does this for every one of their associates.
They can thereby track the actual revenues of their firm and compare it with
the budgeted revenues. They can see whether any shortfalls or overages are
due to charging out more or fewer billable hours than expected, or to charging
clients more or less than the standard rate, or to some combination of the two.
It gives them an excellent tool to see how their firm is doing. They can also analyze
productivity in the firm: in total, month by month, as well as by departments
within the law firm, such as trust and estate, corporate, litigation, family
law, and so on, right down to individual lawyers in the firm. And knowing what
has happened in the past, they have an excellent tool for beginning to plan for
the future. I think we should be doing something similar!
"If we do, we'll have an idea whether the production staff is working efficiently.
If we have those standards in hand, then we can check how much our
product should be costing us. And, we'll be able to compare that figure with actual
product cost. Checking the difference between actual and budget will tell
us where our big problems are. With that information in hand, we should be
able to get our costs much more under control and our productivity up."
"Agreed," responded Ahmad. "People will pay for a quality product if it is
competitively priced. We've just got to make sure that we're working as efficiently
as our competition, and we'll be fine. That means, when we draw up
a price quote, we need to be able to come in at or below the quotes of our
competitors."
"That's all very well for you to say," said Tom, feeling a little aggrieved.
"You're not the one who has to draw up these productivity standards. I've tried
doing this before and it's not easy, let me tell you. For starters everyone seems
to want perfection."
"The other thing that I think we need to be aware of," added Ahmad, "is
that variance analysis is just a start. We need a range of performance measures
that capture not only our productivity but also the value that we are adding to
our customers. For instance, we know from the newspapers that the firm saved
the Prescots tens of thousands of dollars. That was a very successful case for
them, and that needs noting. What we really need is a balanced scorecard that
adds a customer perspective to our more internal focus."1
With that the meeting broke up. Tom went back to his office, realizing
that he was not quite sure where to begin. For one thing, he hadn't shared the
fact that he had not succeeded in his last attempt to install a standard cost system.
What chance did he have this time? A call to a friend of his, Jane Halverson,
who had just completed her MBA, seemed in order.
BUDGETARY CONTROL
"Jane, I need your help badly," Tom pleaded. "My boss is after a set of production
standards and I don't know what to do or where to begin!"
202 Understanding the Numbers
Def ining Standards
That evening Tom went over to Jane's home, and she pulled out her cost accounting
textbook. "Tell me everything you think I need to know about standard
costs," Tom said.
"Okay. First, Tom, let's get straight what we mean by a standard and
why we're calculating it. A standard is a basis of comparison; it's a norm, if
you will, or a yardstick. Some like to compare it to a gauge—a gauge to measure
efficiency.
"But a standard is more than that really because it is also the basis for control.
Standards enable management to keep score. The difference between
standards and actuals directs management's attention to areas requiring their
efforts. In that sense, standards are attention getters. They form the heart of
what is known as management by exception, the concept that one does not
watch everything all the time; instead one focuses one's attention on the exceptions,
the events that are unexpected."
Tom smiled knowingly. "I've experienced this and it's terrible. My boss at
my last job never noticed the good job that I did every day. But, when something
went wrong, he was down like a shot to bawl me out!"
"That's one of the traps of managing by exception," said Jane. "But you're
smart enough as a manager to know that people need to be rewarded for their
regular jobs. You also know that the exceptions are highlighted so that you can
help them remedy things—not shout at them. Also, outstanding performance
should be rewarded, and so, by means of management by exception, favorable
results are highlighted, allowing high performers to receive praise."
Types of Standards
"Then you have to realize," Jane went on, "that there are different kinds of
standards. First you have your basic standards. These are the one's that are unchanging
over long periods of time. Many of these are captured in policy statements
and may ref lect things like the percentage of waste that is permitted or
the amount of time one might be away from a workstation. Basic standards are
not much use in forming costs, though, because the work environment tends to
change too much.
"At the other extreme there are theoretical or ideal standards. These get
set by engineers and are the ideals to which one is expected to strive. These are
the standards that I think you feel are unrealistic."
"Hear! Hear!" broke in Tom. "My guys never would accept those standards—
that's the perfection mentality I was telling you about."
"But," asked Jane, "aren't the Japanese always striving towards ideal
standards?"
"True, but the difference between them and us is that their system of
lifetime employment provides a more supportive atmosphere in which they can
strive for perfection and not feel they are going to get fired if they don't quite
Measuring Productivity 203
make it this time around. It's not enough to look at standards in isolation. One
must view them in the context of total management."
"Right," said Jane approvingly. "And that means that your best norms to
develop are probably what are called currently attainable standards. These are
standards that can be met but still represent a challenging goal. Let me read
you a quote:
Such standards provide definite goals, which employees can usually be expected
to reach, and they also appear to be fair bases from which to measure
deviations for which the employees are held responsible. A standard set at a
level which is high yet still attainable with reasonably diligent effort and attention
to the correct methods of doing the job may also be effective for stimulating
efficiency.2
I think that's the kind of standard you are after."
"You're right. And, I tell you there are real advantages to standards set at
this level. My guys find them very motivating. Also, when it comes time to costing
jobs out for pricing purposes, we have a reasonable shot at making those
standards. Of course, that wouldn't stop us from trying for perfection. It's just
that we wouldn't have management breathing down our necks when we didn't
make it."
Budgets
"Tell me one more thing, though," said Tom. Why do we have to go to all this
bother to develop standards. Why can't top management just use last year's
numbers? That will give them a base for comparison."
"True," said Jane. "But you've got to remember that last year's actuals ref
lect last year's circumstances. Things may have changed this year so much
that last year is not a fair comparison. How would you like it if they didn't adjust
your materials budget for inf lation but expected you to produce as much
this year as you did last?"
"Okay—you've made your point. But, why can't they just get our controller
to draw up a budget at the start of the year. Why do I have to get
involved?"
"Two reasons. One is that the controller can't draw up a budget without
standards. Standard costs are the unit costs that go into a budget. The budget
contains your standards multiplied by the expected volume of sales provided
by the marketing department.
"The other reason you need to get involved is that the budget needs to be
adjusted for volume. You want them to evaluate you on the basis of a f lexible
budget, as opposed to a static budget. The only way to be fair to people is to use
a f lexible budget. Look at these numbers for instance." Jane scribbled down
the numbers appearing in Exhibit 7.1.
"Notice how the budget is drawn up in the first column: You estimate the
volume for the year and multiply it by the estimated unit selling price or the
204 Understanding the Numbers
estimated unit cost, the standard cost. Fixed costs remain the same, of course,
and are just inserted into the budget. The last column shows the actual revenues
and actual costs: To get them you multiply the actual selling or the actual
unit cost by the actual volume. The middle column shows the estimated selling
price and the estimated unit costs multiplied by the actual volume.
"Note that the only difference between the f lexible budget in column 2
and the static budget in column 1 lies in the volume being used. The static budget
uses the expected volume while the f lexible budget uses the actual volume.
In other words, the difference between f lexible and static may be attributed
entirely to changing activity levels. The difference is, therefore, dubbed an activity
variance.
"The unit price and cost terms for the actual revenues and costs in column
3 differ from the corresponding price and cost terms for the f lexible budget
in column 2; however, the activity level is the same: Both use the actual
level of sales. In other words, the difference between actual and f lexible may
be attributed to changing selling and cost prices. These differences are dubbed
the price variances. Let's summarize the definitions of these terms.
"Now look what happens if all you have is the budget from the beginning of the
year. The variable costs, for which you are responsible, are $1,400 above budget.
You could reasonably expect to have your boss down here chewing you out
for not controlling your costs. But, if you know your standard costs, you can adjust
the budget for volume and give him the number in the second column.
That comparison shows that you actually got your costs down by $900. Let me
show you what I mean in more depth."
Price Variance Actual Results Flexible Budget
Activity Variance Flexible Budget Static Budget
Price Index
Actual Results
Flexible Budget
Activity Index =
Flexible Budget
Static Budget
= −
= −
=
EXHIBIT 7.1 Static versus f lexible budgets.
Budget (Static) Budget (Flexible) Actual
Volume in reams 1,000 1,200 1,200
Revenues $12,000 $14,400 $13,800
at $12/ream at $12/ream at $11.50/ream
Variable costs $7,000 $8,400 $7,500
at $7.00/ream at $7.00/ream at $6.25/ream
Fixed costs $4,000 $4,000 $4,680
Net income $1,000 $2,000 $1,620
Measuring Productivity 205
With that Jane started to prepare Exhibit 7.2. First, to prepare Panel A
she compared the actual results with the original budget, the static budget. She
derived the percentage change by dividing the actual by the budget, subtracting
one from the result, and multiplying the remainder by 100. For instance, in
the case of revenue:
She did similar computations for the other lines and other panels.
Step 1.
Step 2.
Step 3.
13 800
12 000
1 15
1 15 1 0 15
0 15 100 15
,
,
.
. .
. %
=
− =
× =
EXHIBIT 7.2 Comparing the budgets.
Panel A
Actual versus Static Budget
Static Percentage
Budget Actual Indixes Change
Revenue $12,000 $13,800 1.15 15
Variable costs 7,000 7,500 1.07 7
Contribution $ 5,000 $ 6,300 1.26 26
Fixed costs 4,000 4,680 1.17 17
Net income $ 1,000 $ 1,620 1.62 62
Panel B
Actual versus Flexible Budget
Flexible Percentage
Budget Actual Indixes Change
Revenue $14,400 $13,800 0.96 (4)
Variable costs 8,400 7,500 0.89 (11)
Contribution $ 6,000 $ 6,300 1.05 5
Fixed costs 4,000 4,680 1.17 17
Net income $ 2,000 $ 1,620 0.81 (19)
Panel C
Static versus Flexible Budget
Static Flexible Percentage
Budget Budget Indixes Change
Revenue $12,000 $14,400 1.20 20
Variable costs 7,000 8,400 1.20 20
Contribution $ 5,000 $ 6,000 1.20 20
Fixed costs 4,000 4,000 1.00 0
Net income $ 1,000 $ 2,000 2.00 100
206 Understanding the Numbers
Price Indices
"If you only examine Panel A of Exhibit 7.2," Jane said, "you will think that net
income leaped 62% and that the reason for the dramatic increase lies in the relatively
sharp increase of 15% in revenue. This increase in revenue appears to
have more than compensated for the apparent increase in variable costs of 7%
and fixed costs of 17%. You might be tempted to attribute the increase in net
income to the superior ability of the sales staff."
"The fallacy of this interpretation is apparent when you examine Panel B,
which compares the actual results with the f lexible budget. Now, after adjusting
for sales volume, we find that instead of that dramatic increase of 62% in
net income, there was a 19% drop in net income from budget. Using that same
basis of comparison, revenue actually fell by 4% instead of our earlier increase
of 15%. Now you can also see that, after adjusting for sales activity, variable
costs actually showed a steep decline of 11% rather than the increase of 7%
shown in Panel A. In other words, at the actual volume of 1,200 units as opposed
to the budgeted volume of 1,000 units, you should have budgeted more
for variable costs than at first expected. The $8,400 is, in retrospect, the more
appropriate budget figure.
"The apparent rise in revenues shown in Panel A melts away in Panel B, as
does the apparent rise in variable costs shown in Panel A. The result is a whole
new story. Volume rose perhaps because of the efforts of the sales staff but
more probably because of the fall in the selling price from $12 per unit to
$11.50 per unit.
"Fortunately," Jane said with a broad grin on her face, "the loss was partially
offset by the heroic efforts of the production staff in getting their perunit
costs down by 11%."
"I like that heroic part," said Tom approvingly.
"You should, because with the volume effect eliminated, all of the fall in
variable costs must be attributed to a fall in unit variable costs. More precisely,
standard variable costs were $7.00 but actual unit variable costs were just
$6.25. Dividing the actual unit cost of $6.25 by the standard variable cost of
$7.00 yields an index of 0.89, or precisely the 11% decrease in variable costs
noted earlier."
Activity Indices
"Now look at Panel C," said Jane. "This compares the f lexible budget with the
static budget. The only factor that changes between the two is sales activity, so
the percentages measure the change in the number of units sold. As there is
only one measure of activity, it is not surprising that all the activity-based indices
show an increase of 20%, that is, 200 units extra on a base of 1,000. Fixed
costs, though, are independent of activity levels. Net income, which is a combination
of activity-related and activity-independent numbers, shows an increase
that ref lects its mixed nature."
Measuring Productivity 207
Market Effects
"The rise in volume may or may not be attributable to good management. One
possibility is that it was driven by an increase in the total market. For instance,
one can imagine the larger market to have an expected 8,000 units in sales. The
company was expecting to get 12.5% of the market. If one now assumes that
the market grew to 12,000 units, then the company's sales of 1,200 units actually
represents a decrease in market share. Writing this out more formally:
In other words, given this scenario, the sales staff really should be queried on
why they had a decrease of 20% in market share in a market that increased
50%."
Summary
"Finally, let's try to summarize what we have learned to this point. First, note
that Panel B confirms that the price index in any variance computation can be
derived by dividing the actual figure by the f lexible budget figure. Panel C
demonstrates that the activity index can be derived by dividing the f lexible figure
by the static figure. In short, the relationship between the overall index of
the change from budget to actual is given by:
To summarize, then, in the example shown in Exhibits 7.1 and 7.2, one has the
following relationships connecting the actual results back to the static, through
the f lexible budget:
Overall Index Price Index Activity Index
Revenue:
Variable Cost:
Fixed Cost:
= ×
= ×
= ×
= ×
1 15 0 96 1 20
1 07 0 89 1 20
1 17 1 17 1 00
. . .
. . .
. . .
Overall Index
Actual
Static
Actual
Flexible
Flexible
Static
Price Index Activity Index
=
=
×
= ×
Sales Activity Index =
=
×
×
=
×
= ×
1 200
1 000
10 12 000
12 5 8 000
10
12 5
12 5
8 000
0 80 1 50
,
,
( % , )
( . % , )
%
. %
. %
,
. .
208 Understanding the Numbers
So, as you can see, the pieces fit together quite logically. The points underlying
these pieces can be summarized quite brief ly:
1. First, we saw the need to distinguish between basic, ideal, and currently
attainable standards.
2. Second, we saw the wisdom of distinguishing f lexible from static budgets.
3. Third, we noted that our standards are the foundation stones on which
these budgets are based.
4. We noted that all cost variances follow one simple formula: Actual Cost
less Budgeted Cost equals Standard Cost Variance.
5.
6. Flexible budgets adjust variable cost and their variances for volume.
7. Volume has no effect on fixed costs or the variances derived from fixed
costs.
VARIABLE COST BUDGETS
"That's fine, but what am I going to do with these variances?" Tom asked a little
impatiently. "Everything that I've seen so far may help top management, but
it's not much help to me."
"Good point, Tom. That's why we need to examine productivity, which
is the relationship between inputs and outputs. We'll enhance your productivity
and your control over costs if we can focus on the elements that go into
your costs."
With that Jane began to explain how in a typical cost accounting system
the variable cost of a product or service is a function of:
1. The hours of labor (both direct and indirect) that go into a product.
2. The units of material that are used.
3. The other components of overhead.
4. The unit cost of each of these items.
"Let's call the amount of input that goes into one unit of output the productivity
rate. For instance, one might need 500 pages or sheets of paper and
16 minutes of labor to produce a ream of letterhead. The material productivity
rate is 500 pages per ream; the labor productivity rate is 18 minutes or 0.30
hour per ream. When the expected cost of the inputs is attached to the expected
productivity rates, a standard cost is said to result. The productivity
Activity Variances Flexible Budget Static Budget
Price Variances Actual Results Flexible Budget
Activity Indices
Flexible Budget
Static Budget
Price Indices
Actual Results
Flexible Budget
= −
= −
=
=
Measuring Productivity 209
rates themselves are also known as standards. They are typically established by
engineers."
As before, Jane began sketching out a numerical illustration of the points
that she was making. Her sketches appear in Exhibit 7.3. "These are the standards,"
she said, "that determine the variable portion of the budget for production.
Note the assumption here that variable overhead is a function of
machine hours, or how long the machine runs. Other assumptions are possible
but we will stick with this one in our example.
"Fixed overhead is a little different because it does not really have a productivity
rate. Let's just put down the fixed overhead on a budgeted and an actual
basis, and we can come back and discuss the details later." From these
standards she began to derive the standard variable cost of the product; also its
actual variable cost:
Standard Cost Material Cost Labor Cost Variable Overhead Cost
pages per page) hours $5.00 per hour)
( . hours $ . per hour)
per ream
Actual Cost Material Cost Labor Cost Variable Overhead Cost
pages per page) hours $6.00 per hour)
( . hours $ . per hour)
= + +
= × + ×
+ ×
= + +
=
= + +
= × + ×
+ ×
= +
( $. ( .
$ . $ . $ .
$ .
( $. ( .
$ . $
500 0 008 0 30
0 10 15 00
4 00 1 50 1 50
7 00
500 0 007 0 25
0 125 10 00
3 50 1 50 1 25
6 25
. $.
$ .
+
= per ream
EXHIBIT 7.3 Standards and actuals for letterhead paper.
Budgeted Actual
Material:
Productivity rate (pages per ream) 500 500
Cost per unit of input (per page) $0.008 $0.007
Cost per unit of output (per ream) $4.00 $3.50
Labor:
Productivity rate (labor hours per ream) 0.30 0.25
Wage per unit of input (per labor hour) $5.00 $6.00
Wage per unit of output (per ream) $1.50 $1.50
Variable Overhead:
Productivity rate (machine hours per ream) 0.10 0.125
Cost per unit of input (per machine hour) $15.00 $10.00
Cost per unit of output (per ream) $1.50 $1.25
210 Understanding the Numbers
Jane then used these numbers to show how the budgeted and actual variable
costs in Exhibit 7.1 were derived. For the static budget:
For the f lexible budget:
For the actual costs:
Material Indices
Jane also used the standards in Exhibit 7.3 to show Tom how indices for each of
the components of the variable costs could be determined and interpreted.
Consider first the material costs:
In words, the material portion of the variable cost fell 12.5% from the f lexible
budget to the actual because of the 12.5% decrease in the cost of paper
from $0.008 per page to $0.007 per page. There were no efficiencies or
Material Index
Actual Costs
Flexible Budget
per page pages per ream reams)
per page pages per ream reams)
=
=
=
× ×
× ×
=
×
×
= × ×
=
$ ,
$ ,
($ . ,
($ . ,
.
.
,
,
. . .
.
4 200
4 800
0 007 500 1 200
0 008 500 1 200
0 007
0 008
500
500
1 200
1 200
0 875 1 00 1 00
0 875
Material Costs per ream reams
Labor Costs per ream reams
Variable OH per ream reams
Total Variable Costs as reported in Exhibit 7.1
= × =
= × =
= × =
=
$ . , $ ,
$ . , $ ,
$ . , $ ,
$ ,
3 50 1 200 4 200
1 50 1 200 1 800
1 25 1 200 1 500
7 500
Material Costs per ream reams
Labor Costs per ream reams
Variable OH per ream reams
Total Variable Costs as reported in Exhibit 7.1
= × =
= × =
= × =
=
$ . , $ ,
$ . , $ ,
$ . , $ ,
$ ,
4 00 1 200 4 800
1 50 1 200 1 800
1 50 1 200 1 800
8 400
Material Costs per ream reams
Labor Costs per ream reams
Variable OH per ream reams
Total Variable Costs as reported in Exhibit 7.1
= × =
= × =
= × =
=
$ . , $ ,
$ . , $ ,
$ . , $ ,
$ ,
4 00 1 000 4 000
1 50 1 000 1 500
1 50 1 000 1 500
7 000
Measuring Productivity 211
inefficiencies in the use of the paper: The number of pages actually used per
ream was equal to budget.
Labor Indices
Jane then performed an identical analysis for labor costs:
In words, the labor portion of the variable cost remained the same from flexible
to actual because the rise of 20% in the hourly wage was exactly offset by
the 16.67% decrease in the time to produce a ream of letterhead.
"I've just realized that what we have here," said Tom, "is a great way to
measure increases in productivity. Dana keeps on talking about how our productivity
is falling. One way to counteract that is to check how efficiently
people are working. Before one measures physical productivity, though, one
has to eliminate the wage effect, which is just what you have shown me how
to do here."
Variable Overhead Indices
"I think I can now do the variable overhead analysis myself," said Tom. "I just
take the three components of the actual cost and divide that by the three components
of the f lexible budget. Check me if you will."
Variable OH Index
Actual Costs
Flexible Budget
$ 0. .1 5 )
$1 . . 0 )
=
=
= × ×
× ×
= × ×
= × ×
=
$ ,
$ ,
( ,
( ,
$ .
$ .
.
.
,
,
. . .
.
1 500
1 800
1 00 0 2 1 200
5 00 0 1 1 200
10 00
15 00
0 125
0 10
1 200
1 200
0 667 1 25 1 00
0 833
Labor Index
Actual Costs
Flexible Budget
$ . per hour . 5 hours per ream reams)
$ . per hour . 0 hours per ream reams)
=
=
= × ×
× ×
= × ×
= × ×
=
$ ,
$ ,
( ,
( ,
$ .
$ .
.
.
,
,
. . .
.
1 800
1 800
6 00 0 2 1 200
5 00 0 3 1 200
6 00
5 00
0 25
0 30
1 200
1 200
1 20 0 833 1 00
1 00
212 Understanding the Numbers
"I can even tell you what that means in words: The overhead portion of the
variable cost declined 16.67% from the f lexible budget because the hourly
overhead rate fell by 33.33% while the overhead used per ream rose 25%. How
do you like that explanation?"
Variance Analysis
"Another way, in fact the more traditional way, to think about this," said Jane,
"is to focus on the numbers rather than the percentages. The cost of the paper
fell 0.001 cents per page while the company used 600,000 pages (500 pages per
ream × 1,200 reams.) This price drop saved $600; since this price variance is
favorable, it's denoted by an F. The company used the amount of paper that was
budgeted, so the usage variance is zero.
"In the case of labor, the wage paid was $1.00 per hour more than
planned, which over the 300 hours that were worked meant an unfavorable
wage variance of $300 denoted by a U. Employees actually worked 300 hours
(0.25 hours per ream × 1,200 reams), whereas the plan was for them to work
360 hours (0.30 × 1,200 reams). That saved 60 hours, which, at the standard
wage rate of $5.00, saved $300. The wage variance and the use variance offset
one another here.
"Finally, the variable overhead rate was $5.00 per machine hour less than expected.
This gives a favorable rate variance of $750 or $5.00 × 150 actual machine
hours. The base on which variable overhead was applied, namely
machine hours, increased by 30 hours since the budget called for just 120 machine
hours. At the standard rate of $15.00 per hour this gives an unfavorable
usage variance of $450 or $15.00 × 30 machine hours. This leaves a favorable
difference of $300.
"All this is summarized in Exhibit 7.4."
Overhead Variance 150 0 hours $15.00 per hour
10.00 per hour 1 0 hours
= [( − ) × ]
+ [ ( − ) × ]
=
12
15 00 5
300
$ .
$
Labor Variance 300 60 hours $5.00 per hour
6.00 per hour 300 hours
= [( − ) × ]
+ [ ( − ) × ]
=
3
5 00
0
$ .
$
Materials Variance 600, 000 600, 000 pages $0.008 per page
0.007 per page 600, 000 pages
= [( − ) × ]
+ [ ( − ) × ]
=
$ .
$
0 008
600 F
Measuring Productivity 213
Review
"One last question, Jane: Where do these variable overhead rates come from?"
"That's another subject altogether," said Jane. "Do you want a cup of coffee?
I'm bushed. But before we break, let's summarize what we've learned.
1. The cost of a product consists of material, labor, and overhead.
2. Each of these components is made up of a productivity rate multiplied by
a unit cost for that component.
3. Standard Costs = Standard Productivity Rates × Standard Unit Costs
4. Actual Costs = Actual Productivity Rates × Actual Unit Costs
5. Price Indices = Actual Unit Costs/Standard Costs
6. Activity Indices = Actual Productivity Rate/Standard Productivity Rate."
COLLECTING STANDARDS
After their coffee break, Jane and Tom shifted their conversation to how to develop
these standard costs. Jane reminded Tom that standard costs are made up
of two parts:
1. A standard cost per unit times.
2. A standard usage, or quantity of units of input per unit of output.
She pointed out that he was responsible for defining the amount of material
and labor that should go into the product. The purchasing department was
responsible for determining the amount that should be paid for materials, the
personnel department determined wages. There are, as she explained, several
ways to determine the appropriate usage.
Engineering Studies
"First, one can do an engineering study. In other words, one can look at the
specifications of the product. Many products that are designed by engineers
have quite detailed and explicit instructions on what materials should go into
them. These standards often include an allowance for waste, though this
isn't necessary. Where they do not include such an allowance they border on
the ideal.
EXHIBIT 7.4 Variance analysis.
Rate Variance Usage Variance Total Variance
Materials $600 F $0 $600 F
Labor 300 U 300 F 0
Variable overhead 450 U 750 F 300 F
214 Understanding the Numbers
"To take an obvious example, most automobiles have one battery, and an
engineering statement would so state. A perfection standard would call for 1
battery per automobile. When it comes to actual production, however, it would
not be unusual for one or more batteries to be damaged during installation.If
10,100 batteries are used in the manufacture of 10,000 cars, then it might appear
as if each automobile actually had 1.01 batteries. One might, therefore,
want to set as one's standard a currently attainable goal of 1.01 batteries on average,
thus providing a 1% allowance for wastage."
Time and Motion Studies
"Time and motion studies are the usual way in which engineering standards are
set for the labor component," Jane explained. "An engineer watches over laborers
as they work and determines how much time it should take for each part of
the production process. When doing this, it is vital that the engineer gain
labor's cooperation. If not, disastrous results can occur. I love the following
quotation:"
You got to use your noodle while you're working and think your work out ahead
as you go along! You got to add in movements you know you ain't going to make
when you're running the job! Remember, if you don't screw them, they're going
to screw you! . . . Every moment counts! . . .
When the time-study man came around, I set the speed at 180. I knew
damn well he would ask me to push it up, so I started low enough. He finally
pushed me up to 445, and I ran the job later at 610. If I'd started out at 445,
they'd have timed it at 610. Then I got him on the reaming, too. I ran the
reamer for him at 130 speed and .025 feed. He asked me if I couldn't run the
reamer any faster than that, and I told him I had to run the reamer slow to keep
the hole size. I showed him two pieces with oversize holes that the day man
ran. I picked them out for the occasion! But later on I ran the reamer at 610
speed and .018 feed, same as the drill. So I didn't have to change gears.3
Tom smiled appreciatively at the story. As an old f loor hand, he understood the
sentiments completely.
Motivation
"This raises a broader question, you know," said Tom. "Should we invite people
to participate in setting the standards? Will it make them more motivated? I've
pondered this from a variety of angles. What's interesting about it is that participation
doesn't always work.
"What I have discovered from my reading around the topic is that many
people prefer to be told what to do. This seems to be particularly true for people
who find their jobs boring and for those with a more authoritarian personality.
So one has to be really careful when inviting people to participate."
"You know more about this than I do," responded Jane. "How do you handle
feedback, then. That's a sort of after-the-fact participation isn't it."
Measuring Productivity 215
"Well, I don't know about after the fact, but everyone that I've read—and
my own experience for that matter—indicates that timely feedback is essential
and a good motivator. People really need to know, and know as soon as possible,
how they have done. That's especially true when they've done a good job,
because it really builds their self-esteem. And in some cases, it makes them
want to participate more before the fact in the next round.
"Of course, I don't want to lead you to think that a little participation and
a lot of feedback is all one needs. These are what the psychologists call intrinsic
motivators. People need these, but they also need extrinsic motivators like
better pay for doing a better job.
"And, the other problem that I've encountered is that the more you focus
people's attention on one goal, the more they tend to ignore other goals. It's
only human nature: Ask salespeople to increase their turnover, and they'll sell
goods at a loss.
"That's one of the reasons why I have misgivings about calling in a bunch
of engineers to set standards. It's much easier to time how long a job should
take and reward people for quantity than to measure and to reward quality. I
really rely upon the innate good sense of my staff to provide quality products.
Too much emphasis on measurement can make my task of maintaining quality
much more difficult."
Past Data
"Probably, then, an easier way," Jane said, "to get the data you need for your
business is to go back over your past records to see how much time various jobs
have taken and how much material was used in the past. Some of that will have
to be adjusted for changes in machines, changes in personnel, different kinds of
material, and so on. But you know all that better than I do."
"Enough!" Tom exclaimed. "Enough for now! I'll come over tomorrow
night and we can talk some more. We still need to discuss fixed overheads as
you promised."
FIXED COST BUDGETS
"Fixed costs," Jane started out the next night after the two had gathered again,
"are both easier and more difficult to control than variable costs. They are easier
because there are no components into which to break them. Their variance
is simply:
Their index is simply:
Actual Fixed Costs
Budgeted Fixed Costs
Actual Fixed Costs −Budgeted Fixed Costs
216 Understanding the Numbers
In our case, the budgeted fixed costs were $4,000 and the actual fixed costs
were $4,680. The variance was simply $680, which means a 17% increase.
"Fixed costs are more difficult to control than variable costs because one
cannot create an illusion of control through the elaborate computation of price,
mix, and usage variances or indices."
"How, then, does one control fixed costs?" asked Tom.
"First," Jane replied, "one must recognize that if costs are truly fixed,
there is no reason to control them. Consider depreciation costs as an example.
Once one has purchased an item, the total depreciation costs are set—unless
one disposes of the machinery when a disposal cost will substitute for the depreciation
cost. No control is possible here. The control in this case has to be
exerted when the machinery is purchased. Thereafter, it is a sunk cost that
cannot be controlled. In other words, controlling fixed costs is in the first place
a matter of timing.
"Traditional variance analysis uses one cost driver only, the volume of
production. More modern variance analysis, such as that in activity based costing,
uses multiple cost drivers.4 For example, setup costs may not vary with volume
of production but might vary with the number of batches. What appears
at first glance to be a fixed cost may just be variable with respect to some other
driver. The analysis of variance proceeds exactly as before except that one
changes the driver from units produced to number of batches. One converts
the fixed cost into a quasi-variable cost by finding and using the appropriate
cost driver.
"Controlling fixed costs is also a matter of scale. Consider the machine
again. Assume one has just one machine with a capacity of 1,000 boxes of
greeting cards per day. Its cost is certainly fixed within this range. However, if
the analysis is being done in terms of tens of thousands of boxes, and if the
corporation has a hundred of these machines, then it is possible to think of machine
costs as being a variable. One can ask, in other words, what the cost
would be to produce an additional 'unit' of 1,000 boxes.
"This last question points to the fact that most fixed costs are usually only
fixed within the context of a particular analysis. Consider, for instance, the ink
you use in production. Assume its price is reset by a cartel every three months.
Assume also that its planned usage is reset at the same time. A budgetary control
system that computed variances every month and set the budgeted price
and quantity to those of the latest quarter might show a variance of zero each
month. This might lead everyone to believe that they were dealing with a fixed
cost. However, were the same analysis to be done on an annual basis, with
prices and quantities set at the start of the year, a substantial variance could
arise. The example points up the old truism that all costs are variable in the
long run.
"The example above also points up the need to set your net large enough
to catch the fish you want. Many fixed costs cannot be controlled by a monthly,
or even annual, budget system because they change too slowly. One needs a
coarser net, that is, an annual, triennial, or even longer budgetary system to
Measuring Productivity 217
capture their change. The reverse is also true. A net that is too fine can capture
a great deal of random noise. Consider, for instance, a product whose price
f luctuates randomly around a fixed mean. If all you want is to see the true exceptions,
then you should set the net to capture only those f luctuations that are
greater than a certain number of standard deviations away from the mean.
"In short, fixed costs are best controlled in the long run and at a more aggregate
level. In other words, it is important in the budgetary control of fixed
costs to establish appropriate time and space horizons for one's analysis."
"Those are all good points," said Tom, "and it's good to be reminded of
them. What you haven't yet told me, though, is whether there is a fixed overhead
rate like the variable overhead rate that you had in Exhibit 7.3 and how
the fixed overhead rate fits into the whole picture."
"Well, fixed overhead does and doesn't have a rate," responded Jane.
"The rate itself comes from knowing the total fixed overhead and dividing it by
the volume; for example, the budgeted fixed overhead of $4,000 divided by the
budgeted 1,000 units gives us a fixed overhead rate of $4.00. In a sense, fixed
overhead rates are secondary—unlike variable overhead rates, which are primary,
meaning that fixed overhead rates are computed by dividing the total
overhead by volume. Total variable overhead, on the other hand, is computed
by multiplying the variable overhead rate by the volume. In other words, fixed
overhead computes just the other way round from variable overhead.
"Variable overhead rates are used in computing variances and indices.
Fixed overhead rates are completely ignored in this context. Their main purpose
is to give you an estimate of the total product cost. We computed earlier
that the estimated variable cost of a ream of letterhead was $7.00. We can now
add the $4.00 fixed cost in and say the estimated total cost of a ream is $11.00.
So fixed overhead rates fit in when calculating unit product costs. It's just that
they don't fit into the rest of the budgetary control systems. But let's talk about
standard cost systems when all this might become clearer. Let's pick it up tomorrow
when we are both fresher."
STANDARD COST ACCOUNTING SYSTEMS
"Companies rarely enter their budgets into their ledgers. Usually budgetary
control takes place outside of the books of the company. In other words, the
budget is typically drawn up using spreadsheets outside of the general ledger
system. At the end of the period under investigation, the actual results are
drawn out of the ledger and transferred to the spreadsheet where the comparisons
are done. Two exceptions to this general rule occur."
Government Accounting
"The first exception does not affect private companies but does affect state
and local governments. It is common practice in their accounting systems to
218 Understanding the Numbers
enter a budgeted number in the ledgers in anticipation of an actual number. For
instance, city governments will enter budgeted revenues as a debit on the left
side of the ledger account. Then when the sales are actually made, they will
enter the actual revenues as a credit on the right column of the ledger account.
The effect is that at the end of the year, only variances are left in accounts. For
instance, sales greater than expected would leave a credit variance."
Standard Variable Costs
"The second exception involves so-called standard cost systems. In a typical
implementation, the standard cost of a product, not the actual cost incurred, is
entered into the work-in-process account. The difference between the standard
cost and the actual cost creates a variance—in the actual accounts. For
example, in the case of paper used, the inventory account would be charged
with the standard $4.00 for every ream used but only $3.50 would be paid to
the supplier. The difference of $0.50 would be shown in a separate variance
account in the books of the company.
"The existence of a credit variance in the accounts indicates that the budgeted
unit cost exceeds the actual unit cost, that is, there is a favorable variance.
Were the variance a debit, it would be unfavorable.
"By the end of the job, after they have produced 1,200 reams, they will
show in their accounts a variance of $0.50 per ream on all their variable costs
times 1,200 reams, or a credit of $600. This is the same favorable $600 variance
that we saw in Exhibit 7.4 when we subtracted the actual cost from the f lexible
budget. Standard cost systems, in other words, track the f lexible budget.
"Each of these variances is identical to the variances computed above;
each can be stated in percentage terms to indicate their relative size, that is,
material costs are down 12.5%, labor costs are even, and variable overhead
costs are down 16.67%. The key point to realize is that variances generated by
a standard cost system are identical to those generated by a budgetary control
system—once one removes the volume effect."
Standard Fixed Costs
"The parallels between standard cost systems and budgetary control systems
do not extend to fixed costs, unfortunately. The reason lies in the way fixed
costs are applied to products. In a standard cost system, a fixed overhead rate
is established at the start of a period by dividing the budgeted fixed overhead
by the budgeted volume. In our case, the predetermined fixed overhead rate
was $4,000 divided by 1,000 reams, which equals $4.00 per ream. The predetermined
fixed overhead rate is therefore based on the static budget.
"Fixed overhead is then applied to goods as they are produced by multiplying
the number of reams produced by this overhead rate. In this case, one
charges $4.00 of fixed overhead to each of the 1,200 reams produced. The result
is $4,800, which is known as the applied overhead. The problem is that this
Measuring Productivity 219
is neither actual nor budgeted. It is really a miscomputed number. If the number
of actual reams had been known in advance, one should have divided the
$4,000 by 1,200 reams, giving $3.33 per ream. In other words, one should have
used the f lexible budget. Using that rate would have led to the application of
$4,000 of fixed overhead exactly. The difference between the budgeted
amount of $4,000 and the amount actually applied, namely $800, is said to have
been over-applied—one might say over-applied in error. A correcting entry is
typically made in the accounting system to fix this error.
"The accounts of the company record that it actually had fixed overhead
costs of $4,680 and applied overhead of $4,800. This generates a credit variance
of $120 in the accounts. Regardless of what appears in the accounts, the
spending variance that should be reported is an unfavorable $680—not a favorable
$120. No matter the confusions in the ledger, the only variance that one is
interested in is:
"The difference between the variance produced by a standard cost system and
the variance wanted for budgetary control purposes is:
"In short, the error in the fixed overhead variance appearing in a standard cost
system is due to volume changing from 1,000 units to 1,200 units. The result is
a variance in the standard cost system that is useless for control purposes.
"The budgeted overhead will be equal to the applied overhead only when
the actual volume equals the budgeted volume, which rarely happens. More
commonly, a fixed cost variance is found in the ledger, but this is of no interest
for budgetary control. For control purposes, you should compute the spending
variance directly and simply ignore the net overhead variance derived in the
books."
"Now I see why you ignored the fixed overhead when doing the variances
originally," said Tom. "Let's hope that my management understands this as well
as you seem to do!"
BUDGETARY CONTROL REVISITED
"Budgetary control, as we noted at the outset," Jane continued, "consists of
comparing actual results with budget estimates. When doing this one is advised
to distinguish between revenues and costs that vary with volume and those that
are fixed with respect to volume changes. A revised budget, adjusted for the
actual volumes rather than the predicted volumes, yields a f lexible budget as
opposed to the original or static budget.
Budgeted Overhead− Applied Overhead = −
= × − ×
= ×
$ , $ ,
($ , ) ($ , )
$
4 000 4 800
4 1 000 4 1 200
4 200
Applied Overhead−Budgeted Overhead = $4,680 − $4, 000
220 Understanding the Numbers
"Since the static and the f lexible budgets for fixed costs are identical, the
fixed-cost spending variance is simply the difference between the actual and
the original budget. The spending index for fixed costs is their quotient.
"In the case of variable costs and revenues, a few simple rules emerge.
The ratio between the f lexible and the static budgets indicates the difference
in the quantities expected and the quantities actually experienced. The ratio
between the actual results and the f lexible budget indicates the change in costs
or revenues that can be attributed to changes in unit costs or selling prices.
"In the case of multiple outputs or multiple inputs, the quantity indices
can be further refined. They break into at least two indices. The first reveals
the effect of changing mixes of either outputs or inputs. The second reveals
the effect of changing the overall volume. The mix variance may be computed
directly or simply by dividing the quantity index by the volume index. In the
case of variable costs, it is usually possible to draw out another index indicating
the total yield, that is, the amount of input required to produce a given amount
of output.
"All these indices can be computed using an accounting system that collects
only actual costs and comparing these in a spreadsheet with the budgeted
costs. Alternatively, they may be derived by keeping a standard cost system.
The variances that emerge as one enters standard costs into work-in-process
and credits the corresponding asset or liability account at actual are identical
to those derived from a f lexible budgeting control system. The one exception
to this identity is fixed costs, but the difference here is easily reconciled.
"In short, budgetary control analysis provides one vehicle for controlling
a business. The budget ref lects, ideally, a company's strategies and objectives.
As actual results emerge they are compared with the budget to see to what extent
the enterprise has met its goals and productivity targets. Any difference
encountered can be decomposed to determine whether it was due to a change
in usage or a change in price. Where inputs or outputs are substitutable, one
can also examine the changing mix for further insight into how one achieved
one's goals.
"In each case, the index derived is neither good nor bad. It simply indicates
a change. As noted earlier, the same rise in sales may be a matter for congratulation
when markets are declining and a matter for concern when markets
are expanding faster than one's sales. All that the index does is to point one to
where still more information must be gathered."
FOR FURTHER READING
Anthony, Robert N., David F. Hawkins, and Kenneth A. Merchant, Accounting: Text
and Cases, 10th ed. (New York: Irwin/McGraw-Hill, 1999), esp. chs. 19 and 20.
Davidson, Sidney, and Roman L. Weil, Handbook of Cost Accounting (New York:
McGraw-Hill, 1978), esp. chs. 15 and 16.
Measuring Productivity 221
Ferris, Kenneth R., and J. Leslie Livingstone, eds., Management Planning and
Control: The Behavioral Foundations (Columbus, OH: Century VII, 1989), esp.
chs. 3, 8, and 9.
Horngren, Charles T., Gary L. Sundem, and William O. Stratton, Introduction
to Management Accounting, 11th ed. (Englewood Cliffs, NJ: Prentice-Hall,
1999), esp. chs. 7 and 8.
Kaplan, Robert S., and Anthony A. Atkinson, Advanced Management Accounting, 3rd
ed. (Englewood Cliffs, NJ: Prentice-Hall, 1998), esp. chs. 9 and 10.
Maher, Michael W., Clyde Stickney, Roman L. Weil, and Sidney Davidson, Managerial
Accounting (Fort Worth, TX: Harcourt College Publishers, 1999), esp.
chs. 10 and 11.
Shank, J.K., and N.C. Churchill, "Variance Analysis: A Management-Oriented Approach,"
The Accounting Review, 52 (Oct. 1977): 950–957.
Welsch, Glenn A., Ronald W. Hilton, and Paul N. Gordon, Budgeting: Profit Planning
and Control, 5th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1988), esp. ch. 16.
INTERNET LINKS
Internet links and Web sites have an uncomfortable way of disappearing. The
reader is advised, therefore, to do her or his own search under key words
such as "variance analysis" and "standard costing." This will turn up sites such
as Conoco's and Corn Products International's discussions of their results at
www.conoco.com and www.cornproducts.com. Both make excellent use of
variance analysis. The U.S. Army Cost and Economic Analysis Center at
www.ceac.army.mil/web/default.html provides a good discussion of standards,
while the Association of Accounting Technicians, at www.aat.co.uk, provides
an excellent forum for questions and answers on this and many other accounting
topics. The Institute of Management Accountants maintains a site at www
.imanet.org that provides all kinds of managerial accounting resources. Finally,
the reader is invited to visit my own site, at www.smu.edu/∼mvanbred, with its
many links and notes on both financial and managerial accounting.
NOTES
1. R. Kaplan and D. Norton, "The Balanced Scorecard—Measures That Drive
Performance," Harvard Business Review, 70 (Jan.–Feb. 1992): 71–79.
2. National Association of Accountants, Standard Costs and Variance Analysis
(New York: NAA, 1974): 9.
3. Whyte, W.F., ed., Money and Motivation: An Analysis of Incentives in Industry
(New York: Harper & Row, 1955).
4. Cooper, Robin, and Robert S. Kaplan, "How Cost Accounting Distorts Product
Costs," Management Accounting, 69 (Apr. 1988): 20–27.
PART TWO
PLANNING AND
FORECASTING
225
8 CHOOSING A
BUSINESS FORM
Richard P. Mandel
THE CONSULTING FIRM
Jennifer, Jean, and George had earned their graduate business degrees together
and had paid their dues in middle management positions in various large
corporations. Despite their different employers, the three had maintained
their friendship and were now ready to realize their dream of starting a consulting
practice. Their projections showed modest consulting revenue in the
short term offset by expenditures for supplies, a secretary, a small library, personal
computers, and similar necessities. Although each expected to clear no
more than perhaps $25,000 for his or her efforts in their first year in business,
they shared high hopes for future growth and success. Besides, it would be a
great pleasure to run their own company and have sole charge of their respective
fates.
THE SOFTWARE ENTREPRENEUR
At approximately the same time that Jennifer, Jean, and George were hatching
their plans for entrepreneurial independence, Phil was cashing a seven-figure
check for his share of the proceeds from the sale of the computer software
firm he had founded seven years ago with four of his friends. Rather than rest
on his laurels, however, Phil saw this as an opportunity to capitalize on a complex
piece of software he had developed in college. Although Phil was convinced
that there would be an extensive market for his software, there was
226 Planning and Forecasting
much work to be done before it could be brought to market. The software had
to be converted from a mainframe operating system to the various popular microcomputer
systems. In addition, there was much marketing to be done prior
to its release. Phil anticipated that he would probably spend over $300,000 on
programmers and salespeople before the first dollar of royalties would appear.
But he was prepared to make that investment himself, in anticipation of retaining
all the eventual profit.
THE HOTEL VENTURE
Bruce and Erika were not nearly as interested in high technology. Directly following
their graduation from business school, they were planning to construct
and operate a resort hotel near a popular ski area. They had chosen as their
location a beautiful parcel of land in Colorado owned by their third partner,
Michael. Rich in ideas and enthusiasm, the three lacked funds. They were certain,
however, that they could attract investors to their enterprise. The location,
they were sure, would virtually sell itself.
THE PURPOSE OF THIS CHAPTER
Each of these three groups of entrepreneurs would soon be faced with what
might well be the most important decision of the initial years of their businesses:
which of the various legal business forms to choose for the operation of
their enterprises. It is the purpose of this chapter to describe, compare, and
contrast the most popular of these forms in the hope that the reader will then
be able to make such choices intelligently and effectively. After discussing the
various business forms, we will revisit our entrepreneurs and analyze their
choices.
BUSINESS FORMS
Two of the most popular business forms could be described as the default
forms because the law will deem a business to be operating under one of these
forms unless it makes an affirmative choice otherwise. The first of these forms
is the sole proprietorship. Unless he or she has actively chosen another form,
the individual operating his or her own business is considered to be a sole proprietor.
Two or more persons operating a business together are considered a
partnership (or general partnership), unless they have elected otherwise. Both
of these forms share the characteristic that for all intents and purposes they
are not entities separate from their owners. Every act taken or obligation assumed
as a sole proprietorship or partnership is an act taken or obligation assumed
by the business owners as individuals.
Choosing a Business Form 227
Many of the rules applicable to the operation of partnerships are set forth
in the Uniform Partnership Act, which has been adopted in one form or another
by 49 states. That Act defines a partnership as "an association of two or more
persons to carry on as co-owners a business for profit." Notice that the definition
does not require that the individuals agree to be partners. Although most
partnerships can point to an agreement between the partners (whether written
or oral), the Act applies the rules of partnership to any group of two or more
persons whose actions fulfill the definition. Thus, the U.S. Circuit Court of Appeals
for the District of Columbia, in a rather extreme case, held, over the defendant's
strenuous objections, that she was a partner in her husband's burglary
"business" (for which she kept the books and upon whose proceeds she lived),
even though she denied knowing what her husband was doing at nights. As a result
of this status, she was held personally liable for damages to the wife of a
burglary victim her husband had murdered during a botched theft.
In contrast, a corporation is a legal entity separate from the legal identities
of its owners, the shareholders. In the words James Thurber used to describe a
unicorn, the corporation "is a mythical beast," created by the state at the request
of one or more business promoters upon the filing of a form and the payment
of the requisite, modest fee. Thereupon, in the eyes of the law, the corporation
becomes for most purposes a "person" with its own federal identification
number! Of course, one cannot see, hear, or touch a corporation, so it must interact
with the rest of the world through its agents, the corporation's officers
and employees.
Corporations come in different varieties. The so-called professional corporation
is available in most states for persons conducting professional practices,
such as doctors, lawyers, architects, psychiatric social workers, and the
like. A subchapter S corporation is a corporation that is the same as a regular
business corporation in all respects other than taxation. These variations are
discussed later.
A fourth common form of business organization is the limited partnership,
which may best be described as a hybrid of the corporation and the general
partnership. The limited partnership consists of one or more general
partners—who manage the business much in the same way as do the partners
in a general partnership—and one or more limited partners, who are essentially
silent investors with no control over business operations. Like the general
partnership, limited partnerships are governed in part by a statute, the Uniform
Limited Partnership Act (or its successor, the Revised Uniform Limited
Partnership Act), which has also been adopted in one form or another by
49 states.
The limited liability company (LLC), is now available to entrepreneurs in
all 50 states. The LLC is a separate legal entity owned by "members" who may,
but need not, appoint one or more "managers" (who may but need not be members)
to operate the business. A few states require that there be more than
one member, but the trend is toward allowing single-member LLCs. An LLC
is formed by filing an application with the state government and paying the
228 Planning and Forecasting
prescribed fee. The members then enter into an operating agreement setting
forth their respective rights and obligations with respect to the business. Most
states that have adopted the LLC have also authorized the limited liability
partnership, which allows general partnerships to obtain limited liability for
their partners by filing their intention to do so with the state. This form of
business entity is normally used by professional associations that previously operated
as general partnerships, such as law and accounting firms.
COMPARISON FACTORS
The usefulness of the five basic business forms could be compared on a virtually
unlimited number of measures, but the most effective comparisons will
likely result from employing the following eight:
1. Complexity and cost of formation. What steps must be taken before your
business can exist in each of these forms?
2. Barriers to operation across state lines. What steps must be taken to move
your business to other states? What additional cost may be involved?
3. Recognition as a legal entity. Who does the law recognize as the operative
entity? Who owns the assets of the business? Who can sue and be sued?
4. Continuity of life. Does the legal entity outlive the owner? This may be
especially important if the business wishes to attract investors or if the
goal is an eventual sale of the business.
5. Transferability of interest. How does one go about selling or otherwise
transferring one's ownership of the business?
6. Control. Who makes the decisions regarding the operation, financing,
and eventual disposition of the business?
7. Liability. Who is responsible for the debts of the business? If the company
cannot pay its creditors, must the owners satisfy these debts from
their personal assets?
8. Taxation. How does the choice of business form determine the tax
payable on the profits of the business and the income of its owners?
FORMATION OF SOLE PROPRIETORSHIPS
Ref lecting its status as the default form for the individual entrepreneur, the
sole proprietorship requires no affirmative act for its formation. One operates
a sole proprietorship because one has not chosen to operate in any of the other
forms. The only exception to this rule arises in certain states when the owner
chooses to use a name other than his own as the name of his business. In such
event, he may be required to file a so-called d /b/a certificate with the local
authorities, stating that he is "doing business as" someone other than himself.
Choosing a Business Form 229
This allows creditors and those otherwise injured by the operation of the business
to determine who is legally responsible.
FORMATION OF PARTNERSHIPS
Similarly, a general partnership requires no special act for its formation other
than a d /b/a certificate if a name other than that of the partners will be used.
If two or more people act in a way which fits the definition set forth in the
Uniform Act, they will find themselves involved in a partnership. However, it is
strongly recommended that prospective partners consciously enter an agreement
(preferably in writing) setting forth their understandings on the many
issues which will arise in such an arrangement. Principal among these are the
investments each will make in the business, the allocation and distribution of
profits (and losses), the method of decision making (i.e., majority or unanimous
vote), any obligations to perform services for the business, the relative compensation
of the partners, and so on. Regardless of the agreements that may
exist among the partners, however, the partnership will be bound by the actions
and agreements of each partner—as long as these actions are reasonably
related to the partnership business, and even if they were not properly authorized
by the other partners pursuant to the agreement. After all, third parties
have no idea what the partners' internal agreement says and are in no way
bound by it.
CORPORATIONS
In order to form a corporation, in contrast, one must pay the appropriate fee
and must complete and file with the state a corporate charter (otherwise
known as a Certificate of Incorporation, Articles of Incorporation, or similar
name in the various states). The fee is payable both at the outset and annually
thereafter (often approximately $200). A promoter may form a corporation
under the laws of whichever state she wishes; she is not required to form the
corporation under the laws of the state in which she intends to conduct most
of her business. This partially explains the popularity of the Delaware corporation.
Delaware spent most of the last century competing with other states
for corporation filing fees by repeatedly amending its corporate law to make it
increasingly favorable to management. By now, the Delaware corporation has
taken on an aura of sophistication, so that many promoters form their companies
in Delaware just to appear to know what they are doing! In addition, it
is often less expensive under Delaware law to authorize large numbers of
shares for future issuance than it would be in other states. Nevertheless, the
statutory advantages of Delaware apply mostly to corporations with many
stockholders (such as those which are publicly traded) and will rarely be significant
to a small business such as those described at the beginning of this
230 Planning and Forecasting
chapter. Also, formation in Delaware (or any state other than the site of the
corporation's principal place of business) will subject the corporation to additional,
unnecessary expense. It is thus usually advisable to incorporate in the
company's home state.
The charter sets forth the corporation's name (which cannot be confusingly
similar to the name of any other corporation operating in the state) as
well as its principal address. The names of the initial directors and officers of
the corporation are often listed. Most states also require a statement of corporate
purpose. Years ago this purpose defined the permitted scope of the corporation's
activities. A corporation which ventured beyond its purposes risked
operating "ultra vires," resulting in liability of its directors and officers to its
stockholders and creditors. Today virtually all states allow a corporation to define
its purposes extremely broadly (e.g., "any activities which may be lawfully
undertaken by a corporation in this state"), so that operation ultra vires is generally
impossible. Still directors are occasionally plagued by lawsuits brought
by stockholders asserting that the diversion of corporate profits to charitable
or community activities runs afoul of the dominant corporate purpose, which
is to generate profits for its stockholders. The debate over the responsibility
of directors to so-called corporate "stakeholders" (employees, suppliers, customers,
neighbors, and so forth) currently rages in many forms but is normally
not a concern of the beginning entrepreneur.
Corporate charters also normally set forth the number and classes of equity
securities that the corporation is authorized to issue. Here an analysis of a
bit of jargon may be appropriate. The number of shares set forth in the charter
is the number of shares authorized, that is, the number of shares that the directors
may issue to stockholders at the directors' discretion. The number of
shares issued is the number that the directors have in fact issued and is obviously
either the same or smaller than the number authorized. In some cases, a
corporation may have repurchased some of the shares previously issued by the
directors. In that case, only the shares which remain in the hands of shareholders
are outstanding (a number obviously either the same or lower than the
number issued). Only the shares outstanding have voting rights, rights to
receive dividends, and rights to receive distributions upon full or partial liquidation
of the corporation. Normally, we would expect an entrepreneur to authorize
the maximum number of shares allowable under the state's minimum
incorporation fee (e.g., 200,000 shares for $200 in Massachusetts) and then
issue only 10,000 or so, leaving the rest on the shelf for future financings, employee
incentives, and so forth.
The charter also sets forth the par value of the authorized shares, another
antiquated concept of interest mainly to accountants. The law requires only
that the corporation not issue shares for less than the par value, but it can, and
usually does, issue the shares for more. Thus, typical par values are $0.01 per
share or even "no par value." Shares issued for less than par are watered stock,
subjecting both the directors and holders of such stock to liability to other
stockholders and creditors of the corporation.
Choosing a Business Form 231
Corporations also adopt bylaws, which are not filed with the state but are
available for inspection by stockholders. These are usually fairly standard documents
describing the internal governance of the corporation and setting forth
such items as the officers' powers and notice periods for stockholders' meetings.
LIMITED PARTNERSHIPS
As you might expect, given the limited partnership's hybrid nature, the law requires
both a written agreement among the various general and limited partners
and a Certificate of Limited Partnership to be filed with the state, along
with the appropriate initial and annual fees. The agreement sets forth the partners'
understanding of the items discussed earlier regarding general partnerships.
The certificate sets forth the name and address of the partnership, its
purposes, and the names and addresses of its general partners. In states where
the Revised Uniform Limited Partnership Act has been adopted, it is no longer
necessary to reveal the names of the limited partners, just as the names of corporate
stockholders do not appear on a corporation's incorporation documents.
LIMITED LIABILITY COMPANIES
The LLC is formed by filing a charter (e.g., a Certificate of Organization) with
the state government and paying a fee (usually similar to that charged for the
formation of a corporation). The charter normally sets forth the entity's name
and address, its business purpose, and the names and addresses of its managers
(or persons authorized to act for the entity vis-a-vis the state if no managers
are appointed). The same broad description of the entity's business which is
allowable for modern corporations is acceptable for LLCs. The members of
the LLC are also required to enter into an operating agreement that sets forth
their rights and obligations with regard to the business. These agreements are
generally modeled after the agreements signed by the partners in a general or
limited partnership.
OUT OF STATE OPERATION OF SOLE
PROPRIETORSHIPS AND PARTNERSHIPS
Partly as a result of both the Commerce clause and Privileges and Immunities
clause of the U.S. Constitution, states may not place limits or restrictions on
the operations of out-of-state sole proprietors or general partnerships that are
different from those placed on domestic businesses. Thus, a state cannot force
registration of a general partnership simply because its principal office is located
elsewhere, but it can require an out-of-state doctor to undergo the same
licensing procedures it requires of its own residents.
232 Planning and Forecasting
OUT OF STATE OPERATION OF
CORPORATIONS, LIMITED PARTNERSHIPS,
AND LIMITED LIABILITY COMPANIES
Things are different, however, with corporations, limited partnerships, and
LLCs. As creations of the individual states, they are not automatically entitled
to recognition elsewhere. All states require (and routinely grant) qualification
as a foreign corporation, limited partnership, or LLC to nondomestic entities
doing business within their borders. This procedure normally requires the
completion of a form very similar to a corporate charter, limited partnership
certificate, or LLC charter, and the payment of an initial and annual fee similar
in amount to the fees paid by domestic entities. This requirement, incidentally,
is one reason not to form a corporation in Delaware if it will operate
principally outside that state. Much litigation has occurred over what constitutes
"doing business" within a state for the purpose of requiring qualification.
Similar issues arise over the obligation to pay income tax, collect sales tax, or
accept personal jurisdiction in the courts of a state. Generally these cases turn
on the individualized facts of the particular situation, but courts generally look
for offices or warehouses, company employees, widespread advertising, or
negotiation and execution of contracts within the state.
Perhaps more interesting may be the penalty for failure to qualify. Most
states will impose liability for back fees, taxes, interest, and penalties. More
important, many states will bar a nonqualified foreign entity from access to its
courts and, thus, from the ability to enforce obligations against its residents.
In most of these cases, the entity can regain access to the courts merely by paying
the state the back fees and penalties it owes, but in a few states access will
then be granted only to enforce obligations incurred after qualification was
achieved, leaving all prior obligations unenforceable.
RECOGNITION OF SOLE PROPRIETORSHIPS
AS A LEGAL ENTITY
By now it probably goes without saying that the law does not recognize a sole
proprietorship as a legal entity separate from its owner. If Phil, our computer
entrepreneur, were to choose this form, he would own all the company's assets;
he would be the plaintiff in any suits it brought, and he would be the defendant
in any suits brought against it. There would be no difference between Phil, the
individual, and Phil, the business.
RECOGNITION OF PARTNERSHIPS AS A LEGAL ENTITY
A general partnership raises more difficult issues. Although most states allow
partnerships to bring suit, be sued, and own property in the partnership name,
this does not mean that the partnership exists for most purposes separately from
Choosing a Business Form 233
its partners. As will be seen, especially in the areas of liability and taxation, partnerships
are very much collections of individuals, not separate entities.
Ownership of partnership property is a particularly problematic area. All
partners own an interest in the partnership, which entitles them to distributions of
profit, much like stock in a corporation. This interest is the separate property of
each partner and is attachable by the individual creditors of a partner in the form
of a "charging order." Each partner also owns the assets of the partnership jointly
with his other partners. This form of ownership (similar to joint ownership of a
family home by two spouses) is called tenancy in partnership. Each partner may
use partnership assets only for the benefit of the partnership's business; such assets
are exempt from attachment by the creditors of an individual partner, although not
from the creditors of the partnership. Tenancy in partnership also implies that, in
most cases of dissolution of a partnership, the ownership of partnership assets devolves
to the remaining partners, to the exclusion of the partner who leaves in violation
of the partnership agreement or dies. The former partner is left only with
the right to a dissolution distribution in respect of her partnership interest.
RECOGNITION OF CORPORATIONS AND LIMITED
LIABILITY COMPANIES AS LEGAL ENTITIES
The corporation and LLC are our first full-f ledged separate legal entities.
Ownership of business assets is vested solely in the corporation or LLC as a
separate legal entity. The corporation or LLC itself is plaintiff or defendant in
suits and is the legally contracting party in all its transactions. Stockholders and
members own only their stock or membership interests and have no direct
ownership rights in the business's assets.
RECOGNITION OF LIMITED PARTNERSHIPS AS
A LEGAL ENTITY
The limited partnership, as a hybrid, is a little of both partnership and corporation.
The general partners own the partnership's property as tenants in partnership
operating in the same manner as partners in a general partnership. The
limited partners, however, have only their partnership interests and no direct
ownership of the partnership's property. This is logically consistent with their
roles as silent investors. If they directly owned partnership property, they
would have to be consulted with regard to its use.
CONTINUITY OF LIFE
The issue of continuity of life is one which should concern most entrepreneurs,
because it can affect their ability to sell the business as a unit when it comes
234 Planning and Forecasting
time to cash in on their efforts as founders and promoters. The survival of the
business as a whole in the form of a separate entity must be distinguished from
the survival of the business's individual assets and liabilities.
Sole Proprietorships
Although a sole proprietorship does not survive the death of its owner, its individual
assets and liabilities do. In Phil's case, for example, to the extent that
these assets consist of the computer program, filing cabinets, and the like, they
would all be inherited by Phil's heirs, who could then choose to continue the
business or liquidate the assets as they pleased. Should they decide to continue
the business, they would then have the same choices of business form which
confront any entrepreneur. However, if Phil's major asset were a government
license, qualification as an approved government supplier, or a contract with a
software publisher, the ability of the heirs to carry on the business might be
entirely dependent upon the assignability of these items. If the publishing contract
is not assignable, Phil's death may terminate the business's major asset. If
the business had operated as a corporation, Phil's death would likely have been
irrelevant (other than to him); the corporation, not Phil, would have been party
to the contract.
Partnerships
Consistent with the general partnership's status as a collection of individuals,
not an entity separate from its owners, a partnership is deemed dissolved upon
the death, incapacity, bankruptcy, resignation, or expulsion of a partner. This
is true even if a partner's resignation violates the express terms of the partnership
agreement. Those assets of the partnership that may be assigned devolve
to those partners who are entitled to ownership, pursuant to the rules of tenancy
in partnership. These rules favor the remaining partners if the former
partner has died, become incapacitated or bankrupt, been expelled, or resigned
in violation of the partnership agreement. If the ex-partner resigned
without violating the underlying agreement, she or he retains ownership rights
under tenancy in partnership. Those who thus retain ownership may continue
the business as a new partnership, corporation, or LLC with the same or new
partners and investors or may liquidate the assets at their discretion. The sole
right of any partner who has forfeited direct ownership rights is to be paid
a dissolution distribution after the partnership's liabilities have been paid or
provided for.
Corporations
Corporations, in contrast, normally enjoy perpetual life. Unless the charter
contains a stated dissolution date (extremely rare), and as long as the corporation
pays its annual fees to the state, it will go on until and unless it is voted out
Choosing a Business Form 235
of existence by its stockholders. The death, incapacity, bankruptcy, resignation,
or expulsion of any stockholder is entirely irrelevant to the corporation's
existence. Such a stockholder's stock continues to be held by the stockholder, is
inherited by his heirs, or is auctioned by creditors as the circumstances demand,
with no direct effect on the corporation.
Limited Partnerships
As you may have guessed, the hybrid nature of the limited partnership dictates
that the death, incapacity, bankruptcy, resignation, or expulsion of a limited
partner will have no effect on the existence of the limited partnership. The
limited partner's partnership interest is passed in the same way as that of a
stockholder's. However, the death, incapacity, bankruptcy, resignation, or expulsion
of a general partner does automatically dissolve the partnership in the
same way as it would in the case of a general partnership. This automatic dissolution
can be extremely inconvenient if the limited partnership is conducting a
far-f lung enterprise with many limited partners. Thus, in most cases the partners
agree in advance in their limited partnership agreement that upon such a
dissolution the limited partnership will continue under the management of a
substitute general partner chosen by those general partners who remain. In
such a case, the entity continues until it is voted out of existence by its partners,
in accordance with their agreement, or until the arrival of a termination
date specified in its certificate.
Limited Liability Companies
The laws of the several states generally impose dissolution on an LLC upon the
occurrence of a list of events similar to those which result in the dissolution of
a limited partnership. However, these laws usually allow the remaining members
to vote to continue the LLC's existence notwithstanding an event of dissolution.
Under such laws, the LLC may effectively have perpetual life in the
same manner as corporations.
TRANSFERABILITY OF INTEREST
To a large extent, transferability of an owner's interest in the business is similar
to the continuity of life issue.
Sole Proprietorships
A sole proprietor has no interest to transfer because he and the business are
one and the same, and thus he must be content to transfer each of the assets of
the business individually—an administrative nightmare at best and possibly
236 Planning and Forecasting
impractical in the case of nonassignable contracts, licenses, and government
approvals.
Partnerships
To discuss transferability in the context of a general partnership, one must
keep in mind the difference between ownership of partnership assets as tenants
in partnership and ownership of an individual's partnership interest. A
partner has no right to transfer partnership assets except as may be authorized
by vote in accordance with the partnership agreement and in furtherance of
the partnership business. However, a partner may transfer her partnership interest,
and it may be attached by individual creditors pursuant to a charging
order. This transfer does not make the transferee a partner in the business, because
partnerships can be created only by agreement of all parties. Rather, it
sets up the rather awkward situation in which the original partner remains, but
his or her economic interest is, at least temporarily, in the hands of another. In
such cases, the Uniform Partnership Act gives the remaining partners the right
to dissolve the partnership by expelling the transferor partner.
Corporations
No such complications attend the transfer of one's interest in a corporation.
Stockholders simply sell or transfer their shares. Since stockholders (solely as
stockholders) have no day-to-day involvement in the operation of the business,
the transferee becomes a full-f ledged stockholder upon the transfer. This
means that if Bruce, Erika, and Michael decide to operate as a corporation,
each risks waking up one day to find that he or she has a new "partner" if one
of the three has sold his or her shares. To protect themselves against this eventuality,
most closely-held corporations include restrictions on stock transfer in
their charter, their bylaws, or in stockholder agreements. These restrictions set
forth some variation of a right of first refusal either for the corporation or the
other stockholders whenever a transfer is proposed. In addition, corporate
stock, as well as most limited partnership interests and LLC membership interests,
is a security under the federal and state securities laws, and because the
securities of these entities will not initially be registered under any of these
laws, their transfer is closely restricted.
Limited Partnerships
Just as with general partnerships, the partners of limited partnerships may
transfer their partnership interests. The rules regarding the transfer of the interests
of the general partners are similar to those governing general partnerships
described earlier. Limited partners may usually transfer their interests
(subject to securities laws restrictions) without fear of dissolution, but transferees
normally do not become substituted limited partners without the consent
of the general partners.
Choosing a Business Form 237
Limited Liability Companies
As previously mentioned, although a membership interest in an LLC may be
freely transferable under applicable state law, most LLCs require the affirmative
vote of at least a majority of the members or managers before a member's
interest may be transferred. Furthermore, membership interests in an LLC
will usually qualify as securities under relevant securities laws and will therefore
be subject to the restrictions on transfer imposed by such laws.
CONTROL
Simply put, control in the context of a business entity means the power to make
decisions regarding all aspects of its operations. But the implications of control
extend to many levels. These include control of the equity or value of the business,
control over distribution of profits, control over day-to-day and long-term
policy making, and control over distribution of cash flow. Each of these is
different from the others, and control over each can be allocated differently
among the owners and other principals of the entity. This can be seen either as
complexity or f lexibility, depending upon one's perspective.
Sole Proprietorships
No such debate over allocation exists for the sole proprietorship. In that business
form, control over all these factors belongs exclusively to the sole proprietor.
Nothing could be simpler or more straightforward.
Partnerships
Things are not so simple in the context of general partnerships. It is essential to
appreciate the difference between the partners' relationships with each other
(internal relationships) and the partnership's relations with third parties (external
relationships).
Internally, the partnership agreement governs the decision-making process
and sets forth the agreed division of equity, profits, and cash flows. Decisions
made in the ordinary course of business are normally made by a majority
vote of the partners, whereas major decisions, such as changing the character
of the partnership's business, may require a unanimous vote. Some partnerships
may weight the voting in proportion to each partner's partnership interest,
while others delegate much of the decision-making power to an executive
committee or a managing partner. In the absence of an agreement, the Uniform
Partnership Act prescribes a vote of the majority of partners for most
issues and unanimity for certain major decisions.
External relationships are largely governed by the law of agency; that is,
each partner is treated as an agent of the partnership and, derivatively, of the
other partners. Any action that a partner appears to have authority to take will
238 Planning and Forecasting
be binding upon the partnership and the other partners, regardless of whether
such action has been internally authorized (see Exhibit 8.1).
Thus, if Jennifer purchases a subscription to the Harvard Business Review
for the partnership, and such an action is perceived to be within the ordinary
course of the partnership's business, that obligation can be enforced
against the partnership, even if Jean and George had voted against it. Such
would not be the case, however, if Jennifer had signed a purchase and sale
agreement for an office building in the name of the partnership, because reasonable
third parties would be expected to know that such a purchase was not
in the ordinary course of business.
These rules extend to tort liability, as well. If Jean were wrongfully to induce
a potential client to breach its consulting contract with a competitor, the
partnership would be liable for interference with contractual relations, even if
the other two partners were not aware of Jean's actions. Such might not be the
case, however, if Jean decided to dynamite the competition's offices, because
such an act could be judged to be outside the normal scope of her duties as
a partner.
These obligations to third parties can even extend past the dissolution of
the partnership if an individual partner has not given adequate notice that he
or she is no longer associated with the others. Thus, a former partner can be
held liable for legal fees incurred by the other former partners, if he has not
notified the partnership's counsel about leaving the firm.
It should also be noted that agency law reaches into the internal relationships
of partners. The law imposes upon partners the same obligations of fiduciary
loyalty, noncompetition, and accountability as it does upon agents with
respect to their principals.
Corporations
There can be much f lexibility and complexity in the allocation of control in
the partnership form, but not nearly so much as in the corporate form. Many
EXHIBIT 8.1 Principal and agent.
Principal
Agent Agent
Principal
Outsider
Governed
by:
Agreement
and
Fiduciary
Principles
Express,
Apparent Authority,
and
Scope of Employment
Choosing a Business Form 239
aspects of the corporate form have been designed specifically for the purpose
of splitting off individual aspects of control and allocating them differently.
Stockholders
At its simplest, a corporation is controlled by its stockholders. Yet, except in
those states which have specific (but rarely used) close corporation statutes
governing corporations with very few stakeholders, the decision-making function
of stockholders is exercised only derivatively. Under most corporate
statutes, a stockholder vote is required only with respect to four basic types of
decisions: an amendment to the charter, a sale of the company, a dissolution
of the company, and an election of the board of directors.
Charter amendments may sound significant, until one remembers what
information is normally included in the charter. A name change, a change in
purpose (given the broad purpose of clauses now generally employed), and an
increase in authorized shares (given the large amounts of stock normally left
on the shelf ) are neither frequent nor usually significant decisions. Certainly, a
sale of the company is significant, but it normally can occur only after the recommendation
of the board and will happen only once, if at all. The same can
be said of the decision to dissolve. It is the board of directors that makes all the
long-term policy decisions for the corporation. Thus, the right to elect the
board is significant but indirectly so. Day-to-day operation of the corporation's
business is accomplished by its officers, who are normally elected by the board,
not the stockholders.
Even given the relative unimportance of voting power for stockholders,
the corporation provides many opportunities to differentiate voting power
from other aspects of control and allocate it differently. Assume Bruce and
Erika (our hotel developers) were willing to give Michael a larger piece of the
equity of their operation to ref lect his contribution of the land but wished to
divide their voting rights equally. They could authorize a class of nonvoting
common stock and issue, for example, 1,000 shares of voting stock to each of
themselves and an additional 1,000 shares of nonvoting stock to Michael. As a
result, each would have one-third of the voting control, but Michael would have
one-half of the equity interest.
Alternatively, Michael could be issued a block of preferred stock representing
the value of the land. This would guarantee him a fair return on his
investment before any dividends could be declared to the three of them as
holders of the common stock. As a holder of preferred stock, Michael would
also receive a liquidation preference upon dissolution or sale of the business, in
the amount of the value of his investment, but any additional value created by
the efforts of the group would be ref lected in the increasing value of the common
shares.
The previous information illustrates how one can separate and allocate
decision-making control differently from that of the equity in the business, as
well as from the distribution of profits. Distribution of cash flow can, of
240 Planning and Forecasting
course, be accomplished totally separately from the ownership of securities,
through salaries based upon the relative efforts of the parties, rent payments
for assets leased to the entity by the principals, or interest on loans to the
corporation.
Stockholders exercise what voting power they have at meetings of the
stockholders, held at least annually but more frequently if necessary. Each
stockholder of record, on a future date chosen by the party calling the meeting,
is given a notice of the meeting containing the date, time, and purpose of
the meeting. Such notice must be sent at least 7 to 10 days prior to the date
of the meeting depending upon the individual state's corporate law, although
the Securities and Exchange Commission requires 30 days' notice for publicly
traded corporations. No action may be taken at a meeting unless a majority of
voting shares is represented (known as a quorum). This results in the aggressive
solicitation of proxy votes in most corporations with widespread stock
ownership. Unless otherwise provided (as for a sale or dissolution of the company,
for which most states require a two-thirds vote of all shares), a resolution
is carried by a majority vote of those shares represented at the meeting.
The preceding rules require the conclusion that the board of directors
will be elected by the holders of a majority of the voting shares. Thus, in the
earlier scenario, even though Bruce and Erika may have given Michael onethird
of the voting shares of common stock, as long as they continue to vote
together, Bruce and Erika will be able to elect the entire board. To prevent
this result, prior to investing Michael could insist upon a cumulative voting
provision in the charter (under those states' corporate laws that allow it).
Under this system, each share of stock is entitled to a number of votes equal to
the number of directors to be elected. By using all their votes to support a single
candidate, individuals with a significant minority interest can guarantee
themselves representation on the board.
More directly (and in states which do not allow cumulative voting),
Michael could insist upon two different classes of voting stock, differing only
in voting rights. Bruce and Erika would each own 1,000 shares of class A stock
and elect two directors. Michael, the sole owner of the 1,000 outstanding
shares of class B stock, would elect a third director. Of course, the board also
acts by majority, so Bruce and Erika's directors could dominate board decisions
in any case, but at least Michael would have access to the deliberations.
In the absence of a meeting, stockholders may vote by unanimous written
consent, where each stockholder indicates his approval of a written resolution
by signing it. This eliminates the need for a meeting and is very effective in
corporations with only a few stockholders (such as our hotel operation). Unlike
the rules governing stockholders' meetings, however, in most states unanimity
is required to adopt resolutions by written consent. This apparently ref lects the
belief that a minority stockholder is owed an opportunity to sway the majority
with his arguments. A few states, notably Delaware, permit written consents of
a majority, apparently reacting to the dominance of proxy voting at most meetings
of large corporations, where the most eloquent of minority arguments
would fall upon deaf ears (and proxy cards).
Choosing a Business Form 241
Directors
At the directors' level, absent a special provision in the corporation's charter,
all decisions are made by majority vote. Typically, directors concentrate on
long-term and significant decisions, leaving day-to-day management to the officers
of the corporation. Decisions are made at regularly scheduled directors'
meetings or at a special meeting if there is need to respond to a specific situation.
Under most corporate laws, no notice need be given for regular meetings,
and only very short notice need be given for special meetings (24 to 48 hours).
The notice must be sent to all directors and must contain the date, time, and
place of the meeting but, unlike stockholders' notices, need not contain the
purpose of the meeting. It is assumed that directors are much more involved in
the business of the corporation and do not need to be warned about possible
agenda items or given long notice periods.
At the meeting itself, no business can be conducted in the absence of a
quorum, which, unless increased by a charter or bylaw provision, is a majority
of the directors then in office. Ref lecting recent advances in technology, many
corporate statutes allow directors to attend meetings by conference call or
teleconference as long as all directors are able to hear and speak to each other
at all times during the meeting. Individual telephone calls to each director will
not suffice. Unlike stockholders, directors cannot vote by proxy, because each
director owes to the corporation his or her individual judgment on items coming
before the board. The board of directors can also act by written consent,
but, even in Delaware, such consent must be unanimous, in recognition that
the board is fundamentally a deliberative body.
Boards of directors, especially in publicly held corporations with larger
boards, frequently delegate some of their powers to executive committees, or
other committees formed for defined purposes. However, most corporate
statutes prohibit boards from delegating certain fundamental powers, such as
the declaration of dividends, the recommendation of charter amendments, or
sale of the company. The executive committee can, however, be a powerful organizational
tool to streamline board operations and increase efficiency and
responsiveness.
Although directors are not agents of the corporation—in that they cannot
bind the corporation to contract or tort liability through their individual actions—
they are subject to many of the obligations of agents discussed in the
context of partnerships, such as fiduciary loyalty. Directors are bound by the
so-called corporate opportunity doctrine, which prohibits them from taking
personal advantage of any business opportunity that may come their way, if the
opportunity would reasonably be expected to interest the corporation. In such
an event, the director must disclose the opportunity to the corporation, which
normally must consider it and vote not to take advantage before the director
may act on her or his own behalf.
Unlike stockholders, who under most circumstances can vote their shares
totally in their own self-interest, directors must use their best business judgment
and act in the corporation's best interest when making decisions for the
242 Planning and Forecasting
corporation. At the very least, the director must keep informed regarding the
corporation's operations, although he or she may in most circumstances rely on
the input of experts hired by the corporation, such as its attorneys and accountants.
Thus, when the widow of a corporation's founder accepted a seat on the
board as a symbolic gesture of respect to her late husband, she found herself liable
to minority stockholders for the misbehavior of her fellow board members.
Nonparticipation in the misdeeds was not enough to exempt her from liability;
she had failed to keep herself informed and exercise independent judgment.
Directors may also find themselves sued personally by minority stockholders
or creditors of the corporation for declaration of dividends or other
distributions to stockholders that render the corporation insolvent or for other
decisions of the board that have injured the corporation. Notwithstanding such
lawsuits, however, directors are not guarantors of the success of the corporation's
endeavors; they are required only to have used their best independent
"business judgment" in making their decisions. When individual directors cannot
be totally disinterested (such as the corporate opportunity issue or when
the corporation is being asked to contract with a director or an entity in which
a director has an interest), the interested director is required to disclose her or
his interest and is disqualified from voting. In many states, the director 's presence
will not even count for the maintenance of a quorum.
Apart from the question of the interested director, much of the modern
debate on the role of the corporate director has focused around which constituencies
a director may take into account when exercising his or her best
business judgment. The traditional view has been that the director's only concern
is to maximize return on the investment of the stockholders. More recently,
especially in the context of hostile takeovers, directors have been
allowed to take into account the effect of their decisions on other constituencies,
such as suppliers, neighboring communities, customers, and employees.
In an early case on this subject, the board of directors of the corporation
which owned Wrigley Field and the Chicago Cubs baseball team was judged to
have appropriately considered the effect on its neighbors and on the game of
baseball in voting to forgo the extra revenue that it would probably have earned
if it had installed lights for night games.
When the stockholders believe the directors have not been exercising
their best independent business judgment in a particular instance, the normal
procedure is to make a demand on the directors to correct the decision either
by reversing it or by reimbursing the corporation from their personal funds.
Should the board refuse (as it most likely will), the stockholders then bring a
derivative suit against the board on behalf of the corporation. They are, in effect,
taking over the board's authority to decide whether such a suit should be
brought in the corporation's name. The board's vote not to institute the suit is
not likely to be upheld on the basis of the business judgment rule, since the
board members are clearly interested in the outcome of the vote. As a result,
the well-informed board will delegate the power to make such a decision to an
independent litigation committee, usually composed of directors who were not
Choosing a Business Form 243
involved in the original decision. The decision of such a committee is much
more likely to be upheld in a court of law, although the decision is not immune
from judicial review.
A more detailed discussion on the board of directors is contained in
Chapter 15, "The Board of Directors."
Officers
The third level of decision making in the normal corporation is that of the
officers, who take on the day-to-day operational responsibilities. Officers are
elected by the board and consist, at a minimum, of a president, a treasurer, and
a secretary or clerk (keeper of the corporate records). Many corporations elect
additional officers such as vice presidents, assistant treasurers, CEOs, and
the like.
Thus, the decision-making control of the corporation is exercised on
three very different levels. Where each decision properly belongs may not be
entirely obvious in every situation. The decision to go into a new line of business
would normally be considered a board decision. Yet if by some chance the
decision requires an amendment of the corporate charter, a vote of stockholders
may be necessary. On the contrary, if the decision is merely to add a
twelfth variety of relish to the corporation's already varied line of condiments,
the decision may be properly left to a vice president of marketing.
Often persons who have been exposed to the preceding analysis of the
corporate-control function conclude that the corporate form is too complex for
any but the largest and most complicated publicly held companies. This is a
gross overreaction. For example, if Phil, our software entrepreneur, should decide
that the corporate form is appropriate for his business, it is very likely that
he will be the corporation's 100% stockholder. As such, he will elect himself
the sole director and his board will then elect him as the president, treasurer,
and secretary of the corporation. Joint meetings of the stockholders and directors
of the corporation may be held in the shower adjacent to Phil's bathroom
on alternate Monday mornings.
Limited Partnerships
As you might expect, the allocation of control in a limited partnership ref lects
its origin as a hybrid of the general partnership and the corporation. Simply
put, virtually all management authority is vested in the general partners. Like
outside stockholders in a corporation, the limited partners normally have little
or no authority. Third parties cannot rely on any apparent authority of a limited
partner because that partner's name will not appear, as a general partner's
name may, on the limited partnership's certificate on the public record.
General partners exercise their authority in the same way as they do in a
general partnership. Voting control is allocated internally as set forth in the
partnership agreement, but each general partner has the apparent authority to
244 Planning and Forecasting
bind the partnership to unauthorized contracts and torts to the same extent as
the partners in a general partnership.
Limited partners will normally have voting power over a very small list of
fundamental business events, such as amending the partnership agreement and
certificate, admitting new general partners, changing the basic business purposes
of the partnership, or dissolving the partnership. These are similar to the
decisions that must be put to a stockholders' vote in a corporation. The Revised
Uniform Limited Partnership Act, now accepted by most states, has widened
the range of decisions in which a limited partner may participate without losing
his or her status as a limited partner. However, this range is still determined
by the language of the agreement and certificate for each individual
partnership.
Limited Liability Companies
An LLC which chooses not to appoint managers is operated much like a general
partnership. The operating agreement sets forth the percentages of membership
interests required to authorize various types of actions on the LLC's
behalf, with the percentage normally varying according to the importance of
the act. Although the LLC is a relatively new phenomenon, courts can be expected
to deem members (in the absence of managers) to have apparent authority
to bind the entity to contracts (regardless of whether they have been
approved internally) and to expose the entity to tort liability for acts occurring
within the scope of the entity's business.
An LLC that appoints managers is operated much like a limited partnership.
The managers make most of the decisions on behalf of the entity, as do
the general partners of a limited partnership. The members are treated much
like limited partners and have voting rights only in rare circumstances involving
very significant events. It can be expected that apparent authority to act
for the entity will be reserved by the courts to the managers, as only their
names will appear on the Certificate of Organization.
LIABILITY
Possibly the factor that most concerns the entrepreneur is personal liability.
If the company encounters catastrophic tort liability, finds itself in breach of
a significant contract, or just plain can't pay its bills, must the owner reach
into her or his own personal assets to pay the remaining liability after the
company's assets have been exhausted? If so, potential entrepreneurs may
well believe that the risk of losing everything is not worth the possibility of
success, and their innovative potential will be diminished or lost to society.
Most entrepreneurs are willing to take significant risk, however, if the
amount of that risk can be limited to the amount they have chosen to invest in
the venture.
Choosing a Business Form 245
Sole Proprietorships
With the sole proprietorship, the owner has essentially traded off limitation of
risk in favor of simplicity of operation. Since there is no difference between
the entity and its owner, all the liabilities and obligations of the business are
also liabilities and obligations of its owner. Thus, all the owner's personal assets
are at risk. Failure of the business may well mean personal bankruptcy for the
owner.
Partnerships
The result may be even worse within a general partnership. There, each owner
is liable not only for personal mistakes but also for those of his or her partners.
Each partner is jointly and severally liable for the debts of the partnership remaining
after its assets have been exhausted. This means that a creditor may
choose to sue any individual partner for 100% of any liability. The partner may
have a right to sue the other partners for their share of the debt, as set forth in
the partnership agreement, but that is of no concern to a third party. If the
other partners are bankrupt or have f led the jurisdiction, the targeted partner
may end up holding the entire bag.
If our three consultants operate as a partnership, Jennifer is 100% personally
liable not only for any contracts she may enter into but also for any contracts
entered into by either Jean or George. What's more, she is liable for
those contracts, even if they were entered into in violation of the partnership
agreement, because, as was demonstrated earlier, each partner has the apparent
authority to bind the partnership to contracts in the ordinary course of the
partnership's business, regardless of the partners' internal agreement. Worse,
Jennifer is also 100% individually liable for any torts committed by either of
her partners as long as they were committed within the scope of the partnership's
business. The only good news in all this is that neither the partnership
nor Jennifer is liable for any debts or obligations of Jean or George incurred
in their personal affairs. If George has incurred heavy gambling debts in Las
Vegas, his creditors can affect the partnership only by obtaining a charging
order against George's partnership interest.
Corporations
Thus, we have the historical reason for the invention of the corporation. Unlike
the sole proprietorship and partnership, the corporation is recognized as
a legal entity separate from its owners. Its owners are thus not personally liable
for its debts; they are granted limited liability. If the corporation's debts
exhaust its assets, the stockholders have lost their investment, but they are
not responsible for any further amounts. In practice, this may not be as attractive
as it sounds, because sophisticated creditors, such as the corporation's
bank, will likely demand personal guarantees from major stockholders.
246 Planning and Forecasting
But the stockholders will normally escape personal liability for trade debt and,
most important, for torts.
This major benefit of incorporation does not come without some cost.
Creditors may, on occasion, be able to "pierce the corporate veil" and assert
personal liability against stockholders, using any one of three major arguments.
First, to claim limited liability behind the corporate shield, stockholders must
have adequately capitalized the corporation at or near its inception. There is no
magic formula with which to calculate the amount necessary to achieve adequate
capitalization, but the stockholders normally will be expected to invest
enough money or property and obtain enough liability insurance to offset the
kinds and amounts of liabilities normally encountered by a business in their industry.
Thus, the owner of a f leet of taxicabs did not escape liability by canceling
his liability insurance and forming a separate corporation for each cab. The
court deemed each such corporation inadequately capitalized and, in a novel
decision, pierced the corporate veil laterally by combining all the corporations
into one for purposes of liability.
It is necessary to capitalize only for those liabilities normally encountered
by corporations in the industry. The word normally is key because the
corporation obviously need not have resources adequate to handle any circumstance
no matter how unforeseeable. Also, adequate capitalization is necessary
only at the outset. A corporation does not expose its stockholders to personal
liability by incurring substantial losses and ultimately dissipating its initial
capitalization.
A second argument used by creditors to reach stockholders for personal liability
is failure to respect the corporate form. This may occur in many ways.
The stockholders may fail to indicate that they are doing business in the corporate
form by leaving the words "Inc." or "Corp." off their business cards and
stationery, thus giving the impression that they are operating as a partnership.
They may mingle the corporate assets in personal bank accounts or routinely
use corporate assets for personal business. They may fail to respect corporate
niceties such as holding annual meetings and filing the annual reports required
by the state. After all, if the stockholders don't take the corporate form seriously,
why should their creditors? Creditors are entitled to adequate notice
that they may not rely on the personal assets of the stockholders. Even Phil,
the software entrepreneur imagined earlier holding stockholder's and director's
meetings in his shower, would be well advised to record the minutes in a
corporate record book.
A third argument arises from a common mistake made by entrepreneurs.
Fearful of the expense involved in forming a corporation, they wait until they
are sure that the business will get off the ground before they spring for the attorneys'
and filing fees. In the meantime, they may enter into contracts on behalf
of the corporation and perhaps even commit a tort or two. Once the
corporation is formed, they may even remember to have it expressly accept all
liabilities incurred by the promoters on its behalf. Under simple agency law,
however, one cannot act as an agent of a nonexistent principal. And a later
Choosing a Business Form 247
assignment of one's liabilities to a newly formed corporation does not act to release
the original obligor without the consent of the obligee. The best advice
here is to form the corporation before incurring any liability on its behalf. Most
entrepreneurs are surprised at how little it actually costs to get started.
Limited Partnerships
In keeping with its hybrid nature, a limited partnership borrows some of its aspects
from the corporation and some from the general partnership. In summary,
each general partner has unlimited joint and several liability for the
debts and obligations of the limited partnership after exhaustion of the partnership's
assets. In this respect, the rules are identical to those governing the
partners in a general partnership. Limited partners are treated as stockholders
in a corporation. They have risked their investment, but their personal assets
are exempt from the creditors of the partnership.
As you might expect, however, things aren't quite as simple as they may
initially appear. In limited partnerships, it is rather common for limited partners
to make their investments in the form of a cash down payment and a
promissory note for the rest, partly for reasons of cash flow and partly for purposes
of tax planning. This arrangement is much less common in corporations
because many corporate statutes do not permit it and because the tax advantages
associated with this arrangement are generally not available in the corporate
form. Should the limited partnership's business fail, limited partners will
be expected, despite limited liability, to honor their commitments to make future
contributions to capital.
In addition, it is fundamental to the status of limited partners that they
have acquired limited liability in exchange for foregoing virtually all management
authority over the business. The corollary to that rule is that a limited
partner who excessively involves her- or himself in management may forfeit
limited liability and be treated, for the purposes of creditors, as a general partner,
with unlimited personal liability. Mitigating this somewhat harsh rule, the
Revised Uniform Limited Partnership Act increased the categories of activities
in which a limited partner may participate without crossing the line. Furthermore,
and perhaps more fundamentally, in states that have adopted the
Revised Act, the transgressing limited partner is now only personally liable to
those creditors who were aware of the limited partner's activities and detrimentally
relied upon his or her apparent status as a general partner.
Limited Liability Companies
One of the major benefits of employing the LLC form is that it shields all
members and managers from personal liability for the debts of the business.
However, even though the LLC is relatively new on the legal scene, courts
can be expected to apply most of the same doctrines they use in piercing the
corporate veil to pierce the veil of the LLC as well. Furthermore, it can be
248 Planning and Forecasting
expected that the managers of an LLC will be held to the same fiduciary standards
as corporate directors and general partners of limited partnerships, resulting
in their potential personal liability to the members.
TAXATION
Entrepreneurs make a remarkable number of significant business decisions
without first taking into account the tax consequences. Tax consequences
should almost never be allowed to force an entrepreneur to take actions he or
she otherwise would not have considered. But often tax considerations lead one
to do what one wants in a different manner and to reap substantial savings as a
consequence. Such is often the case in the organization of a business. The following
discussion will be confined to the federal income tax, the tax with the
largest and most direct effect upon organizational issues. Each entrepreneur
would be well advised to consult a tax adviser regarding this tax as well as state
income, estate, payroll, and other taxes to find out how they might impact a
specific business.
Sole Proprietorships
Not surprisingly given the factors already discussed, a sole proprietorship is
not a separate taxable entity for federal income tax purposes. The taxable income
and deductible expenses of the business are set forth on Schedule C
of the entrepreneur's Form 1040 and the net profit (loss) is carried back to
page 1, where it is added to (or subtracted from) all the taxpayer's other income.
The net effect of this is that the sole proprietor will pay tax on the income
from this business at his highest marginal rate, possibly as high as 39.1%
(in 2001), depending upon the amount of income received from this and other
sources (see Exhibit 8.2).
In Phil's case, for example, if his software business netted $100,000 in
2001, that amount would be added to the substantial interest and dividend income
from his other investments, so that he would likely owe the IRS $39,100
on this income. If Phil's business were run as a separate taxable corporation,
the income generated from it would be taxed at the lowest levels of the tax-rate
structure, because this corporate income would not be added to any other income.
The first $50,000 of income would be taxed at only 15% and the next
$25,000 at only 25% (see Exhibit 8.3).
This argument is turned on its head, however, if a business anticipates
losses in the short term. Using Phil again as an example, if his business operated
at a $100,000 loss and as a separate taxable entity, the business would pay
no tax in its first year and would be able to net its early losses only against
profits in future years and only if it ever realized such profits. At best, the
value of this tax benefit is reduced by the time value of money: At worst, the
loss may never yield a tax benefit if the business never does more than break
Choosing a Business Form 249
even. If Phil operated the business as a sole proprietorship, by contrast, the
loss calculated on his Schedule C would be netted against the dividend and
interest income generated by his investments, thus effectively rendering
$100,000 of that income tax free. One can strongly argue, therefore, that the
form in which one should operate one's business is dictated in part by the
likelihood of its short-term success and the presence or absence of other income
flowing to its owner.
EXHIBIT 8.2 Individual federal income tax rates.
Under
$6,000
Over
$27,050
Over
$65,550
Over
$136,750
Over
$297,350
Marginal tax rate (percent)
Individual income 2001
0
10
20
30
40
50
Over
$6,000
EXHIBIT 8.3 Corporate federal income tax rates.
Below $50 >$50 >$75 >$100 >$335 >$10,000 >$15,000 >$18,333
Marginal tax rate (percent)
Corporate income (thousands)
0
10
20
30
40
50
250 Planning and Forecasting
Partnerships
Partnerships are also not separate taxable entities for the purposes of the federal
income tax, although, in most cases, they are required to file informational
tax returns with the IRS. Any profits generated by a partnership appear on the
federal income tax returns of the partners, generally in proportions indicated
by the underlying partnership agreement. Thus, as with sole proprietorships,
this profit is taxed at the individual partner's highest marginal tax rate, and the
lower rates for the initial income of a separate taxable entity are forgone. In addition,
each partner is taxed upon his or her proportion of the income of the
partnership regardless of whether that income was actually distributed.
As an example, if Bruce and Erika, our hotel magnates, were to take
$50,000 of a year's profits to add a deck to one of their properties, this expenditure
would not lower the business's profits by that amount. As a capital expense
it may be deducted over time only in the form of depreciation. Thus,
assuming they were equal partners, even if Michael had objected to this expenditure,
each of the three, including Michael, would be forced to pay a tax
on $16,667 (minus that year's depreciation) despite having received no funds
with which to make such a payment. The result would be the same in a sole
proprietorship, but this obligation is considered less of a problem since it can
be expected that the owner would manage cash f low in a way which would minimize
this negative effect upon her- or himself.
As with a sole proprietorship, this negative result becomes a positive one
if the partnership is losing money. The losses appear on the partners' individual
tax returns in the proportions set forth in the partnership agreement and
render an equal amount of otherwise taxable income tax free. In addition, not
all losses suffered by businesses result from the dreaded negative cash flow. As
illustrated earlier in the case of the deck, the next year the hotel business
might well break even or show a small profit on a cash-flow basis, but the depreciation
generated by the earlier addition of the deck might well result in a
loss for tax purposes. Thus, with enough depreciation a partner might have the
double benefit of a tax sheltering loss on his tax return and ownership of a
growing, profitable business. This is especially true regarding real estate, such
as the hotel itself. While generating a substantial depreciation loss each year,
the value of the building may well be increasing, yielding the partners a current
tax-sheltering loss while generating a long-term capital gain for a few years
hence.
Corporations
Corporations are treated as separate entities for federal income tax purposes,
consistent with their treatment for most other purposes. They have their own
set of progressive tax rates, moving from 15% for the first $50,000 of income,
through 25% for the next $25,000, to 34% and 35% for amounts above
that. There are also 5% and 3% additional taxes at higher levels of income to
Choosing a Business Form 251
compensate for the lower rates in the lower brackets. Certain "professional
service corporations" have only a f lat 35% rate at all levels of income. Also,
losses currently generated by a corporation may be carried back as many as 2
years to generate a tax refund or carried forward as many as 20 years to shelter
future income.
Although corporate rates may be attractive at lower levels of income, the
common fear of using the corporate form is the potential for double taxation.
Simply put, the corporation pays tax upon its profits and then distributes the
remaining profit to its stockholders as nondeductible dividends. The stockholders
then pay tax on the receipt of the dividends, thus amounting to two taxes on
the same money. In 2001, for a corporation in the 34% bracket with stockholders
in the 27.5% bracket, the net effect is a combined tax rate of 52.15%. Yet
double taxation is rarely a concern for the small business. Such businesses
generally manage compensation to their employees, who are usually their
shareholders, in such a way that there is rarely much, if any, corporate profit
remaining at the end of the year. Since compensation (as opposed to dividends)
is deductible, the only level of taxation incurred by such businesses is at the
stockholder level. Other opportunities for legitimate deductible payments to
stockholders that have the effect of eliminating corporate profit include rental
payments on assets leased by a stockholder to the corporation and interest on
that portion of a stockholder's investment made in the form of debt.
Thus, the existence of the separate corporate entity with its own set of
tax rates presents more of an opportunity for tax planning than a threat of double
taxation. If the corporation intends to distribute all of its excess cash to its
owners, it should manage compensation and other payments so as to show little
profit and incur taxation only on the stockholder level. If the corporation intends
to retain some of its earnings in the form of capital acquisitions (thus resulting
in an unavoidable profit for tax purposes), it can take advantage of the
lower corporate rates without subjecting its stockholders to taxation at their
level. Contrast this to a partnership where the partners would be required to
pay tax at their highest marginal rates on profits that they never received.
There are limits to the usefulness of these strategies. To begin with, one
cannot pay salaries and bonuses to nonemployee stockholders who are not performing
services for the corporation. Dividends may be the only way to give
such shareholders a return on their investment. In addition, the Internal Revenue
Service will not allow deductions for what it considers to be unreasonable
compensation (as measured by compensation paid to comparable employees in
the same industry). Thus, a highly profitable corporation might find some of its
excessive salaries to employee-stockholders recharacterized as nondeductible
dividends. Lastly, even profits retained at the corporate level will eventually
be indirectly taxed at the stockholder level as increased capital gain when the
stockholders sell their shares.
For most startup businesses, however, this corporate tax planning strategy
will be useful, at least in the short term. In addition, entrepreneurs will find
certain employee benefits are better offered in the corporate form because
252 Planning and Forecasting
they are deductible to employers but excluded from income only for employees.
Since a sole proprietor or partner is not considered an employee, the value of
benefits such as group medical insurance, group life insurance, and disability
insurance policies would be taxable income to them but tax free to the officers
of a corporation.
Professional Corporations
There are two common variations of the corporate form. The first of these is
the professional corporation. Taxation played a major part in its invention.
Originally, limitations on the amounts of money that could be deducted as a
contribution to a qualified retirement plan varied greatly depending upon
whether the business maintaining the plan was a corporation, a partnership, or
a sole proprietorship. The rules greatly favored the corporation. Partnerships
and sole proprietorships were required to adopt Keogh plans with their substantially
lower limits on deductibility. However, doctors, lawyers, architects,
and other professionals, who often could afford large contributions to retirement
plans, were not allowed to incorporate under applicable state laws. The
states were offended by the notion that such professionals could be granted
limited liability for the harms caused by their businesses.
Eventually, a compromise was struck and the "professional corporation"
was formed. Using that form, professionals could incorporate their businesses,
thus qualifying for the higher retirement plan deductions but giving up any
claim to limited liability. As time went by, however, the Internal Revenue
Code was amended to eliminate most of the differences between the deductions
available to Keogh plans and those available to corporate pension and
profit-sharing plans. Today, professional corporations are subject to virtually
all the same rules as other corporations, with the exception that most are classified
as professional service corporations and therefore taxed at a f lat 35%
rate on undistributed profit.
As the tax incentive for forming professional corporations has decreased,
many states, perhaps with an eye toward maintaining the flow of fees from
these corporations, have greatly liberalized the availability of limited liability
for these corporations. Today in many states professional corporations now
afford their stockholders protection from normal trade credit as well as tort liability
arising from the actions of their employees or other stockholders. Of
course, even under the normal business corporation form, a stockholder is personally
liable for torts arising from his or her own actions.
Subchapter S Corporations
The second common variation is the subchapter S corporation, named for the
sections of the Internal Revenue Code that govern it. Although indistinguishable
from the normal (or subchapter C) corporation in all other ways, including limited
liability for its stockholders, the subchapter S corporation has affirmatively
Choosing a Business Form 253
elected to be taxed similarly to a partnership. Thus, like the partnership, it is
not a separate taxable entity and files only an informational return. Profits appear
on the tax returns of its stockholders in proportion to shares of stock
owned, regardless of whether those profits were distributed to the stockholders
or retained for operations. Losses appear on the returns of the stockholders
and may potentially be used to shelter other income.
Although the subchapter S corporation is often referred to as a small
business corporation, the size of the business has no bearing on whether this
election is available. Any corporation that meets the following tests may, but
need not, elect to be taxed as a subchapter S corporation:
1. It must have 75 or fewer stockholders.
2. It may have only one class of stock (although variations in voting rights
are acceptable).
3. All stockholders must be individuals (or certain kinds of trusts).
4. No stockholder may be a nonresident alien.
5. With certain exceptions, it may not own or be owned by another
corporation.
The subchapter S corporation is particularly suited to resolving problems
presented by certain discrete situations. For example, if a corporation is concerned
that its profits are likely to be too high to eliminate double taxation
through compensation to its stockholders, the subchapter S election eliminates
the worry over unreasonable compensation. Since there is no tax at the corporate
level, it is not necessary to establish the right to a compensation deduction.
Similarly, if a corporation has nonemployee stockholders who insist upon
current distributions of profit, the subchapter S election would allow declaration
of dividends without the worry of double taxation. This would undoubtedly
be attractive to most publicly traded corporations were it not for the
75-stockholder limitation.
Many entrepreneurs have turned to the subchapter S election to eliminate
the two layers of tax otherwise payable upon sale or dissolution of a corporation.
The corporate tax otherwise payable upon the gain realized on the sale of corporate
assets is eliminated by the use of the subchapter S election as long as the
election has been in effect for 10 years or, if less, since the corporation's inception.
Finally, many entrepreneurs elect subchapter S status for their corporations
if they expect to show losses in the short term. These losses can then be passed
through to their individual tax returns to act as a shelter for other income. When
the corporation begins to show a profit, the election can be reversed.
Limited Partnerships
The tax treatment of limited partnerships is much the same as general partnerships.
The profits and losses of the business are passed through to the partners in
the proportions set forth in the partnership agreement. It must be emphasized
254 Planning and Forecasting
that these profits and losses are passed through to all partners, including limited
partners, even though one could argue that those profits and losses are derived
entirely from the efforts of the general partners. It is this aspect of the
limited partnership which made it the form of choice for tax-sheltered investments.
The loss incurred by the business (much of which was created on paper
through depreciation and the like) could be passed through to the limited partners,
who typically had a considerable amount of other investment and compensation
income to be sheltered.
Although the tax treatments of limited partnerships and subchapter S
corporations are similar, there are some differences that drove the operators of
tax shelters to use partnerships over the corporate form even at the risk of
some unlimited liability. For one, although profits and losses must be allocated
according to stock ownership in the subchapter S corporation, they are allocated
by agreement in the limited partnership. Thus, in order to give the investors
the high proportion of losses they demand, promoters did not
necessarily have to give them an identically high proportion of the equity. The
IRS will attack economically unrealistic allocations, but reasonable allocations
will be respected. In addition, whereas the amount of loss the investor can use
to shelter other income is limited to the tax basis in both types of entities, the
tax basis in subchapter S stock is essentially limited to direct investment in
the corporation, while in a limited partnership it is augmented by certain types
of debt incurred by the entity itself.
Both types of entities are aff licted by the operation of the passive loss
rules, added by the Tax Reform Act of 1986 in an attempt to eliminate the tax
shelter. Thus, unless one materially participates in the operations of the entity
(virtually impossible, by definition, for a limited partner), losses generated by
those operations can normally be applied only against so-called passive income
and not against active (salaries and bonuses) or portfolio (interest and dividend)
income. Furthermore, owners of most tax pass-through real estate ventures
are treated as subject to the passive loss rules, regardless of material
participation.
Limited Liability Companies
LLCs are taxed in a manner substantially identical to limited partnerships. This
combination of limited liability for all members (without the need to construct
the unwieldy, double-entity, limited partnership with a corporate general partner)
and a pass-through of all tax effects to the members' personal returns,
makes the LLC the ideal vehicle for whatever tax shelter activity remains after
the imposition of the passive-activity rules.
Technically, under recently adopted "check the box" regulations, LLCs,
limited partnerships, and all other unincorporated business entities may
choose to be taxed either as partnerships or as taxable corporations. Recognizing
that the vast majority of these entities are formed to take advantage of the
opportunity to have taxable income or loss pass through to the owners, these
Choosing a Business Form 255
regulations provide that these entities will be taxed as partnerships unless the
entity affirmatively chooses to be taxed as a corporation. Most corporations
have already achieved that level of comfort through the availability of the subchapter
S election.
Although the LLC would seem to have the advantage of affording tax
pass-through treatment without the limitations of the subchapter S corporation
rules, there are some disadvantages as well. Since the nonelecting LLC is not a
corporation, it is not eligible for certain provisions the Internal Revenue Code
grants only to the corporate entity. Among these privileges are the right to
grant incentive stock options (ISOs) to employees and the right to take advantage
of tax-free reorganizations when selling the company. LLCs must be converted
to taxable entities well before relying on these provisions.
CHOICE OF ENTITY
The sole proprietorship, partnership, corporation (including the professional
corporation and subchapter S corporation), the limited partnership, and the
LLC are the most commonly used business forms. Other forms exist, such as
the so-called Massachusetts business trust, in which the business is operated by
trustees for the benefit of beneficiaries who hold transferable shares. But these
are generally used for limited, specialized purposes. Armed with this knowledge
and the comparative factors discussed previously, how should our budding
entrepreneurs operate their businesses?
Consulting Firm
It will be obvious to Jennifer, Jean, and George that they can immediately
eliminate the sole proprietorship and limited partnership as choices for their
consulting business. The sole proprietorship, by definition, allows for only one
owner, and there does not seem to be any need for the passive silent investors
who would serve as limited partners. Certainly, none of the three would be
willing to sacrifice the control and participation necessary to achieve limited
partnership status.
The corporation gives the consultants the benefit of limited liability, not
for their own mistakes but for the mistakes of each other and their employees.
It also protects them from personal liability for trade debt. This protection,
however, comes at the cost of additional complexity and expense, such as additional
tax returns, annual reports to the state, and annual fees. Ease of transferability
and enhanced continuity do not appear to be deciding factors,
because a small consulting firm is often intensely personal and not likely to be
transferable apart from its principals. Also, fear of double taxation does not
appear to be a legitimate concern, since it is likely that the stockholders will
be able to distribute any corporate profit to themselves in the form of
compensation. In fact, to the extent that they may need to make some capital
256 Planning and Forecasting
expenditures for word-processing equipment and office furniture, the corporate
form would afford them access to the lower corporate tax brackets for
small amounts of income (unless they were characterized as a personal service
corporation). Furthermore, if the consultants earn enough money to purchase
various employee benefits, such as group medical insurance and group life and
disability, they will qualify as employees of the corporation and can exclude
the value of such benefits from their taxable income, while the corporation
deducts these amounts.
These positive aspects of choosing the corporate form argue strongly
against making the subchapter S election. That election would eliminate the
benefit of the low-end corporate tax bracket and put our consultants in the position
of paying individual income tax on the capital purchases made. The election
would also eliminate the opportunity to exclude the value of employee
benefits from their personal income tax. The same problems argue against the
choice of an LLC for this business.
The other possibility would be the general partnership. In essence, by
choosing the partnership the consultants would be trading away limited liability
for less complexity. The partnership would not be a separate taxable entity
and would not be required to file annual reports and pay annual fees. From a
tax point of view, the partnership presents the same disadvantages as the subchapter
S corporation and LLC.
In summary, it appears that our consultants will be choosing between the
subchapter C corporation and the partnership. The corporation adds complexity
but grants limited liability. And it certainly is not necessary for a business to
be large in order to be incorporated. One might question, however, how much
liability exposure a consulting firm is likely to face. In addition, although the
corporation affords them the tax benefits associated with employee benefits
and capital expenditures, it is not likely that our consultants will be able to afford
much in the way of employee benefits and capital expenditures in the
short term. Further, these consultants will not likely have personal incomes
placing them in tax brackets considerably higher than the corporation's. A
strong case can be made for either the C corporation or the partnership in this
situation. One can always incorporate the partnership in the future if the business
grows to the point that some of the tax benefits become important.
It may also be interesting to speculate on the choice that would be made if
our three consultants were lawyers or doctors. Then the choice would be
between the partnership and the professional corporation. The comparisons
would be the same except that, as a personal service corporation, the professional
corporation does not have the benefit of the low-end corporate tax brackets.
Software Entrepreneur
Phil can easily eliminate the partnership and the limited partnership. Phil is
clearly the sole owner of his enterprise and will not brook any other controlling
persons. In addition, his plan to finance the enterprise with earnings from his
Choosing a Business Form 257
last business eliminates the need for limited partner investors. Almost as easily,
Phil can eliminate the sole proprietorship since it would seem highly undesirable
to assume personal liability for whatever damage may be done by a product
manufactured and distributed to thousands of potential plaintiffs. The
corporation, therefore, appears to be Phil's obvious choice. It gives the benefit
of limited liability, as well as the transferability and continuity essential to a
business that seems likely to be an acquisition candidate in the future. Again,
the lack of size is not a factor in this choice. Phil will likely act as sole director,
president, treasurer, and secretary.
There remains, however, the choice between subchapters C and S. As
may well be obvious by now, Phil's corporation fits the most common profile of
the subchapter S candidate. For the first year or more, the corporation will suffer
serious losses as Phil pays programmers and marketers to develop and presell
his product. Subchapter S allows Phil to show these losses on his personal
tax return, where they will shelter his considerable investment income. The
passive loss limitations will not affect Phil's use of these losses, since he is
clearly a material participant in his venture.
Phil could achieve much the same results by choosing an LLC, rather
than a subchapter S corporation. Unfortunately, however, many states require
that an LLC have two or more members, making Phil's business ineligible. In
states which allow single-member LLCs, there would be little to recommend
one choice over the other. Phil might feel more comfortable with an S corporation,
however, if he fears that suppliers, customers, and potential employees
might be put off by the relative novelty of the LLC. This might especially be
true if he has any plans to eventually go public, as the LLC has not gained wide
acceptance in the public markets. An S corporation can then usually revoke its
S election without undue negative tax effect. Beginning as an S corporation
would also eliminate the need to reincorporate as a corporation prior to selling
the business in a potentially tax-free transaction.
Hotel Venture
The hotel venture contemplated by Bruce, Erika, and Michael presents the opportunity
for some creative planning. One problem they may encounter in making
their decision is the inherent conf lict presented by Michael's insistence
upon recognition and reasonable return for his contribution of the land. Also,
Bruce and Erika fear being unduly diluted by Michael's share, in the face of
their more than equal contribution to the ongoing work.
One might break this logjam by looking to one of the ways of separating
cash f low from equity. Michael need not contribute the real estate to the business
entity at all. Instead, the business could lease the land from Michael on a
long-term (99-year) basis. This would give Michael his return in the form of
rent without distorting the equity split among the three entrepreneurs. From a
tax point of view, this plan also changes a nondepreciable asset (land) into deductible
rent payments for the business. As their next move, the three may
258 Planning and Forecasting
decide to form an entity to construct and own the hotel building, separate from
the entity that manages the ongoing hotel business.
This plan would convert a rather confusing real estate/operating venture
into a pure real estate investment opportunity for potential investors. The real
estate entity would receive enough revenue from the management entity to
cover its cash f low and would generate tax losses through depreciation, interest,
and real estate taxes. These short-term losses would eventually yield long-term
capital gains when the hotel is sold, so this entity would attract investors looking
for short-term losses and long-term capital appreciation. For the short-term
losses to be attractive, however, they must be usable by the investors on their
personal returns and not trapped at the business entity level.
All these factors point inevitably to the use of either the limited partnership,
LLC, or subchapter S corporation for the hotel building entity. All three
entities allow the tax losses to pass through to the owners for use on their personal
returns. Among these three choices, the limited partnership and LLC
allow more f lexibility in allocating losses to the investors, and away from
Bruce, Erika, and Michael (who most likely do not need them), and they provide
higher limits on the amounts of losses each investor may use.
In past years, our entrepreneurs would thus face the unenviable choice
between losing the tax advantages of the limited partnership to preserve the
limited liability offered by the subchapter S corporation or preserving the tax
advantages (and the ability to attract investors) by either accepting personal liability
as general partners or attempting to adequately capitalize a corporate
general partner. This choice is no longer necessary with the advent of the LLC,
which solves the problem by offering the tax advantages of the limited partnership
and the liability protection of the subchapter S corporation. However, the
passive loss limitations will still impact upon the usefulness of the losses for the
members who do not have significant passive income, making this project (as
is the case with most real estate investments in today's climate) more difficult
to sell.
This leaves the entity which will operate the hotel business itself. The
presence of our three principals immediately eliminates the sole proprietorship
as a possibility. Because all the investment capital has already been raised for
the real estate entity, there does not seem to be a need for further investors,
thus eliminating the limited partnership as a possibility. The partnership seems
inapplicable, since it is unlikely that any of the principals would wish to expose
himself or herself to unlimited liability in such a consumer-oriented business.
Thus, the corporation and LLC with their limited liability, continuity,
and transferability, seem to be the obvious choices for this potentially growing
and successful business. As with Phil, it becomes necessary to decide whether
to make the subchapter S election or choose an LLC to achieve tax passthrough.
This decision will be made on the basis of the parties' projections.
Are there likely to be serious losses in the short-term, which might be usable on
their personal tax returns? Will there be a need for significant capital expenditures,
thus indicating a need for the low-end corporate tax rates? Will the
Choosing a Business Form 259
company offer a variety of employee benefits, which our principals would wish
to exclude from their taxable income? Is the company likely to generate more
profit than can be distributed in the form of "reasonable" compensation, thus
calling for the elimination of the corporate-level tax. If these factors seem to
favor a tax pass-through entity, the principals will likely analyze the choice between
subchapter S and LLC in a manner similar to Phil. In addition, they may
find the LLC's lack of eligibility rules attractive in the short run should they
ever consider the possibility of corporate or foreign investors, or creative divisions
of equity.
CONCLUSION
These and the many other factors described in this chapter deserve careful
consideration by the thousands of entrepreneurs forming businesses every
month. After the basic decision to start a new business itself, the choice of the
appropriate form for the business may well be the most significant decision
facing the entrepreneur in the short run.
FOR FURTHER READING
Bischoff, William, Choosing the Right Business Entity (New York: Harcourt Brace,
1997).
Burstiner, Irving, The Small Business Handbook: A Comprehensive Guide to Starting
and Running Your Own Business (New Jersey: Fireside, 1997).
Diamond, Michael R., How to Incorporate (New York: John Wiley, 1996).
Pressment, Stanley, Choice of Business Entity Answer Book (Gaithersburg, MD:
Aspen, 1998).
Shenkman, Martin M., Starting a Limited Liability Company (New York: John Wiley,
1996).
INTERNET LINKS
www.tannedfeet.com
/choice_of_entity.htm Entrepreneurs' Help Page
www.smallbiz.findlaw.com
/book/su_structures/articles/01.html Findlaw Small Business Center
www.lexspace.com/html Lexspace-Business Entity
/formation.html Formation
260
9 THE BUSINESS PLAN
Andrew Zacharakis
The sole purpose of a business plan is to explore and answer questions—critical
questions starting with whether the business idea is a viable opportunity.
During the dot-com boom of the late 1990's, many entrepreneurs and venture
capitalists questioned the importance of the business plan. Typical of
this hyperstartup phase are stories like James Walker. He generated financing
on a 10-day-old company based on "a bunch of bullet points on a piece of
paper." He added, "It has to happen quick" in the hypercompetitive wireless-
Internet-technology world. "There's a revolution every year and a half now,"
Mr. Walker said.1
Media stories abounded of the whiz kid college dropout who received
venture capital, zoomed to IPO (initial public offering), and cashed out a multimillionaire
in 18 months or less. The mythology of the dot-com entrepreneur
was that he didn't have a business plan, only a couple of PowerPoint slides.
That was all it took to identify the opportunity, secure venture backing, and go
public. Why spend the 200 hours or so that a solid business plan often takes?
The NASDAQ crash of March 2000 and the subsequent death of many dot-com
high f lyers provides the clearest answer. Many of these businesses didn't have
the potential to make profits—not then, not now, and not anytime in the future.
The easy money and quick returns of the late nineties have disappeared,
and what we are left with is the fact that good opportunities need good execution
in order to succeed and a rigorous business plan process can assist in the
pursuit of entrepreneurial gold.
There is a common misperception that a business plan is primarily used
for raising capital. Although a good business plan assists in raising capital, the
The Business Plan 261
primary purpose of the process is to help the entrepreneur gain deep understanding
of the opportunity he or she is envisioning. A business plan tests the
feasibility of an idea. Is it truly an opportunity? Many a would-be entrepreneur
has doggedly pursued ideas that are not opportunities; the time invested in a
business plan would save thousands of dollars and hours spent on such wild
goose chases. For example, if a person makes $100,000 a year, spending 200
hours on a business plan equates to a $10,000 investment in time spent ($50/hour
times 200 hours). However, the costs of launching a f lawed business concept can
quickly accelerate into the millions. Most entrepreneurial ventures raise enough
money to survive two years even if the business ultimately fails. Assuming that
the only expense is the time value of the lead entrepreneur, a two-year investment
equates to $200,000, not to mention the lost opportunity cost and the likelihood
that other employees were hired and paid and that other expenses were
incurred. So do yourself a favor and spend the time and money up front.
The business plan process can not only prevent entrepreneurs from pursuing
a bad opportunity but also help them reshape their original visions into
better opportunities. As we will explore in the remainder of this chapter, the
business plan process involves raising a number of critical questions and then
seeking answers. Part of that question-answering process involves talking to
target customers and gauging what is their "pain." These conversations with
customers as well as other trusted advisors can assist in better targeting the
features and needs that customers most want in a good or service. This
prestartup work saves untold effort and money otherwise spent trying to reshape
the product after the launch has occurred. This is not to say that new
ventures don't adjust their offering based upon customer feedback, but the
business plan process can anticipate some of these adjustments in advance of
the initial launch.
Perhaps the greatest benefit of the business plan is that it allows the entrepreneur
to articulate the business opportunity to various stakeholders in
the most effective manner. The plan provides the background to enable the
entrepreneur to communicate the upside potential and attract equity investment,
and the validation needed to convince potential employees to leave their
current jobs for the uncertain future of a new venture. It is also the instrument
that can secure a strategic partner, key customer, or key supplier. In
short, the business plan provides the entrepreneur the deep understanding he
needs to answer the critical questions that various stakeholders will ask, even
if the stakeholders don't actually read the written plan. Completing a wellfounded
business plan gives the entrepreneur credibility in the eyes of various
stakeholders.
TYPES OF PLANS
A business plan can take a number of forms depending on its purpose. The primary
difference between business plan types is length. If outside capital is
262 Planning and Forecasting
needed, a business plan geared towards equity investors or debt providers typically
is 25 to 40 pages long. Professional equity investors such as venture capitalists
and professional debt providers such as bankers will not read the entire
plan from front to back. Recognizing this fact, the entrepreneur needs to produce
the plan in a format that facilitates spot reading. We will investigate the
major sections that comprise business plans throughout this chapter. My general
rule of thumb is that less is more. For instance, I've seen a number of plans
receive venture funding that were closer to 25 pages than 40 pages.
A second type of business plan, the operational plan, is primarily for the
entrepreneur and his team to guide the development, launch, and initial growth
of the venture. There really is no length specification for this type of plan;
however, it is common for these plans to exceed 80 pages. The basic organization
format between the two types of plans is the same, however the level of
detail tends to be much greater in an operational plan. This effort is where the
entrepreneur really gains the deep understanding important in discerning how
to build and run the business.
The last type of plan is called a dehydrated business plan. This type is
considerably shorter than the previous two, typically no more than 10 pages.
Its purpose is to provide an initial conception of the business. As such, it can be
used to test initial reaction to the entrepreneur's idea and can be shared with
his confidants to obtain feedback before he invests significant time and effort
on a longer business plan.
FROM GLIMMER TO ACTION: THE PROCESS
Perhaps the hardest part of writing any business plan is getting started. Compiling
the data, shaping it into an articulate story, and producing the finished
product can be a daunting task. The best way to attack a business plan, therefore,
is in steps. First, write a four-to-five-page summary of your current vision.
This provides a roadmap for you and others to follow as you complete the
rest of the plan. Second, start attacking major sections of the plan. Although all
of the sections interact and inf luence every other section, it is often easiest for
entrepreneurs to write the product /service description first. This is usually the
most concrete component of the entrepreneur's vision. Keep in mind, however,
that writing a business plan isn't purely a sequential process. You will be filling
in different parts of the plan simultaneously or in whatever order makes the
most sense in your mind. Finally, after completing a first draft of all the major
sections, come back and rewrite a shorter, more concise executive summary
(one to two pages). Not too surprisingly, the executive summary will be quite
different from the original summary because of all the learning and reshaping
that the business plan process facilitates.
Common wisdom is that the business plan is a living document. Although
your first draft will be polished, most business plans are obsolete the day they
come off the presses. That means that entrepreneurs are continuously updating
The Business Plan 263
and revising their business plan. Again, the importance of the business plan
isn't the final product but the learning that is gleaned from going through the
process. The business plan is the story line of your vision. It articulates what
you see in your mind and crystallizes that vision for you and your team. It also
provides a history, a photo album, if you will, of the birth, growth, and maturity
of your business. Each major revision should be kept and filed and occasionally
looked back upon for the lessons you have learned. I find writing
a business plan, although daunting, exciting and creative, especially if I am
working on it with a founding team. Whether it is over a glass of wine, beer, or
coffee, talking about your business concept with your founding team is invigorating,
and the business plan is a critical outcome of these discussions. So now
let us dig in and examine how to write effective business plans.
THE STORY MODEL
One of the major goals for business plans is to attract and convince various
stakeholders of the potential of your business. You have to keep in mind, therefore,
how these stakeholders will interpret your plan. The guiding principal is
that you are writing a story. All good stories have a plot line, a unifying thread
that ties the characters and events together. If you think about the most successful
businesses in America, they all have well-publicized plot lines, more
appropriately called taglines. When you hear these taglines, you immediately
connect them to the business. For example, when you hear "absolutely, positively
has to be there overnight," you probably connect that tagline to Federal
Express and package delivery. Similarly, "Just do it" is intricately linked to
Nike and the image of athletic proficiency (see Exhibit 9.1). A tagline is a sentence
or fragment of a sentence that summarizes the pure essence of your business.
It is the plot line that every sentence, paragraph, page, diagram, and other
part of your business plan should correlate to. One useful tip that I share with
every entrepreneur I work with is to put that tagline in a footer that runs on the
bottom of every page. Most word-processing packages, such as Microsoft Word,
enable you to insert a footer that you can see as you type. As you are writing, if
the section doesn't build on, explain, or otherwise directly relate to the tagline,
it most likely isn't a necessary component to the business plan. Rigorous adherence
to the tagline facilitates writing a concise business plan.
EXHIBIT 9.1 Taglines.
Nike Just do it!
Federal Express Absolutely, positively has to be there overnight.
McDonalds We love to see you smile.
Cisco Systems Discover all that's possible on the Internet.
Microsoft Where do you want to go today.
264 Planning and Forecasting
The key to beginning the story model is capturing the reader's attention.
The tagline is the foundation, but in writing the plan you want to create a number
of visual catch points. Too many business plans are dense, text-laden manifestos.
Only the most diligent reader will wade through all that text to find the
nuggets of value. Help the reader by highlighting different key points throughout
the plan. How do you create these catch points? Some effective techniques
include extensive use of headings and subheadings, strategically placed bulletpoint
lists, diagrams, charts, and the use of sidebars.2 The point is to make the
document not only content rich but visually attractive.
Now, let's take a look at the major sections of the plan (see Exhibit 9.2).
Keep in mind that although there are some different variations, most plans
have these components. It is important to keep your plan as close to this format
as possible because many stakeholders are used to the format and it facilitates
EXHIBIT 9.2 Business plan outline.
I. Cover
II. Title Page
III. Executive Summary
a. Hook—potential size of
opportunity
b. Business Concept—company and
products
c. Industry Overview
d. Target Market
e. Competitive Advantage
f. Business Model
g. Team
h. Offering
IV. Industry, Customer, and Competitor
Analysis
a. Industry
i. Overview—Market Demand,
Market Size and Structure,
and Margin Analysis
ii. Trends
iii. Market Space or Segment you
will compete in
b. Customer Analysis
c. Competitor Analysis
V. Company and Product Description
a. Company Description
b. Product Description
c. Competitive Advantage
d. Entry Strategy
e. Growth Strategy
VI. Marketing Plan
a. Target Market Strategy
b. Product /Service Strategy
c. Pricing Strategy
d. Distribution Strategy
e. Advertising and Promotion Strategy
f. Sales Strategy
g. Sales and Marketing Forecasts
VII. Operations Plan
a. Operations Strategy
b. Scope of Operations
c. Ongoing Operations
VIII. Development Plan
a. Development Strategy
b. Development Timeline
IX. Team
a. Team Bios and Roles
b. Advisory Boards, Board of
Directors, Strategic Partners,
External Members
c. Compensation and Ownership
X. Critical Risks
a. Market Interest and Growth
Potential
b. Competitor Actions and Retaliation
c. Time and Cost of Development
d. Operating Expenses
e. Availability and Timing of
Financing
f. Other Risks
XI. Offering
XII. Financial Plan
a. Description of Financial
Assumptions
b. Income Statement
c. Cash Flow Statement
d. Balance Sheet
XIII. Appendices
The Business Plan 265
spot reading. So if you are seeking venture capital, for instance, you want to facilitate
quick perusal because venture capitalists often spend, research shows,
as little as five minutes on a plan before rejecting it or putting it aside for later
study. If a venture capitalist becomes frustrated with an unfamiliar format, he
will more likely reject it than try to pull out the pertinent information.
THE BUSINESS PLAN
We will progress through the sections in the order that they typically appear,
but keep in mind that you can work on the sections in any order that you wish.
The Cover
The plan's cover should include the following information: company name,
tagline, contact person and address, phone, fax, e-mail address, date, disclaimer,
and copy number. Most of the information is self-explanatory, but I
should point out a few things (see Exhibit 9.3). First, the contact person for a
new venture should be the president or some other founding team member. I
have seen some business plans that failed to have the contact person's name
and phone on the cover. Imagine the frustration of an excited potential investor
who can't find out how to contact the entrepreneur to gain more information;
such plans usually end up in the rejected pile. Second, business plans
should have a disclaimer along these lines:
This business plan has been submitted on a confidential basis solely to selected,
highly qualified investors. The recipient should not reproduce this plan nor distribute
it to others without permission. Please return this copy if you do not
wish to invest in the company.
Controlling distribution is particularly important when seeking investment
capital, especially to comply with Regulation A of the Securities and Exchange
Commission, which specifies that you must solicit qualified investors (high
net-worth and income individuals).
The cover should also have a line specifying the copy number. You will
often see on the bottom right portion of the cover a line that says something
like "Copy 1 of 5 copies." Entrepreneurs should keep a log of who has copies so
that they can control for unexpected distribution.
Finally, the cover should be eye-catching. If you have a product or prototype,
a picture of it can draw the reader in. Likewise, a catchy tagline draws attention
and encourages the reader to look further.
Table of Contents
Continuing the theme of making the document easy to read, a detailed table of
contents is critical. It should list major sections, subsections, exhibits, and appendices.
The table provides the reader a roadmap to your plan (see Exhibit 9.4).
266 Planning and Forecasting
Note that the table of contents is customized to the specific business so that it
doesn't perfectly correlate to the business plan outline presented in Exhibit 9.2.
Nonetheless, a look at Exhibit 9.4 shows that the company's business plan includes
most of the elements highlighted in the business outline and that the
order of information is basically the same as well.
EXHIBIT 9.3 Cover of PurePlay Golf business plan.
Bringing Information to the Golfer's Palm
www.PurePlayGolf.com
Prepared by:
Amy Ball, Michael Bear, Christy Long,
Geoff Mall, and Hilary Tabor
Contact: Geoff Mall, gmall@PurePlayGolf.com
PurePlayGolf.com
Reynolds Center, Suite 1
Babson Park, MA 02457
(781) 555-5252
(781) 555-5253 (fax)
Draft: December 6, 2000
The information in this Business Plan is highly confidential and is provided to you conditioned on your agreement
not to disclose or use this information for any purpose other then contemplating an investment in PurePlay Golf.
Do not copy, fax, reproduce, or distribute without permission.
Copy 5 of 5.
The Business Plan 267
Executive Summary (1–3 pages)
This section is the most important part of the business plan. If you don't capture
readers' attention in the executive summary, it is unlikely that they will
read any other parts of the plan. Therefore, you want to hit them with the most
compelling aspects of your business opportunity right up front.
EXHIBIT 9.4 Sample table of contents.
1.0 Executive Summary 3
2.0 Market Analysis 6
2.1 Entertainment Industry 6
2.2 Accessing Music Online 7
2.3 Telematics Industry 8
2.5 Market Research 11
3.0 Competition 13
3.1 Direct Competition 13
3.2 Indirect Competition 15
4.0 Company Description and Services 16
4.1 The Personal Radio Station 16
4.2 Listener 's Choice 16
4.3 The Personal Music Collection 17
4.4 Recurring Royalties 17
4.5 Listener Consumption Data 17
5.0 Strategic Partners 20
5.1 Device Partners 20
5.2 Content Partners 21
5.3 Service Providers and Other 22
6.0 Development Strategy 23
6.1 Engineering Activities 23
6.2 Business Development Activities 24
7.0 Marketing and Sales Activities 25
8.0 Operations 27
8.1 VMC Core of Engineers 27
8.2 VMC Live Services 27
8.3 VMC Customer Service 27
9.0 Management Team 28
9.1 Founding Team 28
9.2 Advisors 29
10.0 Critical Risk Factors 30
11.0 Financials 31
11.1 Economics of the Business 31
11.2 VMC Consumer Assumptions 32
11.3 Service Assumptions 32
11.4 Personal Radio Station Assumptions 32
11.5 Listener 's Choice Assumptions 33
11.7 Break-Even/Positive Cash Flow 34
11.8 Sources and Uses Schedule 35
11.9 Headcount Schedule 35
268 Planning and Forecasting
Hook the Reader
That means having the first sentence or paragraph highlight the potential of
the opportunity. I have read too many plans that start with "Company XYZ, incorporated
in the state of Delaware, will develop and sell widgets." Ho-hum.
That doesn't excite me; but if, in contrast, the first sentence states, "The current
market for widgets is $50 million and is growing at an annual rate of 20%.
The emergence of the Internet is likely to accelerate this market's growth.
Company XYZ is positioned to capture this wave with its proprietary technology—
the secret formula VOOM." This creates the right tone. It tells me that
the potential opportunity is huge and that company XYZ has some competitive
advantage that enables it to become a big player in this market. I don't really
care at this point whether the business is incorporated or that it is a Delaware
corporation (aren't they all?).
Common subsections within the executive summary include: description
of opportunity, business concept, industry overview, target market, competitive
advantage, business model and economics, team, and offering. Remember
that, since this is an executive summary, all these components are covered
in the body of the plan. We will explore them in greater detail as we progress
through the sections.
Since the executive summary is the most important part of the finished
plan, it should be written after you have gained your deep learning by going
through all the other sections.3 The summary should be 1 to 3 pages, although
I prefer executive summaries be no more than 2 pages.
Industry, Customer, and Competitor
Analysis (3 – 6 pages)
Industry
The goal of this section is to illustrate the opportunity and how you are going to
capture that opportunity. A useful framework for visualizing the opportunity is
Timmons's model of opportunity recognition.4 Using the "3Ms" helps quantify
an idea and assess how strong an opportunity the idea is. First, examine Market
demand. If the market is growing at 20% or better, the opportunity is more exciting.
Second, we look at Market size and structure. A market that is currently
$50 million with $1 billion potential is attractive. This often is the case in
emerging markets, those that appear poised for rapid growth and have the potential
to change how we live and work. For example, the PC, disk drive, and
computer hardware markets of the eighties were very hot. Many new companies
were born and rode the wave of the emerging technology, including
Apple, Microsoft, and Intel. In the nineties, it was anything dealing with the
Internet. As we enter the twenty-first century, it appears that wireless communications
may be the next big market. Another market structure that tends to
have promise is a fragmented market where many small, dispersed competitors
The Business Plan 269
compete on a regional basis. Many of the big names in retail revolutionized
fragmented markets. For instance, category killers such as Wal-Mart, Staples,
and Home Depot consolidated fragmented markets by providing quality products
at lower prices. These firms replaced the dispersed regional and local
discount, office-supply, and hardware stores. The final M is Margin analysis.
Do firms in the industry enjoy high gross margins (revenues minus cost of
goods sold) of 40% or greater? Higher margins allow for higher returns, which
again leads to greater potential business.
The 3Ms help distinguish opportunities and as such should be highlighted
as early as possible in your plan. Describe your overall industry in
terms of revenues, growth, and pertinent future trends. Avoid in this section
discussing your concept, the proposed product or service you will offer. Instead,
use dispassionate, arms-length analysis of the industry with the goal of
highlighting a space or gap that is underserved. Thus, how is the industry segmented
currently, and how will it be segmented in the future? After identifying
the relevant industry segments, identify the segment that your product
will target. Again, what are the important trends that will shape the segment
in the future?
Customer
Once the plan has defined the market space it plans to enter, the target customer
needs to be examined in detail. The entrepreneur needs to define who
the customer is by using demographic and psychographic information. The better
the entrepreneur can define his customer, the more apt he is to deliver a
product that the customer truly wants. A venture capitalist recently told me
that the most impressive entrepreneur is the one who not only identifies who
the customer is in terms of demographics and psychographics but can also
name who that customer is by address, phone number, and e-mail address.
When you understand who your customer is, you can assess what compels them
to buy, how your company can sell to them (direct sales, retail, Internet, direct
mail, etc.), how much acquiring and retaining that customer will cost, and so
forth. A schedule inserted into the text describing customers on these basic parameters
communicates a lot of data quickly and can be very powerful.
Competition
The competition analysis follows directly from the customer analysis. You have
just identified your market segment, described what the customer looks like,
and what the customer wants. Now the key factor leading to competitive analysis
is what the customer wants in a particular product. These product attributes
form a basis of comparison against your direct and indirect competitors. A
competitive profile matrix not only creates a powerful visual catch point, it
conveys information regarding your competitive advantage and also the basis
for your company's strategy (see Exhibit 9.5). The competitive profile matrix
270 Planning and Forecasting
should lead the section and be followed by text describing the analysis and its
implications.
Finding information about your competition can be easy if the competing
company is public, harder if it is private, and very difficult if it is operating in
"stealth" mode (i.e., it hasn't yet announced itself to the world). Most libraries
have access to databases that contain a mother lode of information about publicly
traded companies (see Exhibit 9.6 for some sample sources), but privately
held companies or stealth ventures represent a greater challenge. The best way
for savvy entrepreneurs to gather this information is through their network and
via trade shows. Who should be in the entrepreneur's network? First and foremost
are the customers the entrepreneur hopes to sell to in the near future.
Just as you are (or should be) talking to your potential customers, your existing
competition is interacting with the customers every day, and your customers
are likely aware of the stealth competition on the horizon. Although many entrepreneurs
are fearful (verging sometimes on the brink of paranoia) that valuable
information will fall in the wrong hands and lead to new competition that
invalidates the current venture, the reality is that entrepreneurs who operate in
a vacuum (don't talk to customers, attend tradeshows, etc.) fail far more often
than those who are talking to everyone they can. Talking allows entrepreneurs
to get invaluable feedback that enables them to reshape their product offering
prior to launching a product that may or may not be accepted by the marketplace.
So you should network not only to find out about your competition but
also to improve your own venture concept.
EXHIBIT 9.5 Competitive profile matrix.
VMC Napster Mp3.com MYRadio SonicNet XM Radio
Have to be online to listen to music No No No No Yes No
Customized ads to individual users Yes N/A No N/A No No
Can purchase physical media on
Web site No No Yes No Yes No
Can access personal music collection
from remote location Yes No No No No No
Automatic play list generation Yes No No Yes Yes Yes
Offers a service without ads Yes N/A No No No Yes
Can choose to play specific songs on
demand Yes Yes No No No No
Easy feedback for enhanced listening
experience Yes No No No Yes No
Streams media Yes No Yes N/A Yes Yes
Download media Yes Yes Yes N/A No No
Can distribute user collections to
other people No Yes No No Yes No
Offers portable device player option Yes Yes Yes Yes No Yes
Offers a free service Yes Yes Yes Yes Yes No
Offers service in telematics industry Yes No No No No Yes
The Business Plan 271
Company and Product Description (1–2 pages)
Completing the dispassionate analysis described in the previous section lays
the foundation for describing your company and concept. In one paragraph
identify the company name, where it is incorporated, and a brief overview of
the company concept. Also highlight in this section what the company has
achieved to date—what milestones have you accomplished that show progress.
More space should be used to describe the product. Again, graphic representations
can be visually powerful (see Exhibit 9.7). Highlight how your product
fits into the customer value proposition. What is incorporated in your
product and what value do you add to the customer? This section should clearly
and forcefully identify your venture's competitive advantage. Based upon your
competitive analysis, why is your product better, cheaper, faster than what
customers currently have? Your advantage may be a function of proprietary
technology, patents, distribution. In fact, the most powerful competitive advantages
are derived from a bundle of factors because this makes them more
difficult to copy.
Entrepreneurs also need to identify their entry and growth strategies.
Since most new ventures are resource constrained, especially in terms of available
capital, it is crucial that the lead entrepreneur establish the most effective
way to enter the market. Based upon analysis in the market and customer sections,
entrepreneurs need to identify their primary target audience (PTA). Focusing
on a particular subset of the overall market niche allows new ventures
to utilize scarce resources to reach those customers and prove the viability of
their concept.
EXHIBIT 9.6 Sample source for information on public/private companies.
Infotrac Index /abstracts of journals, general business and finance magazines; market
overviews; and profiles of public and private firms.
Dow Jones Interactive Searchable index of articles from over 3,000 newspapers.
Lexis/Nexis Searchable index of articles.
Dun's Principal International Business International business directory.
Dun's One Million Dollar Premium Database of public and private firms with revenues
greater than $1 million or more than eight employees.
Hoover's Online Profiles of private and public firms with links to Web sites, etc.
Corp Tech Profiles of high technology firms.
Bridge Information Services Detailed financial information on 1.4 million international
securities that can be manipulated in tables and graphs.
RDS Bizsuite Linked databases providing data and full-text searching on firms.
Bloomberg Detailed financial data and analyst reports.
272 Planning and Forecasting
EXHIBIT 9.7 Product/concept/description.
Video or
audio
content
customized
ads
Commercial tower
PDA Computer
Satellite dish
Automobile
VMC Detailed Network Overview
Example of advertisers
Example of digital audio and video
content libraries
VMC
B2B
Exchange
VMC
B2C
Distribution
B2B intranet
Customer profile management
(Web site)
Content
information
database
(ratings,
availability,
etc.)
Consumer
usage and
advertising
database
Consumer
profile
database
Customized
advertising
data
Catalog
Receiver
Routing and
transmitting
VMC
compliant
device
component
Home
entertainment
system
T.V.
Portable
audio
device
Consumer
data
Time
Warner
BVG Sony EMI
NPR
CBS TMP
World Wide
CKS Omnicom
Group Inc.
Dentsu Interpublic
The Business Plan 273
The business plan should also sell the entrepreneur's vision for growth because
that vision indicates the business's true potential. Thus, a paragraph or
two should be devoted to the firm's growth strategy. If the venture achieves
success in its entry strategy, it will either generate internal cash f low that can
be used to fuel the growth strategy or attract further equity financing at improved
valuations. The growth strategy should talk about the secondary target
audience and tertiary target audiences that the firm will pursue. For example,
if I were starting a restaurant, my entry strategy might be to establish a presence
in Wellesley, Massachusetts, geared toward college students and young
professionals. Assuming that I achieved some success (e.g., generating sales and
high table turns), my growth strategy might be to open up five more restaurants
around the greater Boston area. If these restaurants also proved successful,
I might franchise the concept nationwide to achieve rapid growth with less
capital infusion than if I opened all company-owned restaurants. This in fact,
appears to be the strategy that Joey Crugnale, the founder of Steve's Ice
Cream, Bertucci's Brick Oven Pizza, and more recently the Naked Fish, is following.
Crugnale opened the first Naked Fish in May 1999. After testing
and refining the concept, he has opened another nine outlets (as of December
2000). The establishment of nine Naked Fish restaurants shows growth and
success and enables Mr. Crugnale to attract further financing to grow the concept
around Boston and beyond.
Marketing Plan (4 – 6 pages)
To this point, we have laid the stage for your company's potential to enter a
market successfully and grow. Now we need to devise the strategy that will
allow the company to reach its potential. The primary components of this section
include a description of the target market strategy, product /service strategy,
pricing strategy, distribution strategy, advertising and promotion, sales
strategy, and sales and marketing forecasts. Let's take a look at each of these
subsections in turn.
Target Market Strategy
Every marketing plan needs some guiding principals. Based on the knowledge
gleaned from the target market analysis, entrepreneurs need to position their
product. All product strategies fall somewhere on the continuum between "rational
purchase" and "emotional purchase." As an example, when I buy a new
car, the rational purchase might be a low-cost reliable car such as the Ford Aspire.
However, there is an emotional element as well. I want the car to be an extension
of my personality, so based on my economic means and self-perception,
I will buy a BMW or Audi because of the emotional benefits I derive from
owning a high-status car. Within every product space, there is room for products
at different points along the continuum. Entrepreneurs need to decide
274 Planning and Forecasting
where their product fits or where they would like to position it, because this
position determines the other aspects of the marketing plan.
Product/Service Strategy
Building from the target market strategy, this section of the plan describes
how your product is differentiated from the competition. Discuss why customers
will switch to your product and how you will retain them so that they
don't switch to your competition in the future. Using the attributes defined in
your customer profile matrix, a powerful visual is a product attribute map
showing how your firm compares to the competition. It is best to focus on the
two most important attributes, one on the x-axis and the other on the y-axis.
The map should show that your product is clearly distinguishable from your
competition on desirable attributes (see Exhibit 9.8).
This section should also address how you will service the customer. What
type of technical support will you provide? Will you offer warranties? What
kind of product upgrades will be available and when? It is important to detail
all these efforts and account for each in the pricing of the product. Entrepreneurs
frequently underestimate the costs of these services, which leads to a
drain on cash flow and can ultimately lead to bankruptcy.
Pricing Strategy
Determining how to price your product is always difficult. The two primary
approaches are the "cost-plus" approach and the "market demand" approach. I
advise entrepreneurs to avoid cost-plus pricing for a number of reasons. First,
it is difficult to accurately determine your actual cost, especially if this is a
new venture with a limited history. New ventures consistently underestimate
the true cost of developing their products. For example, how much did it really
EXHIBIT 9.8 Competitive map for PurePlay Golf.
IntelliGolf
Inforetech
PurePlay
ultraCaddie
Low High
High
Availability to consumers
Technology/functionality
The Business Plan 275
cost to write that software? The cost would include salaries and burden, computer
and other assets, overhead contribution, and so forth. Since most entrepreneurs
underestimate these costs, there is a tendency to underprice the
product. Often entrepreneurs claim that they are offering a low price so that
they can penetrate and gain market share rapidly. The problems with a low
price are that it may be difficult to raise later, may create demand that overwhelms
your ability to produce the product in sufficient volume, and may unnecessarily
strain cash flow. Therefore, the better method is to canvass the
market and determine an appropriate price based upon what the competition
is currently offering and how your product is positioned. If you are offering a
low-cost value product, price below market rates. If your product is of better
quality and has lots of features (the more common case), it should be priced
above market rates.
Distribution Strategy
This section identifies how you will reach the customer. For example, the
e-commerce boom of the late 1990s assumed that the growth in Internet usage
and purchases would create new demand for pure Internet companies. Yet the
distribution strategy for many of these firms did not make sense. Pets.com and
other online pet supply firms had a strategy where the pet owner would log on,
order the product from the site, and then receive delivery via UPS or U.S.
mail. In theory this works, but in practice the price the market would bear for
this product didn't cover the exorbitant shipping costs of a forty-pound bag of
dog food.
It is wise to examine how the customer currently acquires the product. If
I buy my dog food at Wal-Mart, then you should probably use primarily traditional
retail outlets to sell me a new brand of dog food. This is not to say that
entrepreneurs might not develop a multichannel distribution strategy, but if
they want to achieve maximum growth, at some point they will have to use
common distribution techniques, or reeducate the customer on a new buying
process (which can be very expensive).
If you determine that Wal-Mart is the best distribution channel, the next
question becomes whether you can access it. As a new startup in dog food, it
may be difficult to get shelf space at Wal-Mart. That may suggest an entry
strategy of boutique pet stores to build brand recognition. The key here is to
identify appropriate channels and then assess how costly it is to access them.
Advertising and Promotion
Communicating effectively to your customer requires advertising and promotion.
Referring again to the dot-com boom of the late nineties, the soon to be
defunct Computer.com made a classic mistake in its attempt to build brand
recognition. It blew over half of the venture capital it raised on a series of expensive
Super Bowl ads in January 2000 ($3 million of $5.8 million raised on
276 Planning and Forecasting
three Super Bowl ads).5 Resource-constrained entrepreneurs need to carefully
select the appropriate strategies. What avenues most effectively reach
your PTA (primary target audience)? If you can identify your PTA by names,
then direct mail may be more effective. Try to utilize grassroots techniques
such as public relations efforts geared toward mainstream media. Sheri Poe,
founder of Ryka shoes, geared towards women, appeared on the Oprah Winfrey
show touting shoes for women, designed by women. The response was
overwhelming. In fact, she was so besieged by demand that she couldn't supply
enough shoes.
As you develop a multipronged advertising and promotion strategy, create
detailed schedules that show which avenues you will pursue and the associated
costs (see Exhibits 9.9a and 9.9b). These types of schedules serve many purposes
including providing accurate cost estimates that will help in assessing
how much capital you need to raise. These schedules also build credibility in
the eyes of potential investors since it shows that you understand the nuances
of your industry.
Sales Strategy
This section provides the backbone that supports all of the above. Specifically,
it illustrates what kind and level of human capital you will devote to the effort.
How many salespeople, customer support staff, and the like do you need? Will
these people be internal to the organization or outsourced? Again, this section
builds credibility if the entrepreneur demonstrates an understanding of how
the business should operate.
Sales and Marketing Forecasts
Gauging the impact of the above efforts is difficult. Nonetheless, to build a
compelling story, entrepreneurs need to show projections of revenues well into
the future. How do you derive these numbers? There are two methods, the
comparable method and the buildup method. After detailed investigation of
EXHIBIT 9.9a Advertising schedule.
Promotional Tools Budget over 1 Year
Print advertising $1,426,440
Television advertising 780,000
Sales promotions 100,000
Direct marketing 100,000
Public relations 93,560
Total $2,500,000
The Business Plan 277
the industry and market, entrepreneurs know the competitive players and have
a good understanding of their history. The comparable method models sales
forecasts after what other companies have achieved, adjusting for age of company,
variances in product attributes, support services such as advertising and
promotion, and so forth. In essence, the entrepreneur monitors a number of
comparable competitors and then explains why her business varies from those
models. The one thing we know for certain is that these forecasts will be
wrong, but the question is the degree of error. Detailed investigation of comparable
companies reduces that error. The smaller the error, the less likely the
company will run out of cash. Also, rigorous comparable analysis builds credibility
with your investors.
What happens when the market space you are entering doesn't have comparable
companies because they are private or differ significantly on some
other major parameter? In such situations, entrepreneurs may be able to identify
similar business models in other industries, or what I call first-cousin
companies. If that proves difficult, the other avenue is the buildup method.
Starting with each revenue source, the entrepreneur estimates how much of
that revenue type he can generate per day or some other small time period. For
example, if Joey Crugnale was trying to estimate sales for his Naked Fish
restaurant, he might identify the following revenue sources along with the average
ticket price for each: bar, appetizers, entrees, and dessert. Then he might
estimate the number of people to come through the restaurant on a daily basis
and what percentage would purchase each revenue source. Those estimates can
then be aggregated into larger blocks of time (say, months, quarters, or years)
to generate rough estimates, which might be further adjusted based upon seasonality
in the restaurant industry.
The buildup technique is an imprecise method for the new startup with
limited operating history, but it is critically important to assess the viability
of the opportunity—so important, in fact, that I advise entrepreneurs to use
both the comparable and buildup techniques to assess how well they converge.
If the two methods widely diverge, go back through and try to determine why.
The deep knowledge you gain of your business model will greatly help you to
articulate the opportunity to stakeholders as well as to manage the business
when it is launched.
EXHIBIT 9.9b Magazine advertisement schedule.
Publication Circulation Ad Price Cost per Thousand
Golf Digest 1,550,000 $35,820 $23.11
Sports Illustrated 3,150,000 57,600 18.29
Golf Magazine 1,400,000 26,000 18.57
Fortune 775,000 21,600 27.87
Money Magazine 1,400,000 34,900 24.93
278 Planning and Forecasting
Operations Plan (2–3 pages)
The operations section of the plan has progressively shortened as more companies
outsource nonvital aspects of their operation. The key in this section is
to address how operations will add value to your customers and, furthermore,
to detail the production cycle so that you can gauge the impact on working capital.
For instance, when does the company pay for inputs? How long does it take
to produce the product? When does the customer buy the product and, more
importantly, when does the customer pay for the product? The time from the
beginning of this process until the product is paid for will drain cash flow and
has implications for financing. Counterintuitively, many rapidly growing new
companies run out of cash, even though they have increasing sales, because
they fail to properly finance the time that cash is tied up in the procurement,
production, sales, and receivables cycle.
Operations Strategy
The first subsection provides a strategy overview. How does your business
win/compare on the dimensions of cost, quality, timeliness, and f lexibility?
The emphasis should be on those aspects that provide your venture with a
comparative advantage.
You should also discuss geographic location of production facilities and
how this enhances the firm's competitive advantage. Discuss available labor,
local regulations, transportation, infrastructure, proximity to suppliers, and so
forth. The section should also provide a description of the facilities, how the
facilities will be acquired (bought or leased), and how future growth will be
handled (e.g., renting an adjoining building).
Scope of Operations
What is the production process for your product or service? A diagram powerfully
illustrates how your company adds value to the various inputs (see Exhibit
9.10a). Constructing the diagram also facilitates the decision of which production
aspects to keep in-house and which to outsource. Considering that cash
f low is king and that resource-constrained new ventures typically should minimize
fixed expenses on production facilities, the general rule is to outsource
as much production as possible. However, there is a major caveat to that rule:
Your venture should control aspects of production that are central to your competitive
advantage. Thus, if you are producing a new component with hardwired
proprietary technology, let's say a voice recognition security door entry,
it is wise to internally produce that hardwired component. The locking mechanism,
however, can be outsourced to your specifications. Outsourcing the aspects
that aren't proprietary reduces fixed cost for production equipment and
facility expenditures, which means that you have to raise less money and give
up less equity.
The Business Plan 279
The scope of operations should also discuss partnerships with vendors,
suppliers, partners, and the like. Again, the diagram should illustrate the supplier
and vendor relationships by category (or by name if the list isn't too long
and you have already identified your suppliers). The diagram helps you visualize
the various relationships and ways to better manage or eliminate them. The
operations diagram also helps entrepreneurs identify personnel needs. For example,
the diagram provides an indication of how many production workers
might be needed depending on the hours of operations, number of shifts, and
so forth.
Ongoing Operations
This section builds upon the scope of operations by providing details on day-today
activities. For example, how many units will be produced in a day and what
kind of inputs are necessary? An operating-cycle overview diagram graphically
illustrates the impact of production on cash f low (see Exhibit 9.10b). As entrepreneurs
complete this detail, they can start to establish performance parameters,
which will help them monitor and modify the production process in the
future. If this is an operational business plan the level of detail may include
specific job descriptions, but for the typical business plan this level of detail
would be much more than an investor, for example, would need or want to see
in the initial evaluation phase.
Development Plan (2–3 pages)
The development plan highlights the development strategy and also provides a
detailed development timeline. Many new ventures will require a significant
level of effort and time to launch the product or service. This section tells how
the business will be developed. For example, new software or hardware products
EXHIBIT 9.10a Operations f low diagram.
SOURCE: Adapted from Professor Bob Eng, Babson College.
Materials
from
vendor 2
Materials
from
vendor 3
Materials
from
vendor 1
Assembly
Finished
product
Shipping
department
Warehouse
280 Planning and Forecasting
often require months of development. Discuss what types of features you will
develop and tie them to the firm's competitive advantage. This section should
also talk about patent, trademark, or copyright efforts if applicable.
Development Strategy
What work remains to be completed? What factors need to come together for
development to be successful? What risks to development does the firm face?
For example, software development is notorious for taking longer and costing
more than most companies originally imagined. Detailing the necessary work
and the criteria for the work to be considered successful helps entrepreneurs to
understand and manage the risks involved. After you have laid out these details,
a development timeline is assembled.
EXHIBIT 9.10b Operating cycle overview diagram.
SOURCE: Adapted from Professor Bob Eng, Babson College.
Order
materials
Receive
materials Make
product
Pick/ship
product
Bill to
customer
Collect
money
from
customer
Days
Pay
supplier
Customer
order
received
Order
entered
X Days
Production flow
Order
Cash
The Business Plan 281
Development Timeline
A development timeline is a schedule that highlights major milestones and can
be used to monitor progress and make changes (see Exhibit 9.11). The timeline
helps entrepreneurs track major events and to schedule activities to best execute
on those events.
Team (2–3 pages)
Georges Doriot, the father of venture capital and founder of American Research
and Development Corporation (the first modern venture capital firm),
said that he would rather "back an 'A' entrepreneur with a 'B' idea than a 'B'
entrepreneur with an 'A' idea." The team section of the business plan is often
the section that professional investors read after the executive summary. Thus,
it is critical that the plan depict the members responsible for key activities and
convey that they are exceptionally skilled.
Team Bios and Roles
The best place to start is by identifying the key team members and their titles.
Often, the lead entrepreneur assumes a CEO role. However, if you are young
and have limited business experience, it is usually more productive to state
that the company will seek a qualified CEO as it grows. The lead entrepreneur
may then assume the role of chief technology officer (if he develops the technology)
or vice president of business development. However, don't let these options
confine you. The key is to convince investors that you have assembled the
best team possible and that your team can execute on the brilliant concept you
are proposing.
Once responsibilities and titles have been defined, names and a short bio
should be filled in. The bios should demonstrate records of success. If you have
previously started a business (even if it failed), highlight the company's accomplishments.
If you have no previous entrepreneurial experience, discuss your
achievements within your last job. For example, bios often contain a description
of the number of people the entrepreneur previously managed and, more
important, a measure of economic success, such as growing division sales by
20+%. The bio should demonstrate your leadership capabilities. To complement
this description, resumes are often included as an appendix.
Advisory Boards, Board of Directors, Strategic Partners,
External Members
To enhance the team's credentials, many entrepreneurs find that they are more
attractive to investors if they have strong advisory boards. In building an advisory
board, identify individuals with relevant experience within your industry.
282
EXHIBIT 9.11 Development timeline.
VMC engineering activities
2/1 1/1 1/1 3/1 4/1 5/1 6/1 8/1 9/1 10/1 11/1 12/1 1/1 2/1 3/1 4/1 5/1 6/1 7/1 8/1 9/1 11/1 12/1
VMC
distribution
system
development
alpha
VMC
beta
Ongoing innovation and development
of VMC distribution system
Telematics
development
Telematics
beta
Innovation and
enhancement
October 2002
VMC telematics
service launch
Wireless device and
network appliance R&D
Record label
recruitment
Advertising
recruitment
Telematics
negotiations Wireless device and network appliance OEM
partnering
Content provider
recruiting
Business development
and sales activities
VMC marketing
campaign
July 2001
site launch
2001 2002 2003
10/1 7/1
The Business Plan 283
Industry experts provide legitimacy to your new business as well as strong
technical advice. Other advisory board members may bring financial, legal, or
management expertise. Thus, it is common to see lawyers, professors, accountants,
and others who can assist the venture's growth on advisory boards.
Moreover, if your firm has a strategic supplier or key customer, it may make
sense to invite him or her onto your advisory board. Typically, these individuals
are remunerated with a small equity stake and compensation for any organized
meetings.
By law, most organization types require a board of directors. This is different
than an advisory board (although these members can also provide
needed expertise). The board's primary role is to oversee the company on
behalf of the investors. Therefore, the business plan needs to brief ly describe
the size of the board, its role within the organization and any current board
members. Most major investors, such as venture capitalists, will require one
or more board seats. Usually, the lead entrepreneur and one or more inside
company members (e.g., chief financial officers, vice presidents) will also
have board seats.
Strategic partners, though not necessarily on your advisory board or
board of directors, may still provide credibility to your venture. In such cases,
it makes sense to highlight their involvement in your company's success. It is
also common to list external team members, such as the law firm and accounting
firm that your venture uses. The key in this section is to demonstrate that
your firm can successfully execute the concept. A strong team provides the
foundation on which your venture will implement the opportunity successfully.
Compensation and Ownership
The capstone to the team section should be a table containing key team members
by role, compensation, and ownership equity. A brief description of the
table should explain why the compensation is appropriate. Many entrepreneurs
choose not to pay themselves in the early months. Although this strategy
conserves cash flow, it would misrepresent the individual's worth to the
organization. Therefore, the table should contain what salary the employee is
due, and then, if necessary, that salary can be deferred until cash f low is
strong. Another column that can be powerful shows what the person's current
or most recent compensation was and what he will be paid in the new company.
I am most impressed by highly qualified entrepreneurs taking a smaller
salary than at their previous job. It suggests that the entrepreneur really believes
in the upside payoff the company's growth will generate. Of course,
the entrepreneur plans on increasing this salary as the venture grows and
starts to thrive. As such, the description of the schedule should underscore
the plan to increase salaries in the future. It is also a good idea to hold stock
aside for future key hires and to establish a stock option pool for lower-level
but critical employees, such as software engineers. Again, the plan should discuss
such provisions.
284 Planning and Forecasting
Critical Risks (1–2 pages)
Every new venture faces a number of risks that may threaten its survival. Although
the business plan, at this point, is creating a story of success, there are
a number of threats that readers will identify and recognize. The plan needs to
acknowledge these potential risks; otherwise, investors may believe that the
entrepreneur is naive or untrustworthy and therefore reject investment. How
should you present these critical risks without scaring your investor? Identify
the risk and then state your contingency plan (see Exhibit 9.12). Critical risks
are critical assumptions, factors that need to happen if your venture is to succeed.
The critical assumptions vary from one company to another, but some
common categories are: market interest and growth potential, competitor actions
and retaliation, time and cost of development, operating expenses, availability
and timing of financing.
Market Interest and Growth Potential
The biggest risk any new venture faces is that once the product is developed,
no one will buy it. Although there are a number of things that can be done to
minimize this risk, such as market research, focus groups, beta sites, and others,
it is difficult to gauge overall demand and growth of that demand until
your product hits the market. This risk must be stated but tempered with the
tactics and contingencies the company will undertake. For example, sales risk
can be reduced by an effective advertising and marketing plan or identifying
not only a primary target customer but secondary and tertiary target customers
that the company will seek if the primary customer proves less interested.
Competitor Actions and Retaliation
Having worked with entrepreneurs and student entrepreneurs over the years, I
have always been struck by the firmly held belief that direct competition either
didn't exist or that it was sleepy and slow to react. There have been many cases
EXHIBIT 9.12 Sample critical risk.
6.2 Group's lack of experience in starting own company Within our present team,
we realize that we lack the real world experience in starting up a company, but we feel that
this can be overcome in two different ways. First, we plan on hiring someone who has a
background in managing a startup company and has a history in working with e-commerce
businesses. Secondly, we will draw on family expertise within our group. William Smith's
family has started a successful golf retail store that has been in operation for nearly 20 years
and is just starting to utilize the Web to foster continued growth. Jim Meier 's father is the
managing partner of the largest public accounting firm in western Massachusetts. Mike
Santana's uncle is an investment banker and has some good friends in the venture capital firm
Canyon Partners in Beverly Hills. Pat Crown's father is the founder and president of Mathtech
Corporation in Boston, Massachusetts. Mr. Crown's company develops math software.
The Business Plan 285
where this is indeed true, but I caution against using it as a key assumption of
your venture's success. Most entrepreneurs passionately believe that they are
offering something new and wonderful that is clearly different from what
is currently being offered. They are confident that existing competition won't
attack their niche in the near future. The risk that this assessment is wrong
should be acknowledged. One counter to this threat is that the venture has
room in its gross margin and cash available to withstand and fight such attacks.
You should also identify some strategies to protect and reposition yourself
should an attack occur.
Time and Cost to Development
As mentioned in the development plan section, many factors can delay and add
to the expense of developing your product. The business plan should identify
the factors that may hinder development. For instance, during the extended
high-tech boom of the late nineties and into the new century, there has been
an acute shortage of skilled software engineers. One way to counter the resulting
risk in hiring and retaining the most qualified professionals might be to
outsource some development to the underemployed engineers in India. Compensation,
equity participation, f lexible hours, and other benefits that the firm
could offer might also minimize the risk.
Operating Expenses
Operating expenses have a way of growing beyond expectations. Sales and administration,
marketing, and interest expenses are some of the areas that the
entrepreneur needs to monitor and manage. The business plan should highlight
how these expenses were forecast (comparable companies and detailed analysis)
but also discuss contingencies such as slowing the hiring of support personnel,
especially if development or other key tasks take longer than expected.
Availability and Timing of Financing
I can't stress enough how important cash f low is to the survival and growth of
a new venture. One major risk that most new ventures face is that they will
have difficulty obtaining needed financing, both equity and debt. If the current
business plan is meant to attract investors and is successful, that first capital
infusion isn't a near-term risk, but most ventures will need multiple rounds
of financing. If the firm fails to make progress (or meet key milestones), it may
not be able to secure additional rounds of financing on favorable terms. To mitigate
this risk, the firm could identify alternative sources that are viable or
strategies to slow the "burn rate."6
There are a number of other risks that might apply to your business. Acknowledge
them and discuss how you can overcome them. Doing so generates
confidence in your investors.
286 Planning and Forecasting
Offering (1⁄2–1 page)
Based upon the entrepreneur's vision and estimates of the capital required to
get there, the entrepreneur can develop a "sources and uses schedule" (see Exhibit
9.13). The sources section details how much capital the entrepreneur
needs and the types of financing such as equity investment and debt infusions.
The uses section details how the money will be spent. Typically, the entrepreneur
should secure enough financing to last 12 to 18 months. Taking more capital
means that the entrepreneur gives up more equity. Taking less means that
the entrepreneur may run out of cash before reaching milestones that equate to
higher valuations.
Financial Plan (4 –8 pages)
If the preceding plan is your verbal description of the opportunity and how you
will execute it, the financial plan is the mathematical equivalent. The growth
in revenues speaks to the upside of your opportunity. The expenses illustrate
what you need to execute on that opportunity. Cash f low statements serve as
an early warning system to potential problems (or critical risks), and the balance
sheet enables monitoring and adjusting the venture's progress. That being
said, generating realistic financials is one of the most intimidating hurdles entrepreneurs
face. I will highlight a dual strategy to building your model: comparable
analysis and the buildup technique. Entrepreneurs should do both
approaches; with work and skill the two approaches allow the entrepreneur to
triangulate into a credible facsimile.
Entrepreneurs are notoriously overoptimistic in their projections. One
phrase that entrepreneurs overuse in their business plan, especially the financial
plan, is "conservative estimate." History proves that 99% of all entrepreneurs
are amazingly aggressive in their projections. Professional investors
recognize this problem and often discount financials up to 50% from the entrepreneur's
projections. How do you prevent that from happening? Validate
your projections by comparing your firm's pro forma financials to existing
firm's actual performance. Obviously, no two firms are exactly alike, and if you
were to launch an online bookstore, it would be unlikely that your firm would
perfectly mirror Amazon.com. However, the comparable method doesn't mean
that you substitute another firm's financials for your own; it means that you use
EXHIBIT 9.13 Sources and uses schedule.
Sources Uses
5,000,000 VC 1,688,750 Systems development
1,652,000 Equipment
1,125,000 Sales/business development
534,250 Working capital
5,000,000 Total 5,000,000
The Business Plan 287
that comparable firm as a starting point. Entrepreneurs then need to articulate
why their projections vary from the comparable firm, both in a positive and
negative manner. Continuing the online bookstore example, I would be insane
to believe that I could achieve the same rapid growth that Amazon.com experienced,
because there is now more competition, especially from Amazon.com.
On the f lip side, I should be able to argue that my expenses won't be as stif ling
as Amazon's, because I have studied and learned from their excesses. I would
also articulate how my fulfillment is more efficient than Amazon's. So the key
in the comparable method is to use other firms and industry standards as a
starting point and then adjust your projections based upon your strategy and
other factors.
Industry averages also provide useful comparable information. The Almanac
of Business and Industrial Financial Ratios, published by Prentice-
Hall, or Industry Norms and Key Business Ratios, published by Dun and
Bradstreet are excellent sources to use as starting points in building financial
statements relevant to your industry. Specifically, these sources help entrepreneurs
build income statements by providing industry averages for costs of
goods sold, salary expenses, interest expenses, and the like. Again, your firm
will differ from these industry averages, but you should be able to explain why
your firm differs.
The second method is the buildup method. This approach derives from
the scientific finding that people make better decisions by decomposing a
problem into smaller parts. For financial pro forma construction, this is relatively
easy. The place to start is the income statement. Identify all of your revenue
sources (usually the various product offerings). Instead of visualizing
what you will sell in a month or a year, break it down to the day. For example,
if I am starting a new restaurant, I would estimate how many customers I
might serve in a particular day and how much they would spend per visit
based upon the types of meals and beverages they would buy. In essence, I am
developing an average ticket price per customer. I then multiply that price by
the number of days of operation in the year. Once I have the typical day, I can
make adjustments for cyclical aspects of the business, such as slow days or
slow months. If I were, say, to open up a chain of restaurants, I could then
multiple my estimates by the number of restaurants. Once you have gone
through a couple of iterations of each approach, you should be able to reconcile
the differences.
One schedule that is particularly powerful in building up your cost estimates
is a headcount schedule. This table should have time across the top and
job categories down the side (see Exhibit 9.14). Next assign average salaries
and burden to these employees and then funnel them into the appropriate income
statement lines. Breaking down to this level of detail enables entrepreneurs
to more accurately aggregate up to their real headcount expenses, which
tend to be the major line item in most companies.
Going through the above exercises allows you to construct a realistic set
of pro forma financials. The financial statements that must be included in your
288 Planning and Forecasting
plan are the income statement, cash f low statement, and balance sheet. I typically
call for five years of financials, recognizing that the farther out one goes,
the less accurate the forecasts are. The rationale behind five years is that the
first two years show the firm surviving and the last three years show the upside
growth potential. The majority of new ventures lose money for the first two
years. Therefore, the income statement and cash flow statement should be
month-to-month during the first two years to show how much cash is needed
until the firm can become self-sustaining. Month-to-month analysis shows cash
f low decreasing and provides an early warning system as to when the entrepreneur
should seek the next round of financing. Years 3 through 5 need to be illustrated
only on an annual basis, because these projections communicate your
vision for growth but are likely to be less accurate because they are further out.
The balance sheet can be on an annual basis for all five years since it is reporting
a snapshot on the last day of a particular period.
Once the financial spreadsheets are completed, a two-to-three-page explanation
of the financials should be written and it should precede the statements.
Although you understand all the assumptions and comparisons that
went into building the financial forecast, the reader needs the background
spelled out. The explanation should have four subheadings: overview, income
statement, cash flow, and balance sheet. The overview section should highlight
the major assumptions that drive your revenue and expenses. This section
should explain several of the critical risks you identified earlier. The income
statement description goes into more detail as to some of the revenue and cost
drivers that haven't been discussed in the overview section. The cash flow description
talks about the timing of cash infusions, accounts payable, accounts
receivable, and so forth. The balance sheet description illustrates how major
ratios change as the firm grows.
Appendices (as many pages as necessary)
The appendices can include anything that you think further validates your
concept but doesn't fit or is too large to insert in the main parts of the plan.
EXHIBIT 9.14 Headcount chart.
Month Month Month Month Month Month Month
1 6 12 18 24 30 36
Business development 1 2 3 3 3 3 3
Sales and administration 2 2 6 10 10 14 14
Software developers 3 3 3 18 18 23 26
Customer service 0 2 3 5 5 10 10
Total head count 6 9 15 36 36 50 53
The Business Plan 289
Common inclusions would be one-page resumes of key team members, articles
that feature your venture, and technical specifications.
CONCLUSION
The business plan is more than just a document; it is a process. Although the
finished product is often a written plan, the deep thinking that goes into that
document provides the entrepreneur keen insight needed to marshal resources
and direct growth. The whole process can be painful, but the returns on a solid
effort almost always minimize the costs of starting a business, because the process
allows the entrepreneur to better anticipate, instead of reacting to, the
many issues the venture will face. More important, the business plan provides a
talking point so that entrepreneurs can get feedback from a number of experts,
including investors, vendors, and customers. Think of the business plan as one
of your first steps on the journey to entrepreneurial success.
OTHER RESOURCES
A number of resources exist for those seeking help to write business plans.
There are numerous software packages, but I find that generally the templates
are too confining. The text boxes asking for information box writers into a dull,
dispassionate tone. The best way to learn about business plans is digging out
the supporting data, writing sections as you feel compelled, and circulating
drafts among your mentors and advisors. I also think that the entrepreneur
should read as many other articles, chapters, and books about writing business
plans as possible. You will want to assimilate different perspectives so that you
can find your own personal voice. To that end, I want to suggest a number of
sources that you might want to check out.
FOR FURTHER READING
Timmons, J. A., New Venture Creation, 5th ed. (New York: Irwin/McGraw-Hill,
1999). Classic textbook on the venture creation process.
Tracy, J., How to Read a Financial Report, 5th ed. (New York: John Wiley, 1999).
Classic book on how to create pro forma financial statements and how these
statements tie together.
Sahlman, W., "How to Write a Great Business Plan," Harvard Business Review
(July–Aug. 1997): 98–108.
Bhide, A., "The Questions Every Entrepreneur Should Ask," Harvard Business Review
(Nov.–Dec. 1996): 120–130.
Kim, C., and R. Mauborgne, "Creating New Market Space," Harvard Business Review
(Jan.–Feb. 1999): 83–93.
290 Planning and Forecasting
INTERNET LINKS
Business Plan Sites
www.pasware.com
www.brs-inc.com
www.jian.com
Other Useful Sites
www.entreworld.org
www.babson.edu/entrep
NOTES
1. P. Thomas, "Rewriting the Rules: A New Generation of Entrepreneurs Find
Themselves in the Perfect Time and Place to Chart Their Own Course," Wall Street
Journal, May 22, 2000, R4.
2. Running sidebar is a visual device that is positioned down the right hand side
of the page that periodically highlights some of the key points in the plan. Don't
overload the sidebar, but one or two items per page can draw attention to highlights
that maintain reader interest.
3. Don't confuse the executive summary included in the plan with the expanded
executive summary that I suggested you write as the very first step of the business
plan process. Again, the two summaries are likely to be significantly different since
the later summary incorporates all the deep learning that you have gained throughout
the process.
4. J. Timmons, New Venture Creation, 5th ed. (New York: Irwin/McGraw-Hill,
1999).
5. O. Sacirbey, "Private Companies Temper IPO Talk," The IPO Reporter,
Dec. 18, 2000, 9.
6. Burn rate is how much more cash the company is expending each month than
earning in revenue.
291
10 PLANNING CAPITAL
EXPENDITURE
Steven P. Feinstein
A beer company is considering building a new brewery. An airline is deciding
whether to add f lights to its schedule. An engineer at a high-tech company has
designed a new microchip and hopes to encourage the company to manufacture
and sell it. A small college contemplates buying a new photocopy machine.
A nonprofit museum is toying with the idea of installing an education center for
children. Newlyweds dream of buying a house. A retailer considers building a
Web site and selling on the Internet.
What do these projects have in common? All of them entail a commitment
of capital and managerial effort that may or may not be justified by later
performance. A common set of tools can be applied to assess these seemingly
very different propositions. The financial analysis used to assess such projects
is known as "capital budgeting." How should a limited supply of capital and
managerial talent be allocated among an unlimited number of possible projects
and corporate initiatives?
THE OBJECTIVE: MAXIMIZE WEALTH
Capital budgeting decisions cut to the heart of the most fundamental questions
in business. What is the purpose of the firm? Is it to create wealth for investors?
To serve the needs of customers? To provide jobs for employees? To
better the community? These questions are fodder for endless debate. Ultimately,
however, project decisions have to be made, and so we must adopt a
292 Planning and Forecasting
decision rule. The perspective of financial analysis is that capital investment
belongs to the investors. The goal of the firm is to maximize investors' wealth.
Other factors are important and should be considered, but this is the primary
objective. In the case of nonprofit organizations, wealth and return on investment
need not be measured in dollars and cents but rather can be measured in
terms of benefits to society. But in the case of for-profit companies, wealth is
monetary.
A project creates wealth if it generates cash flows over time that are
worth more in present-value terms than the initial setup cost. For example,
suppose a brewery costs $10 million to build, but once built it generates a
stream of cash f lows that is worth $11 million. Building the brewery would create
$1 million of new wealth. If there were no other proposed projects that
would create more wealth than this, then the beer company would be well advised
to build the new brewery.
This example illustrates the "net present value" rule. Net present value
(NPV) is the difference between the setup cost of a project and the value of
the project once it is set up. If that difference is positive, then the NPV is
positive and the project creates wealth. If a firm must choose from several
proposed projects, the one with the highest NPV will create the most wealth,
and so it should be the one adopted. For example, suppose the beer company
can either build the new brewery or, alternatively, can introduce a new product—
a light beer, for example. There is not enough managerial talent to oversee
more than one new project, or maybe there are not enough funds to start
both. Let us assume that both projects create wealth: The NPV of the new
brewery is $1 million, and the NPV of the new-product project is $500,000. If
it could, the beer company should undertake both projects; but since it has to
choose, building the new brewery would be the right option because it has
the higher NPV.
COMPUTING NPV: PROJECTING CASH FLOWS
The first step in calculating a project's NPV is to forecast the project's future
cash flows. Cash is king. It is cash flow, not profit, that investors really care
about. If a company never generates cash flow, there can be no return to investors.
Also, profit can be manipulated by discretionary accounting treatments
such as depreciation method or inventory valuation. Regardless of
accounting choices, however, cash flow either materializes or does not. For
these reasons, cash f low is the most important variable to investors. A project's
value derives from the cash f low it creates, and NPV is the value of the future
cash f lows net of the initial cash outflow.
We can illustrate the method of forecasting cash flows with an example.
Let us continue to explore the brewery project. Suppose project engineers inform
you that the construction costs for the brewery would be $8 million. The
Planning Capital Expenditure 293
expected life of the new brewery is 10 years. The brewery will be depreciated
to zero over its 10-year life using a straight-line depreciation schedule. Land
for the brewery can be purchased for $1 million. Additional inventory to stock
the new brewery would cost $1 million. The brewery would be fully operational
within a year. If the project is undertaken, increased sales for the beer
company would be $7 million per year. Cost of goods sold for this beer would
be $2 million per year; and selling, administrative, and general expenses associated
with the new brewery would be $1 million per year. Perhaps advertising
would have to increase by $500,000 per year. After 10 years, the land can be
sold for $1 million, or it can be used for another project. After 10 years the salvage
value of the plant is expected to be $1.5 million. The increase in accounts
receivable would exactly equal the increase in accounts payable, at $400,000,
so these components of net working capital would offset one another and generate
no net cash flow.
No one expects these forecasts to be perfect. Paraphrasing the famous
words of baseball player Yogi Berra, making predictions is very difficult, especially
when they are about the future! However, when investors choose among
various investments, they too must make predictions. As a financial analyst,
you want the quality of your forecasts to be on a par with the quality of the
forecasts made by investors. Essentially, the job of the financial analyst is to estimate
how investors will value the project, because the value of the firm will
rise if investors decide that the new project creates wealth and will fall if investors
conclude that the project destroys wealth. If the investors have reason
to believe that sales will be $7 million per year, then that would be the correct
forecast to use in the capital budgeting analysis. Investors have to cope with
uncertainty in their forecasts. Similarly, the financial analyst conducting a capital
budgeting analysis must tolerate the same level of uncertainty.
Note that cash flow projections require an integrated team effort across
the entire firm. Operations and engineering personnel estimate the cost of
building and operating the new plant. The human resources department contributes
the labor data. Marketing people tell you what advertising budget is
needed and forecast revenue. The accounting department estimates taxes, accounts
payable, and accounts receivable and tabulates the financial data. The
job of the financial analyst is to put the pieces together and recommend that
the project be adopted or abandoned.
Initial Cash Outf low
The initial cash outflow required by the project is the sum of the construction
cost ($8 million), the land cost ($1 million), and the required new inventory
($1 million). Thus, this project requires an investment of $10 million to launch.
If accounts receivable did not equal accounts payable, then the new accounts
receivable would add to the initial cash outflow, and the new accounts payable
would be subtracted. These cash f lows are tabulated in Exhibit 10.1.
294 Planning and Forecasting
Cash Flows in Later Years
We find cash f low in years 1 through 10 by applying the following formula:
Notice that we already have most of the data needed for the cash-f low formula,
but we are missing the forecasts for income tax and windfall tax. Before we can
finalize the cash f low computation, we have to forecast taxes.
Income tax equals earnings before taxes (EBT) times the income tax rate.
EBT is computed using the following formula:
The formula for EBT is similar to the formula for cash-flow, with a few important
exceptions. The cash-f low calculation does not subtract out depreciation,
whereas the EBT calculation does. This is because depreciation is not a cash
f low; the firm never has to write a check payable to "depreciation." Depreciation
does reduce taxable income, however, because the government allows this
deduction for tax purposes. So depreciation inf luences cash f low via its impact
on income tax, but it is not a cash f low itself. The greater the allowable depreciation
is in a given year, the lower taxes will be, and the greater the resulting
cash f low to the firm.
Earnings before Taxes = Sales − Cost of goods sold
− Selling, administrative, and general expenses
− Advertising
− Depreciation
Cash Flow = Sales − Cost of goods sold
− Selling, administrative, and general expenses
− Advertising
− Income tax
+ Decrease in inventory (or − increase)
+ Decrease in accounts receivable (or − increase)
− Decrease in accounts payable (or + increase)
+ Salvage
− Windfall tax on salvage
EXHIBIT 10.1 Initial year cash f low for
brewery project ($1,000s).
Year 0
Construction $ (8,000)
Land (1,000)
Inventory (1,000)
Account receivable (400)
Accounts payable 400
Total cash f low $(10,000)
Planning Capital Expenditure 295
Treatment of Net Working Capital
Changes in inventory, accounts receivable, and accounts payable are included
in the cash-flow calculation but not in EBT. Changes in the components of
working capital directly impact cash flow, but they are not deductible for tax
purposes. When a firm buys inventory, it has essentially swapped one asset,
(cash) for another asset (inventory). Though this is a negative cash flow, it is not
considered a deductible expenditure for tax purposes.
Similarly, a rise in accounts receivable means that cash that otherwise
would have been in the company coffers is now owed to the company instead.
Thus, an increase in accounts receivable effectively sucks cash out of the company
and must be treated as a cash outflow. Increasing accounts payable has
the opposite effect.
One way to gain perspective on the impact of accounts payable and accounts
receivable on a company's cash f low is to think of them as adjustments
to sales and costs of goods sold. If a company makes a sale but the customer has
not yet paid, clearly there is no cash f low generated from the sale. Though the
sales variable will increase, the increase in accounts receivable will exactly offset
that increase in the cash f low computation. Similarly, if the company incurs
expenses in the manufacture of the goods sold but has not yet paid its suppliers
for the raw materials, the costs of goods sold will be offset by the increase in
accounts payable.
Depreciation
According to a straight-line depreciation schedule, depreciation in each year is
the initial cost of the plant or equipment divided by the number of years over
which the asset will be depreciated. So, the $8 million plant depreciated over
10 years generates depreciation of $800,000 each year. Land is generally not
depreciated. Straight-line depreciation is but one acceptable method for determining
depreciation of plant and equipment. The tax authorities often sanction
other methods and schedules.
Windfall Profit and Windfall Tax
In order to compute windfall profit and windfall tax, we must be able to track
an asset's book value over its life. Book value is the initial value minus all previous
depreciation. For example, the brewery initially has a book value of $8
million, but that value falls $800,000 per year due to depreciation. At the end
of the first year, book value falls to $7.2 million. By the end of the second year,
following another $800,000 of depreciation, the book value will be $6.4 million.
By the end of the tenth year, when the brewery is fully depreciated, the
book value will be zero.
Windfall profit is the difference between the salvage value and book
value. We are told the beer company will be able to sell the old brewery for
296 Planning and Forecasting
$1.5 million at the end of 10 years. By then, however, the book value of the
brewery will be zero. Thus, the beer company will realize a windfall profit of
$1.5 million. The government will want its share of that windfall profit. Multiplying
the windfall profit by the tax rate determines the windfall tax. In this
particular case, with a windfall profit of $1.5 million and a tax rate of 40%, the
windfall tax would equal $600 thousand (= $1.5 million × 40%).
Taxable Income and Income Tax
Exhibit 10.2 shows how taxable income and income tax are computed for the
brewery example. Income tax equals EBT times the company's income tax rate.
In each of years 1 through 10, EBT is $2.7 million, so income tax is $1,080,000
(= $2.7 million × 40%).
Interest Expense
Notice that the calculation of taxable income and income tax in Exhibit 10.2
does not deduct any interest expense. This is not an oversight. Even if the company
intends to finance the new project by selling bonds or borrowing from a
bank, we should not deduct any anticipated interest expense from our taxable
income, and we should not subtract interest payments in the cash f low computation.
We will take the tax shield of debt financing into account later when we
compute the company's cost of capital. The reason for omitting interest expense
at this stage cuts to the core of the purpose of capital budgeting. We are
trying to forecast how much cash is required from investors to start this project
and then how much cash this project will generate for the investors once the
project is up and running. Interest expense is a distribution of cash to one class
of investors—the debt holders. If we want the bottom line of our cash-flow
computation to ref lect how much cash will be available to all investors, we
must not subtract out cash f low going to one class of investors before we get to
that bottom line.
EXHIBIT 10.2 Income tax forecasts for brewery
project (thousands).
Years 1–10
Sales $ 7,000
Cost of goods sold (2,000)
Selling, administrative, and general expenses (1,000)
Advertising (500)
Depreciation (800)
Earnings before taxes $ 2,700
Income tax (40%) $(1,080)
Planning Capital Expenditure 297
Putting the Pieces Together to
Forecast Cash Flow
We now have all the puzzle pieces to construct our capital budgeting cash-flow
projection. These pieces and the resulting cash-flow projection are presented
in Exhibit 10.3. Cash f lows in years 1 through 9 are forecast to be $2.42 million,
and the cash f low in year 10 is expected to be $5.32 million. Year 10 has a
greater cash flow because of the recovery of the inventory and the assumed
sale of the land and plant.
GUIDING PRINCIPLES FOR
FORECASTING CASH FLOWS
The brewery example is one illustration of how cash f lows are forecast. Every
project is different, however, and the financial analyst must be keen to identify
all sources of cash flow. The following three principles can serve as a guide:
(1) Focus on cash flow, not on raw accounting data, (2) use expected values,
and (3) focus on the incremental.
Principle No. 1: Focus on Cash Flow
NPV analysis focuses on cash flows—that is, actual cash payments and receipts
flowing into or out of the firm. Recall that accounting profit is not the same
thing as cash flow. Accounting profit often mixes variables whose timings differ.
A sale made today may show up in today's profits, but since the cash receipt
for the sale may be deferred, the corresponding cash f low takes place
EXHIBIT 10.3 Cash f low projections for brewery project
(thousands).
Year: 0 1–9 10
Construction $ (8,000)
Land (1,000) $1,000
Inventory (1,000) 1,000
Account receivable (400) 400
Accounts payable 400 (400)
Sales $7,000 7,000
Cost of goods sold (2,000) (2,000)
Selling, admin., and general (1,000) (1,000)
Advertising (500) (500)
Income tax (1,080) (1,080)
Salvage 1,500
Windfall tax (600)
Total cash f low $(10,000) $2,420 $5,320
298 Planning and Forecasting
later. Since the cash f low is deferred, the true value of that sale to the firm is
somewhat diminished.
By focusing on cash flows and when they occur, NPV ref lects the true
value of increased revenues and costs. Consequently, NPV analysis requires
that accounting data be unraveled to reveal the underlying cash f lows. That is
why changes in net working capital must be accounted for and why depreciation
does not show up directly.
Principle No. 2: Use Expected Values
There is always going to be some uncertainty over future cash f lows. Future
costs and revenues cannot be known for sure. The analyst must gather as much
information as possible and assemble it to construct expected values of the
input variables. Although expected values are not perfect, these best guesses
have to be good enough. What is the alternative? The uncertainty in forecasting
the inputs is accounted for in the discount rate that is later used to discount
the expected cash f lows.
Principle No. 3: Focus on the Incremental
NPV analysis is done in terms of "incremental" cash flows—that is, the change
in cash flow generated by the decision to undertake the project. Incremental
cash f low is the difference between what the cash flow would be with the project
and what the firm's cash flow would be without the project. Any sales or
savings that would have happened without the project and are unaffected
by doing the project are irrelevant and should be ignored. Similarly, any costs
that would have been incurred anyway are irrelevant. It is often difficult yet
nonetheless important to focus on the incremental when calculating how cash
f lows are impacted by opportunity costs, sunk costs, and overhead. These troublesome
areas will be elaborated on next.
Opportunity Costs
Opportunity costs are opportunities for cash inf lows that must be sacrificed in
order to undertake the project. No check is written to pay for opportunity
costs, but they represent changes in the firm's cash f lows caused by the project
and must, therefore, be treated as actual costs of doing the project. For example,
suppose the firm owns a parking lot, and a proposed project requires use of
that land. Is the land free since the firm already owns it? No; if the project
were not undertaken then the company could sell or rent out the land. Use of
the company's land is, therefore, not free. There is an opportunity cost. Money
that could have been earned if the project were rejected will not be earned if
the project is started. In order to ref lect fully the incremental impact of the
proposed project, the incremental cash f lows used in NPV analysis must incorporate
opportunity costs.
Planning Capital Expenditure 299
Sunk Costs
Sunk costs are expenses that have already been paid or have already been committed
to. Past research and development are examples. Since sunk costs are
not incremental to the proposed project, NPV analysis must ignore them. NPV
analysis is always forward-looking. The past cannot be changed and so should
not enter into the choice of a future course of action. If research was undertaken
last year, the effects of that research might bear on future cash f lows,
but the cost of that research is already water under the bridge and so is not relevant
in the decision to continue the project. The project decision must be
made on the basis of whether the project increases or decreases wealth from
the present into the future. The past is irrelevant.
Overhead
The treatment of overhead often gives project managers a headache. Overhead
comprises expenditures made by the firm for resources that are shared by
many projects or departments. Heat and maintenance for common facilities are
examples. Management resources and shared support staff are other examples.
Overhead represents resources required for the firm to provide an environment
in which projects can be undertaken. Different firms use different formulas
for charging overhead expenses to various projects and departments. If
overhead charges accurately ref lect the shared resources used by a project,
then they should be treated as incremental costs of operating the project. If
the project were not undertaken, those shared resources would benefit another
moneymaking project, or perhaps the firm could possibly cut some of the
shared overhead expenditures. Thus, to the extent that overhead does represent
resources used by the project, it should be included in calculating incremental
cash f lows. If, on the other hand, overhead expense is unaffected by the
decision to undertake the new project, and no other proposed project could use
those shared resources, then overhead should be ignored in the NPV analysis.
Sometimes the formulas used to calculate overhead for budgeting purposes are
unrealistic and overcharge projects for their use of shared resources. If the financial
analyst does not correct this unrepresentative allocation of costs, some
worthwhile projects might incorrectly appear undesirable.
COMPUTING NPV: THE TIME VALUE OF MONEY
In deciding whether a project is worthwhile, one needs to know more than
whether it will make money. One must also know when it will make money.
Time is money! Project decisions involve cash f lows spread out over several periods.
As we shall see, cash f lows in different periods are distinct products in
the financial marketplace—as different as apples and oranges. To make decisions
affecting many future periods, we must know how to convert the different
periods' cash f lows into a common currency.
300 Planning and Forecasting
The concept that future cash f lows have a lower present value and the set
of tools used to discount future cash f lows to their present values are collectively
known as "time value of money" (TVOM) analysis. I have always thought
this to be a misnomer; the name should be the "money value of time." But
there is no use bucking the trend, so we will adopt the standard nomenclature.
You probably already have an intuitive grasp of the fundamentals of
TVOM analysis, as your likely answer to the following question illustrates:
Would you rather have $100 today or $100 next year? Why?
The answer to this question is the essence of TVOM. You no doubt answered
that you would rather have the money today. Money today is worth
more than money to be delivered in the future. Even if there were perfect certainty
that the future money would be received, we prefer to have money in
hand today. There are many reasons for this. Having money in hand allows
greater f lexibility for planning. You might choose to spend it before the future
money would be delivered. If you choose not to spend the money during the
course of the year, you can earn interest on it by investing it. Understanding
TVOM allows you to quantify exactly how much more early cash f lows are
worth than deferred cash f lows. An example will illuminate the concept.
Suppose you and a friend have dinner together in a restaurant. You order
an inexpensive sandwich. Your friend orders a large steak, a bottle of wine, and
several desserts. The bill arrives and your friend's share is $100. Unfortunately,
your friend forgot his wallet and asks to borrow the $100 from you. You
agree and pay. A year passes before your friend remembers to pay you back the
money. "Here is the $100," he finally says one day. Such events test a friendship,
especially if you had to carry a $100 balance on your credit card over the
course of the year on which interest accrued at a rate of 18%. Is the $100 that
your friend is offering you now worth the same as the $100 that he borrowed a
year earlier? Actually, no; a $100 cash f low today is not worth $100 next year.
The same nominal amount has different values depending on when it is paid. If
the interest rate is 18%, a $100 cash f low today is worth $118 next year and is
worth $139.24 the year after because of compound interest. The present value
of $118 to be received next year is exactly $100 today. Your friend should pay
you $118 if he borrowed $100 from you a year earlier.
The formula for converting a future value to a present value is:
where PV stands for present value, FV is future value, n is the number of periods
in the future that the future cash f low is paid, and r is the appropriate interest
rate or discount rate.
Discounting Cash Flows
Suppose in the brewery example that the appropriate discount rate for translating
future values to present values was 20%. Recall that the brewery project
PV
FV
r
n =
(1 + )
Planning Capital Expenditure 301
was forecast to generate $2.42 million of cash in year 1. The present value of
that cash flow, as of year 0, is $2,016,670, computed as follows:
Similarly, the year-2 cash flow was forecast to be $2.42 million also. The present
value of that second-year cash f low is only $1,680,560:
The longer the time over which a cash f low is discounted, the lower is its present
value. Exhibit 10.4 presents the forecasted cash f lows and their discounted
present values for the brewery project.
Summing the Discounted Cash Flows
to Arrive at NPV
Finally, we can calculate the NPV. The NPV is the sum of all discounted cash
f lows, which in the brewery example equals $614,000. To understand precisely
what this means, observe that the sum of the discounted cash f lows from years
1 through 10 is $10,614,000. This means that the project generates future cash
f lows that are worth $10,614,000 today. The initial cost of the project is
$10,000,000 today. Thus, the project is worth $10,614,000 but costs only
$10,000,000 and therefore creates $614,000 of new wealth. The managers of
the beer company would be well advised to adopt this project, because it has a
positive NPV and therefore creates wealth.
PV =
( )
$ , , =
.
$ , ,
2 420 000
1 20
1 680 560 2
PV =
( )
$ , , =
.
$ , ,
2 420 000
1 20
2 016 670 1
EXHIBIT 10.4 Discounted cash f lows for
brewery project (thousands).
Year Cash Flow Discounted Cash Flow
0 $(10,000) $(10,000)
1 2,420 2,017
2 2,420 1,681
3 2,420 1,400
4 2,420 1,167
5 2,420 973
6 2,420 810
7 2,420 675
8 2,420 563
9 2,420 469
10 5,320 859
302 Planning and Forecasting
MORE NPV EXAMPLES
Consider two alternative projects, A and B. They both cost $1,000,000 to set
up. Project A returns $800,000 per year for two years starting one year after
setup. Project B also returns $800,000 per year for two years, but the cash
f lows begin two years after setup. The firm uses a discount rate of 20%. Which
is the better project, A or B?
Like project A, project C also costs $1,000,000 to set up, and it will pay
back $1,600,000. For both A and C, the firm will earn $800,000 per year for
two years starting one year after setup. However, C costs $500,000 initially and
the other $500,000 need only be paid at the termination of the project (it may
be a cleanup cost, for example). Project A requires the initial outlay all at once
at the outset. Which is the better project, A or C? Of projects A, B, and C,
which project(s) should be undertaken?
We should make the project decision only after analyzing each project's
NPV. Exhibit 10.5 tabulates each project's cash f lows, discounted cash f lows,
and NPVs. The NPVs of Projects A, B, and C, are, respectively, $222,222,
−$151,235, and $375,000. Project C has the highest NPV. Therefore, if only
one project can be selected, it should be project C. If more than one project
can be undertaken, then both A and C should be selected since they both have
positive NPVs. Project B should be rejected since it has a negative NPV and
would therefore destroy wealth.
It makes sense that project C should have the highest NPV, since its cash
outf lows are deferred relative to the other projects, and its cash inf lows are
early. Project B, alternatively has all costs up front, but its cash inf lows are
deferred.
Suppose a project has positive NPV, but the NPV is small, say, only a few
hundred dollars. The firm should nevertheless undertake that project if there
are no alternative projects with higher NPV. The reason is that a firm's value
is increased every time it undertakes a positive-NPV project. The firm's value
increases by the amount of the project NPV. A small NPV, as long as it is positive,
is net of all input costs and financing costs. So, even if the NPV is low,
EXHIBIT 10.5 Cash f lows and discounted cash f lows for three
alternative projects (thousands).
Project A Project B Project C
Project A Discounted Project B Discounted Project C Discounted
Year Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow
0 $(1,000,000) $(1,000,000) $(1,000,000) $(1,000,000) $(500,000) $(500,000)
1 800,000 666,667 0 0 800,000 666,667
2 800,000 555,556 0 0 300,000 208,333
3 0 0 800,000 462,963 0 0
4 0 0 800,000 385,802 0 0
NPV = $0,(222,222 $0,(151,235) $ 375,000
Planning Capital Expenditure 303
the project covers all its costs and provides additional returns. If accepting
the small-NPV project does not preclude the undertaking of a higher-NPV
project, then it is the best thing to do. A firm that rejects a positive-NPV project
is rejecting wealth.
Of course, this does not mean a firm should jump headlong into any project
that at the moment appears likely to provide positive NPV. Future potential
projects should be considered as well, and they should be evaluated as
potential alternatives. The projects, current or future, that have the highest
NPV should be the projects accepted. For maximum wealth-creation efficiency,
the firm's managerial resources should be committed toward undertaking
maximum NPV projects.
THE DISCOUNT RATE
At what rate should cash f lows be discounted to compute net present values? In
most cases, the appropriate rate is the firm's cost of funds for the project. That
is, if the firm secures financing for the project by borrowing from a bank, the
after-tax interest rate should be used to discount cash f lows. If the firm obtains
funds by selling stock, then an equity financing rate should be applied. If the
financing combines debt and equity, then the appropriate discount rate would
be an average of the debt rate and the equity rate.
Cost of Debt Financing
The after-tax interest rate is the interest rate paid on a firm's debt less the impact
of the tax break they get from issuing debt. For example, suppose that a
firm pays 10% interest on its debt and the firm's income tax rate is 40%. If the
firm issues $100,000 of debt, then the annual interest expense will be $10,000
(10% × $100,000). But this $10,000 of interest expense is tax deductible, so the
firm would save $4,000 in taxes (40% × the $10,000 interest). Thus, net of the
tax break, this firm would be paying $6,000 to service a $100,000 debt. Its
after-tax interest rate is 6% ($6,000/$100,000 principal).
The formula for after-tax interest rate (RD, af ter-tax) is:
where RD is the firm's pretax interest rate, and ô is the firm's income tax rate.
Borrowing from a bank or selling bonds to raise funds is known as "debt
financing." Issuing stock to raise funds is known as "equity financing." Equity
financing is an alternative to debt financing, but it is not free. When a firm sells
equity, it sells ownership in the firm. The return earned by the new shareholders
is a cost to the old shareholders. The rate of return earned by equity investors
is found by adding dividends to the change in the stock price and then
dividing by the initial stock price:
RD, RD( ) after -tax= 1 − ô
304 Planning and Forecasting
where RE is the return on the stock and also the cost of equity financing, D is
the dollar amount of annual dividends per share paid by the firm to stockholders,
P0 is the stock price at the beginning of the year, and P1 is the stock price
at the end of the year. For example, suppose the stock price is $100 per share at
the beginning of the year and $112 at the end of the year, and the dividend is
$8 per share. The stockholders would have earned a return of 20%, and this
20% is also the cost of equity financing:
The capital asset pricing model (CAPM) is often used to estimate a firm's
cost of equity financing. The idea behind the CAPM is that the rate of return
demanded by equity investors will be a function of the risk of the equity,
where risk is measured by a variable beta (â). According to the CAPM, â and
cost of equity financing are related by the following equation:
where RF is a risk-free interest rate, such as a Treasury bill rate, and RM is the
expected return for the stock market as a whole. For example, suppose the expected
annual return to the overall stock market is 12%, and the Treasury bill
rate is 4%. If a stock has a â of 2, then its cost of equity financing would be
20%, computed as follows:
Analysts often use the Standard & Poor's 500 stock portfolio as a proxy
for the entire stock market when estimating the expected market return. The
âs for publicly traded firms are available from a variety of sources, such as
Bloomberg, Standard & Poor's, or the many companies that provide equity research
reports. How â is computed and the theory behind the CAPM are beyond
the scope of this chapter, but the textbooks listed in the bibliography to
this chapter provide excellent coverage.
Weighted Average Cost of Capital
Most firms use a combination of both equity and debt financing to raise money
for new projects. When financing comes from two sources, the appropriate discount
rate is an average of the two financing rates. If most of the financing is
debt, then debt should have greater weight in the average. Similarly, the weight
given to equity should ref lect how much of the financing is from equity. The
RE = 4%+ [2 × (12%− 4%)] = 20%
R R R R E F M F = + â( − )
RE = $ + $ − $ =
$
%
8 112 100
100
20
R
D P P
P E =
+ − 1 0
0
Planning Capital Expenditure 305
resulting number, the "weighted average cost of capital" (WACC), ref lects the
firm's true cost of raising funds for the project:
where WE is the proportion of the financing that is equity, WD is the proportion
of the financing that is debt, RE is the cost of equity financing, RD is the
pretax cost of debt financing, and ô is the tax rate.
For example, suppose a firm acquires 70% of the funds needed for a project
by selling stock. The remaining 30% of financing comes from borrowing.
The cost of equity financing is 20%, the pretax cost of debt financing is 10%,
and the tax rate is 40%. The weighted average cost of capital would then be
15.8%, computed as follows:
This 15.8% rate should then be used for discounting the project cash f lows.
Most often the choice of the discount rate is beyond the authority of the
project manager. Top management will determine some threshold discount rate
and dictate that it is the rate that must be used to assess all projects. When this
is the policy, the rate is usually the firm's WACC with an additional margin
added to compensate for the natural optimism of project proponents. A higher
WACC makes NPV lower, and this biases management toward rejecting projects.
The Effects of Leverage
Leverage refers to the amount of debt financing used: the greater the ratio of
debt to equity in the financing mix, the greater the leverage. The following example
illustrates how leverage impacts the returns generated by a project. Suppose
we have two companies that both manufacture scooters. One company is
called NoDebt Inc., and the other is called SomeDebt Inc. As you might guess
from its name, NoDebt never carries debt. SomeDebt is financed with equal
parts of debt and equity. Neither company knows whether the economy will be
good or bad next year, but they can make projections contingent on the state of
the economy. Exhibit 10.6 presents balance-sheet and income-statement data
for the two companies for each possible business environment.
Each company has $1 million of assets. Therefore, the value of NoDebt's
equity is $1 million, since debt plus equity must equal assets—the balancesheet
equality. Since SomeDebt is financed with an equal mix of debt and equity,
its debt must be worth $500,000, and its equity must also be worth
$500,000. Aside from capital structure—that is, the mix of debt and equity used
to finance the companies—the two firms are identical. In good times both companies
make $1 million in sales. In bad times sales fall to $200,000. Cost of
goods sold is always 50% of sales. Selling, administrative, and general expenses
are a constant $50,000. For simplicity we assume there is no depreciation.
WACC = (0.7 × 20%)+ 0.3 × [10%× (1 − 40%)] = 15.8%
WACC W R W R E E D D = + [ (1 − ô)]
306 Planning and Forecasting
Earnings before interest and taxes (EBIT) is thus $450,000 for both companies
in good times, and $50,000 for both in bad times. So far, this example illustrates
an important lesson about leverage: Leverage has no impact on EBIT. If
we define return on assets (ROA)1 as EBIT divided by assets, then leverage has
no impact on ROA.
If the pre-tax interest rate is 10%, however, then SomeDebt must pay
$50,000 of interest on its outstanding $500,000 of debt, regardless of whether
business is good or bad. NoDebt, of course, pays no interest. Because this is a
standard income statement, not a capital budgeting cash-f low computation, we
must account for interest. EBT (earnings before taxes, which is the same thing
as taxable income) for NoDebt is the same as its EBIT: $450,000 in good times
and $50,000 in bad times. For SomeDebt, however, EBT will be $50,000 less in
both states: $400,000 in good times and zero in bad times. Income tax is 40% of
EBT, so it must be $180,000 for NoDebt in good times, $20,000 for NoDebt
in bad times, $160,000 for SomeDebt in good times, and zero for SomeDebt in
bad times. Here we see the second important lesson about leverage: Leverage
reduces taxes.
Net earnings is EBT minus taxes. For NoDebt, net earnings is $270,000 in
good times and $30,000 in bad times. For SomeDebt, net earnings is $240,000
in good times and zero in bad times. Return on equity (ROE) equals net earnings
divided by equity. ROE is the profit earned by the equity investors as a
function of their equity investment. If, as in this example, there is no depreciation,
no changes in net working capital, and no capital expenditures, then net
earnings would equal the cash flow received by equity investors, and ROE
would be that year's cash return on their equity investment. Notice that ROE
for NoDebt is 27% in good times and 3% in bad times. ROE for SomeDebt is
much more volatile: 48% in good times and 0% in bad times. This is the third
EXHIBIT 10.6 Performance of NoDebt Inc. and SomeDebt Inc.
NoDebt Inc. (thousands) SomeDebt Inc. (thousands)
Net Earnings Good Times Bad Times Good Times Bad Times
Assets $1,000 $1,000 $1,000 $1,000
Debt 0 0 500 500
Equity $1,000 $1,000 $1,500 $1,500
Revenue $1,000 $1,200 $1,000 $1,200
COGS 500 100 500 100
SAG 50 50 50 50
EBIT 450 50 450 50
Interest 0 0 50 50
EBT 450 50 400 0
Tax (40%) 180 20 160 0
Net Earnings $1,270 $1,030 $1,240 $11,00
ROA 45.0% 5.0% 45.0% 5.0%
ROE 27.0% 3.0% 48.0% 0.0%
Planning Capital Expenditure 307
and most important lesson to be learned about leverage from this example: For
the equity investors, leverage makes the good times better and the bad times
worse. One student of mine, upon hearing this, exclaimed, "Leverage is a lot
like beer!"
Because leverage increases the riskiness of the cash f lows to equity investors,
leverage increases the cost of equity capital. But for moderate amounts
of leverage, the impact of the tax shield on the cost of debt financing overwhelms
the rising cost of equity financing, and leverage reduces the WACC.
Economists Franco Modigliani and Merton Miller were each awarded the
Nobel Prize in economics (in 1985 and 1990, respectively) for work that included
research on this very issue. Modigliani and Miller proved that in a world
where there are no taxes and no bankruptcy costs the WACC is unaffected by
leverage. What about the real world in which taxes and bankruptcy exist? What
we learn from their result, known as the Modigliani-Miller irrelevance theorem,
is that as leverage is increased WACC falls because of the tax savings, but
eventually WACC starts to rise again due to the rising probability of bankruptcy
costs. The choice of debt versus equity financing must balance these
countervailing concerns, and the optimal mix of debt and equity depends on
the specific details of the proposed project.
Divisional versus Firm Cost of Capital
Suppose the beer company is thinking about opening a restaurant. The risk inherent
in the restaurant business is much greater than the risk of the beer
brewing business. Suppose the WACC for the brewery has historically been
20%, but the WACC for stand-alone restaurants is 30%. What discount rate
should be used for the proposed restaurant project?
Considerable research, both theoretical and empirical, has been applied
to this question, and the consensus is that the 30% restaurant WACC should be
used. A discount rate must be appropriate for the risk and characteristics of
the project, not the risk and characteristics of the parent company. The reason
for this surprising result is that the volatility of the project's cash flows and
their correlation with other risky cash f lows are the paramount risk factors in
determining cost of capital, not simply the likelihood of default on the company's
obligations. The financial analyst should estimate the project's cost of
capital as if it were a new restaurant company, not an extension of the beer
company. The analyst should examine other restaurant companies to determine
the appropriate â, cost of equity capital, cost of debt financing, financing mix,
and WACC.
OTHER DECISION RULES
Some firms do not use the NPV decision rule as the criterion for deciding
whether a project should be accepted or rejected. At least three alternative decision
rules are commonly used. As we shall see, however, the alternative rules
308 Planning and Forecasting
are f lawed. If the objective of the firm is to maximize investors' wealth, the alternative
rules sometimes fail to identify projects that further this end and in
fact sometimes lead to acceptance of projects that destroy wealth. We will examine
the payback period rule, the discounted payback rule, and the internal
rate of return rule.
The Payback Period
The payback period rule stipulates that cash flows must completely repay the
initial outlay prior to some cutoff payback period. For example, if the payback
cutoff were three years, the payback rule would require that all projects return
the initial outlay within three years. Projects that satisfy the rule would be accepted;
projects that do not satisfy the rule would be rejected.
For example, suppose a project initially costs $100,000 to set up. Suppose
the cash f lows in the first three years were $34,000 each. The sum of the first
three years' cash f lows is $102,000. This is greater than the initial $100,000
outlay, and so this project would be accepted under the payback period rule.
There are two major problems with the payback period rule. First, it does
not take into account the time value of money. Second, it ignores what happens
after the payback. Because of these two failings, the payback rule sometimes
accepts projects that should be rejected and rejects projects that should be accepted.
A project that costs $100,000 to set up and returns $34,000 for three
years would have a negative NPV at a 10% discount rate, since the $102,000 in
deferred cash f lows are worth less than the initial $100,000 outlay. Yet, the
project would be adopted under the payback rule criterion.
Consider a project that costs $100,000 to set up, returns nothing for three
years, and then returns $10 million in year 4. This project would have a positive
NPV at any reasonable discount rate, yet would be rejected by the payback
rule. The rejection stems from the fact that the payback rule is myopic, that is,
it fails to take into account what happens after the payback period. Empirical
studies have shown that, contrary to popular perceptions, stockholders do reward
firms that take the longer view, NPV approach to project analysis.
The Discounted Payback Period
An improved, though still f lawed, variant of the payback period rule is the discounted
payback period rule. The discounted payback rule stipulates that the
discounted cash f lows from a project over some payback horizon must exceed
the initial outlay. If the horizon were three years, the rule would require that
the discounted present value of a project's first three years of cash flows be
greater than the initial outlay. Although this rule explicitly takes into account
the time value of money, it still ignores what might happen after the payback
horizon. A project may be rejected even if the expected cash f lows from the
fourth year and beyond are very large, as might be the case in a research and
development project. A project might be accepted even if there is a large
Planning Capital Expenditure 309
cleanup cost that would have to be paid after the payback horizon. Although the
rule incorporates the time value of money, it is still shortsighted. One might
conjecture that the payback and discounted payback rules are popular since
they are easy to apply. Yet, this ease is paid for in lost opportunities for creating
wealth and occasional misallocation of resources into wasteful projects.
Internal Rate of Return
A project's internal rate of return (IRR) is the interest rate that the project essentially
pays out. It is the interest rate that a bank would have to pay so that
the project's cash outflows would exactly finance its cash inf lows. Instead of
investing money in the project, one could invest money in a bank paying a rate
of interest equal to the project's IRR and receive the same cash flows. One can
think of the IRR as an interest rate that a project pays to its investors. For example,
a project that costs $100,000 to set up but then returns $10,000 every
year forever has an IRR of 10%. If a project costs $100,000 to set up and then
ends the following year when it pays back $105,000, that project would have an
IRR of 5%. The IRR is the rate of return generated by the project.
Most financial calculators and spreadsheet programs have functions that
find IRR using cash f lows supplied by the user. For example, consider a project
that requires a cash outf low of $100 in year 0 and produces cash inf lows of $40
for each of four years. To find the IRR using a financial calculator one must
specify that the present value equals −$100, annual payments equal +$40, and
n, the number of years, equals 4. The present value and the annuity payments
must have opposite signs in order to indicate to the calculator that the direction
of cash f lows has changed. The last step is to issue the instruction for the
calculator to find the interest rate that allows these cash flows to make sense.
The answer is the IRR, which in this example is 21.9%. For the beer brewery
cash f lows specified in Exhibit 10.4, the IRR is 21.7%.
Most TOVM problems involve specifying an interest rate and some of the
cash flows and then instructing the calculator to find the missing cash flow
variable—either present value, future value, or annual payment. IRR calculations
involve specifying all of the cash flows and instructing the calculator to
find the missing interest rate.
The IRR also happens to be the discount rate at which the project's cash
f lows have an NPV of zero. This relationship can be used to verify that an IRR
is correct. First calculate NPV at a guessed IRR. If the resulting NPV is zero,
the guessed IRR is in fact correct. If not, guess again. The IRR eventually can
be found by trial and error.
For example, consider again the case in which the initial cash outf low is
$100, followed by four annual cash inf lows of $40. To use the trial and error
method, one should calculate the NPV at a guessed discount rate. When we
find the discount rate at which the NPV is zero, we will have identified the
IRR. If we guess 10%, the NPV is $26.79. Apparently, the guessed discount
rate is too low. A higher discount rate will give a lower NPV. So guess again,
310 Planning and Forecasting
maybe 30% this time. At 30%, the NPV is −$13.35. Apparently, 30% is too
high. The next guess should be lower. Following this algorithm, the IRR of
21.9% will eventually be located.
The IRR rule stipulates that a project should be accepted if its IRR is
greater than some agreed-on threshold, and rejected otherwise. That is, to be accepted
a project must produce percentage returns higher than some companymandated
minimum. Often the minimum threshold is set equal to the firm's cost
of capital. If the IRR beats the WACC, then the project is accepted. If the IRR
is less than the WACC, the project is rejected.
For example, suppose a project costs $1,000 to set up, and then produces
a one-time cash inf low of $1,100 one year later. The IRR of this project is 10%.
If the company imposes a minimum threshold of 20%, this project will be rejected.
If the company's threshold is 8%, this project will be accepted. We saw
previously that the brewery project IRR was 21.7%. If the agreed threshold is
the brewery's 20% WACC, then the IRR rule would indicate that the project
should be accepted.
The IRR rule is appealing in that it usually gives the same guidance as
the NPV rule when the threshold equals the company's cost of capital. If a
project's IRR exceeds the firm's cost of capital, the project must be creating
wealth for the firm. The project would produce returns greater than the firm's
financing costs, and the spread would be adding wealth for the investors. Unfortunately,
the IRR rule frequently breaks down and gives misleading advice.
The IRR rule suffers from two f laws. First, it ignores the relative sizes of
alternative projects. For example, suppose a firm had to choose between two
projects, each of which lasts one year. The first project costs $10,000 to set up
but then pays back $16,000 one year later. The second project costs $100,000
to set up but pays back $120,000 one year later. Clearly the IRR of the first
project is 60%, and the IRR of the second project is 20%. On the basis of IRR
the first project seems to be superior. However, if the firm's cost of capital is
10%, the first project has an NPV of $4,454, whereas the second project has
an NPV of $9,091. Clearly the second project creates more wealth. The first
project has a higher rate of return but on a smaller investment. The second
project's lower return on a larger scale is a better use of the firm's scarce
managerial resources.
The second f law in the IRR rule stems from the fact that a given project
may have multiple IRRs. IRR is not always a single, unique value. Consider a
two-year project. Initially the project costs $1,000 to set up. In the first year it
returns $3,000. In the second year there is a cleanup costing $2,000. It is easy
to verify that 0% is one correct value for the firm's IRR: Discounting at 0%
and adding up all the discounted cash f lows gives an NPV of zero. Notice, however,
that 100% is another correct value for the IRR: Discounting all cash
flows at 100% per year also gives an NPV of zero. If the firm's cost of capital
is 10%, should this project be accepted or rejected? Ten percent is greater than
0%, but less than 100%. Only by computing the NPV at the discount rate of
10% do we find out that this project has a positive NPV of $74 and so should be
Planning Capital Expenditure 311
accepted. When a project has two or more IRRs, the analyst would have no way
of knowing which was the correct one to use if he or she did not also compute
the NPV and apply the NPV rule. If the analyst only computed the IRR of
100%, then she or he would reject this valuable project.
It turns out that a project will have one IRR for every change in sign in its
cash f lows. If a project has an initial outlay and then subsequently all cash
f lows are positive inf lows, there will be one unique IRR. If a project has an
initial outlay, a string of positive inf lows, and then a cleanup cost at the end,
there will be two IRRs since the direction of cash flow changed twice. If there
were an initial outlay, a positive inflow, another net outflow during a retooling
year, followed by a positive inflow, the three sign changes would produce three
different IRRs. The IRR rule would provide little guidance in such a scenario
and could possibly lead to an incorrect judgment of the project's worth.
In situations where its two fatal f laws are not an issue, the IRR rule gives
the same result as the NPV rule. If the project's cash flows change sign only
once, there is no problem of multiple IRRs. If all competing projects are of the
same magnitude or if there is only one project under consideration, the size
issue will not be a problem either. In such a situation, the firm would be justified
in selecting the project on the basis of IRR.
One circumstance in which alternative projects are of equal size and cash
flows only change direction once is in the analysis of alternative mortgage
plans. These days, a person financing a home may choose from a multitude of
mortgage plans. A variety of payment schedules are available and some plans
charge points in exchange for lower monthly payments. Since all mortgages
considered by the homebuyer finance the same house, the size issue is not a
concern. Also, the typical home mortgage involves a cash inf low at the beginning
and then only cash outf lows over the period when the borrower must pay
back the loan. Thus, there is only one sign change among the cash f lows. A borrower
can thus compare mortgages on the basis of their IRRs. The borrower
should calculate the cash flows over the horizon during which he or she expects
to pay back the mortgage, and should then choose the lowest IRR mortgage
from among those whose monthly payments are affordable. The annual
percentage rate (APR) quoted by mortgage companies is the IRR of the mortgage
calculated after factoring in points and origination fees and assuming the
mortgage will not be prepaid.
RECENT INNOVATIONS IN CAPITAL BUDGETING
Recent years have seen the introduction of two new capital budgeting paradigms.
The fact that new approaches are still being invented tells us that NPV
is not the last word in capital budgeting. Analysts and investors are constantly
looking for better tools for making long-range capital decisions. One new approach,
known as economic value added (EVA), was introduced by the consulting
firm Stern Stewart & Company, which owns the term as a registered
312 Planning and Forecasting
trademark. The second new paradigm we will brief ly examine is known as "real
options."
Economic Value Added
Economic value added (EVA™) is an accounting metric that aims to capture
how much wealth a company creates in a given year. EVA is the amount of invested
capital multiplied by the spread between the company's return on invested
capital and its cost of capital. EVA aims to measure wealth creation in a
given year rather than over the life of a project. EVA's advocates advise managers
to adopt projects that maximize EVA and manage projects so as to maximize
EVA each year. Managers should monitor projects and make modifications,
award incentives, and impose penalties to continuously boost EVA.
Real Options
The real options paradigm seeks to measure not only the value of a project's
forecasted cash flows but also the value of strategic f lexibility that a project
creates for a company. For example, suppose a company is contemplating an initiative
to market its wares on the Internet. The forecast cash flows may be
weak, but establishing a presence on the Internet may be valuable in that it
wards off potential competition and creates opportunities that can later be exploited.
The option to expand or the f lexibility to later pursue a wide range of
initiatives is captured using the real option paradigm, whereas the value of
these options is usually missed completely in the standard NPV approach. The
real options paradigm entails identifying the strategic options inherent in a proposed
project and then valuing them using modern mathematical optionpricing
formulas. If the value of a proposed project complete with its real
options is greater than the cost of initiating the project, then the project should
be given the go-ahead.
SUMMARY AND CONCLUSIONS
Capital budgeting is the process by which a firm chooses which projects to
adopt and which to reject. It is an extremely important endeavor because it ultimately
shapes the firm and the economy as a whole. The fundamental principal
underlying capital budgeting is that a firm should adopt the projects that
create the most wealth. Net present value (NPV) measures how much wealth a
project creates. NPV is computed by forecasting a project's cash f lows, discounting
those cash f lows at the project's weighted average cost of capital
(WACC), and then summing the discounted cash flows. The cost of capital
used to discount the cash f lows is a function of the riskiness of the project and
the financing mix selected.
Planning Capital Expenditure 313
Measures such as payback period, discounted payback period, and internal
rate of return (IRR) give rise to alternative project decision rules. These
rules, however, are f lawed and can potentially lead a company to adopt an inferior
project or reject an optimal one. Economic value added is a new tool recently
introduced to help managers choose among projects and then manage
the projects once started. The real options paradigm is another recent innovation
that aims to capture the value of strategic f lexibility created by projects.
The tools of capital budgeting can be applied to large-scale corporate decisions,
such as whether or not to build a new plant, but they can also be applied
to smaller personal decisions, such as which home mortgage program to choose
or whether to invest in new office equipment. Learning the language and tools
of capital budgeting can help entrepreneurs better pitch their projects to investors
or to the top executives at their own firms. Whether the decision is
large or small, the fundamental principle is the same: A good project is ultimately
worth more than it costs to set up and thereby generates wealth.
FOR FURTHER READING
Amram, Martha, and Nalin Kulatilaka, Real Options: Managing Strategic Investment
in an Uncertain World (Boston: Harvard Business School Press, 1999).
Bodie, Zvi, and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-Hall,
2000).
Brealey, Richard A., and Stewart C. Myers, Principles of Corporate Finance (New
York: Irwin/McGraw-Hill, 2000).
Brigham, Eugene F., Michael C. Ehrhardt, and Louis C. Gapenski, Financial Management:
Theory and Practice (New York: Dryden Press, 1999).
Dixit, Avinash K., and Robert S. Pindyck, "The Options Approach to Capital Investment,"
Harvard Business Review, 73(3) (May/June 1995): 105–115.
Emery, Douglas R., and John D. Finnerty, Corporate Financial Management (Upper
Saddle River, NJ: Prentice-Hall, 1997).
Higgins, Robert C., Analysis for Financial Management (New York: Irwin/McGraw-
Hill, 2001).
Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe, Corporate Finance
(New York: Irwin/McGraw-Hill, 1999).
Trigeorgis, Lenos, Real Options: Managerial Flexibility and Strategy in Resource Allocation
(Cambridge, MA: MIT Press, 1997).
NOTE
1. This is one definition of ROA; another definition is net earnings divided by
total assets. Given the second definition, ROA would be affected by leverage.
314
11
TAXES AND
BUSINESS
DECISIONS
Richard P. Mandel
It is not possible to fully describe the federal taxation system in the space of
one book chapter. It may not even be realistic to attempt to describe federal
taxation in a full volume. After all, a purchaser of the Internal Revenue Code
(the Code) can expect to carry home at least two volumes consisting of more
than 6,000 pages, ranging from Section 1 through Section 9,722, if one includes
the estate and gift tax and administrative provisions. And this does not even
begin to address the myriad Regulations, Revenue Rulings, Revenue Procedures,
Technical Advice Memoranda, private letter rulings, court decisions,
and other sources of federal tax law that have proliferated over the better part
of the twentieth century.
Fortunately, most people who enroll in a federal tax course during their
progression toward an MBA have no intention of becoming professional tax
advisers. An effective tax course, therefore, rather than attempting to impart
encyclopedic knowledge of the Code, instead presents taxation as another
strategic management tool, available to the manager or entrepreneur in his or
her quest to reach business goals in a more efficient and cost-effective manner.
After completing such a course, the businessperson should always be conscious
that failure to consider tax consequences when structuring a transaction may
result in needless tax expense.
It is thus the purpose of this chapter to illustrate the necessity of taking
taxation into account when structuring most business transactions, and of consulting
tax professionals early in the process, not just when it is time to file the
return. This purpose will be attempted by describing various problems and opportunities
encountered by a fictitious business owner as he progresses from
Taxes and Business Decisions 315
early successes, through the acquisition of a related business, to intergenerational
succession problems.
THE BUSINESS
We first encounter our sample business when it has been turning a reasonable
profit for the past few years under the wise stewardship of its founder and sole
stockholder, Morris. The success of his wholesale horticultural supply business
(Plant Supply Inc.) has been a source of great satisfaction to Morris, as has the
recent entry into the business of his daughter, Lisa. Morris paid Lisa's business
school tuition, hoping to groom her to take over the family business, and his investment
seems to be paying off as Lisa has become more and more valuable to
her father. Morris (rightly or wrongly) does not feel the same way about his
only other offspring, his son, Victor, the violinist, who appears to have no interest
whatsoever in the business except for its potential to subsidize his attempts
to break into the concert world.
At this time, Morris was about to score another coup: Plant Supply purchased
a plastics molding business so it could fabricate its own trays, pots, and
other planting containers instead of purchasing such items from others. Morris
considered himself fortunate to secure the services of Brad (the plant manager
of the molding company) because neither he nor Lisa knew very much about
the molding business. He was confident that negotiations then underway would
bring Brad aboard with a satisfactory compensation package. Thus, Morris
could afford to turn his attention to the pleasant problem of distributing the
wealth generated by his successful business.
UNREASONABLE COMPENSATION
Most entrepreneurs long for the day when their most pressing problem is figuring
out what to do with all the money their business is generating. Yet this very
condition was now occupying Morris's mind. Brad did not present any problems
in this context. His compensation package would be dealt with through ongoing
negotiations, and, of course, he was not family. But Morris was responsible for
supporting his wife and two children. Despite what Morris perceived as the
unproductive nature of Victor's pursuits, Morris was determined to maintain
a standard of living for Victor befitting the son of a captain of industry. Of
course, Lisa was also entitled to an aff luent lifestyle, but surely she was additionally
entitled to extra compensation for her long hours at work.
The simple and natural reaction to this set of circumstances would be to
pay Lisa and Morris a reasonable salary for their work and have the corporation
pay the remaining distributable profit (after retaining whatever was necessary
for operations) to Morris. Morris could then take care of his wife and Victor as
he saw fit. Yet such a natural reaction would ignore serious tax complications.
316 Planning and Forecasting
The distribution to Morris beyond his reasonable salary would likely be
characterized by the IRS as a dividend to the corporation's sole stockholder.
Since dividends cannot be deducted by the corporation as an expense, both the
corporation and Morris would pay tax on these monies (the well-known bugaboo
of corporate double taxation). A dollar of profit could easily be reduced to
as little as $0.40 of after-tax money in Morris's pocket (Exhibit 11.1).
Knowing this, one might argue that the distribution to Morris should be
characterized as a year-end bonus. Since compensation is tax deductible to the
corporation, the corporate level of taxation would be removed. Unfortunately,
Congress has long since limited the compensation deduction to a "reasonable"
amount. The IRS judges the reasonableness of a payment by comparing it to
the salaries paid to other employees performing similar services in similar
businesses. It also examines whether such amount is paid as regular salary or as
a year-end lump sum when profit levels are known. The scooping up by Morris
of whatever money was not nailed down at the end of the year would surely
come under attack by an IRS auditor. Why not then put Victor on the payroll
directly, thus reducing the amount that Morris must take out of the company
for his family? Again, such a payment would run afoul of the reasonableness
standard. If Morris would come under attack despite his significant efforts for
the company, imagine attempting to defend payments made to an "employee"
who expends no such efforts.
Subchapter S
The solution to the unreasonable compensation problem may lie in a relatively
well-known tax strategy known as the subchapter S election. A corporation
making this election remains a standard business corporation for all purposes
other than taxation (retaining its ability to grant limited liability to its stockholders,
for example). The corporation elects to forgo taxation at the corporate
level and to be taxed similarly to a partnership. This means that a corporation
that has elected subchapter S status will escape any taxation on the corporate
level, but its stockholders will be taxed on their pro rata share of the corporation's
profits, regardless of whether these profits are distributed to them.
Under this election, Morris's corporation would pay no corporate tax, but Morris
would pay income tax on all the corporation's profits, even those retained
for operations.
EXHIBIT 11.1 Double taxation.
$1.00 Earned
−0.34 Corporate tax at 34%
0.66 Dividend
−0.25 Individual tax at 39.1%*
0.41 Remains
* Highest federal income tax rate in 2001.
Taxes and Business Decisions 317
This election is recommended in a number of circumstances. One example
is the corporation that expects to incur losses, at least in its start-up phase.
In the absence of a subchapter S election, such losses would simply collect at
the corporate level, awaiting a time in the future when they could be "carried
forward" to offset future profits (should there ever be any). If the election is
made, the losses would pass through to the stockholders in the current year and
might offset other income of these stockholders such as interest, dividends
from investments, and salaries.
Another such circumstance is when a corporation expects to sell substantially
all its assets sometime in the future in an acquisition transaction. Since
the repeal of the so-called General Utilities doctrine, such a corporation would
incur a substantial capital gain tax on the growth in the value of its assets from
their acquisition to the time of sale, in addition to the capital gain tax incurred
by its stockholders when the proceeds of such sale are distributed to them.
The subchapter S election (if made early enough), again eliminates tax at the
corporate level, leaving only the tax on the stockholders.
The circumstance most relevant to Morris is the corporation with too
much profit to distribute as reasonable salary and bonuses. Instead of fighting
the battle of reasonableness with the IRS, Morris could elect subchapter S status,
thus rendering the controversy moot. It will not matter that the amount
paid to him is too large to be anything but a nondeductible dividend, because it
is no longer necessary to be concerned about the corporation's ability to deduct
the expense. Not all corporations are eligible to elect subchapter S status.
However, contrary to a common misconception, eligibility has nothing to do
with being a "small business." In simplified form, to qualify for a subchapter S
election, the corporation must have 75 or fewer stockholders holding only one
class of stock, all of whom must be individuals who are either U.S. citizens or
resident aliens. Plant Supply qualifies on all these counts.
Alternatively, many companies have accomplished the same tax results,
while avoiding the eligibility limitations of subchapter S, by operating as limited
liability companies (LLCs). Unfortunately for Morris, however, a few
states require LLCs to have more than one owner.
Under subchapter S, Morris can pay himself and Lisa a reasonable salary
and then take the rest of the money either as salary or dividend without fear of
challenge. He can then distribute that additional money between Lisa and Victor,
to support their individual lifestyles. Thus, it appears that the effective use
of a strategic taxation tool has solved an otherwise costly problem.
Gif t Tax
Unfortunately, like most tax strategies, the preceding solution may not be cost
free. It is always necessary to consider whether the solution of one tax problem
may create others, sometimes emanating from taxes other than the income tax.
To begin with, Morris needs to be aware that under any strategy he adopts, the
gifts of surplus cash he makes to his children may subject him to a federal gift
318 Planning and Forecasting
tax. This gift tax supplements the federal estate tax, which imposes a tax on the
transfer of assets from one generation to the next. Lifetime gifts to the next
generation would, in the absence of a gift tax, frustrate estate tax policy. Fortunately,
to accommodate the tendency of individuals to make gifts for reasons
unrelated to estate planning, the gift tax exempts gifts by a donor of up to
$10,000 per year to each of his or her donees. That amount will be adjusted for
inf lation as years go by. Furthermore it is doubled if the donor's spouse consents
to the use of her or his $10,000 allotment to cover the excess. Thus, Morris
could distribute up to $20,000 in excess cash each year to each of his two
children if his wife consented.
In addition, the federal gift tax does not take hold until the combined
total of taxable lifetime gifts in excess of the annual exclusion amount exceeds
$675,000 in 2001. This amount will increase to $1 million in 2002. Thus, Morris
can exceed the annual $20,000 amount by quite a bit before the government
will get its share.
These rules may suggest an alternate strategy to Morris under which he
may transfer some portion of his stock to each of his children and then have
the corporation distribute dividends to him and to them directly each year.
The gift tax would be implicated to the extent of the value of the stock in the
year it is given, but, from then on, no gifts would be necessary. Such a strategy,
in fact, describes a fourth circumstance in which the subchapter S election is
recommended: when the company wishes to distribute profits to nonemployee
stockholders for whom salary or bonus in any amount would be considered
excessive. In such a case, like that of Victor, the owner of the company can
choose subchapter S status for it, make a gift to the nonemployee of stock, and
adopt a policy of distributing annual dividends from profits, thus avoiding any
challenge to a corporate deduction based on unreasonable compensation.
MAKING THE SUBCHAPTER S ELECTION
Before Morris rushes off to make his election, however, he should be aware of
a few additional complications. Congress has historically been aware of the potential
for corporations to avoid corporate-level taxation on profits and capital
gains earned prior to the subchapter S election but not realized until afterward.
Thus, for example, if Morris's corporation has been accounting for its
inventory on a last in, first out (LIFO) basis in an inf lationary era (such as virtually
any time during the past 50 years), taxable profits have been depressed
by the use of higher cost inventory as the basis for calculation. Earlier lowercost
inventory has been left on the shelf (from an accounting point of view),
waiting for later sales. However, if those later sales will now come during a
time when the corporation is avoiding tax under subchapter S, those higher taxable
profits will never be taxed at the corporate level. Thus, for the year just
preceding the election, the Code requires recalculation of the corporation's
profits on a first in, first out (FIFO) inventory basis to capture the amount
Taxes and Business Decisions 319
that was postponed. If Morris has been using the LIFO method, his subchapter
S election will carry some cost.
Similarly, if Morris's corporation has been reporting to the IRS on a cash
accounting basis, it has been recognizing income only when collected, regardless
of when a sale was actually made. The subchapter S election, therefore, affords
the possibility that many sales made near the end of the final year of
corporate taxation will never be taxed at the corporate level, because these receivables
will not be collected until after the election is in effect. As a result,
the IRS requires all accounts receivable of a cash-basis taxpayer to be taxed as
if collected in the last year of corporate taxation, thus adding to the cost of
Morris's subchapter S conversion.
Of course, the greatest source of untapped corporate tax potential lies in
corporate assets that have appreciated in value while the corporation was subject
to corporate tax but are not sold by the corporation until after the subchapter
S election is in place. In the worst nightmares of the IRS, corporations
that are about to sell all their assets in a corporate acquisition first elect subchapter
S treatment and then immediately sell out, avoiding millions of dollars
of tax liability.
Fortunately for the IRS, Congress has addressed this problem by imposing
taxation on the corporate level of all so-called built-in gain realized by a
converted S corporation within the first 10 years after its conversion. Built-in
gain is the untaxed appreciation that existed at the time of the subchapter S
election. It is taxed not only upon a sale of all the corporation's assets, but any
time the corporation disposes of an asset it owned at the time of its election.
This makes it advisable to have an appraisal done for all the corporation's assets
as of the first day of subchapter S status, so that there is some objective
basis for the calculation of built-in gain upon sale somewhere down the line.
This appraisal will further deplete Morris's coffers if he adopts the subchapter
S strategy. Despite these complications, however, it is still likely that Morris
will find the subchapter S election to be an attractive solution to his family and
compensation problems.
Pass-Through Entity
Consider how a subchapter S corporation might operate were the corporation
to experience a period during which it were not so successful. Subchapter S
corporations (as well as most LLCs, partnerships, and limited partnerships) are
known as pass-through entities because they pass through their tax attributes
to their owners. This feature not only operates to pass through profits to the tax
returns of the owners (whether or not accompanied by cash) but also results in
the pass-through of losses. As discussed earlier, these losses can then be used
by the owners to offset income from other sources rather than having the losses
frozen on the corporate level, waiting for future profit.
The Code, not surprisingly, places limits on the amount of loss which can
be passed through to an owner's tax return. In a subchapter S corporation, the
320 Planning and Forecasting
amount of loss is limited by a stockholder's basis in his investment in the corporation.
Basis includes the amount invested as equity plus any amount the
stockholder has advanced to the corporation as loans. As the corporation operates,
the basis is raised by the stockholder's pro rata share of any profit made
by the corporation and lowered by his pro rata share of loss and any distributions
received by him.
These rules might turn Morris's traditional financing strategy on its head
the next time he sits down with the corporation's bank loan officer to negotiate
an extension of the corporation's financing. In the past, Morris has always attempted
to induce the loan officer to lend directly to the corporation. This way
Morris hoped to escape personal liability for the loan (although, in the beginning
he was forced to give the bank a personal guarantee). In addition, the corporation
could pay back the bank directly, getting a tax deduction for the
interest. If the loan were made to Morris, he would have to turn the money
over to the corporation and then depend upon the corporation to generate
enough profit so it could distribute monies to him to cover his personal debt
service. He might try to characterize those distributions to him as repayment
of a loan he made to the corporation, but, given the amount he had already advanced
to the corporation in its earlier years, the IRS would probably object to
the debt to equity ratio and recharacterize the payment as a nondeductible
dividend fully taxable to Morris. We have already discussed why Morris would
prefer to avoid characterizing the payment as additional compensation: His
level of compensation was already at the outer edge of reasonableness.
Under the subchapter S election, however, Morris no longer has to be
concerned about characterizing cash f low from the corporation to himself in a
manner that would be deductible by the corporation. Moreover, if the loan is
made to the corporation, it does not increase Morris's basis in his investment
(even if he has given a personal guarantee). This fact limits his ability to pass
losses through to his return. Thus, the subchapter S election may result in the
unseemly spectacle of Morris begging his banker to lend the corporation's
money directly to him, so that he may in turn advance the money to the corporation
and increase his basis. This would not be necessary in an LLC, since
most loans advanced to this form of business entity increase the basis of its
owners.
Passive Losses
No discussion of pass-through entities should proceed without at least touching
on what may have been the most creative set of changes made to the Code in recent
times. Prior to 1987, an entire industry had arisen to create and market
business enterprises whose main purpose was to generate losses to pass through
to their wealthy investor/owners. These losses, it was hoped, would normally be
generated by depreciation, amortization, and depletion. These would be mere
paper losses, incurred while the business itself was breaking even or possibly
generating positive cash flow. They would be followed some years in the future
Taxes and Business Decisions 321
by a healthy long-term capital gain. Thus, an investor with high taxable income
could be offered short-term pass-through tax losses with a nice long-term gain
waiting in the wings. In those days, long-term capital gain was taxed at only 40%
of the rate of ordinary income, so the tax was not only deferred but substantially
reduced. These businesses were known as tax shelters.
The 1986 Act substantially reduced the effectiveness of the tax shelter by
classifying taxable income and loss in three major categories: active, portfolio,
and passive. Active income consists mainly of wages, salaries, and bonuses;
portfolio income is mainly interest and dividends; while passive income and
loss consist of distributions from the so-called pass-through entities, such as
LLCs, limited partnerships, and subchapter S corporations. In their simplest
terms, the passive activity loss rules add to the limits set by the earlier described
basis limitations (and the similar so-called at-risk rules), making it impossible
to use passive losses to offset active or portfolio income. Thus, tax
shelter losses can no longer be used to shelter salaries or investment proceeds;
they must wait for the taxpayer's passive activities to generate the anticipated
end-of-the-line gains or be used when the taxpayer disposes of a passive activity
in a taxable transaction (see Exhibit 11.2).
Fortunately for Morris, the passive activity loss rules are unlikely to affect
his thinking for at least two reasons. First, the Code defines a passive activity
as the conduct of any trade or business "in which the taxpayer does not
materially participate." Material participation is further defined in a series of
Code sections and Temporary Regulations (which mock the concept of tax
simplification but let Morris off the hook) to include any taxpayer who participates
in the business for more than 500 hours per year. Morris is clearly materially
participating in his business despite his status as a stockholder of a
subchapter S corporation, and thus the passive loss rules do not apply to him.
EXHIBIT 11.2 Passive activity losses.
Active Portfolio Passive
Material
participation
Pass-throughs
from
partnerships,
Subchapter S,
LLCs, and so on
Passive loss
Salary,
bonus,
and so on
Interest,
dividends,
and so on
322 Planning and Forecasting
The second reason Morris is not concerned is that he does not anticipate any
losses from this business; historically, it is very profitable. Therefore, let us depart
from this detour into unprofitability and consider Morris's acquisition of
the plastics plant.
ACQUISITION
Morris might well believe that the hard part of accomplishing a successful acquisition
is locating an appropriate target and integrating it into his existing operation.
Yet, once again, he would be well advised to pay some attention to the
various tax strategies and results available to him when structuring the acquisition
transaction.
To begin with, Morris has a number of choices available to him in acquiring
the target business. Simply put, these choices boil down to a choice among
acquiring the stock of the owners of the business, merging the target corporation
into Plant Supply, or purchasing the assets and liabilities of the target. The
choice of method will depend on a number of factors, many of which are not
tax related. For example, acquisition by merger will force Plant Supply to acquire
all the liabilities of the target, even those of which neither it nor the target
may be aware. Acquisition of the stock of the target by Plant Supply also
results in acquisition of all liabilities but isolates them in a separate corporation,
which becomes a subsidiary. (The same result would be achieved by merging
the target into a newly formed subsidiary of Plant Supply—the so-called
triangular merger.) Acquisition of the assets and liabilities normally results
only in exposure to the liabilities Morris chooses to acquire and is thus an attractive
choice to the acquirer (Exhibit 11.3).
Yet tax factors normally play a large part in structuring an acquisition. For
example, if the target corporation has a history of losses and thus boasts a taxloss
carryforward, Morris may wish to apply such losses to its future profitable
operations. This application would be impossible if he acquired the assets and
liabilities of the target for cash since the target corporation would still exist
after the transaction, keeping its tax characteristics to itself. Cash mergers are
treated as asset acquisitions for tax purposes. However, if the acquirer obtains
the stock of the target, the acquirer has taken control of the taxable entity itself,
thus obtaining its tax characteristics for future use. This result inspired a
lively traffic in tax-loss carryforwards in years past, where failed corporations
were marketed to profitable corporations seeking tax relief.
Congress has put a damper on such activity by limiting the use of a taxloss
carryforward in each of the years following an ownership change of more
than 50% of a company's stock. The amount of that limit is the product of the
value of the business at acquisition (normally its selling price) times an interest
rate linked to the market for federal treasury obligations. This amount of taxloss
carryforward is available each year, until the losses expire (15 to 20 years
Taxes and Business Decisions 323
after they were incurred). Since a corporation with significant losses would
normally be valued at a relatively low amount, the yearly available loss is likely
to be relatively trivial.
Acquisition of the corporation's assets and liabilities for cash or through a
cash merger eliminates any use by the acquirer of the target's tax-loss carryforward,
leaving it available for use by the target's shell. This may be quite useful
to the target because, as discussed earlier, if it has not elected subchapter S
status for the past 10 years (or for the full term of its existence, if shorter), it is
likely to have incurred a significant gain upon the sale of its assets. This gain
would be taxable at the corporate level before the remaining portion of the
purchase price could be distributed to the target's shareholders (where it will
be taxed again).
EXHIBIT 11.3 Acquisition strategies.
T
Owned by
T's stockholders
Owned by
T's stockholders
Owned by
T's stockholders
Owned by
T's stockholders
Owned by
T's stockholders
Owned by
T's stockholders
Before After
A
Target Acquirer
T
T's assets
T
T
A
A
T
A A
T's assets
Merger
Acquisition
of stock
Purchase
of assets
324 Planning and Forecasting
The acquirer may have lost any carryforwards otherwise available, but it
does obtain the right to carry the acquired assets on its books at the price paid
(rather than the amount carried on the target's books). This is an attractive
proposition because the owner of assets used in business may deduct an annual
amount corresponding to the depreciation of those assets, subject only to the requirement
that it lower the basis of those assets by an equal amount. The amount
of depreciation available corresponds to the purchase price of the asset. This is
even more attractive because Congress has adopted available depreciation
schedules that normally exceed the rate at which assets actually depreciate.
Thus, these assets likely have a low basis in the hands of the target (resulting in
even more taxable gain to the target upon sale). If the acquirer were forced to
begin its depreciation at the point at which the target left off (as in a purchase of
stock), little depreciation would likely result. All things being equal (and especially
if the target has enough tax-loss carryforward to absorb any conceivable
gain), Morris would likely wish to structure his acquisition as an asset purchase
and allocate all the purchase price among the depreciable assets acquired.
This last point is significant because Congress does not recognize all assets
as depreciable. Generally speaking, an asset will be depreciable only if it
has a demonstrable "useful life." Assets that will last forever or whose lifetime
is not predictable are not depreciable, and the price paid for them will not result
in future tax deductions. The most obvious example of this type of asset is
land. Unlike buildings, land has an unlimited useful life and is not depreciable.
This distinction has spawned some very creative theories, including one enterprising
individual who purchased a plot of land containing a deep depression
that he intended to use as a garbage dump. The taxpayer allocated a significant
amount of his purchase price to the depression and took depreciation deductions
as the hole filled up.
Congress has recognized that the above rules give acquirers incentive to
allocate most of their purchase price to depreciable assets like buildings and
equipment and very little of the price to nondepreciable assets such as land.
Additional opportunities include allocating high prices to acquired inventory so
that it generates little taxable profit when sold. This practice has been limited
by legislation requiring the acquirer to allocate the purchase price in accordance
with the fair market value of the individual assets, applying the rest to
goodwill (which may now be depreciated over 15 years).
Although this legislation will limit Morris's options significantly, if he
chooses to proceed with an asset purchase, he should not overlook the opportunity
to divert some of the purchase price to consulting contracts for the previous
owners. Such payments will be deductible by Plant Supply over the life of
the agreements and are, therefore, just as useful as depreciation. However, the
taxability of such payments to the previous owners cannot be absorbed by the
target's tax-loss carryforward. And the amount of such deductions will be limited
by the now familiar "unreasonable compensation" doctrine. Payments for
agreements not to compete are treated as a form of goodwill and are deductible
over 15 years regardless of the length of such agreements.
Taxes and Business Decisions 325
EXECUTIVE COMPENSATION
Brad's compensation package raises a number of interesting tax issues that may
not be readily apparent but deserve careful consideration in crafting an offer to
him. Any offer of compensation to an executive of his caliber will include, at
the very least, a significant salary and bonus package. These will not normally
raise any sophisticated tax problems; the corporation will deduct these payments,
and Brad will be required to include them in his taxable income. The
IRS is not likely to challenge the deductibility of even a very generous salary,
since Brad is not a stockholder or family member and, thus, there is little likelihood
of an attempt to disguise a dividend.
Business Expenses
However, even in the area of salary, there are opportunities for the use of tax
strategies. For example, Brad's duties may include the entertainment of clients
or travel to suppliers and other business destinations. Brad could conceivably
fund these activities out of his own pocket on the theory that such amounts
have been figured into his salary. Such a procedure avoids the need for the
bookkeeping associated with expense accounts. If his salary ref lects these expectations,
Brad may not mind declaring the extra amount as taxable income,
since he will be entitled to an offsetting deduction for these business expenses.
Unfortunately, however, Brad would be in for an unpleasant surprise
under these circumstances. First of all, these expenses may not all be deductible
in full. Meals and entertainment expenses are deductible, if at all, only
to the extent they are not "lavish and extravagant," and even then they are deductible
only for a portion of the amount expended. In addition, Brad's business
expenses as an employee are considered "miscellaneous deductions"; they
are deductible only to the extent that they and other similarly classified deductions
exceed 2% of Brad's adjusted gross income. Thus, if Brad's adjusted gross
income is $150,000, the first $3,000 of miscellaneous deductions will not be
deductible.
Moreover, as itemized deductions, these deductions are valuable only to
the extent that they along with all other itemized deductions available to Brad
exceed the "standard deduction," an amount Congress allows each taxpayer to
deduct, if all itemized deductions are foregone. Furthermore, until 2010, itemized
deductions that survive the above cuts are further limited for taxpayers
whose incomes are over $132,950 (the 2001 inf lation-adjusted amount). The
deductibility of Brad's business expenses is, therefore, greatly in doubt.
Knowing all this, Brad would be well advised to request that Morris revise
his compensation package. Brad should request a cut in pay by the amount of
his anticipated business expenses, along with a commitment that the corporation
will reimburse him for such expenses or pay them directly. In that case,
Brad will be in the same economic position, since his salary is lowered only
by the amount he would have spent anyway. In fact, his economic position is
326 Planning and Forecasting
enhanced, since he pays no taxes on the salary he does not receive and escapes
from the limitations on deductibility described previously.
The corporation pays out no more money this way than it would have if
the entire amount were salary. From a tax standpoint, the corporation is only
slightly worse off, since the amount it would have previously deducted as salary
can now still be deducted as ordinary and necessary business expenses (with
the sole exception of the limit on meals and entertainment). In fact, were
Brad's salary below the Social Security contribution limit (FICA), both Brad
and the corporation would be better off because what was formerly salary (and
thus subject to additional 7.65% contributions to FICA by both employer and
employee) would now be merely business expenses and exempt from FICA.
Before Brad and Morris adopt this strategy, however, they should be aware
that in recent years, Congress has turned a sympathetic ear to the frustration
the IRS has expressed about expense accounts. Legislation has conditioned the
exclusion of amounts paid to an employee as expense reimbursements upon the
submission by the employee to the employer of reliable documentation of such
expenses. Brad should get into the habit of keeping a diary of such expenses for
tax purposes.
Deferred Compensation
Often, a high-level executive will negotiate a salary and bonus that far exceed
her current needs. In such a case, the executive might consider deferring some
of that compensation until future years. Brad may feel, for example, that he
would be well advised to provide for a steady income during his retirement
years, derived from his earnings while an executive of Plant Supply. He may be
concerned that he would simply waste the excess compensation and consider a
deferred package as a form of forced savings. Or, he may wish to defer receipt
of the excess money to a time (such as retirement) when he believes he will be
in a lower tax bracket. This latter consideration was more common when the
federal income tax law encompassed a large number of tax brackets and the
highest rate was 70%.
Whatever Brad's reasons for considering a deferral of some of his salary,
he should be aware that deferred compensation packages are generally classified
as one of two varieties for federal income tax purposes. The first such
category is the qualified deferred compensation plan, such as the pension,
profit-sharing, or stock bonus plan. All these plans share a number of characteristics.
First and foremost, they afford taxpayers the best of all possible
worlds by granting the employer a deduction for monies contributed to the plan
each year, allowing those contributions to be invested and to earn additional
monies without the payment of current taxes, and taxing the employee only
upon withdrawal of funds in the future. However, in order to qualify for such
favorable treatment, these plans must conform to a bewildering array of conditions
imposed by both the Code and the Employee Retirement Income Security
Act (ERISA). Among these requirements is the necessity to treat all
Taxes and Business Decisions 327
employees of the corporation on a nondiscriminatory basis with respect to the
plan, thus rendering qualified plans a poor technique for supplementing a compensation
package for a highly paid executive.
The second category is nonqualified plans. These come in as many varieties
as there are employees with imaginations, but they all share the same disfavored
tax treatment. The employer is entitled to its deduction only when the
employee pays tax on the money, and if money is contributed to such a plan the
earnings are taxed currently. Thus, if Morris were to design a plan under which
the corporation receives a current deduction for its contributions, Brad will
pay tax now on money he will not receive until the future. Since this is the
exact opposite of what Brad (and most employees) have in mind, Brad will most
likely have to settle for his employer's unfunded promise to pay him the deferred
amount in the future.
Assuming Brad is interested in deferring some of his compensation, he
and Morris might well devise a plan which gives them as much f lexibility as
possible. For example, Morris might agree that the day before the end of each
pay period, Brad could notify the corporation of the amount of salary, if any,
he wished to defer for that period. Any amount thus deferred would be carried
on the books of the corporation as a liability to be paid, per their agreement,
with interest after Brad's retirement. Unfortunately, such an arrangement
would be frustrated by the "constructive receipt" doctrine. Using this potent
weapon, the IRS will impose a tax (allowing a corresponding employer deduction)
on any compensation that the employee has earned and might have chosen
to receive, regardless of whether he so chooses. The taxpayer may not turn his
back upon income otherwise unconditionally available to him.
Taking this theory to its logical conclusion, one might argue that deferred
compensation is taxable to the employee because he might have received it if
he had simply negotiated a different compensation package. After all, the impetus
for deferral in this case comes exclusively from Brad; Morris would have
been happy to pay the full amount when earned. But the constructive receipt
doctrine does not have so extensive a reach. The IRS can tax only monies the
taxpayer was legally entitled to receive, not monies he might have received if
he had negotiated differently. In fact, the IRS will even recognize elective deferrals
if the taxpayer must make the deferral election sufficiently long before
the monies are legally earned. Brad might, therefore, be allowed to choose deferral
of a portion of his salary if the choice must be made at least six months
before the pay period involved.
Frankly, however, if Brad is convinced of the advisability of deferring a
portion of his compensation, he is likely to be concerned less about the irrevocability
of such election than about ensuring that the money will be available to
him when it is eventually due. Thus, a mere unfunded promise to pay in the future
may result in years of nightmares over a possible declaration of bankruptcy
by his employer. Again, left to their own devices, Brad and Morris might well
devise a plan under which Morris contributes the deferred compensation to a
trust for Brad's benefit, payable to its beneficiary upon his retirement. Yet such
328 Planning and Forecasting
an arrangement would be disastrous to Brad, since the IRS would currently assess
income tax to Brad on such an arrangement, using the much criticized "economic
benefit" doctrine. Under this theory, monies irrevocably set aside for
Brad grant him an economic benefit (presumably by improving his net worth or
otherwise improving his creditworthiness) upon which he must pay tax.
If Brad were aware of this risk, he might choose another method to protect
his eventual payout by requiring the corporation to secure its promise to
pay with such devices as a letter of credit or a mortgage or security interest in
its assets. All of these devices, however, have been successfully taxed by the
IRS under the same economic benefit doctrine. Very few devices have survived
this attack. However, the personal guarantee of Morris himself (merely
another unsecured promise) would not be considered an economic benefit by
the IRS.
Another successful strategy is the so-called rabbi trust, a device first
used by a rabbi who feared his deferred compensation might be revoked by a
future hostile congregation. This device works similarly to the trust described
earlier except that Brad would not be the only beneficiary of the
money contributed. Under the terms of the trust, were the corporation to experience
financial reverses, the trust property would be available to the corporation's
creditors. Since the monies are thus not irrevocably committed to
Brad, the economic benefit doctrine is not invoked. This device does not protect
Brad from the scenario of his bankruptcy nightmares, but it does protect
him from a corporate change of heart regarding his eventual payout. From
Morris's point of view, he may not object to contributing to a rabbi trust,
since he was willing to pay all the money to Brad as salary, but he should be
aware that since Brad escapes current taxation the corporation will not receive
a deduction for these expenses until the money is paid out of the trust
in the future.
Interest-Free Loans
As a further enticement to agree to work for the new ownership of the plant,
Morris might additionally offer to lend Brad a significant amount of money to
be used, for example, to purchase a new home or acquire an investment portfolio.
Significant up-front money is often part of an executive compensation
package. While this money could be paid as a bonus, Morris might well want
some future repayment (perhaps as a way to encourage Brad to stay in his new
position). Brad might wish to avoid the income tax bite on such a bonus so he
can retain the full amount of the payment for his preferred use. Morris and
Brad might well agree to an interest rate well below the market or even no interest
at all to further entice Brad to take his new position. Economically, this
would give Brad free use of the money for a period of time during which it
could earn him additional income with no offsetting expense. In a sense, he
would be receiving his salary in advance while not paying any income tax until
he earned it. Morris might well formalize the arrangement by reserving the
Taxes and Business Decisions 329
right to offset loan repayments against future salary. The term of the loan
might even be accelerated should Brad leave the corporation's employ.
This remarkable arrangement was fairly common until fairly recently.
Under current tax law, however, despite the fact that little or no interest passes
between Brad and the corporation, the IRS deems full market interest payments
to have been made and further deems that said amount is returned to
Brad by his employer. Thus, each year, Brad is deemed to have made an interest
payment to the corporation for which he is entitled to no deduction. Then,
when the corporation is deemed to have returned the money to him, he realizes
additional compensation on which he must pay tax. The corporation
realizes additional interest income but gets a compensating deduction for additional
compensation paid (assuming it is not excessive when added to Brad's
other compensation).
Moreover, the IRS has not reserved this treatment for employers and employees
only. The same treatment is given to loans between corporations and
their shareholders and loans between family members. In the latter situation,
although there is no interest deduction for the donee, the deemed return of
the interest is a gift and is thus excluded from income. The donor receives interest
income and has no compensating deduction for the return gift. In fact, if
the interest amount is large enough, he may have incurred an additional gift tax
on the returned interest. The amount of income created for the donor, however,
is limited to the donee's investment income except in very large loans. In
the corporation/stockholder situation, the lender incurs interest income and
has no compensating deduction as its deemed return of the interest is characterized
as a dividend. Thus the IRS gets increased tax from both parties unless
the corporation has elected subchapter S (see Exhibit 11.4).
All may not be lost in this situation, however. Brad's additional income tax
arises from the fact that there is no deduction allowable for interest paid on unsecured
personal loans. Interest remains deductible, however, in limited
amounts on loans secured by a mortgage on either of the taxpayer's principal or
EXHIBIT 11.4 Taxable interest.
Employer
Interest
income
Deductible
compensation
Nondeductible
interest
Taxable
compensation
Employee
Employer
Interest
income
Nondeductible
compensation
Nondeductible
interest
Dividend
income
Stockholder
Employer
Interest
income
Nondeductible
gift (gift tax)
Nondeductible
interest
Nontaxable
gift
Donee
330 Planning and Forecasting
secondary residence. If Brad grants Plant Supply a mortgage on his home to secure
the repayment of his no- or low-interest loan, his deemed payment of
market interest may become deductible mortgage interest and may thus offset
his additional deemed compensation from the imaginary return of this interest.
Before jumping into this transaction, however, Brad will have to consider the
limited utility of itemized deductions described earlier as well as certain limits
on the deductibility of mortgage interest.
SHARING THE EQUITY
If Brad is as sophisticated and valuable an executive employee as Morris believes
he is, Brad is likely to ask for more than just a compensation package, deferred
or otherwise. Such a prospective employee often demands a "piece of
the action," or a share in the equity of the business so that he may directly
share in the growth and success he expects to create. Morris may even welcome
such a demand because an equity share (if not so large as to threaten
Morris's control) may serve as a form of golden handcuffs giving Brad additional
reason to stay with the company for the long term.
Assuming Morris is receptive to the idea, there are a number of different
ways to grant Brad a share of the business. The most direct way would be to
grant him shares of the corporation's stock. These could be given to Brad without
charge, for a discount from fair market value or for their full value, depending
upon the type of incentive Morris wishes to design. In addition, given
the privately held nature of Morris's corporation, the shares would probably
carry restrictions designed to keep the shares from ending up in the hands of
persons who are not associated with the company. Thus, the corporation would
retain the right to repurchase the shares should Brad ever leave the corporation's
employ or want to sell or transfer the shares to a third party. Finally, in
order to encourage Brad to stay with the company, the corporation would probably
reserve the right to repurchase the shares from Brad at cost should Brad's
employment end before a specified time. As an example, all the shares (called
restricted stock) would be subject to forfeiture at cost (regardless of their then
actual value) should Brad leave before one year; two-thirds would be forfeited
if he left before two years; and one-third if he left before three years. The
shares not forfeited (called vested shares) would be purchased by the corporation
at their full value should Brad ever leave or attempt to sell them.
One step back from restricted stock is the stock option. This is a right
granted to the employee to purchase a particular number of shares for a fixed
price over a defined period of time. Because the price of the stock does not
change, the employee has effectively been given the ability to share in whatever
growth the company experiences during the life of the option, without
paying for the privilege. If the stock increases in value, the employee will exercise
the option near the end of the option term. If the stock value does not
grow, the employee will allow the option to expire, having lost nothing. The
Taxes and Business Decisions 331
stock option is a handy device when the employee objects to paying for his
piece of the action (after all, he is expecting compensation, not expense) but
the employer objects to giving the employee stock whose current value represents
growth from the period before the employee's arrival. Again, the exercise
price can be more than, equal to, or less than the fair market value of the stock
at the time of the grant, depending upon the extent of the incentive the employer
wishes to give. Also, the exercisability of the option will likely vest
in stages over time.
Often, however, the founding entrepreneur cannot bring herself to give
an employee a current or potential portion of the corporation's stock. Although
she has been assured that the block of stock going to the employee is too small
to have any effect on her control over the company, the objection may be psychological
and impossible to overcome. Or, in the case of a subchapter S corporation
operating in numerous states, the employee may not want to have to
file state income tax returns in all those jurisdictions. The founder seeks a device
which can grant the employee a growth potential similar to that granted
by stock ownership but without the stock. Such devices are often referred to as
phantom stock or stock appreciation rights (SARs). In a phantom stock plan,
the employee is promised that he may, at any time during a defined period so
long as he remains employed by the corporation, demand payment equal to the
then value of a certain number of shares of the corporation's stock. As the corporation
grows, so does the amount available to the employee just as would be
the case if he actually owned some stock. SARs are very similar except that the
amount available to the employee is limited to the growth, if any, that the
given number of shares has experienced since the date of grant.
Tax Effects of Phantom Stock and SARs
Having described these devices to Morris and Brad, it is, of course, important
to discuss their varying tax impacts upon employer and employee. If Brad has
been paying attention, he might immediately object to the phantom stock and
SARs as vulnerable to the constructive receipt rule. After all, if he may claim
the current value of these devices at any time he chooses, might not the IRS insist
that he include each year's growth in his taxable income as if he had
claimed it? Although the corporation's accountants will require that these devices
be accounted for in that way on the corporation's financial statements,
the IRS has failed in its attempts to require inclusion of these amounts in taxable
income because the monies are not unconditionally available to the taxpayer.
In order to receive the money, one must give up any right to continue to
share in the growth represented by one's phantom stock or SAR. If the right is
not exercisable without cost, the income is not constructively received.
However, there is another good reason for Brad to object to phantom
stock and SARs from a tax point of view. Unlike stock and stock options, both
of which represent a recognized form of intangible capital asset, phantom
stock and SARs are really no different from a mere promise by the corporation
332 Planning and Forecasting
to pay a bonus based upon a certain formula. Since these devices are not recognized
as capital assets, they are not eligible to be taxed as long-term capital
gains when redeemed. This difference is quite meaningful since the maximum
tax rate on ordinary income in 2001 is 39.1% and on long-term capital gains is
20%. Thus, Brad may have good reason to reject phantom stock and SARs and
insist on the real thing.
Taxability of Stock Options
If Morris and Brad resolve their negotiations through the use of stock options,
careful tax analysis is again necessary. The Code treats stock options in three
ways depending on the circumstances, and some of these circumstances are
well within the control of the parties (see Exhibit 11.5).
If a stock option has a "readily ascertainable value," the IRS will expect
the employee to include in his taxable income the difference between the
value of the option and the amount paid for it (the amount paid is normally
zero). Measured in that way, the value of an option might be quite small, especially
if the exercise price is close or equal to the then fair market value of the
underlying stock. After all, the value of a right to buy $10 of stock for $10 is
only the speculative value of having that right when the underlying value has
increased. That amount is then taxed as ordinary compensation income, and
the employer receives a compensating deduction for compensation paid. When
the employee exercises the option, the Code imposes no tax, nor does the employer
receive any further deduction. Finally, should the employee sell the
stock, the difference between, on the one hand, the price received and on the
other the total of the previously taxed income and the amounts paid for the option
and the stock is included in his income as a capital gain. No deduction is
then granted to the employer since the employee's decision to sell his stock is
not deemed to be related to the employer's compensation policy.
This taxation scenario is normally quite attractive to the employee because
she is taxed upon a rather small amount at first, escapes tax entirely upon
EXHIBIT 11.5 Taxation of stock options.
Grant Exercise Sale
Readily Ascertainable Value
Employee Tax of value No tax Capital gain
Employer Deduction No deduction No deduction
No Readily Ascertainable Value
Employee No tax Tax on spread Capital gain
Employer No deduction Deduction No deduction
ISOP
Employee No tax No tax Capital gain
Employer No deduction No deduction No deduction
Taxes and Business Decisions 333
exercise, and then pays tax on the growth at a time when she has realized cash
with which to pay the tax at a lower long-term capital gain rate. Although the
employer receives little benefit, it has cost the employer nothing in hard assets,
so any benefit would have been a windfall.
Because this tax scenario is seen as very favorable to the employee, the
IRS has been loathe to allow it in most cases. Generally, the IRS will not recognize
an option as having a readily ascertainable value unless the option is
traded on a recognized exchange. Short of that, a case has occasionally been
made when the underlying stock is publicly traded, such that its value is readily
ascertainable. But the IRS has drawn the line at options on privately held
stock and at all options that are not themselves transferable. Since Morris's corporation
is privately held and since he will not tolerate Brad's reserving the
right to transfer the option to a third party, there is no chance of Brad's taking
advantage of this beneficial tax treatment.
The second tax scenario attaches to stock options which do not have a
readily ascertainable value. Since, by definition, one cannot include their value
in income on the date of grant (it is unknown), the Code allows the grant to escape
taxation. However, upon exercise, the taxpayer must include in income
the difference between the then fair market value of the stock purchased
and the total paid for the option and stock. When the purchased stock is later
sold, the further growth is taxed at the applicable rate for capital gain. The employer
receives a compensation deduction at the time of exercise and no deduction
at the time of sale. Although the employee receives a deferral of
taxation from grant to exercise in this scenario, this method of taxation is generally
seen as less advantageous to the employee, since a larger amount of income
is exposed to ordinary income rates, and this taxation occurs at a time
when the taxpayer has still not received any cash from the transaction with
which to pay the tax.
Recognizing the harshness of this result, Congress invented a third taxation
scenario which attaches to incentive stock options (ISOs). The recipient of
such an option escapes tax upon grant of the option and again upon exercise.
Upon sale of the underlying stock, the employee includes in taxable income the
difference between the price received and the total paid for the stock and option
and pays tax on that amount at long-term capital gain rates. This scenario is
extremely attractive to the employee who defers all tax until the last moment
and pays at a lower rate. Under this scenario, the employer receives no deduction
at all, but since the transaction costs him nothing, that is normally not a
major concern. Lest you believe that ISOs are the perfect compensation device,
however, be aware that, although the employee escapes income taxation
upon exercise of the option, the exercise may be deemed taxable under the alternative
minimum tax described later in this chapter.
The Code imposes many conditions upon the grant of an incentive stock
option. Among these are that the options must be granted pursuant to a written
plan setting forth the maximum number of shares available and the class of
employees eligible; only employees are eligible recipients; the options cannot
334 Planning and Forecasting
be transferable; no more than $100,000 of underlying stock may be initially exercisable
in any one year by any one employee; the exercise price of the options
must be no less than the fair market value of the stock on the date of grant; and
the options must expire substantially simultaneously with the termination of
the employee's employment. Perhaps most important, the underlying stock may
not be sold by the employee prior to the expiration of two years from the option
grant date or one year from the exercise date, whichever is later.
This latter requirement has led to what was probably an unexpected consequence.
Assume that Plant Supply has granted an incentive stock option to
Brad. Assume further that Brad has recently exercised the option and has plans
to sell the stock he received. It may occur to Brad that by waiting a year to resell,
he will be risking the vagaries of the market for a tax savings which cannot
exceed 19.1% (the difference between the maximum income-tax rate of 39.1%
and the maximum capital-gain rate of 20%). By selling early, Brad will lose the
chance to treat the option as an incentive stock option but will pay, at worst,
only a marginally higher amount at a time when he does have the money to pay
it. Furthermore, by disqualifying the options, he will be giving his employer a
tax deduction at the time of exercise. An enterprising employee might go so far
as to offer to sell early in exchange for a split of the employer's tax savings.
Tax Impact on Restricted Stock
The taxation of restricted stock is not markedly different from the taxation
of nonqualified stock options without a readily ascertainable value (see Exhibit
11.6). Restricted stock is defined as stock that is subject to a condition
that affects its value to the holder and which will lapse upon the happening of
an event or the passage of time. The Code refers to this as "a substantial risk of
forfeiture." Since the value of the stock to the employee is initially speculative,
the receipt of the stock is not considered a taxable event. In other words, since
Brad may have to forfeit whatever increased value his stock may acquire, if he
leaves the employ of the corporation prior to the agreed time, Congress has allowed
him not to pay the tax until he knows for certain whether he will be able
to retain that value. When the stock is no longer restricted (when it "vests"),
EXHIBIT 11.6 Restricted stock tax impact.
Grant Restriction Removed Sale
Restricted Stock
Employee No tax Tax based on current value Capital gain
Employer No Deduction Deduction No deduction
Restricted Stock 83(b) Election
Employee Tax based on value without No tax Capital gain
restriction
Employer Deduction No deduction No deduction
Taxes and Business Decisions 335
the tax is payable. Of course, Congress is not being entirely altruistic in this
case; the amount taxed when the stock vests is not the difference between
what the employee pays for it and its value when first received by the employee
but the difference between the employee's cost and the stock's value at the
vesting date. If the value of the stock has increased, as everyone involved has
hoped, the IRS receives a windfall. Of course, the employer receives a compensating
deduction at the time of taxation, and further growth between the
vesting date and the date of sale is taxed upon sale at appropriate capital gain
rates. No deduction is then available to the employer.
Recognizing that allowing the employee to pay a higher tax at a later time
is not an unmixed blessing, Congress has provided that an employee who receives
restricted stock may, nonetheless, elect to pay ordinary income tax on
the difference between its value at grant and the amount paid for it, if the employee
files notice of that election within 30 days of the grant date (the socalled
83b election). Thus, the employee can choose for herself which gamble
to accept.
This scenario can result in disaster for the unaware employee. Assume
that Morris and Brad resolve their differences by allowing Brad to have an equity
stake in the corporation, if he is willing to pay for it. Thus, Brad purchases
5% of the corporation for its full value on the date he joins the corporation,
say, $5.00 per share. Since this arrangement still provides incentive in the form
of a share of growth, Morris insists that Brad sell the stock back to the corporation
for $5.00 per share should he leave the corporation before he has been
employed for three years. Brad correctly believes that since he has bought
$5.00 shares for $5.00 he has no taxable income, and he reports nothing on his
income tax return that year.
Brad has failed to realize that despite his paying full price, he has received
restricted stock. As a result, Congress has done him the favor of imposing
no tax until the restrictions lapse. Three years from now, when the shares
may have tripled in value and have finally vested, Brad will discover to his horror
that he must include $10.00 per share in his taxable income for that year.
Despite the fact that he had no income to declare in the year of grant, Brad
must elect to include that nullity in his taxable income for that year by filing
such an election with the IRS within 30 days of his purchase of the stock.
In situations in which there is little difference between the value of stock
and the amount an employee will pay for it (e.g., in start-up companies when
stock has little initial value), a grant of restricted stock accompanied by an 83b
election may be preferable to the grant of an ISO, since it avoids the alternative
minimum tax which may be imposed upon exercise of an ISO.
VACATION HOME
Morris had much reason to congratulate himself on successfully acquiring the
plastics-molding operation as well as securing the services of Brad through an
336 Planning and Forecasting
effective executive compensation package. In fact, the only real disappointment
for Morris was that the closing of the deal was scheduled to take place
during the week in which he normally took his annual vacation.
Some years ago, Morris had purchased a country home for use by himself
and his wife as a weekend getaway and vacation spot. With the press of business,
however, Morris and his wife had been able to use the home only on occasional
weekends and for his two-week summer vacation each year. Morris
always took the same two weeks for his vacation so he could indulge his love of
golf. Each year, during those two weeks, the professional golfers would come to
town for their annual tournament. Hotels were always booked far in advance,
and Morris felt lucky to be able to walk from his home to the first tee and enjoy
his favorite sport played by some of the world's best.
Some of Morris's friends had suggested that Morris rent his place during
the weeks that he and his wife didn't use it. Even if such rentals would not
generate much cash during these off-season periods, it might allow Morris to
deduct some of the expenses of keeping the home, such as real estate taxes,
mortgage payments, maintenance, and depreciation. Morris could see the benefit
in that, since the latter two expenses were deductible only in a business
context. Although taxes and mortgage interest were deductible as personal expenses
(assuming, in the case of mortgage interest, that Morris was deducting
such payments only with respect to this and his principal residence and no
other home), the previously mentioned limits on the use of itemized deductions
made the usefulness of these deductions questionable.
However, in addition to the inconvenience of renting one's vacation home,
Morris had discovered a few unfortunate tax rules which had dissuaded him
from following his friends' advice. First, the rental of a home is treated by the
Code in a fashion similar to the conduct of a business. Thus, Morris would generate
deductions only to the extent that his expenses exceeded his rental income.
In addition, to the extent he could generate such a loss, the rental of real
estate is deemed to be a passive activity under the Code, regardless of how
much effort one puts into the process. Thus, in the absence of any relief provision,
these losses would be deductible only against other passive income and
would not be usable against salary, bonus, or investment income.
Such a relief provision does exist, however, for rental activities in which
the taxpayer is "actively" involved. In such a case, the taxpayer may deduct up
to $25,000 of losses against active or portfolio income, unless his total income
(before any such deduction) exceeds $100,000. The amount of loss which may
be used by such taxpayer, free of the passive activity limitations, is then lowered
by $1 for every $2 of additional income, disappearing entirely at $150,000.
Given his success in business, the usefulness of rental losses, in the absence of
passive income, seemed problematic to Morris, at best.
Another tax rule appeared to Morris to limit the usefulness of losses even
further. Under the Code, a parcel of real estate falls into one of three categories:
personal use, rental use, or mixed use. A personal use property is one
which is rented 14 days or less in a year and otherwise used by the taxpayer and
Taxes and Business Decisions 337
his family. No expenses are deductible for such a facility except taxes and mortgage
interest. A rental use property is used by the taxpayer and his family for
less than 15 days (or 10% of the number of rental days) and otherwise offered
for rental. All the expenses of such an activity are deductible, subject to the
passive loss limitations. A mixed use facility is one that falls within neither of
the other two categories.
If Morris were to engage in a serious rental effort of his property, his occasional
weekend use combined with his two-week stay around the golf tournament
would surely result in his home falling into the mixed use category. This
would negatively impact him in two ways. The expenses that are deductible
only for a rental facility (such as maintenance and depreciation) would be deductible
only on a pro rata basis for the total number of rental days. Worse
yet, the expenses of the rental business would be deductible only to the extent
of the income, not beyond. Expenses which would be deductible anyway (taxes
and mortgage interest) are counted first in this calculation, and only then are
the remaining expenses allowed. The result of all this is that it would be impossible
for Morris to generate a deductible loss, even were it possible to use
such a loss in the face of the passive loss limitations.
Naturally, therefore, Morris had long since decided not to bother with attempting
to rent his country getaway when he was unable to use it. However,
the scheduling of the closing this year presents a unique tax opportunity of
which he may be unaware. In a rare stroke of fairness, the Code, though denying
any deduction of not otherwise deductible expenses in connection with a
home rented for 14 days or less, reciprocates by allowing taxpayers to exclude
any rental income should they take advantage of the 14-day rental window.
Normally, such an opportunity is of limited utility, but with the tournament
coming to town and the hotels full Morris is in a position to make a killing by
renting his home to a golfer or spectator during this time at inf lated rental
rates. All that rental income would be entirely tax-free. Just be sure the tenants
don't stay beyond two weeks.
LIKE-KIND EXCHANGES
Having acquired the desired new business and secured the services of the individual
he needed to run it, Morris turned his attention to consolidating his
two operations so that they might function more efficiently. After some time,
he realized that the factory building acquired with the plastics business was
not contributing to increased efficiency because of its age and, more important,
because of its distance from Morris's home office. Morris located a more
modern facility near his main location that could accommodate both operations
and allow him to eliminate some amount of duplicative management.
Naturally, Morris put the molding facility on the market and planned to
purchase the new facility with the proceeds of the old one plus some additional
capital. Such a strategy will result in a tax on the sale of the older facility equal
338 Planning and Forecasting
to the difference between the sale price and Plant Supply's basis in the building.
If Morris purchased the molding company by merging or purchasing its
assets for cash, then the capital gain to be taxed here may be minimal because
it would consist only of the growth in value since this purchase plus any
amount depreciated after the acquisition. If, however, Morris acquired the
molding company through a purchase of stock, his basis would be the old company's
preacquisition basis, and the capital gain may be considerable. Either
way, it would surely be desirable to avoid taxation on this capital gain.
The Code affords Morris the opportunity to avoid this taxation if, instead
of selling his old facility and buying a new one, he can arrange a trade of the old
for the new so that no cash falls into his hands. Under Section 1031 of the
Code, if properties of "like kind" used in a trade or business are exchanged, no
taxable event has occurred. The gain on the disposition of the older facility is
merely deferred until the eventual disposition of the newer facility. This deferral
is accomplished by calculating the basis in the newer facility, starting with
its fair market value on the date of acquisition, and subtracting from that
amount the gain not recognized on the sale of the older facility. That process
builds the unrecognized gain into the basis of the newer building so that it will
be recognized (along with any future gain) upon its later sale. There has been
considerable confusion and debate over what constitutes like-kind property
outside of real estate, but there is no doubt that a trade of real estate used in
business for other real estate to be used in business will qualify under Section
1031.
Although undoubtedly attracted by this possibility, Morris would quickly
point out that such an exchange would be extremely rare since it is highly unlikely
that he would be able to find a new facility which is worth exactly the
same amount as his old facility, and thus any such exchange would have to involve
a payment of cash as well as an exchange of buildings. Fortunately, however,
Section 1031 recognizes that reality by providing that the exchange is still
nontaxable to Morris so long as he does not receive any non-like-kind property
(i.e., cash). Such non-like-kind property received is known as boot, and would
include, besides cash, any liability of Morris's (such as his mortgage debt) assumed
by the exchange partner. The facility he is purchasing is more expensive
than the one he is selling, so Morris would have to add some cash, not receive
it. Thus, the transaction does not involve the receipt of boot and still qualifies
for tax deferral. Moreover, even if Morris did receive boot in the transaction,
he would recognize gain only to the extent of the boot received, so he might
still be in a position to defer a portion of the gain involved. Of course, if he received
more boot than the gain in the transaction, he would recognize only the
amount of the gain, not the full amount of the boot.
But Morris has an even more compelling, practical objection to this plan.
How often will the person who wants to purchase your facility own the exact facility
you wish to purchase? Not very often, he would surmise. In fact, the proposed
buyer of his old facility is totally unrelated to the current owner of the
facility Morris wishes to buy. How then can one structure this as an exchange of
Taxes and Business Decisions 339
the two parcels of real estate? It would seem that a taxable sale of the one followed
by a purchase of the other will be necessary in almost every case.
Practitioners have, however, devised a technique to overcome this problem,
known as the three-corner exchange. In a nutshell, the transaction is
structured by having the proposed buyer of Morris's old facility use his purchase
money (plus some additional money contributed by Morris) to acquire
the facility Morris wants to buy, instead of giving that money to Morris. Having
thus acquired the new facility, he then trades it to Morris for Morris's old facility.
When the dust settles, everyone is in the same position he would have occupied
in the absence of an exchange. The former owner of the new facility
has his cash; the proposed buyer of Morris's old facility now owns that facility
and has spent only the amount he proposed to spend; and Morris has traded the
old facility plus some cash for the new one. The only party adversely affected is
the IRS, which now must wait to tax the gain in Morris's old facility until he
sells the new one.
This technique appears so attractive that when practitioners first began
to use it, they attempted to employ the technique even when the seller of the
old facility had not yet found a new facility to buy. They merely had the buyer
of the old facility place the purchase price in escrow and promise to use it to
buy a new facility for the old owner as soon as she picked one out. Congress has
since limited the use of these so-called delayed like-kind exchanges by requiring
the seller of the old facility to identify the new facility to be purchased
within 45 days of the transfer of the old one and by further requiring that the
exchange be completed within six months of the first transfer.
DIVIDENDS
Some time after Morris engineered the acquisition of the molding facility, the
hiring of Brad to run it, and the consolidation of his company's operations
through the like-kind exchange, Plant Supply was running smoothly and profitably
enough for Morris's thoughts to turn to retirement. Morris intended to
have a comfortable retirement funded by the fruits of his lifelong efforts on
behalf of the company, so it was not unreasonable for him to consider funding
his retirement through dividends on what would still be his considerable holdings
of the company's stock. Although Brad already held some stock and Morris
expected that Lisa and Victor would hold some at that time, he still expected to
have a majority position and thus sufficient control of the board of directors to
ensure such distributions.
Morris also knew enough about tax law, however, to understand that such
distributions would cause considerable havoc from a tax viewpoint. We have already
discussed how characterizing such distributions as salary or bonus would
avoid double taxation, but with Morris no longer working for the company such
characterization would be unreasonable. These payments would be deemed
dividends on his stock. They would be nondeductible to the corporation (if it
340 Planning and Forecasting
were not a subchapter S corporation at the time) and would be fully taxable to
him. But Morris had another idea. He would embark on a strategy of turning in
small amounts of his stock on a regular basis in exchange for the stock's value.
Although not a perfect solution, the distributions to him would no longer be
dividends but payments in redemption of stock. Thus, they would be taxable
only to the extent they exceeded his basis in the stock and, even then, only at
long-term capital gain rates (not as ordinary income). Best of all, if such redemptions
were small enough, he would retain his control over the company for
as long as he retained over 50% of its outstanding stock.
However, the benefits of this type of plan have attracted the attention of
Congress and the IRS over the years. If an individual can draw monies out of a
corporation, without affecting the control he asserts through the ownership of
his stock, is he really redeeming his stock or simply engaging in a disguised dividend?
Congress has answered this question with a series of Code sections purporting
to define a redemption.
Substantially Disproportionate Distributions
Most relevant to Morris is Section 302(b)(2), which provides that a distribution
in respect of stock is a redemption (and thus taxable as a capital gain after subtraction
of basis), only if it is substantially disproportionate. This is further defined
by requiring that the stockholder hold, after the distribution, less than
half of the total combined voting power of all classes of stock and less than
80% of the percentage of the company's total stock that he owned prior to the
distribution.
Thus, if Morris intended to redeem 5 shares of the company's stock at a
time when he owned 85 of the company's outstanding 100 shares, he would be
required to report the entire distribution as a dividend. His percentage of
ownership would still be 50% or more (80 of 95, or 84%), which in itself dooms
the transaction. In addition, his percentage of ownership will still be 80% or
more than his percentage before the distribution (dropping only from 85% to
84%—99% of his percentage prior to the distribution).
To qualify, Morris would have to redeem 71 shares, since only that
amount would drop his control percentage below 50% (14 of 29, or 48%). And
since his percentage of control would have dropped from 85% to 48%, he
would retain only 56% of the percentage he previously had (less than 80%).
Yet, even such a draconian sell-off as thus described would not be sufficient
for the Code. Congress has taken the position that the stock ownership of
persons other than oneself must be taken into account in determining one's
control of a corporation. Under these so-called attribution rules, a stockholder
is deemed to control stock owned not only by himself but also by his spouse,
children, grandchildren, and parents. Furthermore, stock owned by partnerships,
estates, trusts, and corporations affiliated with the stockholder may also
be attributed to him. Thus, assuming that Lisa and Victor owned 10 of the remaining
15 shares of stock (with Brad owning the rest), Morris begins with
Taxes and Business Decisions 341
95% of the control and can qualify for a stock redemption only by selling all his
shares to the corporation.
Complete Termination of Interest
Carried to its logical conclusion, even a complete redemption would not qualify
for favorable tax treatment, since Lisa and Victor's stock would still be attributed
to Morris, leaving him in control of 67% of the corporation's stock.
Fortunately, however, Code Section 302(b)(3) provides for a distribution to be
treated as a redemption if the stockholder's interest in the corporation is completely
terminated. The attribution rules still apply under this section, but they
may be waived if the stockholder files a written agreement with the IRS requesting
such a waiver. In such an agreement, Morris would be required to divest
himself of any relationship with the corporation other than as a creditor
and agree not to acquire any interest in the corporation for a period of 10 years.
In addition to the two safe harbors described in Sections 302(b)(2) and
(3), the Code, in Section 302(b)(1), grants redemption treatment to distributions
which are "not essentially equivalent to a dividend." Unlike the previous
two sections, however, the Code does not spell out a mechanical test for this
concept, leaving it to the facts and circumstances of the case. Given the obvious
purpose of this transaction to transfer corporate assets to a stockholder on
favorable terms, it is unlikely that the IRS under this section would recognize
any explanation other than that of a dividend.
Thus, Morris's plan to turn in his stock and receive a tax-favored distribution
for his retirement will not work out as planned unless he allows the redemption
of all his stock; resigns as a director, officer, employee, consultant,
and so forth; and agrees to stay away for a period of 10 years. He may, however,
accept a promissory note for all or part of the redemption proceeds and
thereby become a creditor of the corporation. Worse yet, if Lisa obtained her
shares from Morris within the 10 years preceding his retirement, even this
plan will not work unless the IRS can be persuaded that her acquisition of the
shares was for reasons other than tax avoidance. It may be advisable to ensure
that she acquires her shares from the corporation rather than from Morris, although
one can expect, given the extent of Morris's control over the corporation,
that the IRS would fail to appreciate the difference.
Employee Stock Ownership Plans
Although Morris should be relatively happy with the knowledge that he may be
able to arrange a complete redemption of his stock to fund his retirement and
avoid being taxed as if he had received a dividend, he may still believe that the
tax and economic effects of such a redemption are not ideal. Following such a
plan to its logical conclusion, the corporation would borrow the money to pay
for Morris's stock. Its repayments would be deductible only to the extent of the
interest. At the same time, Morris would be paying a substantial capital gain
342 Planning and Forecasting
tax to the government. Before settling for this result, Morris might well wish
to explore ways to increase the corporation's deduction and decrease his own
tax liability.
Such a result can be achieved through the use of an employee stock ownership
plan (ESOP), a form of qualified deferred compensation plan as discussed
earlier in the context of Brad's compensation package. Such a plan
consists of a trust to which the corporation makes deductible contributions of
either shares of its own stock or cash to be used to purchase such stock. Contributions
are divided among the accounts of the corporation's employees (normally
in proportion to their compensation for that year), and distributions are
made to the employees at their retirement or earlier separation from the company
(if the plan so allows). ESOPs have been seen as a relatively noncontroversial
way for U.S. employees to gain more control over their employers, and
they have been granted a number of tax advantages not available to other qualified
plans, such as pension or profit-sharing plans. One advantage is illustrated
by the fact that a corporation can manufacture a deduction out of thin air by issuing
new stock to a plan (at no cost to the corporation) and deducting the fair
market value of the shares.
A number of attractive tax benefits would f low from Morris's willingness
to sell his shares to an ESOP established by his corporation rather than to the
corporation itself. Yet, before he could appreciate those benefits, Morris would
have to be satisfied that some obvious objections would not make such a transaction
inadvisable.
To begin with, the ESOP would have to borrow the money from a bank in
the same way the corporation would; yet the ESOP has no credit record or assets
to pledge as collateral. This is normally overcome, however, by the corporation's
giving the bank a secured guarantee of the ESOP's obligation. Thus,
the corporation ends up in the same economic position it would have enjoyed
under a direct redemption.
Morris might also object to the level of control an ESOP might give to
lower-level employees of Plant Supply. After all, his intent is to leave the corporation
under the control of Lisa and Brad, but qualified plans must be operated
on a nondiscriminatory basis. This objection can be addressed in a number
of ways. First, the allocation of shares in proportion to compensation, along
with standard vesting and forfeiture provisions, will tilt these allocations toward
highly compensated, long-term employees, such as Lisa and Brad. Second,
the shares are not allocated to the employees' accounts until they are paid
for. While the bank is still being paid, an amount proportional to the remaining
balance of the loan would be controlled by the plan trustees (chosen by management).
Third, even after shares are allocated to employee accounts, in a
closely held company, employees are allowed to vote those shares only on questions
which require a two-thirds vote of the stockholders, such as a sale or
merger of the corporation. On all other more routine questions (such as election
of the board) the trustees still vote the shares. Fourth, upon an employee's
retirement and before distribution of his shares, a closely held corporation
Taxes and Business Decisions 343
must offer to buy back the distributed shares at fair market value. As a practical
matter, most employees will accept such an offer rather than moving into
retirement with illiquid, closely held company stock.
If Morris accepts these arguments and opts for an ESOP buyout, the
following benefits accrue. Rather than being able to deduct only the interest
portion of its payments to the bank, the corporation may now contribute the
full amount of such payment to the plan as a fully deductible contribution to
a qualified plan. The plan then forwards it to the bank as a payment of its
obligation.
Furthermore, the Code allows an individual who sells stock of a corporation
to the corporation's ESOP to defer paying any tax on the proceeds of such
sale, if the proceeds are rolled over into purchases of securities. No tax is then
paid until the purchased securities are ultimately resold. Thus, if Morris takes
the money received from the ESOP and invests it in the stock market, he pays
no tax until and unless he sells any of these securities, and then only on those
sold. In fact, if Morris purchases such securities and holds them until his death
(assuming he dies prior to 2010), his estate will receive a step-up in basis for
such securities and thus will avoid income tax on the proceeds of his company
stock entirely (see Exhibit 11.7).
ESTATE PLANNING
Should Morris rebel at the thought of retiring from the company, his thoughts
may naturally turn to the tax consequences of his remaining employed by the
company in some capacity until his death. Morris's lifelong efforts have made
him a rather wealthy man, and he knows that the government will be looking
to reap a rather large harvest from those efforts upon his death. He would no
doubt be rather disheartened to learn that after a $675,000 exemption (which
increases to as much as $3.5 million in 2009), the federal government will receive
37% to anywhere from 45% to 55% of the excess upon his death, depending
upon the year in which he dies. Proper estate planning can double the
amount of that grace amount by using the exemptions of both Morris and his
wife, but the amount above the exemptions appears to be at significant risk. It
should further be noted that the federal estate tax is currently scheduled for repeal
in 2010, but, under current law, will be reinstated in 2011.
EXHIBIT 11.7 Corporate redemption versus ESOP
purchase.
Corporate Redemption ESOP Purchase
Only interest deductible Principal and interest deductible
Capital gain Gain deferred if proceeds rolled over
344 Planning and Forecasting
Redemptions to Pay Death Taxes and
Administrative Expenses
Since much of the money to fund this estate tax liability would come from redemption
of company stock, if Morris had not previously cashed it in, Morris
might well fear the combined effect of dividend treatment and estate taxation.
Of course, if Morris's estate turned in all his stock for redemption at death,
dividend treatment would appear to have been avoided and redemption treatment
under Section 302(b)(3) would appear to be available, since this would
amount to a complete termination of his interest in the company and death
would appear to cut off Morris's relationship with the company rather convincingly.
However, if the effect of Morris's death on the company or of other circumstances
made a wholesale redemption inadvisable or impossible, Morris's
estate could be faced with paying both ordinary income and estate tax rates on
the full amount of the proceeds.
Fortunately for those faced with this problem, Code Section 303 allows
capital gain treatment for a stock redemption if the proceeds of the redemption
do not exceed the amount necessary to pay the estate's taxes and those further
expenses allowable as administrative expenses on the estate's tax return.
To qualify for this treatment, the company's stock must equal or exceed 35% of
the value of the estate's total assets. Since Morris's holdings of company stock
will most likely exceed 35% of his total assets, if his estate finds itself in this
uncomfortable position, it will at least be able to account for this distribution
as a stock redemption instead of a dividend. This is much more important than
it may first appear and much more important than it would have been were
Morris still alive. The effect, of course, is to allow payment at long-term capital
gain rates (rather than ordinary income tax rates) for only the amount received
in excess of the taxpayer's basis in the stock (rather than the entire
amount of the distribution). Given that the death of the taxpayer prior to 2010
increases his basis to the value at date of death, the effect of Section 303 is to
eliminate all but that amount of gain occurring after death, thus eliminating
virtually all income tax on the distribution. This step-up of basis will be significantly
less generous for taxpayer's dying after 2009.
Of course, assuring sufficient liquidity to pay taxes due upon death is one
thing; controlling the amount of tax actually due is another. Valuation of a majority
interest in a closely held corporation is far from an exact science, and the
last thing an entrepreneur wishes is to have his or her spouse and other heirs
engage in a valuation controversy with the IRS after his or her death. As a result,
a number of techniques have evolved over the years which may have the
effect of lowering the value of the stock to be included in the estate or, at least,
making such value more certain for planning purposes.
Family Limited Partnerships
One such technique that has recently gained in popularity is the so-called family
limited partnership. This strategy allows an individual to decrease the size
Taxes and Business Decisions 345
of his taxable estate through gifts to his intended beneficiaries both faster and
at less tax cost than would otherwise be possible, while at the same time retaining
effective control over the assets given away. Were Morris interested in
implementing this strategy, he would form a limited partnership, designating
himself as the general partner and retaining all but a minimal amount of the
limited partnership interests for himself. He would then transfer to the partnership
a significant portion of his assets, such as stock in the company, real estate,
or marketable securities. Even though he would have transferred these
interests out of his name, he would be assured of continued control over these
assets in his role as general partner. The general partner of a limited partnership
exercises all management functions; limited partners sacrifice all control
in exchange for limited liability.
Morris would then embark on a course of gifting portions of the limited
partnership interests to Lisa, Victor, and perhaps even Brad. You will remember
that in each calendar year, Morris and his wife can combine to give no
more than $20,000 to each beneficiary before eating into their lifetime gift tax
exemption. The advantage of the family limited partnership, besides retaining
control over the assets given away, is that the amounts which may be given
each year are effectively increased. For example, were Morris and his wife to
give $20,000 of marketable securities to Lisa in any given year, that would use
up their entire annual gift tax exclusion. However, were they instead to give
Lisa a portion of the limited partnership interest to which those marketable securities
had been contributed, it can be argued that the gift should be valued
at a much lower amount. After all, while there was a ready market for the securities,
there is no market for the limited partnership interests; and while Lisa
would have had control over the securities if they had been given to her, she
has no control of them through her limited partnership interest. These discounts
for lack of marketability and control can be substantial, freeing up more
room under the annual exclusion for further gifting. In proper circumstances,
one might use this technique when owning a rapidly appreciating asset (such as
a pre-IPO stock) to give away more than $20,000 in a year, using up all or part
of the lifetime exclusion, to remove the asset from your estate at a discount
from its present value, rather than having to pay estate tax in the future on a
highly inf lated value.
Of course, the IRS has challenged these arrangements when there was
no apparent business purpose other than tax savings or when the transfer occurred
just before the death of the transferor. And you can expect the IRS to
challenge an overly aggressive valuation discount. But if Morris is careful in his
valuations, he might find this arrangement attractive, asserting the business
purpose of centralizing management while facilitating the grant of equity incentives
to his executive employees.
Buy-Sell Agreements
Short of establishing a family limited partnership, Morris might be interested
in a more traditional arrangement requiring the corporation or its stockholders
346 Planning and Forecasting
to purchase whatever stock he may still hold at his death. Such an arrangement
can be helpful with regard to both of Morris's estate-planning goals: setting a
value for his stock that would not be challenged by the IRS and assuring sufficient
liquidity to pay whatever estate taxes may ultimately be owed.
There are two basic variations of these agreements. Under the most common,
Morris would agree with the corporation that it would redeem his shares
upon his death for a price derived from an agreed formula. The second variation
would require one or more of the other stockholders of the corporation
(e.g., Lisa) to make such a purchase. In both cases, in order for the IRS to respect
the valuation placed upon the shares, Morris will need to agree that he
will not dispose of the shares during his lifetime without first offering them to
the other party to his agreement at the formula price. Under such an arrangement,
the shares will never be worth more to Morris than the formula price, so
it can be argued that whatever higher price the IRS may calculate is irrelevant
to him and his estate.
This argument led some stockholders in the past to agree to formulas that
artificially depressed the value of their shares when the parties succeeding to
power in the corporation were also the main beneficiaries of the stockholders'
estates. Since any value forgone would end up in the hands of the intended beneficiary
anyway, only the tax collector would be hurt. Although the IRS long
challenged this practice, this strategy has been put to a formal end by legislation
requiring that the formula used result in a close approximation to fair market
value.
Which of the two variations of the buy-sell agreement should Morris
choose? If we assume for the moment that Morris owns 80 of the 100 outstanding
shares and Lisa and Brad each own 10, a corporate redemption agreement
leaves Lisa and Brad each owning half of the 20 outstanding shares
remaining. If, however, Morris chooses a cross-purchase agreement with Lisa
and Brad, each would purchase 40 of his shares upon his death, leaving them as
owners of 50 shares each. Both agreements leave the corporation owned by
Lisa and Brad in equal shares, so there does not appear to be any difference between
them.
Once again, however, significant differences lie slightly below the surface.
To begin with, many such agreements are funded by the purchase of a life
insurance policy on the life of the stockholder involved. If the corporation
were to purchase this policy, the premiums would be nondeductible, resulting
in additional taxable profit for the corporation. In a subchapter S corporation,
such profit would pass through to the stockholders in proportion to their shares
of stock in the corporation. In a C corporation, the additional profit would
result in additional corporate tax. If, instead, Lisa and Brad bought policies
covering their halves of the obligation to Morris's estate, they would be paying
the premiums with after-tax dollars. Thus, a redemption agreement will cause
Morris to share in the cost of the arrangement, whereas a cross-purchase
agreement puts the entire onus on Lisa and Brad. This burden can, of course,
be rationalized by arguing that they will ultimately reap the benefit of the
Taxes and Business Decisions 347
arrangement by succeeding to the ownership of the corporation. Or, their compensation
could be adjusted to cover the additional cost.
If the corporation is not an S corporation, however, there is an additional
consideration that must not be overlooked. Upon Morris's death, the receipt of
the insurance proceeds by the beneficiary of the life insurance will be excluded
from taxable income. However, a C corporation (other than certain
small businesses) is also subject to the alternative minimum tax. Simply described,
that tax guards against individuals and profitable corporations paying
little or no tax by "overuse" of certain deductions and tax credits otherwise
available. To calculate the tax, the taxpayer adds to its otherwise taxable income,
certain "tax preferences" and then subtracts from that amount an exemption
amount ($40,000 for most corporations). The result is taxed at 20% for
corporations (26% and 28% for individuals). If that tax amount exceeds the income
tax otherwise payable, the higher amount is paid. The result of this is additional
tax for those taxpayers with substantial tax preferences.
Among those tax preferences for C corporations is a concept known as adjusted
current earnings. This concept adds as a tax preference, three-quarters
of the difference between the corporation's earnings for financial reporting
purposes and the earnings otherwise reportable for tax purposes. A major
source of such a difference would be the receipt of nontaxable income. And the
receipt of life insurance proceeds is just such an event. Therefore, the receipt
of a life insurance payout of sufficient size would ultimately be taxed, at least
in part, to a C corporation, whereas it would be completely tax free to an S corporation
or the remaining stockholders.
An additional factor pointing to the stockholder cross-purchase agreement
rather than a corporate redemption is the effect this choice would have
on the taxability of a later sale of the corporation after Morris's death. If the
corporation were to redeem Morris's stock, Lisa and Brad would each own onehalf
of the corporation through their ownership of 10 shares each. If they then
sold the company, they would be subject to tax on capital gain measured by the
difference between the proceeds of the sale and their original basis in their
shares. However, if Lisa and Brad purchased Morris's stock at his death, they
would each own one-half of the corporation through their ownership of 50
shares each. Upon a later sale of the company, their capital gain would be measured
by the difference between the sale proceeds and their original basis in
their shares plus the amount paid for Morris's shares. Every dollar paid to Morris
lowers the taxable income received upon later sale. In a redemption agreement,
these dollars are lost (see Exhibit 11.8).
SPIN-OFFS AND SPLIT-UPS
Morris's pleasant reverie caused by thoughts of well-funded retirement
strategies and clever estate plans was brought to a sudden halt a mere two
years after the acquisition of the molding operation, when it became clear
348 Planning and Forecasting
that the internecine jealousies between Brad and Lisa were becoming unmanageable.
Ruefully, Morris conceded that it was not unforeseeable that the
manager of a significant part of his business would resent the presence of a
rival who would be perceived as having attained her present position simply
by dint of her relationship to the owner. This jealousy was, of course, inf
lamed by the thought that Lisa might succeed to Morris's stock upon his
death and become Brad's boss.
After some months of attempting to mediate the many disputes between
Lisa and Brad, which were merely symptoms of this underlying disease, Morris
came to the conclusion that the corporation could not survive with both of
them vying for power and inf luence. He determined that the only workable solution
would be to break the two businesses apart once again, leaving the two
rivals in charge of their individual empires, with no future binding ties.
Experienced in corporate transactions by this time, Morris gave the problem
some significant thought and devised two alternate scenarios to accomplish
his goal. Both scenarios began with the establishment of a subsidiary
corporation wholly owned by the currently existing company. The assets, liabilities,
and all other attributes of the molding operation would then be transferred
to this new subsidiary in exchange for its stock. At that point in the first
scenario (known as a spin-off ), the parent corporation would declare a dividend
of all such stock to its current stockholders. Thus, Morris, Lisa, and Brad
EXHIBIT 11.8 Corporate redemption versus cross-purchase agreement.
Corporate Redemption Cross-Purchase
(Assume all parties purchased stock at $100 per share.
Current fair market value, is $200 per share.)
Morris Lisa Brad Morris Lisa Brad
80
shares
10
shares
10
shares
80
shares
10
shares
10
shares
10
shares
10
shares
$8,000 $1,000 $1,000
Cost
$8,000 $8,000
+ +
Total basis: $1,000 $1,000 Total basis: $9,000 $9,000
$8,000 $1,000 $1,000
Cost
Taxes and Business Decisions 349
would own the former subsidiary in the same proportions in which they owned
the parent. Morris, as the majority owner of the new corporation, could then
give further shares to Brad, enter into a buy-sell agreement with him, or sell
him some shares. In any case, upon Morris's death, Brad would succeed to unquestioned
leadership in this corporation. Lisa would stay as a minority stockholder
or, if she wished, sell her shares to Morris while he was alive. Lisa would
gain control of the former parent corporation upon Morris's death.
In the second scenario (known as a split-off ), after the formation of the
subsidiary, Brad would sell his shares of Plant Supply to that parent corporation
in exchange for stock affording him control of the subsidiary. Lisa would
remain the only minority stockholder of the parent corporation (Brad's interest
having been removed) and would succeed to full ownership upon Morris's
death through one of the mechanisms discussed earlier.
Unfortunately, when Morris brought his ideas to his professional advisers,
he was faced with a serious tax objection. In both scenarios, he was told, the
IRS would likely take the position that the issuance of the subsidiary's stock to
its eventual holder (Morris in the spin-off and Brad in the split-off ) was a taxable
transaction, characterized as a dividend. After all, this plan could be used
as another device to cash out the earnings and profits of a corporation at favorable
rates and terms. Instead of declaring a dividend of these profits, a corporation
could spin off assets, with the fair market value of these profits, to a
subsidiary. The shares of the subsidiary could then be distributed to its stockholders
as a nontaxable stock dividend, and the stockholders could sell these
shares and treat their profits as capital gain. The second scenario allows Brad
to receive the subsidiary's shares and then make a similar sale of these shares
at favorable rates and terms.
As a result, the Code characterizes the distribution of the subsidiary's
shares to the parent's stockholders as a dividend, taxable to the extent of the
parent's earnings and profits at the time of the distribution. This would certainly
inhibit Morris if he were the owner of a profitable C corporation. It
would be less of a concern if his corporation were operating as an S corporation,
although even then he would have to be concerned about undistributed
earnings and profits dating from before the S election.
Recognizing that not all transactions of this type are entered into to disguise
the declaration of a dividend, the Code does allow spin-offs and splitoffs
to take place tax-free, under the limited circumstances described in
Section 355. These circumstances track the scenarios concocted by Morris, but
are limited to circumstances in which both the parent and subsidiary will be
conducting an active trade or business after the transaction. Moreover, each
trade or business must have been conducted for a period exceeding five years
prior to the distribution and cannot have been acquired in a taxable transaction
during such time. Since Morris's corporation acquired the molding business
only two years previously and such transaction was not tax free, the benefits of
Section 355 are not available now. Short of another solution, it would appear
350 Planning and Forecasting
that Morris will have to live with the bickering of Brad and Lisa for another
three years.
SALE OF THE CORPORATION
Fortunately for Morris, another solution was not long in coming. Within months
of the failure of his proposal to split up the company, Morris was approached
by the president of a company in a related field, interested in purchasing Plant
Supply. Such a transaction was very intriguing to Morris. He had worked very
hard for many years and would not be adverse to an early retirement. A purchase
such as this would relieve him of all his concerns over adequate liquidity
for his estate and strategies for funding his retirement. He could take care of
both Lisa and Victor with the cash he would receive, and both Lisa and Brad
would be free to deal with the acquirer about remaining employed and collecting
on their equity.
However, Morris knew better than to get too excited over this prospect
before consulting with his tax advisers. His hesitance turned out to be justified.
Unless a deal was appropriately structured, Morris was staring at a significant
tax bite, both on the corporate and the stockholder levels.
Morris knew from his experience with the molding plant that a corporate
acquisition can be structured in three basic ways: a merger, a sale of stock, and
a purchase of assets. In a merger, the target corporation disappears into the acquirer
by operation of law, and the former stockholders of the target receive
consideration from the acquirer. In the sale of stock, the stockholders sell their
shares directly to the acquiring corporation. In a sale of assets, the target sells
its assets (and most of its liabilities) to the acquirer, and the proceeds of the
sale are then distributed to the target's stockholders through the liquidation of
the target. A major theme of all three of these scenarios involves the acquirer
forming a subsidiary corporation to act as the acquirer in the transaction.
In each case, the difference between the proceeds received by the target's
stockholders and their basis in the target's stock would be taxable as capital
gain. Morris was further informed that this tax at the stockholder level
could be avoided if these transactions qualified under the complex rules that
define tax-free reorganizations. In each case, one of the requirements would be
that the target stockholders receive largely stock of the acquirer rather than
cash. Since the acquirer in this case was closely held and there was no market
for its stock, Morris was determined to insist upon cash. He thus accepted the
idea of paying tax on the stockholder level.
Morris was quite surprised, however, to learn that he might also be exposed
to corporate tax on the growth in the corporation's assets over its basis in
them if they were deemed to have been sold as a result of the acquisition transaction.
For one thing, he had been under the impression that a corporation was
exempt from such tax if it sold its assets as part of the liquidation process. He
was disappointed to learn that this exemption was another victim of the repeal
Taxes and Business Decisions 351
of the General Utilities doctrine. He was further disappointed when reminded
that even subchapter S corporations recognize all built-in gain that existed at
the time of their subchapter S election, if their assets are sold within 10 years
after their change of tax status.
As a result of the previous considerations, Morris was determined to avoid
structuring the sale of his corporation as a sale of its assets and liabilities, to
avoid any tax on the corporate level. He was already determined not to structure
it as a sale of stock by the target stockholders, because he was not entirely sure
Brad could be trusted to sell his shares. If he could structure the transaction at
the corporate level, he would not need Brad's minority vote to accomplish it.
Thus, after intensive negotiations, he was pleased that the acquiring corporation
had agreed to structure the acquisition as a merger between Plant Supply and a
subsidiary of the acquirer (to be formed for the purpose of the transaction). All
stockholders of Plant Supply would receive a cash down payment and a fiveyear
promissory note from the parent acquirer in exchange for their stock.
Yet even this careful preparation and negotiation leaves Morris, Lisa, and
Brad in jeopardy of unexpected tax exposure. To begin with, if the transaction
remains as negotiated, the IRS will likely take the position that the assets of
the target corporation have been sold to the acquirer, thus triggering tax at the
corporate level. In addition, the target's stockholders will have to recognize as
proceeds of the sale of their stock both the cash and the fair market value of
the promissory notes in the year of the transaction, even though they will receive
payments on the notes over a period of five years.
Under the General Utilities doctrine, a corporation that was selling substantially
all its assets needed to adopt a "plan of liquidation" prior to entering
into the sale agreement to avoid taxation at the corporate level. The repeal of
the doctrine may have left the impression that the adoption of such a liquidation
plan is unnecessary because the sale will be taxed at the corporate level in
any event. Yet, the Code still requires such a liquidation plan if the stockholders
wish to recognize notes received upon the dissolution of the target corporation
on the installment basis. Moreover, the liquidation of the corporation
must be completed within 12 months of adoption of the liquidation plan.
Thus, Morris's best efforts may still have led to disaster. Fortunately, a
small adjustment to the negotiated transaction can cure most of these problems.
Through an example of corporate magic known as the reverse triangular
merger, the newly formed subsidiary of the acquirer may disappear into Morris's
target corporation, but the target's stockholders can still be jettisoned for
cash, leaving the acquirer as the parent. In such a transaction, the assets of the
target have not been sold; they remain owned by the original corporation. Only
the target's stockholders have changed. In effect, the parties have sold stock
without the necessity of getting Brad's approval. Because the assets have not
changed hands, there is no tax at the corporate level. In addition, since the target
corporation has not liquidated, no plan of liquidation is required, and the
target stockholders may elect installment treatment as if they had sold their
shares directly (see Exhibit 11.9).
352 Planning and Forecasting
CONCLUSION
Perhaps no taxpayer will encounter quite as many cataclysmic tax decisions in
as short a time as did Morris and Plant Supply. Yet, Morris's experience serves
to illustrate that tax issues lurk in almost every major business decision made
by a corporation's management. Many transactions can be structured to avoid
unnecessary tax expense if proper attention is paid to tax implications. To be
unaware of these issues is to play the game without knowing the rules.
FOR FURTHER READING
Gevurtz, Franklin A., Business Planning (New York: Foundation Press, 1995).
Jones, Sally M., Federal Taxes and Management Decisions (New York: Irwin/
McGraw-Hill, 1998).
Painter, William H., Problems and Materials in Business Planning, 3rd ed. (Connecticut:
West /Wadsworth, 1994).
Scholes, Myron S. et al., Taxes and Business Strategy (Upper Saddle River, NJ:
Prentice-Hall, 2001).
INTERNET LINKS
http://smallbiz.biz.findlaw.com FindLaw for Business
/sections/fn_taxes/articles.html
http://www.dtonline.com Deloitte and Touche Tax Planning Guide
/taxguide99/cover.htm
http://www.smartmoney.com/tax Smart Money.com tax guide
EXHIBIT 11.9 Reverse triangle merger.
Owned by
T's stockholders Owned by
T's stockholders
T SUB
S stock
Owned by
T
A A
S
Before After
353
12 GLOBAL FINANCE
Eugene E. Comiskey
Charles W. Mulford
MANAGERIAL AND FINANCIAL REPORTING ISSUES AT
SUCCESSIVE STAGES IN THE FIRM'S LIFE CYCLE
Fashionhouse Furniture started as a small southern retailer of furniture purchased
mainly in bordering southeastern states. With a growing level of both
competition and aff luence in its major market areas, Fashionhouse decided
that its future lay in a niche strategy involving specialization in a high quality
line of Scandinavian furniture. Its suppliers were mainly located in Denmark,
and they followed the practice of billing Fashionhouse in the Danish krone.
Title would typically pass to Fashionhouse when the goods were dropped on
the dock in Copenhagen. Payment for the goods was required within periods
ranging from 30 to 90 days. As its business expanded and prospered, Fashionhouse
became convinced that it needed to exercise greater control over its
furniture supply. This control was accomplished through the purchase of its
principal Danish supplier. Because this supplier also had a network of retail
units in Denmark, the manufacturing operations in Denmark supplied both
the local Danish market as well as the U.S. requirements of Fashionhouse.
More recently, Fashionhouse has been searching for ways to increase
manufacturing efficiency and lower product costs. It is contemplating a relocation
of part of its manufacturing activity to a country with an ample and
low-cost supply of labor. However, Fashionhouse has noted that many such
countries experience very high levels of inf lation and other potentially disruptive
economic and political conditions. It has also become aware that in some of
354 Planning and Forecasting
the countries under consideration business practices are occasionally employed
that could be a source of concern to Fashionhouse management. In some cases,
the practices raise issues that extend beyond simply ethical considerations.
Fashionhouse could become involved in activities that could place it in violation,
not of local laws, but of U.S. laws. Fashionhouse management is still attempting
to determine how to evaluate and deal with some of the identified
managerial and financial issues associated with this contemplated move.
Each of the new stages in the evolution of the Fashionhouse strategy creates
new challenges that have important implications for both management and
financial reporting. The evolution from a strictly domestic operation to one involving
the purchase of goods abroad thrusts Fashionhouse into the global
marketplace, with its attendant risks and rewards. It is common for U.S. firms
with foreign activities to enumerate some of these risks. These disclosures are
normally made, at least in part, to comply with disclosure requirements of the
Securities and Exchange Commission (SEC). As an example, consider the disclosures
made by Western Digital Corporation of risk factors associated with
its foreign manufacturing operations:
• Obtaining requisite U.S. and foreign governmental permits and approvals.
• Currency exchange-rate f luctuations or restrictions.
• Political instability and civil unrest.
• Transportation delays or higher freight fees.
• Labor problems.
• Trade restrictions or higher tariffs.
• Exchange, currency, and tax controls and reallocations.
• Loss or nonrenewal of favorable tax treatment under agreements or
treaties with foreign tax authorities.1
While not listed above as a specific concern, there is the risk that a foreign
government will expropriate the assets of a foreign operation. There were
major expropriations of U.S. assets, for instance, located in Cuba when Fidel
Castro came to power. There were also expropriations by Iran surrounding the
hostage taking at the U.S. embassy in Tehran. Moreover there has been turmoil
in Ecuador in recent years. Baltek, a New Jersey corporation with most of its
operations in Ecuador, disclosed that it had taken out expropriation insurance
to deal with this risk:
All of the Company's balsa and shrimp are produced in Ecuador. The dependence
on foreign countries for raw materials represents some inherent risks.
However, the Company, or its predecessors, has operated without interruption
in Ecuador since 1940. Operating in Ecuador has enabled the Company to produce
raw materials at a reasonable cost in an atmosphere that has been favorable
to exporters such as the Company. To mitigate the risk of operating in
Ecuador, in 1999 the Company obtained a five-year expropriation insurance
policy. This policy provides the Company coverage for its assets in Ecuador
Global Finance 355
against expropriatory conduct (as defined in the policy) by the government of
Ecuador.2
Some of the important issues implicit in the Fashionhouse scenario outlined
above are identified below and are discussed and illustrated in the balance
of this chapter:
1. Fashionhouse incurs a foreign-currency obligation when it begins to acquire
furniture from its Danish suppliers. A decrease in the value of the
dollar between purchase and payment date increases the dollars required
to discharge the Danish krone obligation and results in a foreign-currency
transaction loss.
Financial reporting issue: How are the foreign-currency obligations
initially recorded and subsequently accounted for in the Fashionhouse
books, which are maintained in U.S. dollars?
Management issue: What methods are available to avoid the currency
risk associated with purchasing goods abroad and also being invoiced
in the foreign currency, and should they be employed?
2. The purchase of one of its Danish suppliers requires that this firm henceforth
be consolidated into the financial statements of Fashionhouse and
its U.S. operations.
Financial reporting issues: (a) How are the Danish statements converted
from the krone in order to consolidate them with the U.S. dollar
statements of Fashionhouse? (b) What differences in accounting
practices, if any, exist between Denmark and the United States and
what must be done about such differences?
Management issues: (a) Is there currency risk associated with the Danish
subsidiary comparable to that described previously with the foreign
purchase transactions? Are there methods available to avoid the
currency risk associated with ownership of a foreign subsidiary and
should they be employed? (b) How will the financial aspects of the
management of the Danish subsidiary be evaluated in view of (1) the
availability of two different sets of financial statements, those expressed
in krone and those in U.S. dollars, and (2) the fact that most of
its sales are to Fashionhouse, its U.S. parent?
3. Fashionhouse relocates its manufacturing to a high-inf lation and lowlabor
cost country.
Financial reporting issues: How will inf lation affect the local-country
financial statements and their usefulness in evaluating the performance
of the company and its management?
Management issues: (a) Are their special risks associated with locating
in a highly inf lationary country and how can they be managed?
(b) What are the restrictions on U.S. business practices related to dealing
with business and governmental entities in other countries?
356 Planning and Forecasting
For clarification and to indicate their order of treatment in the subsequent
discussion, the issues raised above are enumerated below, without distinction
between those that are mainly financial reporting as opposed to
managerial issues:
1. Financial reporting of foreign-currency denominated transactions.
2. Risk management alternatives for foreign-currency denominated transactions.
3. Translation of the financial statements of foreign subsidiaries.
4. Managing the currency risk of foreign subsidiaries.
5. Dealing with differences between U.S. and foreign accounting policies.
6. Evaluation of the performance of foreign subsidiaries and their
management.
7. Assessing the effects of inf lation on the financial performance of foreign
subsidiaries.
8. Complying with U.S. restrictions on business practices associated with
foreign subsidiaries and governments.
FINANCIAL REPORTING OF FOREIGN-CURRENCY
DENOMINATED TRANSACTIONS
When a U.S. company buys from or sells to a foreign firm, a key issue is the currency
in which the transaction is to be denominated.3 In the case of Fashionhouse,
its purchases from Danish suppliers were invoiced to Fashionhouse in
the Danish krone. This creates a risk, which is born by Fashionhouse and not its
Danish supplier, of a foreign exchange transaction loss should the dollar fall in
value. Alternatively, a gain would result should the dollar increase between the
time the furniture is dropped on the dock in Copenhagen and the required
payment date. With a fall in the value of the dollar, the Fashionhouse dollar
cost for the furniture will be more than the dollar obligation it originally
recorded. Fashionhouse is said to have liability exposure in the Danish krone.
If, instead, Fashionhouse had been invoiced in the U.S. dollar, then it would
have had no currency risk. Rather, its Danish supplier would bear the currency
risk associated with a claim to U.S. dollars, in the form of a U.S. dollar account
receivable. If the dollar were to decrease in value, the Danish supplier would
incur a foreign exchange transaction loss, or a gain should the dollar increase
in value. The Danish firm would have asset exposure in a U.S. dollar account
receivable.
The essence of foreign-currency exposure or currency risk is that existing
account balances or prospective cash f lows can expand or contract simply as a
result of changes in the values of currencies. A summary of foreign exchange
gains and losses, by type of exposure, due to exchange rate movements is provided
in Exhibit 12.1. To illustrate some of the computational aspects of the
Global Finance 357
patterns of gains and losses in Exhibit 12.1, and the nature of exchange rates,
assume that Fashionhouse recorded a 100,000 krone purchase when the exchange
rate for the krone was $0.1180. That is, it takes 11.8 cents to purchase
one krone. This expression of the exchange rate, dollars per unit of the foreign
currency, is referred to as the direct rate. Alternatively, expressing the rate in
terms of kroner per dollar is referred to as the indirect rate. In this case, the
indirect rate is 1/0.1180, or K8.475. It requires 8.475 kroner to purchase one
dollar. Both the direct and indirect rates are typically provided in the tables of
exchange rates found in the financial press. The rates at which currencies are
currently trading are called the spot rates.
When Fashionhouse records the invoice received from its Danish supplier,
it must do so in its U.S. dollar equivalent. With the direct rate at $0.1180,
the dollar equivalent of K100,000 is $0.1180 × K100,000, or $11,800. That is,
Fashionhouse records an addition to inventory and an offsetting account
payable for $11,800. Assume that Fashionhouse pays this obligation when the
dollar has fallen to $0.1190. It will now take $11,900 dollars to acquire the
K100,000 needed to pay off the account payable. The combination of liability
exposure and a decline in the value of the dollar results in a foreign-currency
transaction loss. This result is summarized below:
The exchange rate is $0.1190 when the account payable from the purchase is
paid.
Dollar amount of obligation at payment date, 100,000 × $0.1190 $11,900
Dollar amount of obligation at purchase date, 100,000 × $0.1180 11,800
Foreign exchange transaction loss $ 100
The dollar depreciated against the krone during the time when Fashionhouse
had liability exposure in the krone. As a result, it took $100 more to discharge
the account payable than the amount at which the liability was originally
recorded by Fashionhouse.
If the foreign exchange losses incurred were significant, it might prove
difficult to pass on this increased cost to Fashionhouse customers, and it could
cause its furniture to be somewhat less competitive than that offered by other
U.S. retailers with domestic suppliers. Fashionhouse might attempt to avoid
the currency risk by convincing its Danish suppliers to invoice it in the dollar.
However, this means that the Danish suppliers would bear the currency risk.
EXHIBIT 12.1 Type of foreign currency
exposure.
Change in Foreign Exposure
Currency Value Asset Liability
Appreciates Gain Loss
Depreciates Loss Gain
358 Planning and Forecasting
Experience indicates that such suppliers would expect to be compensated
for bearing this risk and would charge more for their products.4 An alternative
approach, the use of various hedging procedures, is the more common method
employed to manage the risk of foreign-currency exposure.
RISK MANAGEMENT ALTERNATIVES
FOR FOREIGN-CURRENCY
DENOMINATED TRANSACTIONS
Hedging is designed to protect the dollar value of a foreign-currency asset position
or to hold constant the dollar burden of a foreign-currency liability.5 At
the same time, the volatility of a firm's cash flow or earnings stream is also
reduced. This reduction is accomplished by maintaining an offsetting position
that produces gains when the asset or liability position is creating losses, and
vice versa. These offsetting positions may be created as a result of arrangements
involving internal offsetting balances created through operational activities,
or they may entail specialized external transactions with financial firms
or markets.
Hedging with Internal Offsetting Balances
or Cash Flows
Firms generally attempt to close out as much foreign-currency exposure as possible
by relying upon their own operations. These arrangements are often referred
to as natural hedges. As an example, consider the following commentary
about currency exposure from the 1999 annual report of Air Canada:
Foreign exchange exposure on interest obligations in Swiss francs and Deutsche
marks is fully covered by surplus cash f lows in European currencies, while yendenominated
cash f low surpluses provide a natural hedge to fully cover yen interest
expense.6
Air Canada is able to prevent net exposure in the identified foreign currencies
by having offsetting cash f lows in the same currencies or in currencies whose
values move in parallel to the currencies in which Air Canada has interest obligations.
With the full transition to the Euro in 2002, Air Canada's currency exposure
should be markedly reduced because most of the European Community
countries will share the Euro as their currency.7 This will not, of course, alter
their exposure in the case of Asian currencies.
A sampling of other arrangements that could be characterized as natural
hedges is provided in Exhibit 12.2. Virtually all of these examples illustrate the
offsetting of exposure through the results of normal operations. In the cases of
Baldwin Technologies and Interface, the hedges could be seen to be seminatural
if they result from a conscious action to create offsetting exposure. That is,
does Baldwin Technology determine the cash balances to maintain after first
Global Finance 359
determining the extent of their liability exposure? Similarly, does Interface
make decisions about the currency in which to borrow depending upon its existing
asset exposure?8
Being the product of calculation and design does not make the seminatural
hedges any less effective or desirable. In fact, their existence prompts
management to be proactive in identifying hedging opportunities that do not
EXHIBIT 12.2 Natural foreign currency hedges.
Company Natural Hedge
Adobe Systems Inc. (1999) We currently do not use financial instruments to hedge
local currency denominated operating expenses in
Europe. Instead, we believe that a natural hedge exists,
in that local currency revenue from product upgrades
substantially offsets the local currency denominated
operating expenses.
Armstrong World Industries Inc. Armstrong's global manufacturing and sales provide a
(1999) natural hedge of foreign currency exchange-rate
movements as foreign currency revenues are offset by
foreign currency expenses.
Baldwin Technology Company The Company also maintains certain levels of cash
Inc. (1999) denominated in various currencies which acts as a
natural hedge.
Baltek Corporation (1998) During 1997, the Company began borrowing in Ecuador
in local currency (sucre) denominated loans as a natural
hedge of the net investments in Ecuador.
Interface Inc. (1999) During 1998, the Company restructured its borrowing
facilities which provided for multi-currency loan
agreements resulting in the Company's ability to borrow
funds in the countries in which the funds are expected to
be utilized. Further, the advent of the Euro has provided
additional currency stability with the Company's
European markets. As such, these events have provided
the Company natural hedges of currency f luctuations.
Pall Corporation (2000) About one quarter of Pall's sales are in countries tied to
the Euro. At current exchange rates, this could reduce our
sales by close to 4%. Fortunately, many of our costs in
Europe are also reduced by a weak Euro. The weak
British Pound also reduces our exposure as most Pall sales
to Europe are manufactured in England. This provides a
natural hedge and helps preserve profitability.
Telef lex Inc. (1999) Approximately 65% of the company's total borrowings of
$345 million are denominated in currencies other than the
US dollar, principally Euro, providing a natural hedge
against f luctuations in the value of non-domestic assets.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
360 Planning and Forecasting
require, for example, the use of either exchange-traded or over-the-counter derivative
instruments.
While somewhat less contemporary, there are other examples of using a
firm's own operations and activities to offset foreign-currency exposure. For
example, California First Bank (now part of Union Bank) had a Swiss franc
borrowing in the amount of Sfr20 million.9 As this represented liability exposure
to California First, Exhibit 12.1 shows that an increase in the value of the
Swiss franc results in a foreign-currency transaction loss. The goal of the hedge
would be to create a gain in this circumstance to offset the loss on the Swiss
franc borrowing. Again, Exhibit 12.1 reveals that a gain would be produced
from asset exposure in the Swiss franc in the case where the Swiss franc appreciated
in value.
California First Bank sought an opportunity to establish an asset position
in the Swiss franc for the same amount and term as the existing Swiss franc
obligation. It created this offsetting position by making a loan and denominating
the loan in the Swiss franc. This apparently met the borrower's needs and
also served the hedging objective of California First Bank.
In an even more creative arrangement, Federal Express created a natural
hedge of a term loan that was denominated in the Japanese yen.10 This was accomplished
by a special structuring of transactions with its own customers. As
Federal Express explained:
To minimize foreign exchange risk on the term loan, the Company has commitments
from certain Japanese customers to purchase a minimum level of freight
services through 1993.
Federal Express needed Japanese yen to make periodic repayments on
the term loan. The arrangements with its Japanese customers ensured that yen
would be available to pay down the term loan. If the yen appreciates against
the dollar, the dollar burden of the Federal Express yen debt increases and results
in a transaction loss. However, this loss is offset in turn by the increase in
the dollar value of the stream of yen receipts from the freight-service contracts.
11 If instead the yen depreciates, a gain on the debt will be offset by
losses on the service contracts. A summary of the operation of this hedge is
provided in Exhibit 12.3.
California First and Federal Express both employed arrangements with
their customers in order to create hedges. In addition, purely natural hedges
EXHIBIT 12.3 Offsetting gains and losses produced by Federal Express
hedge.
Change in the value of Change in Dollar Value Change in Dollar Value
Foreign Currency of the Loan (Liability) of the Revenue (Asset)
Appreciates Increases (loss) Increases (gain)
Depreciates Decreases (gain) Decreases (loss)
Global Finance 361
may exist due to offsetting balances that result from ordinary business transactions
with no special arrangements being required. Several hedges that appear
to be of this nature were presented in Exhibit 12.2, for example, Adobe Systems
and Armstrong World Industries. Two other examples that appear to be
totally natural are the cases of Lyle Shipping and Australian mining companies.
Lyle Shipping, a Scottish firm, had borrowings in the U.S. dollar. An increase
in the value of the dollar would increase the pounds required to repay
Lyle's dollar debt and result in a transaction loss. However, because Lyle's
ships were chartered out at fixed rates in U.S. dollars, there would be an offsetting
increase in the pound value of future lease receipts—a transaction
gain.12 A similar natural hedge is generally held to exist for Australian mining
companies whose product is priced in U.S. dollars. Should the U.S. dollar depreciate,
the exposure to shrinkage in the Australian dollar value of U.S. receipts
(asset exposure) is offset by similar shrinkage in the Australian dollar
value of their U.S. dollar debt (liability exposure).13
Fashionhouse would probably find it difficult to duplicate the hedging
techniques used above by California First and Federal Express. Circumstances
giving rise to a natural hedge, as in the case of Lyle Shipping, may not exist. It
might have some capacity to hedge by applying the method of leading and lagging.
This method involves matching the cash f lows associated with foreigncurrency
payables and receivables by speeding up or slowing down their
payment or receipt. Moreover, once Fashionhouse has operations in Denmark,
it may be able to create at least a partial hedge of its asset exposure by funding
operations with Danish krone debt. If natural hedging opportunities are not
available, then Fashionhouse has the full range of both exchange-traded and
privately negotiated currency derivatives that it can use as a hedging instrument
to hedge currency risks.
The hedging requirements of the European operations of Fashionhouse
should be reduced by the introduction of the Euro. Even though Denmark is
not one of the original 11 members of the European Monetary Union (EMU),
its European exposure with the 11 countries will be reduced to a single currency,
the Euro.
Hedging with Foreign-Currency Derivatives
Foreign-currency derivatives are financial instruments that derive their value
from an underlying foreign-currency exchange rate. Some of the more common
currency derivatives include forward contracts to buy or sell currencies in the
future at fixed exchange rates, foreign-currency swaps, foreign-currency futures,
and options. The forward contracts and over-the-counter options have
the advantage of making it possible to tailor hedges to meet individual requirements
in terms of amounts and dates. The exchange-traded futures and options
have liquidity and a ready market, but a limited number of dates and contract
sizes. Examples of the use of both types of instruments, privately negotiated
and exchange traded, are discussed next.
362 Planning and Forecasting
Forward Exchange Contracts
A forward contract is an agreement to exchange currencies at some future date
at an agreed exchange rate. The exchange rate in a contract for either the purchase
or sale of a foreign currency is referred to as the forward rate. Forward
contracts are among the most popular of the foreign-currency derivatives, followed
by privately negotiated (over-the-counter) currency options.14 These privately
negotiated contracts can be tailored to meet the user's needs in term of
both the amount of currency and maturity of the contract. Exchange-traded
currency derivatives, such as options and futures, come in standard amounts of
currency and a limited number of relatively short maturities.
Forward-Contract Hedging Example An example may help to illustrate the
application of a forward contract to hedging currency exposure. Near the end
of 2000, the forward contract rate for the British pound sterling (￡), with a
term of one month, was about $1.45. The $1.45 is the direct exchange rate because
it expresses the price of the foreign currency in terms of dollars. The
comparable indirect rate is found by simply taking the reciprocal of $1.45:
1/$1.45 equals 0.69. The dollar is worth 0.69 pounds.
If a U.S. firm had an account payable of 100,000 pounds due in 30 days, a
hedge of this liability exposure could be effected by entering into a forward
contract to buy ￡100,000 for delivery in 30 days. Buying the currency through
the forward contract is necessary because the firm needs the pound in 30 days
to satisfy its account payable. If the dollar were to decline to $1.48 against the
pound over this 30-day period, then the dollar value of the account payable
would increase, creating a foreign-currency transaction loss. That is, it would
take more dollars to purchase the ￡100,000. However, offsetting this loss would
be a gain from an increase in the value of the forward contract. The right to buy
￡100,000 at the fixed forward rate of $1.45 increases in value as the value of
the pound increases to $1.48. The effects of this foreign-currency exposure and
associated forward-contract hedge are summarized in Exhibit 12.4. For the
EXHIBIT 12.4 Hedge of foreign-currency liability exposure with a
forward contract.
Item hedged: account payable of £100,000
Value of the account payable at payment date, ￡100,000 × $1.48 = $148,000
Value of the account payable when initially recorded, ￡100,000 × $1.45 = 145,000
Foreign currency transaction loss $ 3,000
Hedging instrument: forward contract to buy £100,000 @ $1.45, 30 days
Value of the forward contract at maturity, ￡100,000 × ($1.48 − $1.45) = $ 3,000
Value of the forward contract at inception, ￡100,000 × ($1.45 − $1.45) = 0
Gain on forward contract $ 3,000
Global Finance 363
sake of simplicity, we are assuming that the spot value of the pound is equal to
the forward rate at the inception of the forward contract.15
The gains and losses would be reversed if the U.S. firm in the above example
had a pound sterling accounting receivable. Moreover, the creation of a
hedge of this asset exposure in the pound sterling would call for the sale and
not the purchase of the pound sterling through the forward contract. Appreciation
of the pound sterling to $1.48 produces a transaction gain on the account
receivable for the U.S. firm. This would in turn be offset by a loss on the forward
contract. The value of the forward contract declines when the spot value
of the pound sterling, $1.48, is greater than the rate to be received through the
forward contract, $1.45.
Beckman Coulter Inc. provides a useful description of the offsetting gains
and losses created by hedges:
When we use foreign-currency contracts and the dollar strengthens against foreign
currencies, the decline in the value of the future foreign-currency cash
f lows is partially offset by the recognition of gains in the value of the foreigncurrency
contracts designated as hedges of the transactions. Conversely, when
the dollar weakens, the increase in the value of the future foreign-currency
cash f lows is reduced by . . . the recognition of any loss in the value of the forward
contracts designated as hedges of the transactions.16
Notice that Beckman Coulter talks of its future foreign-currency cash
f lows. This constitutes asset exposure to Beckman Coulter in the foreign currency.
If the dollar strengthens, then it follows that the foreign currency declines
in value. The dollar value of the steam of foreign cash flow decreases.
Because Beckman Coulter is long the cash flow, it would hedge this exposure
by selling (taking a short position) the foreign currency through the forward
contract.
Examples of Forward-Contract Hedging from Annual Reports A sampling of
firms that disclosed the use of forward contracts, and the types of exposure
they are hedging, is provided in Exhibit 12.5. There are a substantial number of
different hedge targets in this small set of companies. They include:
• Inter-company loans.
• Cash f lows associated with anticipated transactions.
• Bonds payable.
• Accounts payable.
• Accounts receivable.
• Net investments in foreign subsidiaries.
• Expected acquisition transaction.
Over-the-counter currency options are a close second in popularity as a
hedging instrument and their nature and use are discussed next.
364 Planning and Forecasting
EXHIBIT 12.5 Hedging with forward contracts.
Company Hedging Targets
Armstrong World Industries Inc. Armstrong also uses foreign currency forward exchange
(1999) contracts to hedge inter-company loans.
Arvin Industries Inc. (1999) Arvin manages the foreign currency risk of anticipated
transactions by forecasting such cash f lows at the operating
entity level, compiling the total Company exposure and
entering into forward foreign exchange contracts to lessen
foreign exchange exposures deemed excessive.
Dow Chemical Company (1999) The Company enters into foreign exchange forward
contracts and options to hedge various currency
exposures or create desired exposures. Exposures
primarily relate to assets and liabilities and bonds
denominated in foreign currencies, as well as economic
exposure, which is derived from the risk that the
currency f luctuations could affect the dollar value of
future cash f lows related to operating activities.
Tenneco Inc. (1999) Tenneco enters into foreign currency forward purchase
and sales contracts to mitigate its exposure to changes in
exchange rates on inter-company and third party trade
receivables and payables. Tenneco has from time to time
also entered into forward contracts to hedge its net
investments in foreign subsidiaries.
UAL Inc. (1999) United enters into Japanese yen forward exchange
contracts to minimize gains and losses on the revaluation
of short-term yen-denominated liabilities. The yen
forwards typically have short-term maturities and are
marked to fair value at the end of each accounting period.
Vishay Intertechnology Inc. In connection with the Company's acquisition of all the
(1999) common stock of TEMIC Semiconductor GmbH and
80.4% of the common stock of Siliconix, Inc., the
Company entered into a forward exchange contract in
December 1997 to protect against f luctuations in the
exchange rate between the U.S. dollar and the Deutsche
mark since the purchase price was denominated in
Deutsche marks and payable in U.S. dollars. At
December 31, 1997, the Company had an unrealized loss
on this contract of $5,295,000, which resulted from
marking the contract to market value. On March 2, 1998,
the forward contract was settled and the Company
recognized an additional loss of $6,269,000.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
Global Finance 365
Currency Option Contracts
A common feature of option contracts is that they provide the right, but not the
obligation, to either acquire or to sell the contracted items at an agreed price.
The agreed price is called the strike price. In addition, options are considered to
be in the money or out of the money based upon the relationship between the
strike price and the current price. The prices in the case of currency options are
currency exchange rates. For example, a currency option contract is out of the
money if the option provides the right to buy the Irish Punt at $1.12 when its
spot price is $1.10. Conversely, an option is in the money if it provides the right
to sell the German Mark at $0.45 when its spot value is $0.43.
An option contract that gives the holder the right to sell a currency at an
agreed rate, the strike price, is called a put option. The contract that provides
the right to purchase the currency at an agreed rate is termed a call option.
The cost of acquiring an option is termed the option premium. The option premium
is a function of a number of variables. These include the strike price,
the spot value of the currency, the time remaining to expiration of the option
and the volatility of currency and interest-rate levels. Option values are
estimated using methodologies such as the widely used Black-Scholes optionpricing
model.
Options Contrasted with Forwards Options are frequently characterized as
one-sided arrangements. Consider the case of a firm that wishes to hedge exposure
resulting from an Euro account receivable. The Euro amount of the receivable
is E62,500. Because the firm wishes to protect the dollar value of an
asset position (exposure) in the Euro, it would invest in a Euro put option, with
a maturity that is consistent with the collection date for the receivable. A single
exchange-traded option is acquired and the option premium is $1,000. The
spot value of the Euro is $0.88, resulting in a dollar valuation for the Euro receivable
of $55,000 ($0.88 × 62,500 = $55,000). The strike price is also $0.88,
meaning that the option contract is at the money, that is, the strike price and
spot value of the currency are the same.17 We will assume that at the expiration
date for the option contract the spot value of the Euro is, alternatively,
$0.84 and $0.92. The effects of these two different outcomes are summarized
in Exhibit 12.6.
Unlike the option contract, a forward contract does not permit the holder
to decline to fulfill the obligation simply because the hedged currency did not
move in an unfavorable direction. The forward contract is a symmetrical
arrangement. If a forward contract had been used to hedge the Euro exposure
in Exhibit 12.6, then there would be offsetting gains and losses on both the
Euro accounts receivable and on the forward contract, whether the Euro appreciated
or depreciated in value.
One-Sided Nature a Hedge with a Currency Option An option contract is
simply permitted to expire unexercised if an option contract is out of the
366 Planning and Forecasting
money at its maturity. The option contract is designed to protect the holder
against possible shrinkage in the dollar value of the Euro account receivable
that would result from a decline in the value of the Euro. In the first case,
where the spot value of the Euro did decline, then the option is exercised and
a gain of $2,500 is produced to offset the transaction loss of $2,500 on the
Euro account receivable. However, in the second case, where the spot value of
the Euro rose, the option is permitted to expire unexercised. After all, it permits
the sale of the Euro at $0.88 when the spot value of the Euro is $0.92.
The option contract expires without value.
Hedging a Euro receivable with a forward contract will result in a gain
on the forward contract when the Euro declines in value and a loss when the
Euro increases in value. These gains and losses will in turn offset the loss on
EXHIBIT 12.6 The operation of a currency option.
Expiration-date spot value of $0.84
Notional amount of the put-option contract, in Euros 62,500
Strike price of the Euro put option $0.88
Spot value of the Euro 0.84
Amount by which option is in the money .04 0.04
Contract gain $ 2,500
Initial dollar value of the Euro receivables
Accounts receivable in Euros 62,500
Times spot exchange rate $0.88
$55,000
Final dollar value of the Euro receivables
Accounts receivable in Euros 62,500
Times spot exchange rate $0.84 52,500
Transaction loss on accounts receivable $ 2,500
Expiration-date spot value of $0.92
Strike price of the Euro put option $0.88
Spot value of the Euro $0.92
The option is permitted to expire without being exercised. The contract provides the opportunity
to sell the Euro for $0.88 when its value in the spot market is $0.92. It has no value
upon its expiration.
Initial dollar value of the Euro receivables
Accounts receivable in Euros 62,500
Times spot exchange rate $0.88
$55,000
Final dollar value of the Euro receivables
Accounts receivable in Euros 62,500
Times spot exchange rate $0.92 57,500
Transaction gain on accounts receivable $ 2,500
Global Finance 367
the account receivable that results when the Euro declines in value and the
gain that results when the Euro increases in value. The behavior of a hedge
using a forward contract versus an option is summarized in Exhibit 12.7.
The symmetrical behavior of the forward contract in its hedging application
is evident in Exhibit 12.7. In each of the four combinations of exposure
and exchange rate movement the gains and losses on the balance sheet exposure
are offset in turn by the losses and gains on the forward contracts. However,
the option contracts produce offsetting gains and losses only in those
cases where the unfavorable exchange rate change takes place.18 Notice that a
gain is produced on the option contract to offset the loss on the balance sheet
asset exposure when the foreign currency depreciated. Currency depreciation
when the firm has asset exposure is an unfavorable rate movement. In the case
of liability exposure, notice that a gain is produced by the option contact when
the foreign currency appreciated. The corollary of appreciation of the foreign
currency is depreciation of the dollar. This is an unfavorable rate movement
because it causes the dollar value of the liability to increase. In the other two
cases, where the option contracts expire without value, the currency movements
are favorable: (a) asset exposure and the foreign currency appreciated
and (b) liability exposure and the foreign currency depreciated.
The positions taken in the forward and option contracts differ based upon
the nature of the foreign-currency exposure. With the forward contract, the
foreign currency is purchased in the case of liability exposure and sold in the
EXHIBIT 12.7 Behavior of hedge gains and losses with a forward
versus an option.
Type of Exposure Hedged Derivative Contract
Asset Forward Contract Put Option
Foreign currency appreciates
Gain on asset exposure Loss on the forward Contract expires with
contract neither gain nor loss; option
holder loses initial option
premium paid
Foreign currency depreciates
Loss on the asset exposure Gain on the forward Contract expires with a gain
contract
Liability Forward Contract Call Option
Foreign currency appreciates
Loss on the liability Gain on the forward Contract expires with a gain
exposure contract
Foreign currency depreciates
Gain on the liability Loss on the forward Contract expires with
exposure contract neither gain nor loss; option
holder loses initial option
premium paid
368 Planning and Forecasting
case of asset exposure. With the option contract, a call option is acquired in
the case of liability exposure and a put option in the case of asset exposure.
Some relevant commentary, in relation to the above discussion, on the
effects of hedging with currency options, is provided by the disclosures of Analog
Devices Inc.:
When the dollar strengthens significantly against the foreign currencies, the
decline in value of the future currency cash f lows is partially offset by the gains
in value of the purchased currency options designated as hedges. Conversely,
when the dollar weakens, the increase in value of the future foreign-currency
cash f lows is reduced only by the premium paid to acquire the options.19
The Analog commentary highlights the one-directional nature of a hedge
that employs a currency option as opposed to a forward contract. The corollary
of the decline in the dollar is a weakening of the foreign currency. This is the
unfavorable outcome that the hedge is designed to offset. Indeed, the above
comments indicate that a gain on the option contract is produced to offset the
decline in future cash f lows that result from a strengthening of the dollar. However,
when the dollar instead weakens, there is no offsetting loss, beyond "the
premium paid to acquire the options." The corollary of the weakening of the
dollar is the strengthening of the foreign currency. A strengthening of the foreign
currency is not the unfavorable currency movement that the currency
option was intended to protect against.
As with the forward contracts, a sampling of disclosures by companies
that are using currency options for hedging purposes is provided in Exhibit
12.8. Currency options are used less frequently than forward contracts.
Most of the options used are over-the-counter (OTC) as opposed to exchangetraded
options. Given the OTC character of these currency options, they share
the tailoring feature of the forward contracts. That is, unlike exchange traded
options that come in standard amounts of currency and limited maturities,
both forward contracts and options can be tailored in terms of currency
amount and maturity. However, unlike forward contracts, the currency options
do require an initial investment—the option premium. Little or no initial investment
is required in the case of the forward contract.
Forwards and options are the most popular currency derivatives, and it is
very common, as both Exhibits 12.5 and 12.8 reveal, for firms to use both instruments.
The last currency derivative that is only brief ly reviewed is the
futures contract. The futures contract shares the symmetrical gain and loss
feature of the forward contract.
Currency Futures
Currency futures are exchange-traded instruments. Entering into a futures
contract requires a margin deposit and a round-trip commission must also be
paid. As is true of exchange-traded currency options, futures contracts come in
fixed currency amounts and for a limited set of maturities. Futures contracts
Global Finance 369
also have the high level of liquidity that is characteristic of other exchangetraded
derivatives. They also share the symmetrical character of the forward
contract. That is, gains and losses will be produced by the futures contract to
offset losses and gains, respectively, on hedged positions. Currency futures are
used rather infrequently in the hedging of foreign-currency exposures.
Summary of Currency Exposure and Hedging Positions
It is common for firms to first attempt to reduce currency exposure by using
their own operating activities and other internal actions. This point is made in
the following comments from the disclosures of JLG Industries: "The Company
manages its exposure to these risks (interest and foreign-currency rates)
EXHIBIT 12.8 Hedging with option contracts.
Company Hedging Targets
Analog Devices Inc. (1999) The Company may periodically enter into foreign currency
option contracts to offset certain probable anticipated, but
no firmly committed, foreign exchange transactions related
to the sale of product during the ensuing nine months.
Arch Chemicals Inc. (1999) The Company enters into forward sales and purchases and
currency options to manage currency risk resulting from
purchase and sale commitments denominated in foreign
currencies (principally Euro, Canadian dollar, and Japanese
yen) relating to anticipated but not yet committed
purchases and sales expected to be denominated in those
currencies.
Olin Corporation (1999) The Company enters into forward sales and purchase
contracts and currency options to manage currency risk
resulting from purchase and sale commitments
denominated in foreign currencies (principally Australian
dollar and Canadian dollar) and relating to particular
anticipated but not yet committed purchases and sales
expected to be denominated in those currencies.
Polaroid Corporation (1999) The Company has limited f lexibility to increase prices in
local currency to offset the adverse impact of foreign
exchange. As a result, the Company primarily purchases
U.S. dollar call/foreign currency put options which allows
it to protect a portion of its expected foreign currency
denominated revenues from adverse currency exchange
movement.
Quaker Oats Company (1999) The Company uses foreign currency options and forward
contracts to manage the impact of foreign currency
f luctuations recognized in the Company's operating results.
York International Corporation To reduce this risk, the Company hedges its foreign
(1999) currency transaction exposure with forward contracts and
purchased options.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
370 Planning and Forecasting
principally through its regular operating and financing activities."20 These
approaches to reducing currency exposure are usually referred to as natural
hedges. A number of examples of natural hedges were provided in Exhibit 12.2.
When natural hedges do not close out sufficient currency exposure, it is common
for firms to turn to currency derivatives to reduce exposure still further.
Based upon the previous discussion of selected currency derivatives, the positions
to be taken in the face of asset versus liability exposure are summarized
in Exhibit 12.9.
The information in Exhibit 12.9 indicates how a number of different instruments
can be used to hedge currency risk. However, management must decide
whether, and to what extent, to hedge such risk. Some of the factors that
bear on the hedging decision are discussed next.
Influences on the Hedging Decision
The first hedging decision is whether or not to hedge currency exposure at all.
The decision of whether or not to hedge currency exposure is inf luenced, at
least in part, by the attitude of management towards the risk associated with
foreign-currency exposure. Other things equal, a highly risk-averse management
will be more inclined to hedge some or all currency-related risk. Moreover,
not all currency exposure is seen to be equal. Firms have different
demands for hedging based upon whether the exposure has the potential to affect
cash f lows and earnings, or simply the balance sheet. Finally, the materiality
of currency exposure as well as expected movement in exchange rates will
also inf luence the demand for hedging.
Is Currency Exposure Material?
A common disclosure made by firms with currency exposure is the effect that a
10% change in exchange rates would have on results. For example, Titan International,
Inc. has currency exposure from its net investment in foreign subsidiaries.
Titan discloses the potential loss associated with an adverse movement
in the exchange rates of these subsidiaries:
The Company's net investment in foreign subsidiaries translated into U.S. dollars
at December 31, 1999, is $55.4 million. The hypothetical potential loss in
EXHIBIT 12.9 Foreign currency exposure and hedging
decisions: Forwards, options, and futures.
Hedging Exposure
Instrument Asset Liability
Forward contract Sell foreign currency Buy foreign currency
Option Buy put options Buy call options
Futures Sell futures contract Buy futures contracts
Global Finance 371
value of the Company's investment in foreign subsidiaries resulting from a 10%
adverse change in foreign-currency exchange rates at December 31, 1999 would
amount to $5.5 million.21
Titan International disclosed no currency hedging activities. This is not surprising
given that the $5.5 million loss in investment value amounts to only
about 2% of its total shareholders' equity at the end of 1999. Beyond this, as
we will see in the subsequent discussion of the translation of the statements of
foreign subsidiaries, the potential reduction in Titan's investment value does
not affect either earnings or cash flow.22 This, combined with the immaterial
size of the potential loss in value, can easily explain the absence of hedging
activity.
What Are Hedging Motivations and Objectives?
Much information on hedging motivation is implicit in the information provided
in Exhibits 12.5 and 12.8. Recurrent themes are those of protecting
earnings and cash f low from the potential volatility produced by exchange rate
f luctuations. Information on the ranking of alternative hedging objectives,
from a survey conducted at the Wharton Business School, is provided in Exhibit
12.10. The dominance of the desire to protect cash f lows and earnings is
clearly the dominant motivator for hedging. However, as will be discussed in
the section on translation of the statements of foreign subsidiaries, there is
some level of hedging of balance-sheet exposure.
How Much Exposure Is Hedged?
The extent to which currency exposure is hedged ranges from zero to 100%. It
is common for firms to announce that they simply do not use currency derivatives
to hedge against currency risk. However, such firms may have already
reduced currency risk to tolerable levels through natural hedges. Again, the appetite
of management for bearing currency risk will in large measure determine
the extent of the hedging. The cost and availability of hedging instruments is
EXHIBIT 12.10 Rankings of alternative hedging objectives.
Percent of Respondents Ranking
Hedging Objective the Objective as Most Important
1. To manage volatility in cash f lows 49%
2. To manage volatility in accounting earnings 41
3. To manage market value of the firm 8
4. To manage balance sheet accounts or ratios 2
100%
SOURCE: G. Bodnar, G. Hayt, and R. Marston, "The Wharton Survey of Derivatives Usage by U.S.
Non-Financial Firms," Financial Management, 25 (Winter 1996), 114–115.
372 Planning and Forecasting
also a factor. As with insurance generally, closing out fully the possibility of loss
is more expensive.
Some firms provide information on the extent of their hedging through
schedules of net exposure. E.I. DuPont de Nemours & Company (DuPont) provides
such a schedule. A slightly abridged version is presented in Exhibit 12.11.
DuPont also declares the following about the objective of its hedging program:
The primary business objective of this hedging program is to maintain an
approximately balanced position in foreign currencies so that exchange gains
and losses resulting from exchange rate changes, net of related tax effects, are
minimized.23
Exhibit 12.11 reveals that DuPont has hedged almost all of its exposure.
The extent of their hedging means that their earnings and cash flows will not
be affected in a material way from the hedged exposures. This is reinforced by
the following disclosure:
Given the company's balanced foreign exchange position, a 10 per cent adverse
change in foreign exchange rates upon which these contracts are based would
result in exchange losses from these contracts that, net of tax, would, in all material
respects be fully offset by exchange gains on the underlying net monetary
exposures for which the contracts are designated as hedges.24
Other firms disclose more limited hedging activity. For example, The
Quaker Oats Company reported that about 60% of its net investment in foreign
subsidiaries was hedged. This disclosure is presented in Exhibit 12.12.25
Other Hedging Considerations
Discussed above are a number of factors that bear on the hedging decision,
such as whether or not to hedge, what to hedge, how to hedge, and how much
to hedge. Some other issues center on the cost and term or duration of hedging
arrangements. A sampling of company references to these issues is provided in
Exhibit 12.13.
EXHIBIT 12.11 Net currency exposure: E.I. DuPont de Nemours &
Company, December 31, 1999 (in millions).
After-Tax Net After-Tax
Monetary Open Contracts Net
Asset/(Liability) to Buy/(Sell) After-Tax Exposure
Currency Exposure Foreign Currency Asset/(Liability)
Brazilian real $ 109 $(101) $ 7
British pound (337) 334 (3)
Canadian dollar 514 (509) 5
Japanese yen 76 (71) 5
Taiwan dollar (136) 136 —
SOURCE: E.I. DuPont de Nemours & Company, annual report, December 1999, 37.
Global Finance 373
EXHIBIT 12.12 Disclosure of net investment hedge: The Quaker Oats
Company, December 31, 1999 (in millions).
Currency Net Investment Net Hedge Net Exposure
Dutch guilders $15.1 $ 9.1 $6.0
German marks 18.3 11.9 6.4
SOURCE: The Quaker Oats Company, annual report, December 1999, 56.
EXHIBIT 12.13 Company references to hedging cost and the terms of
currency derivatives.
Company Reference
Hedging Costs
Baxter International Inc. (1999) The Company's hedging policy attempts to manage these
risks to an acceptable level based on management's
judgment of the appropriate trade-off between risk,
opportunity, and costs. As part of the strategy to manage
risk while minimizing hedging costs, the Company utilizes
sold call options in conjunction with purchased put
options to create collars.
Compaq Computer Corporation The Company also sells foreign exchange option contracts,
(1999) in order to partially finance (reduce their cost) the
purchase of these foreign exchange option contracts.
Interface Inc. (1999) The Euro may reduce the exposure to changes in foreign
exchange rates, due to the netting effects of having assets
and liabilities denominated in a single currency.As a result,
the Company's foreign exchange hedging activity and
related costs may be reduced in the future.
Derivative Maturities
Blyth Industries Inc. (2000) The foreign exchange contracts outstanding at January 31,
2000 have maturity dates ranging from February 2000
through June 2000.
Compaq Computer Corporation The term of the Company's foreign exchange hedging
(1999) instruments currently does not extend beyond six months.
Johnson & Johnson (1999) The Company enters into forward foreign exchange
contracts maturing within five years to protect the value
of existing foreign currency assets and liabilities.
Pall Corporation (2000) The Company enters into forward exchange contracts,
generally with terms of 90 days or less.
Polaroid Corporation (1999) The term of these contracts (forward exchange contracts)
typically does not exceed six months.
Tenneco Inc. (1998) Tenneco uses derivative financial instruments, principally
foreign currency forward purchase and sale contracts,
with terms of less than one year.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
374 Planning and Forecasting
Hedging Costs There is little discussion in company reports about the cost of
hedging. In some cases cost issues surely underlie decisions of firms not to
hedge currency risk, but the consideration of cost is not reported. Also, the act
of using internal operations to reduce currency exposure can be seen as designed
to reduce the exposure that may then be hedged with currency derivatives—
thus reducing hedging costs. Clear efforts to reduce hedging costs are
represented by the activities of Baxter International and Compaq Computer.
Each sells (is a writer of the option) currency option contracts from which it
receives an option premium. They then use these amounts to reduce the cost of
currency options used for hedging and where, as the holder of the option, they
are paying an option premium.
Many firms report that they expect to be able to reduce hedging activity
and hedging costs as a result of the introduction of the Euro. This will result
from the replacement of 11 European currencies with the Euro. Transactions
can take place by one Euro country with up to 10 others without incurring any
currency exposure.
Terms of Currency Derivatives The terms of derivative contracts are kept
relatively short, usually less than one year. This partly ref lects the fact that the
maturity of the underlying item being hedged, an account payable or account
receivable, for example, is also quite short. Moreover, the typical maturity
of exchange traded derivatives are short. Also, the cost to acquire currency
through either a forward or option contract also increases with the maturity.
For example, the forward rate (rate at which the foreign currency can be purchased
for future delivery) for the British pound sterling was the following at
the end of 2000:
Contract Term Forward Rate
One month $1.4574
Three months $1.4588
Six months $1.4606
The prices of currencies in both futures and option contracts display the
same increasing cost as maturity lengthens.
The discussion to this point has focused on currency risk and actions that
management can take to reduce the effect of f luctuations in currency values on
the volatility of earnings and cash flow. The examples have centered on what
are normally termed transaction exposures. Examples of transaction exposure
include accounts payable, accounts receivable and bonds payable that are denominated
in foreign currencies. If left unhedged, increases and decreases in
exchange rates cause these balances to expand and contract. This expansion
and contraction produces transactional gains and losses.
Transaction gains and losses are also produced by the combination of
(1) positions in currency derivatives and (2) increases and decreases in exchange
rates. Offsetting losses and gains result when the derivatives are used
Global Finance 375
for hedging purposes. Holding a derivative contract for other than hedging
purposes is normally termed a speculation. It is common for companies to
declare that they do not hold derivatives for speculative purposes: "The Company
does not use financial instruments for speculative or trading purposes,
nor is the Company a party to leveraged derivatives."26 The disclaimer on the
use of currency derivatives, as well as leveraged derivatives, is the legacy of
huge losses incurred on certain derivative transactions in the late eighties and
early nineties.
Attention now turns to translation currency risk. Here, currency exposure
results from having foreign subsidiaries or investments in foreign firms that are
accounted for using the equity method.27
TRANSLATION OF THE STATEMENTS OF
FOREIGN SUBSIDIARIES
A number of new financial and managerial issues were added to the Fashionhouse
agenda when it purchased its former Danish supplier. Transactional
issues continue to the extent that (1) Fashionhouse continues to make some
of its purchases from foreign suppliers and (2) the foreign suppliers continue
to invoice Fashionhouse in the foreign currency. In addition, the Danish subsidiary
may also have its own transactional exposure. However, with the
emergence of the euro, the Danish subsidiary's currency exposure should be
limited to the extent that it deals mainly with countries that have adopted
the Euro.28
Since the Danish company is a wholly owned subsidiary, U.S. GAAP will
call for its consolidation. However, the financial statements of the Danish
subsidiary are in the Danish krone. This introduces a translational issue; the
Danish subsidiary statements must be restated into dollars before their consolidation
with its parent, Fashionhouse, can take place. To the extent that the accounting
practices used in preparing a subsidiary's statements differ from
those of their parent, the subsidiary's statements would need to be restated to
conform to the accounting practices of the parent.29 This would, of course, be
the case with Fashionhouse and its Danish subsidiary. International GAAP differences
are discussed in a subsequent section of this chapter.
FINANCIAL STATEMENT TRANSLATION
Translation means that the foreign-currency balances in the financial statements
of a foreign subsidiary are restated into U.S. dollars. There is no conversion
of currencies, which means that one currency is exchanged for another.
Translation is accomplished by simply multiplying the foreign-currency statement
balances by an exchange rate. Translation would be a nonevent if every
balance in the statements of the foreign subsidiary were multiplied by the
376 Planning and Forecasting
same exchange rate. Translation would simply amount to a scaling of the statements
of the foreign subsidiary.
However, each of the translation alternatives requires the translation of
some balances at different exchange rates. In accounting parlance, this throws
the books out of balance. The amount by which the books are thrown out of
balance by translation is termed the translation adjustment or remeasurement
gain or loss, depending upon the translation process being applied. In the process
of illustrating statement translation, the creation and interpretation of
these translation balances will be discussed.
TRANSLATION ALTERNATIVES
There are two different translation methods under current GAAP. However,
the second method is technically a remeasurement method as opposed to a
translation method. As translation methods, the two alternatives are called the
(1) all-current and (2) temporal methods, respectively. The key features of
these two methods are summarized in Exhibit 12.14.
Examples of accounting policy notes describing the use of each of these
translation policies are provided below:
The all-current translation method: H.J. Heinz Company (1999)
For all significant foreign operations, the functional currency is the local currency.
Assets and liabilities of these operations are translated at the exchange
rate in effect at each year-end. Income statement accounts are translated at the
average rate of exchange prevailing during the year. Translation adjustments
arising from the use of differing exchange rates from period to period are included
as a component of shareholders' equity.
The temporal remeasurement (translation) method:
Storage Technology Corp. (1999)
The functional currency for StorageTek's foreign subsidiaries is the U.S. dollar,
ref lecting the significant volume of intercompany transactions and associated
cash f lows that result from the fact that the majority of the Company's storage
products sold worldwide are manufactured in the United States. Accordingly,
monetary assets and liabilities are translated at year-end exchange rates, while
non-monetary items are translated at historical exchange rates. Revenue and expenses
are translated at the average exchange rates in effect during the year,
except for cost of revenue, depreciation, and amortization that are translated at
historical exchange rates.
The key to the determination of the use of the all-current translation
method by H.J. Heinz is its statement that the functional currency is the local
currency for its foreign subsidiaries. That is, these subsidiaries conduct their operations
in their local currency. The company does not identify its translation
method as all current, but the combination of (1) the use of year-end, or current,
Global Finance 377
exchange rates and (2) the inclusion of translation adjustments in shareholders'
equity marks it as using the all-current translation method.
Unlike H.J. Heinz, Storage Technology declares that the functional currency
of its foreign subsidiaries is the U.S. dollar, not the local foreign currency.
The explanation for this condition is found it its reference to significant
volume of inter-company transactions and the manufacture of most of its products
in the United States. As with H.J. Heinz, Storage Technology does not
identify the translation method it is using. However, the fact that the U.S. dollar
is the functional currency of its foreign subsidiaries determines that it must
be the temporal method. Moreover, it describes its method as translating monetary
assets and liabilities at year-end exchange rates and nonmonetary items at
EXHIBIT 12.14 Alternative translation methods.
All-Current Translation Method
The all-current translation method is the standard procedure applied to foreign subsidiaries
whose operations are conducted in the local foreign currency. That is, the local currency is the
subsidiary's functional currency. The local foreign currency is expected to be the functional
currency when the foreign subsidiary's operations are "relatively self-contained and
integrated within a particular country." A further requirement for use of the all-current
method is that the subsidiary not be located in a country that has experienced cumulative
inf lation over the previous three-year period of 100% or more. The logic is that meaningful
results cannot be produced under these conditions by simply multiplying the foreign
currency balances by current exchange rates.
• All asset and liability balances are translated at the current or end-of-period exchange
rate.
• Paid-in capital is translated at the exchange rate when the funds were raised.
• Revenues and expenses are translated at the average exchange rate for the current
period.
• The translation adjustment is included in other comprehensive income.
Temporal (Remeasurement) Translation Method
This method is applied in those cases where the local foreign currency is not the functional
currency of the subsidiary. The functional currency is defined as "the currency of the
primary economic environment in which the entity operates; normally, that is the currency
of the environment in which the entity generates and spends cash." Moreover, as noted
above, "A currency in a highly inf lationary environment is not considered stable enough to
serve as a functional currency and the more stable currency of the reporting parent is to be
used instead."
• All monetary assets and liabilities are remeasured at current exchange rates.
• All nonmonetary assets, liabilities, and equity balances are remeasured at historical
exchange rates.
• Revenues and expenses are remeasured at average exchange rates for the period.
However, cost of sales and depreciation are remeasured at the same rates used to
remeasure the related inventory and fixed assets, respectively.
• The remeasurement gain or loss is included in realized net income.
378 Planning and Forecasting
historical exchange rates. These procedures are followed when translation (remeasurement)
follows the temporal method.
Translation under the all-current method and remeasurement under the
temporal method are illustrated next.
The All-Current Translation Method Illustrated
Following the guidance in Exhibit 12.14, the all-current translation method is
illustrated using the data below:
1. Foreign Sub is formed on January 1, 2002 with an initial funding from a
stock issue that raised FC1,000 (FC = Foreign current units).
2. Selected exchange rates for 2002:
Direct Exchange Rates
At January 1, 2002 $0.58
Average for 2002 0.62
At December 31, 2002 0.66
The above rates indicate the amount of U.S. currency required to
equal (buy) a single unit of the foreign currency. The increase in the rate
across the year means that the dollar has lost value and that the foreign
currency has appreciated.
3. The trial balance of Foreign Sub, both in FC and in U.S. dollars and
translated following the all-current rule, is given in Exhibit 12.15. Those
accounts that would have debit balances, assets and expenses, are
EXHIBIT 12.15 Trial Balance in FC and translated US$ at
December 31, 2002.
Accounts FC Exchange Rates U.S.$
Cash $ 200 $0.66 $ 132
Accounts receivable 100 0.66 66
Inventory 300 0.66 198
Property and equipment 2,000 0.66 1,320
Cost of sales 600 0.62 372
SG&A expense 100 0.62 62
Tax provision 120 0.62 74
Totals $3,420 $2,224
Accounts payable $ 400 0.66 $ 264
Notes payable 1,020 0.66 673
Common stock 1,000 0.58 580
Retained earnings 0 0
Translation adjustment 0 87
Sales 1,000 0.62 620
Totals $3,420 $2,224
Global Finance 379
grouped first, and those with credit balances, liabilities, equities, and revenues,
are grouped second.
The totals of the two groupings of account balances must be equal,
that is, in balance. Notice that this is only achieved in the U.S. dollar trial
balance through introduction of a translation adjustment account, with a
balance just sufficient to establish this equality. Without the addition of
the $87 translation adjustment account balance, the total of the translated
assets and expenses, $2,224, exceeds the total of the translated liabilities,
shareholders' equity and sales accounts by $87. This translation
adjustment can also be directly calculated as shown next:
Beginning net assets (assets minus liabilities) FC1,000
times change in exchange rate from 1/1/02 to
12/31/02 (0.66 − 0.58) 0.08 $80
Net income FC180
times difference between end of year and
average exchange rates (0.66 − 0.62) 0.04 7
Translation adjustment $87
The $80 component represents the growth in the beginning net assets due
to appreciation in the value of Sub's foreign currency. The $7 component is the
additional net assets due to the translation of the income statement balances at
the average rate for the year of $0.62 and balance sheet amounts at the end of
year rate of $0.66. There is no retained earnings balance in the above trial balance
because 2002 is the first year of operation and the net income for the year
is added to retained earnings through a later process of closing the books.
The translated balance sheet and income statements are presented in
Exhibits 12.16 and 12.17. They can be constructed from the translated data
above. The translation of the FC data is presented again in these statements
simply to reinforce the nature of the translation process.
EXHIBIT 12.16 Translated income statement, year
ending December 31, 2002.
Income Statement FC Exchange Rates U.S.$
Sales $1,000 $0.62 $620
Less cost of sales 600 0.62 372
Gross margin 400 248
Less SG&A 100 0.62 62
Pretax profit 300 186
Less tax provision 120 0.62 74
Net income $ 180 $112
Other comprehensive income 87
Comprehensive income $199
380 Planning and Forecasting
In the absence of dividends, the retained earnings in the balance sheet
are simply the net income for the year. The translation adjustment of $87 is included
in consolidated shareholders' equity as accumulated other comprehensive
income. The net assets of Foreign Sub are in a currency that appreciated
across the year. This growth in net assets is captured in the process of translation
and represented, again, by the translation adjustment balance. It is common
for the translation adjustment in this case to be referred to as a translation
gain. It resulted because the U.S. parent has a net investment (assets minus liabilities)
in a country whose currency appreciated against the U.S. dollar.
If, instead, the FC had depreciated, then the translation adjustment
would represent a negative balance in the initial accumulated other comprehensive
income for 2002. Also, in this circumstance it is common to see the
translation adjustment referred to as a translation loss. With the translation
completed, the above statements in Exhibit 12.16 and 12.17 would now be
ready for consolidation with those of the U.S. parent.30
The Remeasurement of Statements (Temporal
Translation) Illustrated
This illustration of the remeasurement of the statements of a foreign subsidiary
uses the same data as used in the illustration of the all-current translation
method.31 However, some additional information is required:
1. Property and equipment were acquired when the exchange rate was
$0.58.
2. Depreciation on this property and equipment of FC60 was included in
SG&A expense.
EXHIBIT 12.17 Translated balance sheet, December 31,
2002.
Balance Sheet FC Exchange Rates U.S.$
Cash $ 200 $0.66 $ 132
Accounts receivable 100 0.66 66
Inventory 300 0.66 198
Property and equipment 2,000 0.66 1,320
Total assets $2,600 $1,716
Accounts payable $ 400 0.66 $ 264
Notes payable 1,020 0.66 673
Common stock 1,000 0.58 580
Accumulated OCI* 87
Retained earnings 180 112
Total liabilities and equity $2,600 $1,716
* OCI = Other comprehensive income.
Global Finance 381
3. The ending inventory was acquired at the average exchange rate of $0.62,
and cost of sales is also made up of goods that were acquired when the exchange
rate averaged $0.62.
The previous trial balance is remeasured into the U.S. dollar as shown in
Exhibit 12.18. The income statement and balance sheet, prepared with the remeasured
trial balance data, are presented in Exhibits 12.19 and 12.20.32
Notice how application of the remeasurement method sharply changes
comprehensive income. Comprehensive income was $199 with translation
under the all-current method but only $27 with the temporal method of remeasurement.
This difference of $85 is explained as follows:
All-current method comprehensive income $199
Reduction in depreciation under temporal method:
FC60 (.62 − .58) 2*
Translation gain under the all-current method $(87)
Deduct remeasurement loss under temporal method 87
(174)
Temporal method net income $ 27
*Depreciation was translated at $0.62 as part of SG&A under the all-current method.
However, because the fixed assets, which give rise to the depreciation expense, are translated
at their historical exchange rate of $0.58, the depreciation component of SG&A is
reduced by $2 with remeasurement under the temporal method.
EXHIBIT 12.18 Remeasured trial balance, December 31,
2002.
Accounts FC Exchange Rates U.S.$
Cash $ 200 $0.66 $ 132
Accounts receivable 100 0.66 66
Inventory 300 0.62 186
Property and equipment 2,000 0.58 1,160
Cost of sales 600 0.62 372
SG&A expense 40 0.62 25
Depreciation 60 0.58 35
Tax provision 120 0.62 74
Remeasurement loss 87
Totals $3,420 $2,137
Accounts payable $ 400 0.66 $ 264
Notes payable 1,020 0.66 673
Common stock 1,000 0.58 580
Retained earnings 0 0
Sales 1,000 0.62 620
Totals $3,420 $2,137
382 Planning and Forecasting
The explanation for the remeasurement loss of $87 is that balance-sheet
exposure changed from net asset under the all-current method to net a liability
position under the temporal (remeasurement) method. Asset exposure in an
appreciating foreign currency results in a gain. However, liability exposure in
the same circumstance results in a loss. In the all-current example, all assets
and liabilities are translated using the current rate. Asset exposure existed
under the all-current method because assets exceeded liabilities. As a result,
the appreciation of the foreign currency resulted in a growth (gain) in net assets.
This gain of $87 was reported as other comprehensive income.
Under the temporal method of remeasurement, balance sheet exposure
is the net of monetary assets and liabilities. These balance sheet accounts are
EXHIBIT 12.19 Remeasured income statement, year
ended December 31, 2002.
Accounts FC Exchange Rates U.S.$
Sales $1,000 $0.62 $620
Less Cost of sales 600 0.62 372
Gross margin 400 248
Less: SG&A 40 0.62 25
Depreciation 60 0.58 35
Remeasurement loss (Exhibit 12.18) 87
Pretax profit 300 101
Less: tax provision 120 0.62 74
Net income $ 180 $ 27
Other comprehensive income —
Comprehensive income $ 27
EXHIBIT 12.20 Remeasured balance sheet, December 31,
2002.
Balance sheet FC Exchange Rates U.S.$
Cash $ 200 $0.66 $ 132
Accounts receivable 100 0.66 66
Inventory 300 0.62 186
Property and equipment 2,000 0.58 1,160
Total assets $2,600 $1,544
Accounts payable$ $ 400 0.66 $ 264
Notes payable 1,020 0.66 673
Common stock 1,000 0.58 580
Retained earnings 180 (income statement) 27
Total liabilities and equity $2,600 $1,544
Global Finance 383
remeasured at the ever-changing current rate. However, none of the other nonmonetary
balance-sheet accounts creates exposure because their dollar value is
frozen at fixed, historical exchange rates.
In the above example, monetary liabilities (accounts payable of FC400
plus notes payable of FC1,020) are well in excess of monetary assets (cash of
FC200 plus accounts receivable of FC100) and net liability exposure results.
Appreciation of the foreign currency increased the dollar valuation of this net
liability exposure and produced a remeasurement loss of $87. This remeasurement
loss is included in computing conventional net income, and not in other
comprehensive income as is the case under the all-current translation method.
Beyond these separately reported income statement effects of translation
gains and losses, the translated financial statements are affected in some other
less obvious ways. These are discussed next.
Other Effects of Statement Translation
and Remeasurement
The most noticeable effects of the statement translation and remeasurement
are (1) the translation adjustment that is part of other comprehensive income
under all-current translation and (2) the remeasurement gain or loss that is included
in realized net income with statement remeasurement under the temporal
method.
Statement Relationships under Translation
versus Remeasurement
Significant differences in earnings resulted in the above example with translation
under the all-current method versus remeasurement under the temporal
method. These results are due to (1) differences in currency exposure under
the two methods and (2) differences in the location of translation-related gains
and losses in the financial statements under the two methods. Translation adjustments
go to other comprehensive income under all-current translation, but
remeasurement gains and losses are included in net income with remeasurement
under the temporal method.
Key statement relationships are affected by translation versus remeasurement.
For example, both the current ratio (ratio of current assets to current
liabilities) and the debt to equity ratios differ between the two methods. It is
also common for gross margins to differ between the two methods. However,
the simple nature of this constructed example results in the same gross margins
under each translation/remeasurement method. These measures are presented
in Exhibit 12.21.
Noticeable in Exhibit 12.21 is the fact that the values of each of the measures
from the foreign-currency statements are preserved with translation
under the all-current method. However, both the working capital and debt to
equity measures differ from these values in the case of remeasurement under
384 Planning and Forecasting
the temporal method. The working capital ratio differs because inventory is
translated at a rate of only $0.62 under remeasurement, but at $0.65 with
translation under the all-current method. The debt-to-equity ratio is higher
with the remeasured statements because of the remeasurement loss under the
temporal method, but a translation gain under the all-current method. Preserving
the relationships of the foreign-currency statements in the translated
statements is seen to be a desirable feature of translation under the all-current
method.
Effects of Exchange Rate Changes not Captured by
Translation and Remeasurement
It is common for firms to comment on the effects of exchange-rate changes on
key financial statement items. In particular, the effects of exchange-rate
changes on the growth or decline in sales are frequently commented upon in
Management's Discussion and Analysis (MD&A).
The processes of translation and remeasurement summarize the joint effects
of currency exposure and exchange rate changes in a single summary statistic.
However, there are other effects associated with changing exchange rates
that are not set out separately in any financial statement. For example, assume
that the physical volume of sales and local-currency sales prices are unchanged
for a foreign subsidiary. If the currency of the country in which the subsidiary
is located depreciates in value, then the translated amount of sales revenue will
decline. If the product being sold is manufactured in the foreign country, then
there should also be a partially offsetting decline in cost of sales.33
The disclosures in Exhibit 12.22 attempt to identify the effect of changing
exchange rates on sales and profits. Galey & Lord's disclosure identifies a common
concern about the dollar appreciating in value: it makes U.S. goods more expensive
in the export market. This point is echoed by Illinois Tool Works and its
disclosure that its operating revenues were reduced each of the last three years
because of the strengthening of the U.S. dollar. Revenue reductions associated
with a strengthened dollar normally come from a combination of (1) foreign sales
EXHIBIT 12.21 Key statement relationships under translation versus
remeasurement.
In the FC
Measurement Statements Translation Remeasurement
Working capital ratioa 1.50/1 1.50/1 1.45/1
Gross margin 40% 40% 40%
Debt to equityb .86/1 .86/1 1.11/1
a Only the accounts payable are included in current liabilities.
b Debt includes only the notes payable. Equity under the all-current method includes accumulated
other comprehensive income.
Global Finance 385
simply translating into fewer dollars as well as (2) declines in the volume of foreign
sales due to the weakening of the foreign currency.
The Philip Morris disclosures highlight the value of diversification in foreign
sales by currency. Whereas revenues and profits were reduced by the depreciation
of Western European and Latin American currencies, the Japanese
yen appreciated and offset, but not fully, these negative effects. Notice that
Philip Morris identifies the net effect of the appreciation and depreciation of
foreign currencies on both revenues and income.
Praxair provides sufficient detail to reconcile its actual percentage
growth or decline in sales to the results in the absence of changes in exchange
rates. Notice that Praxair's sales declined by 4% in 1999, and that the decline
was largely explained by currency depreciation in South America. However, explaining
the behavior of sales in 1998 is more involved. The information disclosed
by Praxair for 1998 is summarized here:
EXHIBIT 12.22 Exchange rate effects on sales and profit growth.
Galey & Lord Inc. (1999)
In addition to the direct effects of changes in exchange rates, which are a changed dollar
value of the resulting sales and related expenses, changes in exchange rates also affect the
volume of sales or the foreign currency sales price as competitors products become more or
less attractive.
Illinois Tool Works Inc. (1999)
The strengthening of the U.S. dollar against foreign currencies in 1999, 1998 and 1997
resulted in decreased operating revenues of $59 million in 1999, $122 million in 1998 and
$166 million in 1997 and decreased net income by approximately 1 cent per diluted share in
1999 and 4 cents per diluted share in 1998 and 1997.
Philip Morris Companies Inc. (1999)
Currency movements decreased operating revenues by $782 million ($517 million, after
excluding excise taxes) and operating companies income by $46 million during 1999. Declines
in operating revenues and operating companies income arising from the strength of the U.S.
dollar against Western European and Latin American currencies were partially mitigated by
currency favorabilities recorded against the Japanese yen and other Asian currencies.
Praxair Inc. (1999)
The sales decrease of 4% in 1999 as compared to 1998 was due primarily to unfavorable
currency translation effects in South America. Excluding the impact of currency, sales grew
by 2%.
The productivity improvements and currency translation impacts resulted in an $18 million
decrease in selling, general, and administrative expenses despite the increase due to
acquisitions.
Sales for 1998 were f lat when compared to 1997, primarily because sales volume growth of
4% and price increases of 2% were offset by negative currency translation effects.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
386 Planning and Forecasting
Disclosed sales growth 0%
Breakdown of Sales-Change Components
Volume +5%
Price changes +2%
Currency depreciation −7%
Sales growth 0%
The Praxair zero change in sales revenue in 1998 could be interpreted in
a manner that is too negative. After all, in the face of the zero growth in actual
dollar sales revenue, Praxair was able to increase prices and still improve sales
volume by 5%. Disclosure of quantitative details on the effects of the three elements,
volume, price and currency makes it possible to develop a much better
understanding of Praxair's 1998 business performance.
In the case of positive revenue growth, increases from volume or price
adjustments should be preferred to growth resulting from favorable exchangerate
movements. Revenue growth driven by changes in exchange rates may
prove to be only temporary. Sustained revenue growth, in the absence of volume
growth and/or price increases, would require ongoing strengthening of
foreign currencies—not a very likely prospect.
The effects of changes in exchange rates on sales and profits can be controlled
to some extent by management. As with most foreign-currency exposure,
management can elect to control or hedge this risk through operational
arrangements and currency derivatives. Much discussion of these matters has
already been provided. However, the focus of the next section is on the management
of currency risks associated with foreign subsidiaries.
MANAGING THE CURRENCY RISK OF
FOREIGN SUBSIDIARIES
It is a common view that translation-related currency risk associated with the
statements of foreign subsidiaries is quite different from currency risk associated
with foreign-currency transactions. Transactional exposure has the clear
potential to expand or contract the cash f lows associated with foreign-currency
asset and liability balances. If a U.S. firm holds a Japanese yen account receivable
and the yen falls in value, then there is a loss of cash inflow. If a Japanese
firm has an account payable in the U.S. dollar and the yen strengthens, then a
smaller cash outf low is required to discharge this liability.
There are no identifiable cash inf lows or outf lows in the case of translation
gains or losses that result from either statement translation or remeasurement.
A study of both U.S. and U.K. multinationals found that "it was generally
agreed that translation exposure management was a lesser concern" (less than
transaction exposure management).34 The Wharton survey results on hedging
(Exhibit 12.10) found the management of the volatility of cash f lows as the
major objective of hedging. However, it is very common for disclosures of
transaction-related currency hedging to cite the goal of protecting cash f lows.
Global Finance 387
The reduced level of currency risk-management in the case of translation
exposure is explained largely by the absence of direct cash flow and earnings
risk. There is a somewhat greater effort to manage remeasurement-related risk
because, unlike under the all-current method, remeasurement gains and losses
are included in net income. Some companies do hedge translation exposure
even though the translation adjustments are only included in other comprehensive
income, with this element generally going straight to shareholders' equity.
However, the absence of an impact on earnings under all-current translation
makes it less likely that this exposure will be hedged.
Prior to the issuance of SFAS No. 52, Foreign Currency Translation,
SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions
and Foreign Financial Statements, required all firms to use the temporal
method and to include all translation gains and losses in the computation of net
income.35 As a result, one would expect the hedging of translation exposure to
have declined after the issuance of Statement No. 52. Under SFAS No. 52,
most translation is by the current-rate method and translation adjustments are
omitted from conventional net income. Available evidence supports this view.
For example, Houston and Mueller note: "In particular, firms that must no
longer include all translation gains or losses arising from their foreign operations
in their income statements are more likely to have stopped or reduced
hedging translation exposure."36
To gain some insight into translation hedging practices, disclosures of
translation-hedging policies by a number of firms are presented in Exhibit 12.23.
The examples in Exhibit 12.23 are selective and do not represent the relative frequency
with which translation exposure is hedged. Rather, the disclosures are
simply designed to present some of the matters that appear to inf luence decisions
on the hedging of translation exposure.
Notice that AGCO does not hedge its translation exposure. However, it
attempts to achieve what could be called a natural hedge by the device of financing
its foreign operations with local borrowings. Increasing local-currency
borrowings reduces the net investment in the subsidiary—assets minus liabilities—
and with it translation exposure. This example suggests a potential for misinterpretation
of company statements about their translation hedging. AGCO
apparently means that it does not use currency derivatives to hedge translation
exposure. However, it does attempt to reduce exposure by other means.
Becton Coulter indicates occasional hedging of translation exposure.
Note the reference to the hedge of the market (exchange rate) risk of a subsidiary's
net-asset position. Again, in the case of translation with the allcurrent
method, exposure is approximated by a subsidiary's net-asset position,
that is, assets minus liabilities. Becton Coulter must be making reference to
subsidiaries translated using the all-current method because it indicates that
any gains or losses on hedges of translation exposure are included in accumulated
other comprehensive income. This is also the location of the translation
gains and losses that result from the all-current translation method. The gains
and losses on the hedges of this translation exposure are included in other comprehensive
income and offset, respectively, translation losses and gains.
388 Planning and Forecasting
The Becton Dickenson statement is the clearest statement of the case for
not hedging translation exposure. The key elements of the Becton Dickenson
position are that: (1) translation adjustments are included in shareholders' equity;
(2) translation adjustments do not affect conventional net income; and
(3) translation adjustments do not affect cash flow.
The DaimlerChyrsler reference to the net assets of subsidiaries located
abroad not being included in the management of currencies means that they
are not hedged. The Quaker Oats Company does do some hedging of net investments
in foreign subsidiaries. Both Henry Schein and Titan International
emphasize the long-term nature of the investments in foreign subsidiaries in
explaining the decision not to hedge this exposure.
EXHIBIT 12.23 Hedging of translation exposure: Selected company
policies.
Company Hedging Policy
AGCO Corporation (1999) The Company's translation exposure resulting from
translating the financial statements of foreign subsidiaries
into U.S. dollars is not hedged. When practical, this
translation impact is reduced by financing local operations
with local borrowings.
Becton Coulter Inc. (1999) We occasionally use foreign currency contracts to hedge the
market risk of a subsidiary's net asset position. Market value
gains and losses on foreign currency contracts used to hedge
the market risk of a subsidiary's net asset position are
recognized in "Accumulated Other Comprehensive Income"
as translation gains and losses.
Becton, Dickenson & The Company does not generally hedge these translation
Company (1999) exposures since such amounts are recorded as cumulative
currency translation adjustments, a separate component of
shareholders' equity, and do not affect earnings or current
cash f lows.
DaimlerChyrsler AG (1999) The net assets of the Group which are invested abroad in
subsidiaries and affiliated companies are not included in the
management of currencies.
The Quaker Oats Company The Company uses foreign currency forward and option
(1999) contracts and currency swap agreements to manage foreign
currency rate risk related to certain cash f lows from foreign
entities and net investments in foreign subsidiaries.
Henry Schein Inc. (1998) The Company considers its investments in foreign operations
to be both long-term and strategic. As a result, the Company
does not hedge the long-term translation exposure in its
balance sheet.
Titan International (1999) The Company views its investments in foreign subsidiaries as
long-term commitments and does not hedge foreign currency
transaction or translation exposures.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
Global Finance 389
There is some hedging of translation, but the hedging of translation exposure
is clearly less common than the hedging of transaction exposure. Hedging
practice, based upon cited surveys and our own study of hundreds of company
reports, suggests the following ordering of management demand for hedging,
from high to low:
1. To protect cash flow and earnings, both level and stability.
2. To protect earnings, both level and stability.
3. To protect shareholders' equity, both level and stability.
In continuing to observe hedging motivated by both two and three above,
it is important to consider the significance of earnings and equity amounts
without regard to the issue of cash f lows. For example, there is a tremendous
current focus on whether or not earnings meet the consensus forecasts of Wall
Street. The penalty for missing the forecast, sometimes by pennies, can be dramatic
reductions in share value. Of the two translation methods, only the temporal
(remeasurement) method includes the remeasurement gains or losses in
the computation of net income. There is no evidence that a failure to meet the
Wall Street consensus will be forgiven if it results from unhedged remeasurement
exposure.
Management compensation is often based, directly or indirectly, upon reported
earnings. This provides an incentive for management to hedge in order
to avoid earnings reductions from remeasurement losses.
Finally, it is common for debt and credit agreements to include financial
covenants that require the maintenance of minimum amounts of shareholders'
equity or minimum ratios of debt to equity. Unhedged translation exposure,
under either the all-current or temporal (remeasurement) methods, may reduce
shareholders' equity and cause these covenants to be violated.
Differences in hedging practices are explained in part by different attitudes
towards bearing currency risk as well as the cost and capacity to hedge
exposures in different countries. In addition, firms will differ in their capacity
to minimize currency exposure through various operational, organizational and
business arrangements.
As a final topic in this coverage of currency risk and hedging, an overview
of the current requirements in the accounting for currency derivatives
is provided.
ACCOUNTING FOR HEDGES:
CURRENT GAAP REQUIREMENTS
Important changes in the accounting for currency derivatives were introduced
with the issuance of SFAS No. 133, Accounting for Derivative Instruments and
Hedging.37 Initial required application of the standard begins with the first fiscal
quarter of the first fiscal year beginning after June 15, 2000.
One of the most important requirements of the new standard is that all
derivative instruments must be recognized on the balance sheet and carried
390 Planning and Forecasting
at their fair values. Whether or not these changes in fair value go immediately
into the computation of net income will depend upon (1) whether or
not the derivative is used for hedging purposes and (2) the nature of the
hedge applications.
The accounting for changes in the fair value of a foreign-currency derivative
depend upon its intended use. Possibilities include (1) the hedging of
exposure to changes in the fair value of a recognized asset, liability or an unrecognized
firm commitment, (2) the hedging of exposure to variable cash
f lows of a forecasted transaction, and (3) the hedging of a net investment in a
foreign operation. These three hedging applications are referred to as fair
value, cash flow and net-investment hedges, respectively.
Changes in the fair values of currency derivatives will either be reported
in the income statement as these changes take place or they will initially be reported
in other comprehensive income (OCI). The gains and losses that are initially
included in OCI will subsequently be included in the income statement
when the hedged transaction affects net income.
Fair Value Hedges
A firm purchase commitment in a foreign currency is an example of a transaction
that could be a fair-value hedge candidate. Normally, there is no initial
recording on the books of the firm commitment. However, there is currency
risk and subsequent increases and decreases in the value of the foreign currency
give rise to losses and gains, respectively. To illustrate how a hedge
would be accounted for in this case, assume a purchase commitment made for
100 million yen when the yen rate was $0.008976. By the end of the accounting
period the yen has appreciated to $0.009000. This increase in the yen of
$0.000024 ($0.009000 − $0.008976) creates a loss on the purchase commitment
of $2,400 ($0.000024 × 100 million yen). Also assume that the firm had
entered into a forward contract to buy 100 million yen as a hedge of the firm
commitment. We will assume that the forward contract (the currency derivative)
also increased in value by $2,400.
Under SFAS No. 133, the $2,400 increase in the cost of the purchase
commitment would be recorded as a loss on the commitment. In addition, the
forward contract would also be marked to market value, creating an offsetting
gain of $2,400. Each of these items would be reported in the income statement
where they will offset each other.
The special feature of the above accounting (i.e., hedge accounting), is
the recognition of the loss on the purchase commitment. Prior to SFAS No.
133, it would have been common not to recognize the loss on the purchase
commitment, but to recognize and defer the gain on the forward contract.
Then the loss on the purchase commitment would not be recognized until the
purchase was made. At this time, the deferred gain on the currency derivative
would be deducted from the cost of the purchase. SFAS No. 133 basically
eliminates this type of gain or loss deferral on financial derivatives.
Global Finance 391
Many of the hedging examples disclosed in Exhibits 12.5 and 12.8 involved
balances that were already recorded on the balance sheet of the
hedging firms. The use of hedges in these cases requires no special hedge accounting.
For example, consider the case of a one million pound sterling account
receivable recorded when the sterling rate was $1.50. By the end of the
year, but before the pound receivable was collected, the pound depreciated to
$1.45. Assume that the U.S. firm hedged the full amount of the pound sterling
account receivable by entering a forward contract to sell the one million
pounds at the expected collection date.
Under current GAAP, the pound receivable must be revalued to the new
rate of $1.45, and a foreign currency transaction loss of $50,000 would be recognized.
Moreover, the currency derivative would be marked to its new market
value, which is assumed to be $50,000, a perfect hedge.38 This activity is summarized
below:
£ Account Receivable
Initial value of ￡1,000,000 at $1.50 equals $1,500,000
Value at year-end: ￡1,000,000 at $1.45 equals 1,450,000
Foreign-currency transaction loss 50,000
Currency Derivative
End-of-period value of the currency derivative $ 50,000
Initial value of the forward contract 0
Gain on the currency derivative (50,000)
Net effect on earnings $ 0
No special hedge accounting is required in the above case to cause the loss on
the receivable and the gain on the currency derivative to offset each other in
the income statement.
Cash Flow Hedges
Hedges of forecasted transactions, cash f low hedges, are distinguished from
hedges of firm commitments, which are classified as fair value hedges. As an
example, a forecasted transaction might involve the future receipt of royalty
payments in a foreign currency. There is currency exposure here because a decline
in the value of the foreign currency will reduce the dollar value of the
royalty, a cash flow, when it is received. A hedge of this exposure could be
achieved by selling a futures contract, investing in a put option, or selling the
foreign currency through a forward contract.
In order to illustrate hedge accounting for a cash-flow hedge, assume
that a firm forecasts the receipt of one million German marks (DM) from royalties.
A currency derivative is acquired to hedge all of this exposure. At the
date that the derivative contract is entered into, the DM rate is $0.45. At the
end of the accounting period, but before the royalties are received, the DM
depreciates to $0.43. The value of the derivative contract increases by
$20,000. SFAS No. 133 requires that a gain from the increase in the fair value
392 Planning and Forecasting
of a derivative contract be recognized as it occurs. However, GAAP does not
permit recognition of the loss from the decline in the dollar value of the forecasted
DM cash flow.
Recognition of the $20,000 gain on the currency derivative as part of
earnings would present a problem. There would be no offsetting loss in the income
statement from the decline of the dollar value in the DM royalties.
Hedge accounting deals with this problem by providing that the $20,000 gain
on the derivative be included in other comprehensive income and not net income.
Then, when the DM royalties are received, the $20,000 gain is reclassified
out of accumulated other comprehensive income and in to net income.
To illustrate the above fully, assume that the one million DM of royalties
are received, and that the value of the DM has not changed in value from
its previous year-end rate of $0.43. The hedge accounting is summarized in Exhibit
12.24.
Notice that the total income recognized in the income statement in the
period in which the royalty is received is $450,000. This is equal to the original
value of the expected royalty cash flow. However, the $450,000 is made up of
only $430,000 in royalty value and the remainder is the product of the cash
flow hedge.
Hedges of Net Investments in Foreign Operations
Earlier discussion of statement translation revealed far less hedging of translation
as opposed to transaction exposure. Most translation of the net investments
in foreign operations, typically foreign subsidiaries, employs the all-current
method. Under this translation procedure, all translation adjustments (translation
gains and losses) are recorded in other comprehensive income. These translation
adjustments are only included in the computation of net income if all or a
significant portion of the foreign operation is sold or otherwise disposed of.
Some firms do hedge their translation exposure. Consistent with the translation
adjustments being included in other comprehensive income, offsetting
gains and losses on currency derivatives used to hedge translation exposure are
EXHIBIT 12.24 Hedge accounting for expected cash f low.
Period of Receipt
Initial Period of Royalties
Included in net income
Gain on currency derivative 0 $ 20,000
Royalty cash inf low 0 430,000
$450,000
Included in other comprehensive income:
Gain on currency derivative $20,000 $ (20,000)
Global Finance 393
also recorded in other comprehensive income (see Becton Coulter Inc. in Exhibit
12.23 for an example of this treatment).
The review of current accounting requirements has not explored a number
of technical points related to hedging. These matters go beyond the goals
of this chapter. However, many of these items are included in more technical
and comprehensive treatments of hedging and derivative instruments.39
U.S. AND INTERNATIONAL GAAP DIFFERENCES
A variety of new financial, accounting, tax, and managerial issues faced
Fashionhouse when it acquired a Danish subsidiary. The issues of statement
translation and currency risk-management were discussed above. Recall
that the requirement to consolidate the Danish subsidiary into the dollarbased
statements of Fashionhouse, the parent, requires translation. In addition,
to the extent that Danish accounting practices differ from those in the
U.S., adjustments must be made so that the subsidiary's statements conform
to U.S. GAAP.
International GAAP Differences and the IASC
A review of the statements of companies located in different countries will
reveal cases of both agreement and disagreement between foreign and U.S.
GAAP. In order to address the high level of international disagreement found
in accounting practices, the International Accounting Standards Committee
(IASC) was formed in 1973. The IASC, which was comprised initially of representatives
from the leading professional accounting bodies of Australia,
Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom,
Ireland, and the United States, began working toward the harmonization
of accounting standards internationally. Today, the IASC represents
accounting bodies from over 70 countries. Each member body has agreed to
work towards the compliance of accounting standards in their home countries
with the standards issued by the IASC. In fact, a number of countries, such
as India, Kuwait, Malaysia, Singapore, and Zimbabwe, either adopt IASC
standards as their own generally accepted accounting principles or place
heavy reliance on them in developing their own accounting standards.
To date, 39 international accounting standards and several exposure
drafts have been issued. The IASC has also issued a document that both
identifies major differences in international accounting practices and categorizes
them in terms of their being, (1) the required or preferred treatment,
(2) the allowed alternative treatment, or (3) the treatment eliminated.40 The
immediate goal of the proposal is to eliminate most of the choices in accounting
treatment now available in standards issued by the IASC. The IASC enumerated
the expected benefits of this harmonization in financial reporting as
follows:41
394 Planning and Forecasting
1. Improve the quality of financial reporting.
2. Make easier the comparison of the financial position, performance and
changes in financial position of enterprises in different countries.
3. Reduce the costs borne by multinational enterprises that presently have
to comply with different national standards.
4. Facilitate the mutual recognition of prospectuses for multinational securities
offerings.
A subsequent statement has reported responses to this initial document
and outlined plans for implementation of some of the initial proposals and additional
study for others.42 The major approach to implementation of the IASC
proposals is to incorporate those proposals on which agreement has been
reached into revised International Accounting Standards.
Examples of some of the accounting treatments that would be eliminated
under the IASC proposals follow:
1. Completed contract method for the recognition of revenue on construction
contracts.
2. Deferral of exchange gains and losses on long-term monetary items.
3. Translation of statements of subsidiaries operating in hyperinf lationary
economies, without first applying price-level adjustments.
4. Use of the closing (end of period) exchange rate to translate income statement
balances.
5. Maintenance of investment properties on the books without depreciation
6. Immediate deduction of goodwill against shareholders' equity.
Examples of U.S. and international GAAP differences are provided in the
next section along with an illustration of how international firms mitigate the
impact of differences for U.S. statement users.43
U.S. and International GAAP Differences
In spite of the harmonizing efforts of the IASC, there remain numerous differences
between the GAAP applied in countries around the world. A sampling
of some areas of current or previous differences between U.S. GAAP and
GAAP in selected other countries is provided in Exhibit 12.25.
As GAAP in different countries are constantly changing, as well as the
specific methods selected by firms within countries, some of the GAAP differences
in Exhibit 12.25 may no longer be current. However, they remain illustrative
of areas in which major GAAP differences are found between U.S.
GAAP and those employed in other countries. Fortunately, in the United States
the Securities and Exchange Commission requires that listed foreign firms
provide disclosures of differences between the GAAP on which their statements
are prepared and U.S. GAAP.
Global Finance 395
SEC Requirements for Disclosing the Effects
of GAAP Differences
With the continuing globalization of financial markets, international firms
have become more sensitive to the analytical burdens that result from differences
between foreign and domestic GAAP. Further, the U.S. Securities
and Exchange Commission requires that some foreign firms file reports that
EXHIBIT 12.25 Examples of U.S. and international GAAP differences.
Accounting Policy Country/Company GAAP Difference
Software costs England /Reuters Holdings Reuters expenses all software costs;
a portion of such cost would
normally be capitalized under U.S.
GAAP.
Tax accounting Malaysia /United Malacca Deferred taxes are not booked if
Rubber Estates temporary differences are deferred
indefinitely; deferred taxes are
booked on all temporary differences
under U.S. GAAP.
Investments Australia/BHP Limited Equity accounting is not applied to
investments in excess of 20% of
voting shares; U.S. GAAP generally
requires application of the equity
method.
Property Hong Kong/Hong Kong Tangible fixed assets and property
Telecommunications may be restated on the basis of
appraised values; upward revaluations
are not permitted under U.S. GAAP.
Sale/leaseback gains Netherlands/PolyGram Gains on sale/leaseback transactions
are recognized in the year of sale;
such gains are normally deferred and
amortized into future earnings under
U.S. GAAP.
Construction interest Sweden/Pharmacia Interest related to the construction of
assets is expensed; U.S. GAAP requires
capitalization and amortization.
Foreign exchange gains England /British Airways Foreign exchange gains and losses are
and losses (on loans to deducted from or added to the cost of
acquire aircraft) aircraft; included in income as
incurred under U.S. GAAP.
Unrealized foreign Germany/Continental Losses are deducted from income but
exchange gains and Aktiengesellschaft gains are not recorded; U.S. GAAP
losses recognizes both in earnings.
396 Planning and Forecasting
include schedules reconciling earnings under U.S. and foreign GAAP (the 20-F
Report). An example of such disclosure is provided below from the 20-F report
of the Portuguese firm, Electricidade de Portugal SA (EP). As is required, EP
provides a reconciliation of Portuguese to U.S. GAAP for both net income (Exhibit
12.26) and shareholders' equity (Exhibit 12.27). A selection of the principal
differences between U.S. and Portuguese GAAP underlying these
statements are discussed below:
1. EP writes up the value of its fixed assets. It in turn records depreciation
on these revalued amounts. This causes depreciation in the Portuguese-
GAAP statements to be greater than it would be under U.S. GAAP, where
such revaluations are not permitted. This higher depreciation caused the
EP earnings to be reduced below their level under U.S. GAAP. This explains
the addition to net income made for "depreciation of revaluation of
fixed assets" in the Exhibit 12.26 reconciliation of Portuguese GAAP to
U.S. GAAP net income. Also notice that the cumulative effect of this
GAAP difference results in a reduction in Portuguese GAAP shareholders'
EXHIBIT 12.26 Reconciliation of net income under Portuguese GAAP
to income under U.S. GAAP: Electricidade de Portugal ,
year ended December 31, 1998 (in thousands except
for per-share amounts and shares outstanding).
Escudos U.S.$
Net income as reported under Portuguese GAAP 104,808,918 539,307
U.S. GAAP adjustments increase (decrease) due to:
a. Depreciation of revaluation of fixed assets 48,045,972 247,226
b. Capitalized overheads (949,690) (4,887)
c. Depreciation of exchange differences 5,121,052 26,351
d. Deferred costs (1,537,691) (7,912)
e. Hydrological correction adjustments — —
f. Distribution to management and employees (3,845,532) (19,788)
g. Pension and other post-retirement benefits — —
h. Self-insurance — —
i. Employee termination benefits 19,969,334 102,755
j. Accounts receivable—municipalities (10,429,115) (53,664)
k. Power purchase agreements (343,236) (1,766)
m. Income taxes (19,642,655) (101,074)
Net adjustments 36,388,439 187,241
Approximate net income in accordance with U.S. GAAP 141,197,357 726,548
Net income per share 235 1.21
Number of shares outstanding 600,000,000 600,000,000
SOURCE: Electricidade de Portugal SA, annual report, December 1998. Information obtained from Disclosure
Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC
(Bethesda, MD: Disclosure Inc., June 2000).
Global Finance 397
equity in the Exhibit 12.27 reconciliation of shareholders' equity. Writing
up its fixed assets increased EP's shareholders' equity.
2. EP capitalized a portion of general and administrative overhead that
would not be permitted under U.S. GAAP. This called for a reduction in
both Portuguese GAAP net income and in shareholders' equity. These adjustments
follow the same pattern as those required by the revaluation of
fixed assets.
3. EP capitalized and amortized foreign exchange gains and losses. Under
U.S. GAAP, the capitalization of these items is not permitted. EP's disclosures
indicate that this practice is not followed for new exchange gains
and losses after 1995. The adjustment in Exhibit 12.26 required an addition
to Portuguese GAAP income of $26,351,000. This is the amount by
which Portuguese GAAP earnings were understated in 1998. The adjustment
of $422,925,000 in Exhibit 12.27 represents the remaining cumulative
overstatement of shareholders equity that resulted from the
capitalization of net foreign exchange losses under Portuguese GAAP.
EXHIBIT 12.27 Reconciliation of shareholders' equity under Portuguese
GAAP to income under U.S. GAAP: Electricidade de
Portugal, year ended December 31, 1998 (in thousands).
Escudos U.S. $
Shareholders' equity as reported under Portuguese GAAP 1,228,414,979 6,320,958
U.S. GAAP adjustments increase (decrease) due to:
a. Revaluation of fixed assets (476,437,696) (2,451,568)
b. Overheads capitalized (139,891,196) (719,287)
c. Exchange differences capitalized (82,191,222) (422,925)
d. Deferred costs (4,906,140) (25,245)
e. Hydrological correction account 77,688,063 399,213
f. Distribution to management and employees (3,736,760) (19,228)
g. Pension and other post-retirement benefits 21,868,807 112,529
h. Self-insurance — —
i. Employee termination benefits 25,844,334 132,985
j. Accounts receivable—municipalities (10,429,115) (53,664)
k. Power purchase agreements 2,317,186 11,923
l. Investments 12,659,000 65,139
m. Income taxes 183,082,286 942,072
Net adjustments (394,132,453) (2,028,056)
Approximate shareholders' equity in accordance with
U.S. GAAP 834,282,526 4,292,902
SOURCE: Electricidade de Portugal SA, annual report, December 1998. Information obtained from Disclosure
Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC
(Bethesda, MD: Disclosure Inc., June 2000).
398 Planning and Forecasting
4. Among costs deferred by EP were research and development. These costs
must be expensed as incurred under U.S. GAAP.
5. The line item for "Pension and other post-retirement benefits" highlights
the current consistency between Portuguese and U.S. GAAP in recognizing
the associated expense. However, the adjustment in Exhibit 12.27,
shareholders' equity reconciliation, reveals a continuing difference in the
recognition of the associated benefit liability. EP had recognized a larger
liability, and charged this amount against shareholders' equity, than
would be required under U.S. GAAP. This explains the increase in shareholders'
equity in Exhibit 12.27.
6. Prior to 1995, EP reduced income in recording an accrual for selfinsurance
that was not permitted under U.S. GAAP.
7. Termination benefits were accrued by EP in 1997 that would not have
been accrued in that year under U.S. GAAP. The necessary adjustments
are a $102,755,000 increase in Portuguese GAAP net income and a
$132,985,000 increase in shareholders equity.
8. EP's policy of recognizing bad debts on accounts receivable results in
their being recorded at a later point in time than would be true under U.S.
GAAP.
9. EP records income taxes based upon the amount of taxes currently
payable as determined by government tax regulations. U.S. GAAP requires
that income taxes be recorded on the basis of earnings reported in
the shareholder income statement as opposed to earnings in the income
tax return. This results in an overstatement of the Portuguese-GAAP net
income for 1998 and a cumulative understatement of shareholders' equity
at the end of 1998.44
The differences between Portuguese GAAP net income and shareholders'
equity are fairly substantial, but differences between foreign and U.S. GAAP
in other countries may be far greater. EP's 1998 net income would have been
about 35% higher under U.S. GAAP. However, shareholders' equity would have
been about 32% lower.
This difference between the effects on net income and shareholders' equity
result from the overstatement of assets (overstates depreciation and understates
current earnings) and understated liabilities (understates expenses
and overstates earnings). For a single year, an asset overstatement may understate
net income because a portion of the asset overstatement is amortized as
an additional expense in the income statement. Shareholders' equity remains
overstated because asset net overstatements remain on the balance sheet.
Domestic users of foreign financial statements need to be aware of the
differences in financial reporting practices, and also have some information
on the effect of these differences on such key financial statistics as earningsper-
share and shareholders' equity. For example, security analysts use ratios of
market price to earnings-per-share (the price/earnings or P/E ratio) as one way
Global Finance 399
to judge whether a stock might be either over or undervalued. Electricidade
de Portugal's P/E ratio is higher under Portuguese GAAP because its earnings
per share are lower than they would be under U.S. GAAP. Under Portuguese
GAAP Electricidade de Portugal would appear to be more conservatively valued
than under U.S. GAAP. Similarly, bankers use the relationship of total debt
to stockholders' equity to judge the capacity of firms to handle service and
repay their borrowed funds. By this statistic, Electricidade de Portugal will appear
to be less highly leveraged because its stockholders' equity is much higher
under Portuguese GAAP.
The differences between U.S. and Portuguese GAAP, revealed in Exhibits
12.26 and 12.27, are multiplied if one adds to the types of companies
and numbers of countries. As the markets for securities become more global,
some claim that there is the absence of a level playing field because of these
GAAP differences. If the efforts of the International Accounting Standards
Committee (IASC) are fruitful, then the playing field should become much
more level in the future. However, in the meantime there remains a great deal
of international diversity in GAAP.
GAAP Differences and the Level Playing Field
Some argue that international competitiveness can be impaired if earnings and
financial position under local GAAP appear weaker than they would under the
GAAP of major competitor countries. That is, the playing field will not be
level. As an example, concern has been expressed about international GAAP
differences that deal with acquisition (of other companies) accounting. A typical
acquisition will include the payment of a premium, in some cases involving
billions of dollars, for what is collectively termed goodwill. This amount consists
of the difference between the purchase price and the current value of the
net assets acquired, as in the following example:
Purchase price $1,000
Current fair value of net assets acquired (Assets − Liabilities) 700
Goodwill $ 300
It has been a common practice in some countries to deduct immediately
the goodwill recorded in an acquisition from shareholders' equity. (This is one
of the practices that the IASC hopes to see eliminated under its harmonization
project discussed earlier.) U.S. GAAP has for several decades required that
goodwill be amortized through the income statement. This causes the postacquisition
earnings of a U.S. firm to appear weaker than a comparable firm in
a country that permits the immediate write-off of goodwill.
If a foreign firm, located in a country where the immediate write-off of
goodwill is permitted, and a U.S. firm were both bidding for the same company,
the foreign firm would forecast a stronger post-acquisition earnings picture.
This results because the foreign firm would deduct the goodwill
400 Planning and Forecasting
immediately, whereas the U.S. firm would take the charge through its future
income statements.45
It could be argued that the profit differences that result from the disparity
in accounting for goodwill are purely cosmetic, and that they should not
cause a U.S. bidder to be at a disadvantage in the acquisitions market. That is,
the impact of the acquisition on the bidder's future cash f low should be the
central issue. Differences in accounting policy should not have a direct impact
on future cash flow. However, it is well to remember that, cash f low aside, the
reported numbers take on a significance in their own right to the extent they
are (1) a factor in determining managerial compensation or (2) are used by
lenders to monitor compliance with debt agreements.
The U.S. GAAP requirements for goodwill accounting appear to be on
the verge of major changes in 2001. The requirement to amortize goodwill
would be eliminated in favor of a policy that would require goodwill write-offs
only in cases where the goodwill is considered to be impaired:
From the date of issuance, all goodwill would be accounted for using an impairment
approach. Under that approach, goodwill would be reviewed for impairment,
that is written down and expensed against earnings, only in the
periods in which the recorded value of goodwill is more than its fair value.46
Some countries may criticize this change in goodwill accounting as contributing
to international GAAP diversity. The change will also be seen as roughing
up and not smoothing out the playing field.
The issue of international competitiveness was also raised with respect
to the FASB statement on postretirement benefits accounting, SFAS No. 106,
Employers' Accounting for Postretirement Benefits Other Than Pensions.47 The
Statement requires companies to apply accrual accounting to what are termed
other postretirement benefits, mainly health and life insurance. When proposed,
there was fierce lobbying against issuing the statement. Some excerpts
from a statement to the FASB by the then Chief Financial Officer of Chrysler
Corporation make the key points:48
This higher cost recognition will depress reported profitability, and thereby ultimately
discourage capital formation in job-creating enterprises in the U.S.
There will be a powerful incentive to move our employment base to Canada,
Europe and Third World countries.
Foreign based companies will not be forced to adopt your new rules—all
other things being equal, a European or Japanese company will report a billion
dollars more profit doing the same business as Chrysler. In that environment,
we will simply be unable to compete fairly for investor capital. Ultimately, I believe
you will have added to the trend of foreign ownership of our U.S. industrial
base.
One can only hope for the success of the IASC program to increase international
harmony in reporting practices, if the arguments concerning the anticompetitive
potential of diversity in international GAAP are meritorious.
Global Finance 401
EVALUATING THE PERFORMANCE OF FOREIGN
SUBSIDIARIES AND THEIR MANAGEMENT
With the acquisition of its Danish subsidiary, Fashionhouse is faced with the
need to report and evaluate the performance of the subsidiary as an economic
entity, as well as the performance of the subsidiary's management. The discussion
here will focus only on those differences that result from the foreign character
of the subsidiary. Aside from this, performance evaluation should be
fundamentally the same as for a domestic firm. The fact that, after the translation
process, financial statements are available in both the domestic currency
(krone in the case of Fashionhouse) and the U.S. dollar is an important difference.
Should performance of the subsidiary and its management be judged on
the basis of the krone or dollars results? Moreover, the earnings performance
of the Fashionhouse subsidiary will be affected each year by (1) the movement
of the krone against the dollar and (2) prices set (a transfer price) on the goods
sold to Fashionhouse in the United States.
Impact of Exchange Rate Movements on
Performance Evaluation
A number of years ago, an issue arose concerning the incentive compensation
of the manager of a Netherlands subsidiary of a major U.S. heavy equipment
manufacturer. A strong profit performance was produced in the European currency,
but the translated results were a loss (note: translation followed the temporal
and not the all current method). After lengthy consideration by senior
management, a decision was made that no incentive compensation was to be
awarded. Management held that failure of the Netherlands subsidiary to earn a
profit in dollars resulted in its making no contribution to the parent, whose
goal was to maximize the dollar earnings of the consolidated entity. The manager
of the Netherlands subsidiary was not pleased.
A central precept of performance evaluation is that managers should only
be held responsible for results that incorporate variables over which they exercise
some reasonable control. Depending upon the circumstances, this might
mean that in judging the performance of a department foreman, the quantity
of material used is considered controllable but not its price. For performance
evaluation purposes, the material used would be priced at some prearranged
standard and not its actual cost. On the other hand, the vice president of manufacturing
might well be held responsible for actual material cost on the basis
that he or she has been assigned responsibility for the price of material used,
as well as its quantity.
Applied to evaluating the performance of the management of foreign subsidiary,
the concept of a controllable performance indicator would call for
either (1) using the profit results from the foreign-currency statements or
(2) using the translated dollar earnings, after adjustments designed to remove
402 Planning and Forecasting
the effects of changes in the value of the dollar, that is, the price of the dollar.
As (1) involves no unique adjustments related to foreign subsidiary status, only
(2) will be considered further.
Consider the income statements in Exhibit 12.28 in foreign currency (FC)
and the U.S. dollar. Assume that in the following year, domestic results are as
given in Exhibit 12.28 and that the foreign currency has depreciated to an average
rate of $0.50 for the year (recall that income statement amounts are
translated at the average rate under the all-current method). The new translation
would now be as outlined in Exhibit 12.29.
Net income in year two, in the foreign currency, increased by 65% over
Year 1 (from FC180 to FC 297). However, the income improvement on a translated
dollar basis was less than half this amount, only 32% ($112 to $148). The
impact of the change in exchange rates needs to be removed if the translated
income statement is to be used to evaluate performance of the subsidiary's
management—on the assumption that management has no control over exchange
rates. Net income can be adjusted as follows:
Year 2 net income in the foreign currency FC297
Translate at year 1 exchange rate × 0.62
Year 2 net income at constant exchange rate $184
EXHIBIT 12.28 Year 1 income statement (in foreign
currency and dollars).
FC Exchange Rates U.S.
Sales 1,000 $0.62 $620
Less cost of sales 600 0.62 372
Gross margin 400 248
Less SG&A 100 0.62 62
Pretax profit 300 186
Less tax provision 120 0.62 74
Net income 180 $112
EXHIBIT 12.29 Year 2 income statement (in foreign
currency and dollars).
FC Exchange Rates U.S.
Sales 1,200 $0.50 $600
Less cost of sales 660 0.50 330
Gross margin 540 270
Less SG&A 115 0.50 58
Pretax profit 425 212
Less tax provision 128 0.50 64
Net income 297 $148
Global Finance 403
The previous adjustment holds constant the value of the foreign currency
in measuring net income for purposes of performance evaluation. In judging
the subsidiary itself as an economic unit, translation at the depreciated value of
the foreign currency may still be appropriate. The dollar value of the net income
produced is indeed lower because of the currency depreciation in the
subsidiary's country.49
An alternative approach that is sometimes used is to evaluate the performance
of management is to use budgeted foreign exchange rates. This is similar
to the above in that it holds the exchange rate constant. However, the
constant rate is a budgeted exchange rate and not simply the rate from the previous
year.
There is ample evidence in U.S. annual reports of adjustments to control
for the impact of foreign-exchange changes on performance. It is standard for
the Management's Discussion and Analysis of Operations section, an SEC requirement,
to include commentary on the impact of exchange rate changes on
revenues, though far less frequently on earnings. However, Philip Morris does
identify the effect of exchange-rate changes on both revenues and the income
of operating companies. Three recent examples follow:
Johnson & Johnson Inc. (1999)
Sales by international companies were $12.09 billion in 1999, $11.15 billion in
1998 and $10.93 billion in 1997. This represents an increase of 8.4% in 1999,
1.9% in 1998 and 1.5% in 1997. Excluding the impact of foreign currency f luctuations
over the past three years, international company sales increased 12.4%
in 1999, 7.1% in 1998 and 9.6% in 1997.
Philip Morris Companies Inc. (1999)
Currency movements decreased operating revenues by $782 million ($517 million,
after excluding excise taxes) and operating companies income by $46 million
during 1999.
Praxair Inc. (1999)
The sales decrease of 4% in 1999 as compared to 1998 is due primarily to unfavorable
currency translation effects in South America. Excluding the impact of
currency, sales grew 2%.
Changes in exchange rates present a clear challenge in evaluating the performance
of both the economic units, such as the foreign subsidiaries, as well as
the management of these organizations. The emphasis on foreign operations is
on results in the domestic and not the foreign currency. This can create obvious
problems in the evaluation of the management of foreign subsidiaries because
their results in the foreign currency may improve or decline while their performance
expressed in the domestic (parent's) currency declines or improves.
If foreign entity managers have little control over their results in the parent's
currency, then judging their performance in that currency presents clear
problems. Performance evaluation in the domestic versus the foreign currency
should require that unit management have currency risk management as part
404 Planning and Forecasting
of their responsibilities. At least in the case of transactional exposure, Black &
Decker managers have in the past had this as part of their duties. However,
this would still leave open the effect of translation exposure on results and performance
evaluation. As Black & Decker reports:
Foreign currency transaction and commitment exposures generally are the responsibility
of the Corporation's individual operating units to manage as an
integral part of their business. Management responds to foreign exchange movements
through many alternative means, such as pricing actions, changes in cost
structure, and changes in hedging strategies.50
The goal of the above discussion is to highlight how the evaluation of foreign
subsidiaries and their management represents a special challenge because
of the ways in which exchange rate movements can affect measures of financial
performance. Another factor that also affects such performance evaluation
is the issue of transfer pricing. These are the prices charged when goods are
transferred between related foreign and domestic firms. The issue of transfer
pricing is discussed next.
Transfer Pricing and the Multinational Firm
The prices at which goods or services are transferred between related entities,
such as parents and subsidiaries and divisions of the same firm, are referred to
as transfer prices. Transfer prices could be a major factor in determining the
profits of the Fashionhouse Danish subsidiary because much of its product is
shipped to its U.S. parent. As in the previous case, the discussion here will focus
on the dimensions of transfer pricing that are inf luenced by the foreign status of
the subsidiary. The general topic of transfer pricing has been hotly debated over
many years. The setting of transfer prices, to both encourage optimal decisionmaking
and to facilitate performance evaluation, is not yet a settled matter.
Transfer prices are generally based upon cost, cost plus some markup, or
some approximation of market. Firms with international operations typically
disclose their method of pricing transfers of goods and services among different
taxing jurisdictions—typically countries. Some recent examples of transfer
pricing policies are presented in Exhibit 12.30.
The levels at which transfer prices are set is inf luenced by a wide range of
sometimes conf licting objectives. These include maximizing worldwide profits
after taxes, maintaining f lexibility in the repatriation of profits, encouraging
optimal decision making by profit center management, providing profit data
that are reliable indicators of managerial performance and entity profitability,
building market share, and maintaining competitiveness in foreign markets.51
There is some variation in the transfer pricing policies used by U.S. firms,
with the key distinction being market value versus cost-based transfer prices.
Moreover, these policies can have a major impact on measures of financial performance
of the foreign subsidiary. They become another factor, in addition to
changing exchange rates, that must be considered in evaluating financial performance
of a foreign subsidiary and its management.
Global Finance 405
Taxes and Transfer Pricing
A major issue surrounding transfer prices in the international arena is their effect
upon the total tax burden of parent firms. The levels of income taxes and
tariffs vary considerably across countries. Corporate income tax rates range
from the middle teens up to 50% in some countries. This presents the possibility
that transfer prices may be set in part to minimize a firm's worldwide tax
bill. Establishing the reasonableness of international transfer prices is the principal
defense against a charge of transfer price manipulation.
Ignoring other factors bearing on the setting of transfer prices, assume
that the objective is to minimize worldwide income taxes. Assume that the income
tax rate of the parent is 40% and that of the foreign subsidiary is 30%.
Further, the parent is the manufacturer and transfers are made to the foreign
subsidiary. The total cost of the product is $100 per unit and it can be sold by
the foreign subsidiary at insignificant additional cost for an amount equal to
$150. Therefore, the total worldwide pretax profit to be recognized is $50.
While the parent would not have unlimited f lexibility in setting the transfer
price, tax minimization would call for recognizing as much of the profit as
possible in the earnings of the subsidiary. This is because the subsidiary's tax
rate is only 30% while the parents is 40%. Tax minimization is accomplished by
setting a relatively low transfer price as illustrated in Exhibit 12.31.
EXHIBIT 12.30 Alternative transfer-pricing policies.
Company Transfer-Pricing Policy
Arch Chemicals Inc. (1999) Prevailing market prices
Transfers between geographic areas are priced generally at
prevailing market prices.
Conoco Inc. (1999) Estimated market values
Transfers between segments are on the basis of estimated
market values.
Dow Chemical Company Cost and market-based prices
(1999) Transfers between operating segments are generally valued at
cost. Transfers of products to the Agricultural Products
segment from the other segments, however, are generally
valued at market-based prices.
Pall Corporation (2000) Cost plus a markup on cost
Transfers between geographic areas are generally priced on
the basis of a markup of manufacturing costs to achieve an
appropriate sharing of profit between the parties.
Tenneco Inc. (1998) Market value
Products are transferred between segments and geographic
areas on a basis intended to ref lect as nearly as possible the
market value of the products.
SOURCES: Companies' annual reports. The year following each company name designates
the annual report from which each example is drawn.
406 Planning and Forecasting
The tax authorities of countries are well aware that multinationals have
strong incentives to shift profits into low-rate counties. Recent years have seen
governments increasingly willing to challenge tax computations that they believe
are based upon the use of unreasonable transfer prices. Therefore, the example
above simply shows how total tax payments can be influenced by
alternative transfer prices. The degree of f lexibility shown above may or may
not be available.
Notice, in the above example that no change in policy would result if the
foreign country also had an ad valorem tariff. Worldwide taxes would still be
minimized by a low transfer price because this would also minimize the tariff.
However, circumstances would differ if the parent's income tax rate were less
than that of the subsidiary. Setting a high transfer price would cause more of
the profit to be taxed at the lower income tax rate of the parent. But, this benefit
is offset to some extent by the higher tariff in the subsidiary's country. The
analysis would need to be extended to include tariffs in the total taxes to be
minimized.
Other Influences on Transfer Pricing Policy
and Potential Conf licts
Factors other than tax minimization also bear on the establishment of transfer
prices. An effort to build market share or to respond to severe price competition
might call for low transfer prices. However, this could be in conf lict with
a tax minimization objective if income tax rates in the country receiving the
transferred goods (transferee country) were higher than the income tax rates of
the country from which the transfer was made (transferor country).
Transfer pricing policy may sometimes be employed to circumvent restrictions
on the repatriation of profits by charging high transfer prices. This
effectively involves taking out profits in the form of payments for the goods
EXHIBIT 12.31 International transfer pricing and tax
minimization.
Low Transfer Price High Transfer Price
Parent revenue $110 $140
Cost 100 100
Pretax profit 10 40
Income tax (40%) 4 $ 4 16 $16
Subsidiary revenue 150 150
Cost (transfer price) 110 140
Pretax profit 40 10
Income tax (30%) 12 12 3 3
Worldwide tax $16 $19
Composite tax rate 32% 38%
Global Finance 407
shipped. There are, of course, some potential offsetting disadvantages from
this practice:
1. Charging higher transfer prices will increase ad valorem tariffs.
2. Charging higher transfer prices will lower profits of the transferee firm
and potentially present problems in evaluating the profit performance of
the unit and its management.
3. Charging higher transfer prices might impair the competitive position of
the transferee firm.
4. Charging higher transfer prices lowers profits of the transferee firm and
could reduce its apparent financial strength in the eyes of lenders and
other users of its financial statements.
This enumeration of factors bearing on the setting of transfer prices is not
exhaustive. However, it should be sufficient to highlight the inherent complexity
of setting transfer prices. This complexity is magnified as the global reach
of multinational firms extends into a greater numbers of countries with wide
variations in taxes, competitive conditions, business practices, types of governmental
control, variability in exchange rates, and rates of inf lation. This last
factor, rates of inf lation, is discussed next in terms of its impact on measuring
the financial performance of domestic firms as well as foreign subsidiaries.
IMPLICATIONS OF INFLATION FOR
FINANCIAL PERFORMANCE
As Fashionhouse continued its evolution as a global firm, it considered locating
manufacturing capacity in countries with low labor costs. However, in many
cases high rates of inf lation were linked to low labor costs. Judging performance
in highly inf lationary environments presents special problems. At some
point, financial statements prepared from unadjusted (historical) cost data lose
their ability to provide reasonable indicators of either the financial performance
or status of firms. Several different approaches have been developed to
adjust historical cost financial statements. The principal methods can be classified
as involving either (1) general price level or (2) current cost adjustments.
These two methods are illustrated below and contrasted with historical-cost
statements as the baseline. To provide some useful background, current management
commentary on the impact of inf lation on financial performance
is presented.
Management Commentary on the Impact of and
Response to Inf lation
Management's Discussion and Analysis, a section of the annual report required
by the SEC, often includes commentary on the implications of inf lation for financial
performance. This commentary provides useful insight into management's
408 Planning and Forecasting
assessment of inf lation's effects, as well as any company circumstances or actions
taken which mitigate the negative effects of inf lation. A series of these
comments are presented in Exhibit 12.32.
The examples in Exhibit 12.32 are representative of over 100 such disclosures
that were examined. A recurrent theme is that inf lation has been low in
EXHIBIT 12.32 Management commentary on the effects of inf lation.
Low inf lation and cost recovery contracts: Air T Inc. (2000)
The Company believes that due to the current low levels of inf lation the impact of inf lation
and changing prices on its revenues and net earnings will not have a material effect on its
manufacturing operations, or on its air cargo business. This is because the major cost
components of its operations, consisting principally of fuel, crew and certain maintenance
costs are reimbursed, without markup, under current contract terms.
Inf lation and fixed-price contracts may create problems: American Pacific
Corporation (1999)
Inf lation may have an effect on gross profit in the future as certain of the Company's
agreements with AP and sodium azide customers require fixed prices, although certain such
agreements contain escalation features that should somewhat mitigate the risks associated
with inf lation.
Inf lation leaves assets undervalued, but depreciation understated: Hartmarx
Corporation (1999)
Considering the impact of inf lation, the current value of net assets would be higher than
the Company's $189 million book value after ref lecting the Company's use of the LIFO
inventory method and increases in the value of properties since acquisition. Earnings would
be lower than reported, assuming higher depreciation expense without a corresponding
reduction in taxes.
Cost reduction programs, productivity improvements, and periodic price
increases maintain profit margins: Johnson & Johnson Inc. (1999)
Inf lation rates, even though moderate in many parts of the world during 1999, continue to
have an effect on worldwide economies and, consequently, on the way companies operate. In
the face of increasing costs, the Company strives to maintain its profit margins through cost
reduction programs, productivity improvements and periodic price increases.
Inf lation impact affected by ability to pass on cost increases to customers: Pegasus
Systems Inc. (1999)
Substantial increases in cost and expenses could have a significant impact on results of
operations to the extent such increases are not passed along to customers.
Pricing strategy and efficiency improvements offset inf lation: Polaroid
Corporation (1999)
Inf lation continues to be a factor in many countries in which the Company does business.
The Company's pricing strategy and continuing efficiency improvements have offset to a
considerable degree inf lation and normal cost increases. The overall inf lationary impact on
the Company's earnings has not been material.
Inf lation increases borrowing costs: Silgan Holdings Inc. (1999)
Historically, inf lation has not had a material effect on the Company, other than to increase
its cost of borrowing. In general, the Company has been able to increase the sales prices of
its products to ref lect any increases in the prices of raw materials.
SOURCES: Companies' annual reports. The year following each company name designates the annual report
from which each example is drawn.
Global Finance 409
recent years and, therefore, inf lation has not been a significant issue. However,
other firms with substantial international activity point out that inf lation remains
a significant issue in a number of countries where they are located or in
which they do business.
The disclosed measures taken to mitigate the effects of inf lation were
very consistent and included:
• Selective price increases.
• Productivity improvements.
• Cost-containment efforts.
• Cost reimbursement.
• Price escalation agreements.
Some of the disclosures indicated protection from inflationary cost increases
because of the presence of fixed-price contracts and escalation features
in business agreements. Concern is frequently expressed about the
ability to pass on the effects of inf lationary cost increases in the form of higher
product prices. Some protection from cost inf lation of commodities is often
achieved through the use of the same types of hedging vehicles employed to
avoid cost increases created by exchange rate movements. For example, airlines
and public transit systems routinely hedge the cost of fuel in order to avoid the
erosion of profits from increases in petroleum prices.
A traditional concern, highlighted by the Hartmarx commentary in Exhibit
12.32, is the overstatement of profits in periods of significant inf lation.
The LIFO inventory method has traditionally been viewed as a method that
reduces such profit overstatements. LIFO ensures that cost of sales approximates
replacement cost. Profit overstatement is also avoided in cases where
most depreciable assets are relatively new. In this circumstance depreciation is
closer to replacement cost than if depreciation were based principally on the
lower costs of older assets. The use of accelerated depreciation, especially for
income tax purposes, is also seen to offset some of the potential profit overstatement
associated with inf lation.
The revision of traditional cost-based statements to ref lect the effects of
either general inf lation or specific cost increases is a more comprehensive approach
to assessing the effects of inf lation upon measures of financial performance.
The approach is illustrated next.
Adjusting Financial Statements for the
Effects of Inf lation
The use of LIFO and the reliance upon relatively new depreciable assets or accelerated
depreciation to cause expenses to approximate current (replacement)
costs is only a partial adjustment for the impact of inf lation. Historically, the
comprehensive restatement of results for the effects of general as well as specific
price increases has been emphasized. In fact, in 1979 the FASB issued a
410 Planning and Forecasting
statement that called for the disclosure of supplemental information on pricelevel
adjusted earnings.52 A subsequent statement, issued in 1986, held that
these price-level adjusted disclosures, while still recommended, would no
longer be required.53 There was opposition by the business community to the
requirements of SFAS No. 33, and efforts to demonstrate that the new disclosures
were either used or useful were not successful. While principally of historical
interest in this period of very modest inf lation, some of the disclosures
required by SFAS No. 33 are discussed and presented.54
SFAS No. 33, Price-Level Adjusted Disclosures
Beginning in 1979, certain large U.S. firms were required to provide supplemental
information on the effect of inf lation on financial performance. The disclosures
included new information on earnings computed on both a constant-dollar
and a current-cost basis. The constant-dollar method retains historical cost as
the basis of financial measurement. However, it does make selected restatements
so that all financial statement balances are presented in units of the same
purchasing power, that is, expressed in the same price index. The current-cost
method replaces historical cost balances with current (replacement) costs as the
basis for financial statement measurement. Exhibit 12.33 provides an example
of disclosures of price-level adjusted results under the requirements of SFAS
No. 33.55
A very different message about profitability is conveyed by the adjusted
information in Exhibit 12.33. A significant level of historical-cost profits is almost
eliminated when current-cost adjustments are applied, and profit turns
into loss under the constant-dollar alternative. The purchasing power of the resources
invested in producing the 1980 results, as represented by the constantdollar
amount of expenses, exceeded Tiger's constant-dollar revenues. Closer
EXHIBIT 12.33 Income statements adjusted for changing prices: Tiger
International Inc., December 31, 1980 (in thousands).
Historical Current Constant
Financials Cost Dollar
Revenues $1,562,270 $1,562,270 $1,562,270
Cost and Expenses
Cost of operations 1,104,672 1,108,673 1,109,324
Selling, general, and administrative 139,462 139,462 139,462
Depreciation and amortization 118,332 151,924 171,096
Interest, net 140,929 140,929 140,929
Income tax provision 16,500 16,500 16,500
1,519,895 1,557,488 1,577,311
Net income (loss) $ 42,375 $ 4,782 $ (15,041)
SOURCE: Tiger International Inc., annual report, December 1980, 39.
Global Finance 411
study of these data is necessary to understand the reasons behind these quite
different messages.
The revenues in each of the three income statements are measured in the
average price level for the year based upon the Consumer Price Index for All
Urban Consumers. Tiger's revenues are earned fairly evenly across the year,
and therefore, the revenues in the historical-cost income statement are already
expressed in average prices for the year. Accordingly, the same revenue amount
can be used in both the constant-dollar and current-cost statements. The same
applies to the amounts for selling, general and administrative; interest, net; and
the income tax provision.
Modest adjustments were made to cost of operations to convert them to
constant dollars and current costs, respectively. The constant-dollar adjustment
requires multiplying the historical cost of operations by a ratio of price
indices. The index in the numerator is average price index for the current year,
and in the denominator, is the value of the index at the date closest to the date
on which the expense was incurred. To illustrate, assume that a $1,000 expense
was recorded on January 1, 2002, when the price index was 100; the average
price index for 2002 was 110. Adjustment to constant dollars is:
The same methodology is applied in adjusting historical cost of operations to
current-cost amounts. The difference is that specific indices of replacement
cost, or alternative measures of replacement cost, are used in place of a general
price index.
Tiger reported that increases in inventory costs, included in cost of operations,
accounted for the adjustments to historical cost of operations. In general,
adjustments to the historical cost of sales will be small if the LIFO
inventory valuation method is used; the LIFO cost flow ensures that cost of
sales already approximates current costs. Adjustments will generally be greater
where the FIFO or average cost methods are in use.
Impact of Differences in General and
Specific Price Index Movements
The major Tiger cost adjustments were to depreciation and amortization. Depreciation
and amortization represent the conversion to expense of asset balances.
In many cases these balances were recorded years earlier when the price
indices were far lower. Notice that the percentage increase in the current-cost
and constant-dollar depreciation and amortization over the historical-cost
amount is 28% and 45%, respectively. Tiger's disclosures explain the reason for
the differences: "Depreciation expense is greater when adjusted for general inf
lation than when adjusted for changes in specific prices. The difference ref
lects the Consumer Price Index (general inf lation) rising faster than the
$1, 000 $ ,
110
100
× 1 100
=
412 Planning and Forecasting
increase of costs over the last several years of the type of property, plant and
equipment used in the Company's various businesses."56
Impact of Monetary Balances on Adjusted Results
In addition to the above two inf lation-adjusted income presentations, Tiger
provided additional income data because it did not feel that the required disclosures,
adjusting mainly depreciation and cost of sales, were adequate. These
adjustments, in Exhibit 12.34, expand upon the information in Exhibit 12.33.
The final adjusted net incomes above tell a totally different story from the
initial display in Exhibit 12.33. Both measures of adjusted profits are sharply
higher than the unadjusted historical-cost results. The new income element results
from the impact of changes in the general price level on the purchasing
power of monetary assets and liabilities. Tiger explains the impact of price
changes on monetary balances as follows:
A monetary asset represents money or a claim to receive money without reference
to future changes in prices. Similarly, a monetary liability represents an
obligation to pay a sum of money that is fixed or determinable without reference
to changes in future prices. Holding a monetary asset during periods of inf
lation results in a decline in the value of the asset since the dollar loses
purchasing power when it is held. Conversely, holders of monetary liabilities
benefit during inf lationary periods because less purchasing power is required
to satisfy future obligations when they can be paid with less valuable dollars.57
Under the above reasoning, Tiger earned an unrealized purchasingpower
gain because its monetary liabilities exceeded its monetary assets.
This gain represents the reduction in the purchasing power that Tiger would
need to expend to discharge its net monetary-liability position. The impact of
both inf lation and def lation on purchasing-power gains, under conditions of
both monetary assets exceeding monetary liabilities (net asset exposure) and
EXHIBIT 12.34 Earnings adjusted for purchasing power gains from
monetary position: Tiger International Inc., (in
thousands).
Historical Current Constant
Financials Cost Dollar
Net income $42,375 $ 4,782 $(15,041)
Decrease in depreciation and interest expense
from the decline in the purchasing power of the
net liabilities — 82,195 82,195
Net income adjusted for the decrease in
depreciation and interest expense $42,375 $86,977 $(67,154
SOURCE: Tiger International Inc., annual report, December 1980, 39.
Global Finance 413
monetary liabilities exceeding monetary assets (net liability exposure), are
summarized in Exhibit 12.35.
Tiger treated the purchasing power gain as an adjustment to depreciation
and interest expense based upon the following reasoning: "Because Tiger finances
substantially all of its fixed assets with long-term debt, it effectively
hedges against the impact of inf lation on depreciation and interest expense."
Tiger's liability exposure serves as a hedge because it produces a gain under inf
lationary conditions, to offset increases in the cost of asset replacement and
interest expense, which go hand in hand with inf lation.58
The price-level adjusted reporting illustrated above proved to be a very
controversial requirement. It proved difficult to document that the price-level
adjusted data were used by either creditors or investors, or that they aided
analysis and decision making in any significant way. In 1986, SFAS No. 89: Financial
Reporting and Changing Prices was issued, which eliminated mandatory
disclosure of price-level adjusted data.59 The Statement did encourage
continued disclosure on a voluntary basis. U.S. firms have, however, not responded
to this encouragement and the price-level adjusted disclosures have
not been continued.
U.S. GOVERNMENT RESTRICTIONS ON BUSINESS
PRACTICES ASSOCIATED WITH FOREIGN
SUBSIDIARIES AND GOVERNMENT60
The last issue raised in the opening Fashionhouse scenario dealt with U.S. governmental
restrictions on business practices associated with overseas operations.
Recall that in reviewing the possible relocation of manufacturing to a
high inf lation/low labor-cost country, Fashionhouse management became
aware of potential ethical and legal issues.
Over the years the U.S. government became concerned with the practices
sometimes followed by U.S. firms doing business overseas. Of special concern
were payments to foreign governmental officials made to obtain business. From
hearings over a number of years, which focused on such incidents, a recurring
theme emerged: Even though such payments did take place, key members of
management were often unaware that the payments were being made.
EXHIBIT 12.35 Purchasing power gains and
losses and net monetary position.
Net Monetary Position
Price Movement Asset Liability
Inf lation Loss Gain
Def lation Gain Loss
414 Planning and Forecasting
The U.S. Congress addressed the issue of controlling what they saw to be
improper activities, by passing the Foreign Corrupt Practices Act of 1977. The
key features of this law were:
1. The prohibition of bribery of foreign governmental or political officials
in order to promote business.
2. The requirement that firms (a) keep accurate and detailed records of the
company financial activities and (b) maintain a system of internal accounting
controls sufficient to provide reasonable assurance that transactions
are properly authorized, recorded, and accounted for.
The above requirements are incorporated as amendments to Section 13(b)
of the Securities Exchange Act of 1934, and apply to all publicly held companies.
The record-keeping and internal control features of the Act were a response to
claims that companies had been unaware of bribery payments, because their internal
control systems had failed to detect or prevent them.
In a report addressed to the SEC, the National Commission on Fraudulent
Financial Reporting, made the following recommendation:
All public companies should be required by SEC rule to include in their annual
reports to stockholders management reports signed by the chief executive officer
EXHIBIT 12.36 Report of management: Delta Air Lines Inc., year ended
June 30, 2000.
The integrity and objectivity of the information presented in this Annual Report are the
responsibility of Delta management. The financial statements contained in this report have
been audited by Arthur Andersen LLP, independent public accountants, whose report
appears below.
Delta maintains a system of internal financial controls that are independently assessed on
an ongoing basis through a program of internal audits. These controls include the selection
and training of Delta's managers, organizational arrangements that provide a division of
responsibilities, and communication programs explaining our policies and standards. We
believe that this system provides reasonable assurance that transactions are executed in
accordance with management's authorization; that transactions are appropriately recorded
to permit preparation of financial statements that, in all material respects, are presented in
conformity with accounting principles generally accepted in the United States; and that
assets are properly accounted for and safeguarded against loss from unauthorized use.
The Board of Directors pursues its responsibilities for these financial statements through
its Audit Committee, which consists solely of directors who are neither officers nor employees
of Delta. The Audit Committee meets periodically with the independent public accountants,
the internal auditors and representatives of management to discuss internal control,
accounting, auditing and financial reporting matters.
M. Michele Burns Leo F. Mullin
Executive Vice President and Chairman and
Chief Financial Officer Chief Executive Officer
SOURCE: Delta Air Lines Inc., annual report, June 2000, 53.
Global Finance 415
and the chief accounting officer and/or the chief financial officer. The management
report should acknowledge management's responsibilities for the financial
statements and internal control, discuss how these responsibilities were
fulfilled, and provide management's assessment of the effectiveness of the
company's internal controls.61
While the SEC has not adopted the Commission's recommendation, many
companies have elected to provide voluntarily a report of management's responsibilities.
While the precise title of the report may vary, representative
titles include, Report of Management Responsibility for Financial Statements
and Internal Control and Financial Reporting Responsibility. Although the precise
language of the report differs from company to company, Exhibit 12.36 provides
a representative example from the 2000 annual report of Delta Air Lines.
The precise meaning of the provisions of the Foreign Corrupt Practices
Act continues to evolve. However, in considering expansion into a country,
where improper payments have a long and durable tradition, Fashionhouse
must pay special attention to the existence and requirements of the Act.
SUMMARY
The evolution of Fashionhouse from a purely domestic firm to a truly global
entity continues to confront it with new and increasingly complex problems of
accounting, finance, and management. This chapter has followed Fashionhouse
through this evolution and attempted to help the reader become aware of the
problems faced and how they might be addressed. The range of issues addressed
is broad and can become quite complex. It has not been possible, nor
would it have been appropriate in a chapter such as this, to deal with all aspects
of every issue raised. The reader should consult the books and articles
cited throughout the chapter and in the list of "additional readings" for additional
background.
The following are some key points for the reader to consider:
• International business and international operations raise challenges that
transcend those of a strictly domestic operation.
• Exposure to potentially adverse movements of foreign-currency exchange
rates is a key challenge for firms that engage in international business.
This currency risk can arise from both transactional and translational
exposure.
• Both transactional and translational currency risk can be managed or
hedged to some extent by relying on aspects of a firm's own operations.
This is normally referred to as employing natural hedges.
• Beyond the use of natural hedges, it is common for firms to use a variety
of foreign-currency derivatives. Forward contracts and currency options
are currently the most popular.
416 Planning and Forecasting
• Most hedging activity centers around efforts to protect cash flows and
earnings from the volatility that would be produced by the combination of
unhedged currency exposure and f luctuations in exchange rates. Translation
exposure, which does not pose the same threat to cash flows and
earnings, is hedged far less frequently than transaction exposure.
• Note all of the effects of changes in exchange rates are ref lected in transaction
and translation gains and losses. The strength of the U.S. dollar in
recent years has both reduced the dollar value of foreign sales as well as
the competitiveness of U.S. products.
• The emergence of the Euro has the potential to reduce both the cost and
complexity of hedging because many European currencies are replaced
by a single currency, the Euro. However, some companies express concern
about possible adverse competitive effects associated with the pricing
transparency that results from a common currency.
• Substantial differences continue to exist between GAAP in the U.S. and
that in other countries. However, the International Accounting Standards
Committee (IASC) continues its efforts to create more harmony in GAAP
across the world. These GAAP differences create substantial challenges
when analyzing the financial performance of foreign firms.
• The evaluation of the performance of foreign subsidiaries and their management
can be affected by exchange-rate changes. A common response is
to remove the effects of exchange rate changes from key performance indicators.
Another approach is to evaluate performance using budgeted exchange
rates. The extent to which the responsibility for hedging currency
exposure is delegated to management of these entities should affect decisions
about how to deal with the effects of exchange-rate changes. Removing
the effects of exchange rate changes is consistent with an absence
of responsibility for the hedging of currency risk.
• Recent changes in the accounting for derivative instruments and hedging
activities call for the recording of all foreign-currency derivatives at their
fair values. In some cases, gains and losses from the revaluation of currency
derivatives will initially be included in other comprehensive income.
However, these gains and losses will subsequently be included in
net income when the related hedged transaction is included in earnings.
The deferral of foreign-currency gains and losses on the balance sheet is
no longer permitted.
• Transfer pricing policies between U.S. parents and their foreign subsidiaries
create challenges in terms of both performance evaluation and
worldwide tax minimization.
• Modest levels of inf lation in the U.S. in recent years has meant that increases
in the general price level have not been a major management
issue. However, inf lation continues to present issues for global firms because
of substantial inf lation in some of their foreign markets.
Global Finance 417
• The international expansion of business activities can create potential
problems because of different business and cultural norms. Practices that
may be common in some countries may be in direct conf lict with U.S.
law. Firms should be certain that they are familiar with and in compliance
with the provisions of the Foreign Corrupt Practices Act of 1977.
FOR ADDITIONAL READING
Beaver, W., and W. Landsman, Incremental Information Content of Statement 33
Disclosures (Stamford, CT: FASB, 1983).
Choi, F., ed., Handbook of International Accounting (New York: John Wiley, 1991).
Comiskey, E., and C. Mulford, Guide to Financial Reporting and Analysis (New
York: John Wiley, 2000).
Epstein, B., and A. Mirza, Interpretation and Application of International Accounting
Standards 2001 (New York: John Wiley, 1997).
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (Norwalk,
CT: FASB, June, 1998).
Financial Accounting Standards Board, The IASC-U.S. Comparison Project: A Report
on the Similarities and Differences between IASC Standards and U.S.
GAAP (Norwalk, CT: FASB, November, 1996).
, Financial Reporting in North America—Highlights of a Joint Study (Norwalk,
CT: FASB, December, 1994).
Frishkoff, P., Financial Reporting and Changing Prices: A Review of Empirical Research
(Stamford, CT: FASB, 1982).
Goodwin, J., S. Goldberg, and C. Tritschler, "Understanding Foreign Currency Derivative
Measurements as FASB Moves Toward Fair Value Reporting," The
Journal of Corporate Accounting and Finance, 7, (spring 1996): 75–84.
Goldberg, S., and J. Godwin, "Foreign Corrupt Practices Act: Some Pitfalls and
How to Avoid Them," The Journal of Corporate Accounting and Finance , 7,
(winter 1995–1996): 35–43.
Haskins, M., K. Ferris, and T. Selling, International Financial Reporting and Analysis
(Chicago: Richard D. Irwin, 1996).
Kim, H., Fundamental Analysis Worldwide (New York: John Wiley, 1996).
Mulford, C., and E. Comiskey, Financial Warnings (New York: John Wiley, 1996).
Radebaugh, L., and S. Gray, International Accounting for Multinational Enterprises,
3rd ed. (New York: John Wiley, 1993).
Shapiro, A., Multinational Financial Management, 5th ed. (Upper Saddle River, NJ:
Prentice-Hall, 1996).
ANNUAL REPORTS REFERENCED IN THE CHAPTER
Adobe Systems Inc. (1999)
AGCO Corporation (1999)
418 Planning and Forecasting
Air Canada (1999)
Air T Inc. (2000)
American Pacific Corporation (1999)
Analog Devices Inc. (1999)
Arch Chemicals Inc. (1999)
Armstrong World Industries Inc. (1999)
Arvin Industries Inc. (1999)
Baldwin Technology Company (1999)
Baltek Corporation (1999)
Baxter International Inc. (1999)
Beckman Coulter Inc. (1999)
Becton, Dickenson & Company (1999)
Black and Decker Inc. (1995)
Blyth Industries Inc. (2000)
California First Bank (1987)
Compaq Computer Corporation (1999)
Conoco Inc. (1999)
DaimlerChrysler AG (1999)
Delta Air Lines Inc. (2000)
Dow Chemical Company (1999)
E.I. DuPont de Nemours & Company (1999)
Electricidade de Portugal SA (1998)
Federal Express Inc. (1989)
Galey & Lord Inc. (1999)
Hartmarx Corporation (1999)
H.J. Heinz Co. (1999)
Henry Schein Inc. (1998)
Illinois Tool Works Inc. (1999)
Interface Inc. (1999)
JLG Industries Inc. (2000)
Johnson & Johnson, Inc. (1999)
Olin Corporation (1999)
Pall Corporation (2000)
Pegasus Systems Inc. (1999)
Philip Morris Companies Inc. (1999)
Polaroid Corporation (1999)
Praxair Inc. (1999)
Quaker Oats Company (1999)
Silgan Holdings Inc. (1999)
Global Finance 419
Storage Technology Corporation (1999)
Telef lex Inc. (1999)
Tenneco Inc. (1999)
Tiger International Inc. (1980)
Titan International Inc. (1999)
UAL Inc. (1999)
Vishay Intertechnology Inc. (1999)
Western Digital Corporation (2000)
York International Corporation (1999)
NOTES
1. Western Digital Corporation, annual report, June 2000, 25–26.
2. Baltek Corporation, annual report on Form 10-K to the Securities and Exchange
Commission, December 1999, 3.
3. It is unlikely that either side of the transaction would be indifferent to this
matter. Insisting upon being invoiced by a foreign supplier in your own currency
means that the supplier must bear the currency risk. The supplier will have a foreigncurrency
receivable. It is reasonable to expect the foreign supplier to attempt to be
compensated for bearing this currency risk by charging a higher price for its product.
4. A U.S. electronics company recently attempted to eliminate currency risk by
having its Japanese supplier invoice them in the U.S. dollar. The Japanese supplier
agreed to do this and introduced a new schedule of prices in dollars. The U.S. company
deemed the increases to be so high that they decided to continue to be invoiced
in the Japanese yen and to manage the associated exchange risk.
5. Each of the actual case examples discussed in this section are treated in more
detail, including income tax and cash-f low issues, in E. Comiskey and C. Mulford,
"Risks of Foreign Currency Transactions: A Guide for Loan Officers," Commercial
Lending Review (summer 1990), pp. 44–60.
6. Air Canada, annual report, December 1999 (emphasis added). Information
obtained from Disclosure, Inc., Compact D/SEC: Corporation Information on Public
Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 2000).
7. On January 1, 1999, 11 of the 15 member countries of the European Union
adopted the Euro as their common legal currency and established fixed conversion
rates between their sovereign currencies and the Euro.
8. Holding foreign currency cash, that is, an asset balance, would be consistent
with the need to offset existing liability exposure in these foreign currencies. Alternatively,
borrowing in foreign currencies to produce a hedge implies existing asset exposure
in these foreign currencies.
9. California First Bank, annual report, December 1987, 20.
10. Federal Express Inc., annual report, December 1989, 35.
11. The accounting treatment to insure that the offsetting gains and losses are
included in the income statements at the same time was described by Federal
420 Planning and Forecasting
Express. It reported that "Exchange-rate gains and losses on the term loan are deferred
and amortized over the remaining life of the loan as an adjustment to the related
hedge (service) revenue." Federal Express Inc., annual report, December
1989, 36.
12. This example is discussed in "FX Translation—Lyle Shipping's Losses," Accountancy,
110 (December 1984): 50. Lyle has an economic hedge of its dollar
exposure.
13. See P. Maloney, "Managing Currency Exposure: The Case of Western Mining,"
Journal of Applied Corporate Finance, 2 (winter 1990): 29–34, for an analysis of
the effectiveness of this natural hedge during the eighties.
14. Survey data support this view. See G. Bodnar, G. Hayt, and R. Marston, "The
Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms," Financial Management,
25 (winter 1996): 113–133.
15. Spot and forward exchange rates normally differ. These rate differences are
determined primarily by differences in interest rates in the respective countries of
the domestic and foreign currency.
16. Beckman Coulter Inc., annual report, December 1999, 47.
17. An option that is acquired when the spot value for the currency and the
strike price in the option contract are equal is said to have no intrinsic value. However,
such contracts routinely have positive values. The value of an at-the-money
option contract is normally referred to as time value.
18. A currency option is similar to f light insurance. The option contract (insurance)
only pays off if the plane crashes and the policyholder is injured or dies. That
is, there is a gain only if the unfavorable event takes place. However, if the plane does
not crash, the favorable outcome, the policyholder is simply out the amount of the insurance
(option) premium.
19. Analog Devices Inc., annual report, December 1999. Information obtained
from Disclosure Inc.
20. JLG Industries Inc., annual report, July 2000, 23.
21. Titan International Inc., annual report, December 1999. Information obtained
from Disclosure Inc.
22. To be technically correct, a gain or loss from the translation of the statements
of a foreign subsidiary does affect other comprehensive income. However, it does not
affect net income, which continues to be the number which both company management
and other users of financial statements emphasize.
23. E.I. DuPont de Nemours & Company, annual report, December 1999, 37.
24. Ibid., 37.
25. However, this hedging by Quaker Oats is not aimed at protecting either earnings
or cash flow. Gains and losses from net-investment hedges, along with their offsetting
translation losses and gains, are reported in shareholders' equity.
26. Arch Chemicals Inc., annual report, December 1999, 34.
27. The equity method is usually employed when a voting stock interest of 20%
or more is held in another company. The investor company recognizes its share of the
investee company earnings or loss, without regard to whether any dividends are received.
The receipt of dividends is treated as a reduction in the carrying value of the
investment, and not as dividend income.
Global Finance 421
28. Denmark has not yet (early 2001) adopted the Euro. Its currency exposure
will be limited to the Euro to the extent that it trades mainly with Euro countries.
29. Information on Danish GAAP can be found in E. Comiskey and C. Mulford,
"Comparing Danish Accounting and Reporting Practices with International Accounting
Standards," in Advances in International Accounting, ed. Kenneth S. Most
(Greenwich, CT: JAI Press, 1991), 123–142.
30. If there were differences between generally accepted accounting principles
in the country of the foreign subsidiary and those in the U.S., then the statements
would first have be adjusted to conform to U.S. GAAP before consolidation could
take place.
31. Statement No. 52, Foreign Currency Translation, refers to this alternative procedure
as remeasurement and not translation. However, in the vast majority of cases,
the remeasurement is from the foreign currency to the U.S. dollar. Therefore, remeasurement
produces statements in the U.S. dollar that are ready to be consolidated with
the statements of their U.S. parent. Remeasurement is tantamount to translation.
32. It is simply coincidental that a translation gain of $87 resulted under the allcurrent
translation and a remeasurement loss of $87 resulted from remeasurement
under the temporal method.
33. From this example, a fairly obvious case can be made for, other things equal,
locating manufacturing in the same country where sales are made.
34. P. Collier, E. Davis, J. Coates and S. Longden, "The Management of Currency
Risk: Case Studies of US and UK Multinationals," Accounting and Business Research,
24 (summer 1990): 208.
35. SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions
and Foreign Financial Statements (Stamford, CT: FASB, October 1975).
36. C. Houston and G. Mueller, "Foreign Exchange Rate Hedging and SFAS
No. 52—Relatives or Strangers?," Accounting Horizons, 2 (December 1988): 57.
37. SFAS No. 133, Accounting for Derivative Instruments and Hedging (Norwalk,
CT: FASB, June 1998).
38. A common feature of derivatives is that they have little or no initial value.
This would not be true in the case of some option contracts where an option premium
is paid, even in the case of at or out-of-the-money options.
39. For a reference on these matters, see E. Comiskey and C. Mulford, Guide to
Financial Reporting and Analysis (New York: John Wiley, 2000), chapters 6 and 7.
40. International Accounting Standards Committee, Exposure Draft 32, Comparability
of Financial Statements (January 11, 1989).
41. Ibid., paragraph 6.
42. International Accounting Standards Committee, Statement of Intent, Comparability
of Financial Statements (July 1990).
43. For a standard-by-standard analysis of the differences between current U.S.
GAAP and IASC standards, see The IASC-U.S. Comparison Project: A Report on the
Similarities and Differences between IASC Standards and U.S. GAAP (Norwalk, CT:
FASB, November, 1996).
44. To examine the complete reconciliation disclosures of Electricidade de Portugal,
go to the SEC Web site (www.sec.gov) and search for the Electricidade filings. The
current reconciliation will be found in the most recent 20-F filing for the company.
422 Planning and Forecasting
45. A further negative for a U.S. firm has been the fact that goodwill amortization
was not deductible for tax purposes, whereas it was in some other countries. A
1993 change in the tax law, Internal Revenue Code, section 197, now makes it possible
to amortize goodwill in the tax return for qualifying acquisitions.
46. FASB, News Release, Financial Accounting Standards Board Announces Additional
Decisions Relating to the Treatment of Goodwill (Norwalk, CT: FASB, December
20, 2000).
47. SFAS No. 106, Employers' Accounting for Postretirement Benefits Other
Than Pensions (Norwalk, CT: FASB, December 1990).
48. From a statement made by R. S. Miller Jr., executive vice president and chief
financial officer of Chrysler Corporation, to the Financial Accounting Standards
Board, Washington, DC, November 3, 1989, 3.
49. Removing the effects of exchange rate changes in cases where the subsidiary
is using the temporal (remeasurement) translation method, as opposed to the all-current
method, is a greater challenge and beyond the scope of this chapter.
50. Black and Decker Inc., annual report, December 1995, 35.
51. The following two references were of great assistance in preparing this discussion
of transfer pricing: Frederick D. S. Choi and Gerhard G. Mueller, An Introduction
to Multinational Accounting (Englewood Cliffs, NJ: Prentice-Hall, 1978),
chapter 9; and Jeffrey S. Arpan and Lee H. Radebaugh, International Accounting and
Multinational Enterprises (New York: Warren, Gorham & Lamont, 1981), chapter 10.
52. SFAS No. 33, Financial Reporting and Changing Prices (amended and partially
superseded) (Stamford, CT: FASB, September 1979).
53. SFAS No. 89, Financial Reporting and Changing Prices (Stamford, CT:
FASB, December 1986).
54. Helpful in preparing this section was J. Largay and L. Livingstone, Accounting
for Changing Prices: Replacement Cost and General Price Level Adjustments
(Santa Barbara, CA: John Wiley/Hamilton, 1976). This is an excellent and comprehensive
treatment of this subject area that is recommended for readers interested in
a more expansive treatment of the subject.
55. Tiger International Inc., annual report, December 1980, 39.
56. Ibid., 39.
57. Ibid., 40.
58. Incorporating gain and losses on the net monetary position into the computation
of restated results was not part of the SFAS No. 33 requirements.
59. SFAS No. 89, Financial Reporting and Changing Prices (Stamford, CT:
FASB, 1986).
60. For further background on this topic see: K. Skousen, An Introduction to the
SEC, 4th ed. (Cincinnati: South-Western, 1987), 32–35.
61. Report of the National Commission on Fraudulent Financial Reporting
(Washington, DC, 1987), 44.
423
13
FINANCIAL
MANAGEMENT
OF RISKS
Steven P. Feinstein
For better or worse, the business environment is fraught with risks. Uncertainty
is a fact of life. Profits are never certain, input and output prices change,
competitors emerge and disappear, customers' tastes constantly evolve, technological
progress creates instability, interest rates and foreign-currency values
and asset prices f luctuate. Nonetheless, managers must continue to make decisions.
Businesses must cope with risk in order to operate. Managers and firms
are often evaluated on overall performance, even though performance may be
affected by risky factors beyond their control. The goal of risk management
is to maximize the value of the firm by reducing the negative potential impact
of forces beyond the control of management.
There are essentially four basic approaches to risk management: risk
avoidance, risk retention, loss prevention and control, and risk transfer.1 Suppose
after a firm has analyzed a risky business venture and weighed both the
costs and benefits of exposure to risk, management chooses not to embark on
the project. They determine that the potential rewards are not worth the risks.
Such a strategy would be an example of risk avoidance. Risk avoidance means
choosing not to engage in a risky activity because of the risks. Choosing not to
f ly in a commercial airliner because of the risk that the plane might crash is an
example of risk avoidance.
Risk retention is another simple strategy, in which the firm chooses to engage
in the project and do nothing about the identified risks. After weighing
the costs and benefits, the firm chooses to proceed. It is the "damn the torpedoes"
approach to risk management. For many firms, risk retention is the optimal
strategy for all risks. Investors expect the company's stock to be risky, and
they do not reward managers for reducing risks. Investors cope with business
424 Planning and Forecasting
risks by diversifying their holdings within their portfolios, and so they do not
want business managers to devote resources to managing risks within the firm.
Loss prevention and control involves embarking on a risky project, yet
taking steps to reduce the likelihood and severity of any losses potentially resulting
from uncontrollable factors. In the f lying example, loss prevention and
control would be the response of the airline passenger who chooses to f ly, but
also selects the safest airline, listens to the pref light safety instructions, sits
near the emergency exit, and perhaps brings his or her own parachute. The
passenger in this example has no control over how many airplanes crash in a
given year, but he or she takes steps to make sure not to be on one of them, and
if so, to be a survivor.
Risk transfer involves shifting the negative consequences of a risky factor
to another person, firm, or party. For example, buying f light insurance shifts
some of the negative financial consequences of a crash to an insurance company
and away from the passenger's family. Should the airplane crash, the insurance
company suffers a financial loss, and the passenger's family is financially compensated.
Forcing foreign customers to pay for finished goods in your home currency
rather than in their local currency is another example of risk transfer,
whereby you transfer the risk of currency f luctuations to your customers. If the
value of the foreign currency drops, the customers must still pay you an agreed
upon number of dollars, for example, even though it costs them more to do so in
terms of their home currency.
No one risk management approach is ideal for all situations. Sometimes
risk avoidance is optimal; sometimes risk retention is the desired strategy.
Recent developments in the financial marketplace, however, have made risk
transfer much more feasible than in the past. More and more often now, especially
when financial risks are involved, it is the most desirable alternative.
In recent years there has been revolutionary change in the financial marketplace.
The very same marketplace that traditionally facilitated the transfer
of funds from investors to firms, has brought forth numerous derivative instruments
that facilitate the transfer of risk. Just as the financial marketplace has
been innovative in engineering various types of investment contracts, such as
stocks, bonds, preferred stock, and convertible bonds, the financial marketplace
now engineers risk transfer instruments, such as forwards, futures, options,
swaps, and a multitude of variants of these derivatives.
Reading stories about derivatives in the popular press might lead one to
believe that derivative instruments are dangerous and destabilizing—evil creatures
that emerged from the dark recesses of the financial marketplace. The
cover of the April 11, 1994, Time magazine introduced derivatives with the
caption "High-tech supernerds are playing dangerous games with your money."
The use of derivatives has been implicated in most of the financial calamities
of the past decade: Barings Bank, Procter & Gamble, Metallgesellschaft, Askin
Capital Management, Orange County, Union Bank of Switzerland, and Long-
Term Capital Management, to name a few. In each of the cases, vast sums of
money quickly vanished, and derivatives seemed to be to blame.
Financial Management of Risks 425
WHAT WENT WRONG: CASE STUDIES
OF DERIVATIVES DEBACLES
Derivatives were not responsible for the financial calamities of the 1990s.
Greed, speculation, and probably incompetence were. But just as derivatives
facilitate risk management, they facilitate greed and accelerate the consequences
of speculation and incompetence. For example, consider the following
case histories and then draw your own conclusions.
Barings Bank
On February 26, 1995, Baring PLC, Britain's oldest merchant bank and one of
the most venerable financial institutions in the world collapsed. Did this failure
follow years of poor management and bad investments. Hardly. All of the
bank's $615 million of capital had been wiped out in less than four months, by
one employee, half way around the world from London. It seems that a Barings
derivatives trader named Nicholas Leeson, stationed in Singapore, had
taken huge positions in futures and options on Japanese stocks. Leeson's job
was supposed to be index arbitrage, meaning that he was supposed to take low
risk positions exploiting discrepancies between the prices of futures contracts
traded in both Singapore and Osaka. Leeson's job was to buy whichever contract
was cheaper and sell the one that was more dear. The difference would
be profit for Barings. When he was long in Japanese stock futures in Osaka, he
was supposed to be short in Japanese stock futures in Singapore, and vice
versa. Such positions are inherently hedged. If the Singapore futures lost
money, the Japanese futures would make money, and so little money, if any,
could be lost.
Apparently, Leeson grew impatient taking hedged positions. He began to
take unhedged bets, selling both call options and put options on Japanese
stocks. Such a strategy, consisting of written call options and written put options
is called a straddle. If the underlying stock price stays the same or does
not move much, the writer keeps all the option premium, and profits handsomely.
If, on the other hand, the underlying stock price either rises or falls
substantially, the writer is vulnerable to large losses. Leeson bet and lost. Japanese
stocks plummeted, and the straddles became a huge liability. Like a panicked
gambler, Leeson tried to win back his losses by going long in Japanese
stock futures. This position was a stark naked speculative bet. Leeson lost
again. Japanese stocks continued to fall. Leeson lost more than $1 billion, and
Barings had lost all of its capital. The bank was put into receivership.
Procter & Gamble
Procter & Gamble, the well-known manufacturer of soap and household products,
had a long history of negotiating low interest rates to finance operations.
426 Planning and Forecasting
Toward this end, Procter & Gamble entered an interest rate swap with
Bankers Trust in November of 1993. The swap agreement was far from plainvanilla.
It most certainly fit the description of an exotic derivative. The swap's
cash flows were determined by a formula that involved short-term, mediumterm,
and long-term interest rates. Essentially, the deal would allow Procter &
Gamble to reduce its financing rate by four-tenths of 1% on $200 million of
debt, if interest rates remained stable until May 1994. If, on the other hand,
interest rates spiked upward, or if the spread between 5-year and 30-year
rates narrowed, Procter & Gamble would lose money and have to pay a higher
rate on its debt.
Even in the rarefied world of derivatives, one cannot expect something
for nothing. In order to achieve a cheaper financing rate, Procter & Gamble
had to give up or sell something. In this case, implicit in the swap, they sold
interest rate insurance. The swap contained an embedded option, sold by Procter
& Gamble. If the interest rate environment remained calm, Procter &
Gamble would keep a modest premium, thereby lowering its financing costs. If
interest rates became turbulent, Procter & Gamble would have to make big
payments. Most economists in 1993 were forecasting calm. The bet seemed
safe. But it was a bet, nevertheless. This was not a hedge, this was speculation.
And they lost.
The Federal Reserve unexpectedly raised interest rates on February 4,
1994. Procter & Gamble suddenly found themselves with a $100 million loss.
Rather than lower their financing rate by four-tenths of 1%, they would have to
pay an additional 14%!
Rather than lick its wounds and retire from swaps, Procter & Gamble
went back for more—with prodding, of course, from Bankers Trust. As losses
mounted on the first deal, Procter & Gamble entered a second swap, this one
tied to German interest rates. German medium-term interest rates are remarkably
stable, and so this bet seemed even safer than the first one. Guess what
happened. Another $50 million of losses mounted before Procter & Gamble finally
liquidated its positions. Losses totaled $157 million. Procter & Gamble
sued Bankers Trust, alleging deception, mispricing, and violation of fiduciary
responsibilities. Procter & Gamble claimed that they did not fully understand
the risks of the swap agreements, nor how to calculate their value. Bankers
Trust settled with Procter & Gamble, just as they settled with Gibson Greeting
Cards, Air Products and Chemicals, and other companies that lost money in
similar swaps.
Metallgesellschaf t
Experts are still divided over what went wrong in the case of Metallgesellschaft,
one of Germany's largest industrial concerns. This much is certain:
In 1993, Metallgesellschaft had assets of $10 billion, sales exceeding $16
billion, and equity capital of $50 million. By the end of the year, this industrial
giant was nearly bankrupt, having lost $1.3 billion in oil futures.
Financial Management of Risks 427
What makes the Metallgesellschaft case so intriguing, is that the company
seemed to be using derivatives for all the right reasons. An American subsidiary
of Metallgesellschaft, MG Refining and Marketing (MGRM) had embarked
on an ingenious marketing plan. The subsidiary was in the business of
selling gasoline and heating oil to distributors and retailers. To promote sales,
the company offered contracts that would lock in prices for a period of 10
years. A variety of different contract types was offered, and the contracts had
various provisions, deferments, and contingencies built in, but the important
feature was a long-term price cap. The contracts were essentially forwards.
The forward contracts were very popular and MGRM was quite successful at
selling them.
MGRM understood that the forward contracts subjected the company to
oil price risk. MGRM now had a short position in oil. If oil prices rose, the
company would experience losses, as it would have to buy oil at higher prices
and sell it at the lower contracted prices to the customers. To offset this risk,
MGRM went long in exchange-traded oil futures. The long position in futures
should have hedged the short position in forwards. Unfortunately, things did
not work out so nicely.
Oil prices fell in 1993. As oil prices fell, Metallgesellschaft lost money on
its long futures, and had to make cash payments as the futures were marked to
market. The forwards, however, provided little immediate cash, and their appreciation
in value would not be fully realized until they matured in 10 years.
Thus, Metallgesellschaft was caught in a cash crunch. Some economists argue
that if Metallgesellschaft had held on to its positions and continued to make
margin payments the strategy would have worked eventually. But time ran out.
The parent company took control over the subsidiary and liquidated its positions,
thereby realizing a loss of $1.3 billion.
Other economists argue that Metallgesellschaft was not an innocent victim
of unforeseeable circumstances. They argue that MGRM had designed the
entire marketing and hedging strategy, just so they could profit by speculating
that historical patterns in oil prices would persist. Traditionally, oil futures
prices are lower than spot prices, so the general trend in oil futures prices is
upward as they near expiration. MGRM's hedging plan was to repeatedly buy
short-term oil futures, holding them until just before expiration, at which point
they would roll over into new short-term futures. If the historical pattern had
repeated itself, MGRM would have profited many times from the rollover
strategy. It has been alleged that the futures was the planned source of profits,
while the forward contracts with customers was the hedge against oil prices
dropping.
Regardless of MGRM management's intent, the case teaches at least
two lessons. First, it is important to consider cash flow and timing when constructing
a hedge position. Second, when a hedge is working effectively, it
will appear to be losing money when the position it is designed to offset is
showing profits. Accounting for hedges should not be independent of the position
being hedged.
428 Planning and Forecasting
Askin Capital Management
Between February and April 1994, David Askin lost all $600 million that he
managed on behalf of the investors in his Granite Hedge Funds. Imagine the
surprise of the investors. Not only had they earned over 22% the previous year,
but the fund was invested in mortgage-backed securities—instruments guaranteed
by the U.S. government not to default. The lesson from the Askin experience,
is that in the age of derivatives, investments with innocuous names might
not be as safe and secure as they sound.
The particular type of mortgage-backed securities that Askin purchased
were collateralized mortgage obligations (CMOs), which are bonds whose
cash f lows to investors are determined by a formula. The formula is a function
of mortgage interest rates and also of the prepayment behavior of home buyers.
Since the cash flow to CMOs is a function of some other economic variable,
interest rates in this case, these instruments are categorized as
derivatives. Some CMOs rise in value as interest rates rise, others fall. Askin's
CMOs were very sensitive to interest rates. Askin's portfolio rose in value as
interest rates fell in 1993. When interest rates began to rise again in February
1994, his portfolio suffered. Interest rate increases alone, however, were not
the sole cause of Askin's losses. As interest rates rose and CMO prices fell,
CMO investors everywhere got scared and sold. CMO prices were doubly battered
as the demand dried up. It was a classic panic. Prices fell far more than
the theoretical pricing models predicted. Eventually, calm returned to the
market, investors trickled back, and prices rebounded. But it was too late for
Askin. He had bought on margin, and his creditors had liquidated his fund at
the market's bottom.
Orange County, California
Robert Citron, treasurer of Orange County, California, in 1994, fell into the
same trap that snared Procter & Gamble and David Askin. He speculated that
interest rates would remain low. The best economic forecasts at the time supported
this outlook. Derivatives allowed speculators to bet on the most likely
scenario. Small bets provided modest returns. Big bets promised sizable returns.
What these speculators did was akin to selling earthquake insurance in
New York City. The likelihood of an earthquake there is very small, so insurers
would almost certainly get to keep the modest premiums without having to pay
out any claims. If an earthquake did hit New York, however, the losses to the
insurers would be enormous.
Citron bet and lost. The earthquake that toppled his portfolio was the unexpected
interest rate hikes beginning in February 1994. Citron had borrowed
against the bonds Orange County owned, and he invested the proceeds in derivative
bonds called inverse-f loaters, whose cash f low formulas made them extra
sensitive to interest rate increases. Citron lost about $2 billion of the $7.7 billion
he managed, and Orange County filed for bankruptcy in December 1994.
Financial Management of Risks 429
Union Bank of Switzerland
What happened at Union Bank of Switzerland (UBS) in 1997 would be funny
if it weren't so sad. Imagine a bakery that sells cakes and cookies for less than
the cost of the ingredients. Business would no doubt be brisk, but eventually
the bakers would discover that they were not turning a profit. This is essentially
what happened to UBS. UBS manufactured and sold derivatives to corporate
customers. Unfortunately, there was an error in their pricing model,
and they were selling the derivatives for too low a price. By the time they
found the mistake, they had managed to lose over $200 million. Swiss banking
officials concluded that losses sustained by the Global Equity Derivatives
Business arm of UBS amounted to 625 million Swiss francs (about $428 million),
but these losses stemmed not only from the pricing model error, but also
from unlucky trading, an unexpected change in British tax laws, and market
volatility. Some speculate that these losses forced the merger of UBS with
Swiss Bank Corporation, a merger that was arranged exactly when the derivatives
losses were discovered.
Long-Term Capital Management
The most surprising of the derivatives debacles is also one of the most recent.
It is the saga of Long-Term Capital Management (LTCM). LTCM was a company
founded by John Meriwether, and joined by Myron Scholes and Robert
Merton. Meriwether had a reputation for being one of the savviest traders on
Wall Street. Scholes and Merton are Nobel prize laureates, famous for inventing
the Black-Scholes option pricing model.2 Unlike the folks at Procter &
Gamble, these individuals cannot plead ignorance. They were without a doubt
among the smartest players in the financial marketplace. Paradoxically, it may
have been their intellectual superiority that did them in. Their overconfidence
engendered a false sense of security that seduced investors, lenders, and the
portfolio managers themselves into taking enormous positions. The story of
LTCM is a classic Greek tragedy set on modern Wall Street.
LTCM was organized as a "hedge fund." A hedge fund is a limited partnership,
that in exchange for limiting the number and type of investors who can
buy in, is not required to register with the Securities and Exchange Commission,
and is not bound by the same regulations and reporting standards imposed
on traditional mutual funds. Investors must be rich. A hedge fund can accept
investments from no more than 500 investors who each have net worth of at
least $5 million, or no more than 99 investors if they each have net worth of
at least $1 million. A hedge fund is essentially a private investment club, unfettered
by the rules designed to protect the general public.
Ironically, hedge funds are generally unhedged. Most hedge funds speculate,
aiming to capture profits by taking risks. LTCM was a little different,
and for them the moniker "hedge fund" appeared to fit. Capitalizing on their
brainpower, LTCM sought to exploit market inefficiencies. That is, with an
430 Planning and Forecasting
understanding of what the prices of various financial instruments should be,
LTCM would identify instruments that were priced too high or too low. Once
such an opportunity was identified, they would buy or sell accordingly, hedging
long positions with matching shorts. As the prices in the financial marketplace
trended toward the fair equilibrium dictated by the financial models,
the prices of the assets held long would rise, and the prices of the instruments
sold short would fall, thereby delivering to LTCM a handsome profit.
LTCM's deals were generally not naked speculation, but hedged exploitation
of arbitrage opportunities. With price risk thought to be hedged out, LTCM
and their investors felt comfortable borrowing heavily to lever up the impact
of the trades on profits. The creditors, banks and brokerages mostly, happily
obliged.
LTCM opened its doors in 1994, with an initial equity investment of $150
million from the founding partners, and an investment pool of $1.25 billion in
client accounts. Success was immediate and pronounced. They thrived in the
tumultuous market of the mid-1990s. Apparently, as some of the institutions
described above lost fortunes during this period, it was LTCM that managed to
be on the receiving end. The fund booked a 28% return in 1994, a whopping
59% in 1995, followed by another 57% return in 1996. Word of this success
spread, and new investors were clamoring to get into LTCM.3
LTCM could be picky when it came to choosing investors. This was not a
fund for your typical dentist or millionaire next door. Former students of mine
who have gone on to jobs at some of the world's largest banks and investment
companies have confided to me that their firms subcontracted sizable portions
of their portfolios to LTCM. By the end of 1995, bolstered by reinvested profits
and by newly invested funds, LTCM managed $3.6 billion of invested funds.
However, the portfolio was levered 28 to 1. For every $1 a client invested, the
fund was able to borrow $28 from banks and brokerage houses. Consequently,
LTCM managed positions worth over $100 billion. Moreover, because of the
natural leverage inherent in the derivatives they bought, these positions were
comparable to investments of a much larger magnitude, estimated to be in the
$650 billion range.
By 1997, however, when the fund's capital base peaked at $7 billion,
managers realized that profitable arbitrage opportunities were growing scarce.
The easy pickings of the early days were over. The partners began to intentionally
shrink the fund by returning money to investors, essentially forcing them
out. Performance was sound in 1997, a 25% return, but with the payout of capital,
the fund's capital base fell to $4.7 billion.
Things unraveled disastrously in 1998. Each of LTCM's major investment
strategies failed. Based on sophisticated models and historical data,
LTCM gambled that (1) stock market volatility would stay the same or fall,
(2) swap spreads—a variable used to determine who pays whom how much in
interest rate swaps, would narrow, (3) the spread of the interest rate on
medium-term bonds over long-term bonds would f latten out, (4) the credit
Financial Management of Risks 431
spread—the interest rate differential between risky bonds and high-grade
bonds, would narrow, and (5) calm would return to the financial markets of
Russia and other emerging markets. However, in each case the opposite happened.
Equity volatility increased. Swap spreads widened. The yield curve retained
its hump. Credit spreads grew. Emerging markets deteriorated.
Though LTCM had spread its bets over a wide variety of positions, they
seemed to gain no diversification benefit. Everything went wrong at once. Recent
research has shown that diversification does not protect speculative positions
when markets behave erratically. Markets tend to go awry in tandem.
In August 1998 alone, the fund suffered losses of $1.9 billion. Losses for
the year so far were 52%. Fund managers were confident that their strategies
were sound, and that time would both prove them right and reward their prescience.
But time is not a friend to a levered fund losing money. Banks and brokerages
itched for their loans back. How ironic, Long-Term Capital Management
faced a short-term liquidity crunch.
Leverage amplified LTCM's remaining $2.28 billion of equity into managed
assets of $125 billion. If the market continued to move against them,
LTCM would be wiped out in short order, and that is essentially what happened.
On September 10, LTCM lost $145 million. The next day, they lost $120
million. The following three trading days brought losses of $55 million, $87
million, and $122 million, respectively. On one day alone, Monday, September
21, 1998, LTCM lost $553 million. By now traders at other firms could guess
what LTCM's positions were, and by anticipating what LTCM would have to
eventually sell, they could gauge which securities were good bets to short. This
selling pressure added to LTCM's losses and woes.
At this point, in September 1998, any of several banks could bankrupt
LTCM by calling in its loans. The Federal Reserve, which is the central bank of
the United States, and is responsible for guarantying the stability of the American
banking system, monitored the predicament. Though LTCM's equity was
shrinking precipitously, on account of their borrowed funds and the inherent
leverage of their derivatives positions, the notional principal of their positions
was about $1.4 trillion. To put this quantity into perspective, the gross national
product of the United States was about $8.8 trillion in 1998. Total bank assets
in the United States stood at $4.3 trillion. It was feared that if LTCM went
bankrupt, they would probably default on their derivative positions, triggering
a domino effect of defaults and bankruptcies throughout the world's financial
markets. It was decided, that LTCM was too big too fail.
The Federal Reserve orchestrated a plan for LTCM's creditors to buy the
company's portfolio. Each of 14 banks ponied up money in exchange for a slice
of the portfolio. The $3.65 billion paid by the bank syndicate for the portfolio
was clearly greater than the value of the portfolio by then, but this infusion of
capital prevented defaults that would have cost the banks much more. The
money was used to pay off debts and shore up the trading accounts so that existing
positions would perform without default. Very little was left over for the
432 Planning and Forecasting
original partners who were required to run the fund until it was ultimately liquidated
in 1999. The bottom line is that LTCM had lost $4.5 billion since the
start of 1998. These losses included the personal fortunes amassed so quickly
by the founding partners, which totaled $1.9 billion at one point but were completely
wiped out by the end.
Moral of the Story
The lesson from these case studies should now be obvious. Risk management is
not the art of picking good bets. Bets no matter how good are speculation.
Speculation increases risk, and subjects corporations, investors, and even municipalities
to potential losses. Derivatives are powerful tools to shed risk, but
they can also be used to take on risk. The root causes of the debacles described
in these cases are greed, speculation, and in some cases incompetence, not derivatives.
But just as derivatives facilitate risk management, they facilitate
greed and speculation. Anything that can be done with derivatives, can be
done slower the old fashioned way with positions in traditional financial instruments.
Speculators have always managed to lose large sums. With the aid of derivatives
they now can lose larger sums faster.
Superior intellect and sophistication cannot protect the speculator. As the
Long-Term Capital Management story illustrates, when you are smarter than
the market, you can go broke waiting for the market to wise up.
Government regulation is not the answer either. The benefits of regulation
must be weighed against the costs. Derivatives, properly used, are too important
in the modern financial marketplace to be severely restricted. Abuse
by a few does not warrant constraints on all users. A better solution to prevent
repetition of the past debacles is full information disclosure by firms, portfolio
managers, and municipalities. Investors and citizens should demand to know
how derivatives are being used when their money is at stake. Better information
and oversight is the most promising approach to prevent misuse of derivatives
while retaining the benefits.
Derivatives can be dangerous, but they can also be tremendously useful.
Dynamite is an appropriate analogy. Misused, it is destructive; handled with
care, it is a powerful and constructive tool.
Derivatives are tools that facilitate the transfer of risk. Interest rate derivatives
enable managers to shed business exposure to interest rate f luctuations,
for example. But when one party sheds risk, another party necessarily
must take on that very exposure. And therein lies the danger of derivatives.
The same instrument that serves as a hedge to one firm, might be a destabilizing
speculative instrument to another. Without a proper understanding of derivatives,
a manager who intends to reduce risk, might inadvertently increase
it. This chapter aims to provide the reader with a basic understanding of derivatives
so that they can be used appropriately to manage financial risks. This understanding
should help the reader avoid the common pitfalls that have proved
disastrous to less informed managers.
Financial Management of Risks 433
SIZE OF THE DERIVATIVE MARKET
AND WIDESPREAD USE
A derivative is a financial instrument whose value or contingent cash f lows depend
on the value of some other underlying asset. For example, the value of a
stock option depends on the value of the underlying stock. Derivatives as a
class comprise forwards, futures, options, and swaps. Numerous hybrid instruments,
combining the features of these basic building blocks have also been
engineered. The first thing the interested manager must understand about derivatives
is that the business in these instruments is now huge, and their use is
pervasive. Since the initiation of trading in the first stock index futures contract
in December of 1982—the Standard & Poor's 500 futures contract—the
daily volume of stock index futures has grown so that it now rivals the daily
volume in all trading on the New York Stock Exchange. (Volume of futures is
measured in terms of notional principal, which is a measure of exposure.) On
just one typical day in the 1990s, Tuesday, January 21, 1996, the notional volume
of the Standard & Poor's 500 futures contract was just shy of $40 billion.
The volume on the NYSE that same day was approximately $23 billion. On that
day, therefore, just one specific futures contract was greater than the entire
Big Board stock market in terms of trading volume. More recently, however,
the tables have turned, and the New York Stock Exchange daily trading volume
once again regularly beats that of the S&P 500 futures contract. Still the magnitudes
are comparable, and futures trading is firmly established as a significant
segment of financial market activity.
Similarly, the swaps market has revolutionized banking and finance. The
notional principal of outstanding swaps today, is greater than the sum total of
all assets in banks worldwide. The Bank for International Settlements reports
that the sum total of all assets in banks around the world was approximately
$12 trillion in June 2000. At that same time, according to the same source, the
notional principal of outstanding swaps was over $50 trillion. Measured this
way, the swaps business is now bigger than traditional banking.
The volume of the derivatives market ref lects how widespread derivatives
use has become in business. Almost all major corporations now use them
in one form or another. Some use derivatives to hedge commodity price risks.
Some use them to speculate on price movements. Some firms reduce their exposures
to volatile interest rates and foreign exchange. Other firms take on
exposures via derivatives in order to potentially increase profits. Some firms
use derivatives to secure cheaper financing. Many corporations use derivatives
to reduce the transaction costs associated with managing a pension fund, borrowing
money, or budgeting cash. Some firms implement derivative strategies
to reduce their tax burdens. Many companies offer stock options, a derivative,
as employee compensation. Some investment funds enhance returns by replacing
traditional portfolios with what are called synthetic portfolios—portfolios
composed in part of derivatives. Some investment funds buy derivatives that
act as insurance contracts, protecting portfolio value. Since their emergence in
434 Planning and Forecasting
the early 1980s, derivatives have touched every aspect of corporate finance,
banking, the investments industry, and arguably business in general.
THE INSTRUMENTS
The major derivative instruments are forwards, futures, options, and swaps.
Also available today are hybrid instruments, exotics, and structured or engineered
instruments. The hybrids, exotics, and engineered instruments are contracts
that combine features of the basic building blocks: the options, futures,
forwards, and swaps. Consequently, familiarity with the basic building blocks
goes a long way toward understanding the whole melange of derivative instruments
available today. We will begin with forwards.
Forwards
Imagine the following nearly idyllic scenario. It is late summer. You are a wheat
farmer in Kansas. The hard work of sowing and tending your acreage is about to
pay off. You expect a bumper crop this year, and the harvest is just a few weeks
away. The weather is expected to remain favorable. The crops have been
sprayed to protect them from pests. In fact, you may even have purchased crop
insurance to protect against crop damage.
Still, you cannot relax. One major uncertainty is keeping you awake at
night. You figure that if you are expecting a bumper crop, the likelihood that
your neighbors are also expecting a bumper crop is high. If the market is
f looded with wheat, prices will plummet. If prices drop, you will receive little
revenue for your harvest, and perhaps you will show a loss for the year. A worse
case scenario might be that prices fall so low, that you cannot make the mortgage
payments on your land or the machinery you bought. You very well might
lose the farm—and through no fault of your own. You farmed well, but if prices
fall, you will fail nevertheless.
Meanwhile, at the same time, another group of businesspeople is feeling
similar anxiety. A baked goods company has recently built a new cookie bakery.
The company identified its market niche as a provider of inexpensive,
mass produced, medium quality cookies. The project analysis that led to the
go-ahead for the new bakery assumed that wheat prices would stay fixed at
their current levels. If wheat prices should rise, it is altogether possible that
the firm will not be able to sell its cookies for a profit. The new bakery will
appear to be a failure.
In these scenarios, both the farmers and the bakers are exposed to wheat
price risk. The farmers worry that wheat prices will fall. The bakers worry that
prices will rise. A forward contract is the obvious solution for both parties.
The farmers and bakers can negotiate a deferred wheat transaction. The
farmers will deliver wheat to the bakers, one month from now, for a price currently
agreed upon. Such a contract for a deferred transaction is a forward
Financial Management of Risks 435
contract. A forward contract specifies an underlying asset to be delivered, a
price to be paid, and the date of delivery. The specified transaction price is
called the forward price. The party that will be selling wheat (the farmer) is
known as the "short" party; the party that will be buying wheat (the baker)
is known as the "long" party. In the jargon of the derivatives market, the long
party is said to "buy" the forward, and the short party "sells" the forward.
Note, however, that when the deal is initially struck, no money changes hands
and no one has yet bought or sold anything. The "buyer" and "seller" have
agreed to a deferred transaction.
Notice that the wheat forward reduces risk for both the farmers and the
bakers. In this transaction, both parties are hedgers—that is, they are using
the forward to reduce risk. Forward contracts are "over-the-counter" instruments,
meaning that they are negotiated between two parties and customtailored,
rather than traded on exchanges.
Suppose after one month, when the forward expires and the wheat is delivered,
the current, or spot, price of wheat has risen dramatically. The farmer may
have some regret that he entered into the contract. Had he not sold forward, he
would have been able to receive more for his wheat by selling on the spot market.
He may feel like a loser. The bakers, on the other hand, will feel like winners.
By contracting forward they insulated themselves from the rising wheat
price. When spot prices rise, the long party wins while the short party loses. A
little ref lection, however, will convince the farmer that although he lost some
money relative to what he could have gotten on the spot market, going short in
the forward was indeed a worthwhile strategy. He had piece of mind over the
one month. He was guaranteed a fair price, and he did not have to fear losing the
farm. Though there was an opportunity loss, he benefited by shedding risk. The
farmer probably never regrets that he has never collected on his life insurance
either. He similarly should not regret that the forward contract represents an opportunity
loss. He would be well advised to go short again next year.
The wheat forward contract can be used by speculators as well as
hedgers. An agent who anticipates a rise in wheat prices can profit from that
foresight by going long in the forward contract. By going long in the contract,
the speculator agrees to buy wheat at the fixed forward price. Upon expiration
of the contract, the speculator takes delivery of the wheat, pays the forward
price, and then sells the wheat on the spot market for the higher spot price.
The profit is the difference between the spot and forward prices. Of course, if
the speculator's forecast is wrong, and the wheat price falls, the speculator
would suffer losses equal to the difference between the forward and spot
price. For example, suppose the initial spot price is $3 per bushel, and the forward
price is $3.50 per bushel. If the spot price upon expiration is $4.50 per
bushel, the long speculator would earn a profit of $1 per bushel. The profit is
the terminal spot of $4.50 minus the $3.50 initial forward price. If, alternatively,
the terminal spot price is $3.25, the speculator would lose 25 cents per
bushel—that is, $3.25 minus $3.50. Notice that the $3 initial spot price is irrelevant
in both cases.
436 Planning and Forecasting
Speculators play important roles in the derivatives markets. For one,
speculators provide liquidity. If farmers wish to short forward contracts but
there are no bakers around who want to go long, speculators will step in and
offer to take the long side when the forward price is bid down low enough.
Similarly, they will take the short side when the forward price is bid up high
enough. Speculators also bring information to the marketplace. The existence
of derivatives contracts and the promise of speculative profits make it worthwhile
for speculators to devote resources to forecasting weather conditions,
crop yields, and other factors that impact prices. Their forecasts are made
known to the public as they buy or sell futures and forwards.
Futures
Futures contracts are closely related to forward contracts. Like forwards,
futures are contracts that spell out deferred transactions. The long party
commits to buying some underlying asset, and the short party commits to
sell. The differences between futures and forwards are mainly technical and
logistical. Forward contracts are custom-tailored, over-the-counter agreements,
struck between two parties via negotiation. Futures, alternatively, are
standardized contracts that are traded on exchanges, between parties who
probably do not know each other. The exact quantity, quality, and delivery
location can be negotiated in a forward contract, but in a futures contract
the terms are dictated by the exchange. Because of their standardization and
how they are traded, futures are very liquid, and their associated transaction
costs are very low.
Another feature differentiating futures from forwards is the process of
marking-to-market. All day and every day, futures traders meet in trading pits
at the exchanges and cry out orders to buy and sell futures on behalf of clients.
The forces of supply and demand determine whether futures prices rise or fall.
Marking-to-market is the process by which at the end of each day, losers pay
winners an amount equal to the movement of the futures price that day. For example,
if the wheat futures price at Monday's close is $4.00 per bushel, and the
price rises to $4.10 by the close on Tuesday, the short party must pay the long
party 10 cents per bushel after trading ends on Tuesday. If the price had fallen
10 cents, then long would pay short 10 cents per bushel. Both long and short
parties have trading accounts at the exchange clearinghouse, and the transfer
of funds is automatic. The purpose of marking-to-market is to reduce the
chance of default by a party who has lost substantially on a futures position.
When futures are marked-to-market, the greatest possible loss due to a default
would be an amount equal to one day's price movement.
Futures are marked-to-market every day. When the contract expires, the
last marking-to-market is based on the spot price. For example, suppose two
days prior to expiration the futures price is $4.10 per bushel. On the second to
last day the futures price has risen to $4.30. Short pays long 20 cents per
bushel. Suppose at the end of the next day, the last day of trading, the spot
Financial Management of Risks 437
price is recorded at $4.55. The last mark-to-market payment is from short to
long for 25 cents per bushel, equal to the difference between the spot price
upon expiration and the previous day's futures price.
Upon expiration, the futures contract might stipulate that the short party
now deliver to the long party the specified quantity of wheat. The long party
must now pay the short party the spot price for this wheat. Yes, the spot price,
not the original futures price! The difference between the terminal spot price
and the original futures price has already been paid via marking-to-market. A
numerical example will make the mechanics of futures clearer, and show how
similar futures are to forwards.
Suppose with five days remaining until expiration, the wheat futures
price is $4.00 per bushel. A baker "buys" a futures contract in order to lock in a
purchase price of $4.00. Suppose the futures prices on the next four days are
$4.10, $3.90, $4.00, and $4.25. The spot price on the fifth day, the expiration
day, is $4.30. Given those price movements, short pays the long baker 10 cents
the first day. The long baker pays short 20 cents on the second day. On the
third day, short pays long 10 cents, followed by a payment from short to long of
25 cents on the fourth day, and a payment from short to long of 5 cents on the
last day. On net, over those five days, short has paid long 30 cents. When long
now pays the spot price of $4.30 to short for delivery of the wheat, long indeed
is paying $4.00 per bushel, net of the 30 cents profit on the futures contract.
Recall that $4.00 was the original futures price. Thus, the futures contract did
effectively lock in a fixed purchase price for the wheat.
A contract that stipulates a spot transaction in which the underlying commodity
is actually delivered at expiration, is called a "physical delivery" contract.
Many futures contracts do not stipulate such a final spot transaction with
actual delivery of the underlying asset. After the last marking-to-market, the
game is over. No assets are delivered. Contracts that stipulate no terminal spot
transaction are called "cash settled." It should make little difference to traders
whether a contract is cash settled or physical delivery. A cash settled contract
can be turned into a physical delivery deal simply by choosing to make a spot
transaction at the end. Likewise, a physical delivery contract can be turned
into a cash settled deal by either making an offsetting spot transaction at the
end, or by exiting the futures contract just before it expires.
Examples of the Use of Forwards and
Futures in Risk Management
A wide variety of underlying assets is covered by futures and forwards contracts
these days. For example, exchange-traded futures contracts are available
on stocks, bonds, interest rates, foreign currencies, oil, gasoline, grains, livestock,
metals, cocoa, coffee, sugar, and even orange juice. Consequently, these
instruments are versatile risk management tools in a wide variety of situations.
The most actively traded futures, however, are those that cover financial risks.
Consider the following examples.
438 Planning and Forecasting
A Foreign Currency Hedge
Suppose an American electronics manufacturer has just delivered a large shipment
of finished products to a customer in France. The French buyer has
agreed to pay 1 million French francs in exactly 30 days. The manufacturer is
worried that the French franc may be devalued relative to the American dollar
during that interval. If the franc is devalued, the dollar value of the promised
payment will fall and the American manufacturer will suffer losses. The American
manufacturer can shed this foreign currency exposure by going short in a
franc forward contract or a franc future. The contract will specify a quantity
of francs to be exchanged for dollars, at a fixed exchange rate, 30 days in the
future. The contract locks in the terms at which the deferred franc revenue
can be converted to dollars. No matter what happens to the franc-dollar exchange
rate, the American manufacturer now knows exactly how many dollars
he will receive.
A Short-Term Interest Rate Hedge
Suppose a manufacturer of automotive parts has just delivered a shipment of
finished products to a client. Business has been growing, and the company
has approved plans to expand capacity next year. The manufacturer expects
to receive payment from the customer in 60 days, but will need to use those
funds for the planned capital expenditure 90 days after that. The plan is to
invest the revenue in three-month Treasury bills as soon as the revenue is received.
Interest rates are currently high. Managers worry that by the time
the receivables are collected from the customer, however, interest rates will
fall, resulting in less interest earned on the invested funds. The company can
hedge against this risk by buying a Treasury bill futures contract, which essentially
locks in the price and yield of Treasury bills to be purchased 60
days hence.
Longer-Term Interest Rate Hedge
A manufacturer of speed boats notices that when interest rates rise, sales fall,
and the value of the firm's stock gets battered. The correlation is easy to understand.
Customers buy boats on credit, and so when rates rise, the boats effectively
become more expensive to buy. In order to insulate the company's
fortunes from the vicissitudes of interest rates, the company could enter a contract
that pays money when rates rise. A short position in a Treasury bond
futures contract would pay off when rates rise and could thus be a desirable
hedge. Each time the futures contract expires, the company can roll over into a
new contract. The size of the position in the futures should be geared to the
f luctuation in sales resulting from changes in interest rates. The Treasury bond
hedge can reduce the volatility in the firm's net income, and the volatility of
the firm's equity value.
Financial Management of Risks 439
Synthetic Cash
A company's pension fund is invested primarily in the stocks of the Standard &
Poor's 500. The pension fund manager worries that there may be a downturn
in the stock market sometime over the next six months. She considers selling
all of the stock and investing the funds in Treasury bills. An alternate hedge
strategy that will save considerable transaction costs would be to short S&P
500 futures contracts. By establishing a short futures position, she locks in the
price at which the stocks will be sold six months hence. The fund is now insulated
from any f luctuations in stock prices. Since the fund is now essentially
risk free, it will earn the risk-free interest rate. Selling futures while holding
the underlying spot instrument is a strategy known as "synthetic cash." The
strategy essentially turns stock into cash. The fund performs as if it were invested
in Treasury bills.
Synthetic Stock
A company's pension fund is invested primarily in Treasury bills. The stock
market has been rising rapidly in recent weeks, and the pension fund manager
wishes to participate in the boom. One strategy would be to sell the T-bills and
invest the proceeds in equities. A more economical strategy would be to leave
the value parked in T-bills, and gain exposure to the stock market by going long
in stock futures. When the market rises, the futures will pay off. Should the
market fall, the fund will suffer losses. The fund will thus behave as if it were
invested in stocks. Ergo the name, "synthetic stock."
Market Timing
A manager wishes to be exposed to the stock market when he anticipates a
market rise, and be out of stocks and into T-bills when he anticipates a drop.
Buying and selling stocks to achieve this purpose is very expensive in terms of
commissions. But entering and exiting the market via futures is very cheap.
The manager should keep all his funds invested in T-bills. When he feels the
market will rise, he should go long in stock index futures, such as S&P 500 futures.
When he feels the market will drop, he should sell those futures, unwinding
the position. If alternatively he wished to assemble a diversified
portfolio such as the S&P 500 the old fashion way—a portfolio consisting of
actual stocks and no derivatives—he would have to buy each of the 500 stock
issues while selling his Treasury bills. This positioning would involve 501 separate
transactions. Turning the actual stock portfolio back into T-bills would
similarly require 501 transactions. Turning T-bills effectively into stocks via
long futures contracts, on the other hand, involves just one futures trade. Unwinding
the futures position would also be just one single trade. Market timing
is much more economically executed with futures contracts than with actual
equity trades.
440 Planning and Forecasting
A Cross-Hedge
A manufacturer of plastic water pistols wishes to hedge against increases in raw
plastic pellet prices. Unfortunately, there are no futures contracts covering
plastic prices. There is, however, a contract on oil prices, and the price of plastic
is highly correlated with the price of oil. By going long in an oil contract,
the manufacturer will be paid money when oil prices rise, which will likely
be also when plastic prices rise. Hedging an exposure with a contract tied to a
correlated underlying instrument is called a cross-hedge.
A Common Pitfall
The ease with which futures facilitate hedging sometimes coaxes managers to
occasionally take speculative positions. A photographic film manufacturer, for
example, might become experienced and comfortable hedging silver prices by
going long in silver futures. Managers at the firm might come to believe that no
one is better able to forecast silver prices than they are. A time may come when
they wholeheartedly believe that silver prices will fall. Not only might they
choose not to enter a long silver future hedge at this time, but they may choose
to go short in silver futures so as to capitalize on the falling price. If silver
prices fall they will not only benefit from a cheaper raw input, but the short silver
futures will pay off as well. The danger here is that the manufacturer has
lost sight of the fact that it is in the film manufacturing business, and not the
business of speculating on commodity prices. Although silver prices might be
expected to fall, there is always the possibility that they will rise instead. The
probability of a rise might be small, but the consequences would be catastrophic.
Not only will the firm's raw material price rise, but the firm will suffer
additionally as it loses on the futures contract. The lesson here is that firms
should stay clearly focused on what their business line is, and what role the use
of futures plays in their business. Futures use should generally be authorized
only for hedging and not for speculation. Auditing systems should be in place to
oversee that futures are used appropriately.
Futures and Forwards Summary
As the above examples illustrate, futures and forwards are useful tools for
hedging a wide variety of business and financial risks. Futures and forward
contracts essentially commit the two parties to a deferred transaction. No
money changes hands initially. As prices subsequently change, however, one
party wins at the other's expense. Futures and forwards thus enable businesses
to shed or take on exposure to changing prices. When used to offset an exposure
the firm faces naturally, futures and forwards reduce risk.
Options
Options are another breed of derivatives. They share some similarities with
futures and forwards, but they also differ in many important respects. Like
Financial Management of Risks 441
futures and forwards, option prices are a function of the value of an underlying
asset, thus they satisfy the definition of derivative. Unlike futures and forwards,
however, options are assets that must be paid for initially. Recall that no
money changes hands initially as parties enter into forwards and futures. Options,
though, are an asset that has to be bought for a price at the outset.
There are two kinds of options, call and puts. A call option is an asset that
gives the owner the right but not the obligation to buy some other underlying
asset, for a set price, on or up to a set date. For example, consider a call option
on Disney stock, that gives the owner the right to purchase one share of Disney
stock for $70 per share, on or up to next June 15. (Actually, options are usually
sold in blocks covering 100 shares. For expository purposes, however, we
will describe an option on only one single share.) The underlying asset would
be one share of Disney stock. The prespecified price, known as the "strike
price," would be $70 per share. The expiration date would be June 15. The Disney
option might cost $3 initially.
If on the expiration date, June 15, the market price of Disney stock stood
at $75, the call option owner would exercise the option, allowing him to buy a
share of Disney stock for $70. He could then turn around and sell the share for
$75 in the marketplace, realizing a terminal payoff from the option of $5. The
terminal payoff is $5, so the profit net of the $3 initial option price is $2.
Suppose, alternatively, that the market price of Disney stock on June 15
were $69. It would not be profitable to exercise the call option and thereby
purchase for $70 what is elsewhere available for $69. In such a case, the option
owner would choose not to exercise, and the call would expire worthless.
It is the right not to execute the transaction that is the major difference between
options and forwards. The long party in a forward contract must buy
the goods upon expiration whether it is advantageous to do so or not. By contrast,
a call option owner does not have to buy the underlying asset if he
chooses not to. At expiration, a call option should be exercised if and only if
the market price exceeds the strike price. When the market price is above
the strike price, the call option is said to be "in the money." When the market
price is less than the strike price, the call is "out of the money." When the
market price equals the strike price, the option is "at the money." An option
that is out of the money, or even at the money, at expiration, will expire unexercised
and worthless.
An option's payoff is defined as the maximum amount of money the option
owner would receive at expiration, if she totally liquidated her position. If
the option expires out of the money, the payoff is zero. If the option expires in
the money, the payoff is the amount of money received from exercising the call
option, and then selling the stock in the open market. For example, if the strike
price is $70 and the terminal stock price is $60, the payoff would be zero, since
the option would be out of the money and should not be exercised. If the terminal
stock price were $80, the payoff would be $10, since the option should
be exercised, allowing the owner to buy the stock for $70, and then sell that
stock for $80 in the open market. Mathematically, the payoff is the maximum
of zero or the stock price minus the strike price.
442 Planning and Forecasting
The payoff ignores the initial price that was paid for the option. Payoff
treats the initial price as a sunk cost, and measures only what the option owner
might subsequently receive. The payoff minus the initial price is known as the
option profit. The option payoff is the same for all owners of the option, regardless
of what they each initially paid for it. Profit, however, depends on
what was initially paid and therefore differs from one investor to another.
A payoff diagram is a valuable analytical device for understanding options.
A payoff diagram graphs the payoff of an option as a function of the
underlying asset's spot price at expiration. Exhibit 13.1 depicts the payoff diagram
for the Disney call option with a strike price of $70. The payoff diagram
is a picture of the option. It tells you when you will receive money and when
you will not. It helps to visualize how the contract will perform, and whether
or not the option is appropriate for any particular application.
The payoff diagram is f lat and equal to zero in the entire range where the
option is out of the money—that is, where the stock price is less than the strike
price. This means that someone who buys an option might lose his entire investment
in that option. You may pay $3 for the option, and lose 100% of that
$3 by the expiration date. On the brighter side, the payoff diagram confirms
that the most you can lose in an option is the initial premium, the $3 you paid
for it. Unlike, futures or forwards, you will never be called on to make additional
payments at a later date. Initially, you pay for the option, perhaps $3.
From then on you can only receive cash inf lows.
Note that the payoff diagram begins to rise at the point where the stock
price equals the strike price. The payoff is dollar for dollar greater than zero
for every dollar that the stock price exceeds the strike price. Thus we see that
a call option rises in value as the underlying asset rises in price. For this reason,
some people refer to call options as "bullish" instruments.
EXHIBIT 13.1 Call option payoff diagram.
0
10
5
15
20
25
30
0 10 20 30 40 50 60 70 80 90 100
Payoff (dollars)
Terminal stock price (Strike price = $70)
Financial Management of Risks 443
Hedging with a Call Option
Consider the trucking company whose rates are regulated yet costs f luctuate
with market prices. The chief raw material purchased by the company is diesel
fuel. If fuel prices rise, the trucking company will suffer losses, and may in fact
be put out of business. As we saw above, the company can guarantee a fixed
price for fuel by going long in a future or forward. Another strategy would be to
buy a diesel fuel call option contract. The strike price of the call option would
lock in the highest price that the company will have to pay for fuel. If fuel
prices should drop below the strike price, the company would be under no
obligation to exercise the option. It would simply buy fuel at the low market
price. If, however, fuel prices rise above the strike price, the company would
exercise the option and buy fuel at the relatively low strike price.
The added f lexibility of the option over the futures strategy comes at a
cost. When the company buys the call option it must pay a price or "premium."
The call option is essentially an oil price insurance contract for the firm, insuring
that fuel prices will not exceed the strike price. If fuel prices remain low,
below the strike price, the company will not collect on this insurance policy,
and the initial premiums will be lost.
Pricing Options
At this point the reader may wonder how the initial price of an option is determined.
Option pricing is no trivial exercise, and a thorough treatment of option
pricing is beyond the scope of this chapter. Some basic principles, however,
can be explained here. First, an option's "intrinsic value" prior to expiration is
equal to its payoff. That is, if an option is out of the money, its intrinsic value is
zero. If a call option is in the money, for example, if the strike price is $70 and
the current stock price is $80, then the intrinsic value equals the stock price
minus the strike price, $10.
The value of an option, however, exceeds its intrinsic value. An out-ofthe-
money option is worth more than zero, and the in-the-money option described
above is worth more than $10. This extra value is due to the fact that
the downside losses are capped off, but the upside potential is unlimited. As
long as there is still time remaining in the option's life, it is possible that an outof-
the-money option can go in-the-money. An in-the-money option can go further
in the money, and has more upside potential than downside.
A call option's value is a function of the underlying stock price, the strike
price, the amount of time remaining to expiration, the interest rate, the stock's
dividend rate, and the volatility of the underlying asset price. As the underlying
stock price rises, so will the call option's value. Holding the other variables
constant, a call option's value will be greater when there is a higher stock price,
lower strike price, longer time to expiration, higher interest rate, lower dividend
rate, and more volatility in the underlying asset. Researchers have succeeded
in formalizing an equation that prices options as a function of these
444 Planning and Forecasting
input variables. The formula is known as the Black-Scholes option pricing formula.
It is widely available on programmed computer software and in many
option theory textbooks.
A Written Call Option
In the case of life insurance or automobile insurance, when the insured party
collects another party must pay. It is a zero sum game. So it is with options. The
party that sells the option is liable for the future payoff. "Writing" an option,
and "shorting" an option are synonymous with selling an option. The payoff diagram
for a written call option position is the mirror image of the long or
bought call option position. As shown in Exhibit 13.2, the x-axis is the ref lecting
surface.
Note that once the call option writer has received the initial premium, all
subsequent cash flows will be outf lows. The best the writer can hope for is that
the call will expire out of the money. Note that the potential liability of the
written option position is unlimited. Notice as well, that the amount of money
the buyer of the option might receive at expiration is the exact amount that
writer will have to pay. Thus, when the media report that a particular company
has lost millions of dollars in options, the reader should realize that this means
some other party has made millions. The newspapers tend to focus on the
losers.
Strategies Using Written Call Options
Why would anybody wish to sell a call option if doing so subjects them to the
possibility of unlimited future liabilities? One answer is that speculators sometimes
deem the risks worthwhile in light of the expected reward. They may be
confident that the underlying asset price will not rise and the option will expire
worthless.
EXHIBIT 13.2 Payoff diagram for a written call option position.
–30
–10
–20
0
10
20
30
0 10 20 30 40 50 60 70 80 90 100
Payoff (dollars)
Terminal stock price (Strike price = $70)
Financial Management of Risks 445
Written call options can also be used to hedge in certain circumstances.
Consider oil exporting nations such as Mexico and Venezuela. When oil prices
are low they are hungry for funds, funds that are much needed for national
development projects. When oil prices are high, they have plenty of excess
revenue. A reasonable strategy would be to sell high strike price oil call options
when oil prices are low. The country thus receives premiums when
funds are most needed, and incurs a liability that only needs to be paid when
funds are most plentiful. The oil call options help to smooth the f low of funds
into the country. Abken and Feinstein (1994) elaborate on the use of written
call options in such a setting.
Warrants
Warrants are call options that are sold by the company whose stock is the underlying
asset. If Microsoft pays its executive with Microsoft call options, those options
will be called warrants. When the warrants are exercised, the total
outstanding supply of Microsoft stock will rise. Warrants are valuable, even if
they are not yet in the money. Clearly they must be worth something, otherwise
executives would not want them and would give them away! Offering warrants as
compensation to executives is not free for the firm's shareholders. Stories abound
nowadays of young Internet executives who became fabulously wealthy when
they exercised warrants paid to them as part of their employment compensation.
Put Options
The second type of option is a put. A put option is a contract that gives the
owner the right but not the obligation to sell some underlying asset for a prespecified
price, on or up to a given date. Consider a put option on Microsoft
stock. Suppose the strike price is $100 and the expiration date is December
15th. The put option owner has the right, but not the obligation to sell a share
of Microsoft stock for $100, on or up to December 15. If the market price of
Microsoft is above $100, for example $120, the put option owner would not exercise.
Why should he force someone to pay $100 for the stock? He can make
more money by selling the stock in the open market. Thus, a put option is out
of the money if the stock price is above the strike price. If the stock price is
below the strike price, however, then the put option is in the money. If the
market price of Microsoft is $80 on December 15, the owner of the put can
reap a $20 payoff. To realize this payoff, he would buy the Microsoft stock in
the marketplace for $80, and then turn around and sell it for $100 by exercising
his put option. Thus, a put option is in the money when the stock price is
below the strike price. A put option's payoff at expiration, and its intrinsic
value prior to expiration, is the strike price minus the stock price, or zero,
whichever is greater.
Exhibit 13.3 presents the payoff diagram for a put option. Should the
stock price fall to zero, the put option's payoff would be equal to the strike
446 Planning and Forecasting
price. At that point the put option owner would have the right to sell a worthless
stock for $100. From that point, the put option payoff falls one dollar for
each dollar that the stock price rises. The payoff reaches zero when the stock
price equals the strike price, and then remains at zero no matter how much
higher the stock price goes. As is the case with call options, the put option cannot
fall in value below zero. Once the put option premium is paid, the owner is
never called upon to make another payment. Any subsequent cash f low is positive.
It is altogether possible, however, for the buyer of the put option to lose
the entire premium, so one should not think that buying a put option is a safe
investment.
Notice that the put option payoff rises as the stock price falls. For this
reason, puts are thought of as "bearish" instruments—instruments that are
more profitable the more the underlying asset falls in value. Because of this
negative relationship with the underlying asset, puts can be good hedging instruments
for someone who owns the underlying asset.
Like the call option's payoff diagram, the put's payoff diagram is
kinked—that is, there is an elbow at the strike price. A kinked payoff diagram
is the hallmark of an option. If a payoff diagram has no kink, then the instrument
depicted is not an option.
The payoff diagram for a written put option position is the mirror image
of the put's payoff diagram. Such a payoff diagram is shown in Exhibit 13.4.
The possible payoff reaped by the buyer of the put option is exactly equal to
the possible outflow paid by the writer. Put options too are a zero-sum game.
Notice that whereas the writer of a call option has unlimited potential liability,
the writer of a put option has a potential liability limited to the strike price.
Furthermore, notice that a long put option payoff looks nothing like a short
call option. Similarly, notice that a long call option payoff is not the same as a
short put. Both long puts and short calls are bearish positions, just as both short
puts and long calls are bullish positions, but each of these four positions is
unique in the direction, size, and timing of cash f lows. Long calls and long puts
EXHIBIT 13.3 Put option payoff diagram.
0
40
20
60
80
100
120
0 10 20 30 40 50 60 70 80 90 100 110 120 130
Payoff (dollars)
Terminal stock price (Strike price = $100)
Financial Management of Risks 447
have to be paid for up front, and then receive a subsequent positive payoff depending
on what happens to the underlying stock. Short calls and short puts receive
all of their cash inf lows up front and then become potential liabilities.
A Protective Put Strategy
A put option can be thought of as price insurance for someone who owns the
underlying asset. For example, suppose you are a pension fund manager, and
you hold hundreds of shares of Microsoft stock. You hold the stock because you
believe the stock will rise in value. You worry, however, that the stock price
can fall, and losses will be so great that the fund will be unable to meet the
needs of the retirees. An effective hedging strategy would be to buy Microsoft
put options. You would choose the strike price to be at a level that would guarantee
the solvency of the fund. If Microsoft stock falls below the strike price of
the put options, the put options will pay off the difference between the new
lower market price and the strike price. If Microsoft stock rises, the put options
would expire out of the money. The insurance would not pay off, but you
would reap the high return of the rising stock. This strategy is known as buying
a protective put. It is essentially portfolio insurance. The strategy allows
for the upside appreciation of the portfolio, yet sets a f loor below which the
value of the portfolio cannot fall.
A protective put strategy can also be implemented by a producer who
faces the risk of his product's price falling. For example, a cattle rancher can
buy put options on cattle, thereby fixing the lowest price at which he will be
able to sell his herd.
Swaps
The third category of derivative we will examine is swaps. A swap is an agreement
between two parties to exchange cash flows over a period of time. The
EXHIBIT 13.4 Payoff diagram for a written put option position.
–110
–70
–90
–50
–30
–10
10
30
0 10 20 30 40 50 60 70 80 90 100 110 120 130
Payoff (dollars)
Terminal stock price (Strike price = $100)
448 Planning and Forecasting
size and direction of the cash f lows are determined by an agreed upon formula
spelled out in the swap agreement—a formula that is contingent on the performance
of other underlying instruments. Due to this contingency on other underlying
assets, swaps are considered derivatives.
One easy type of swap to understand is the equity swap. Suppose Back
Bay Investment Management owns a large block of Standard & Poor's 500
stocks. Suppose another firm, Capital Bank owns a large block of NASDAQ
stocks. Back Bay would like to diversify into NASDAQ stocks, and simultaneously
Capital Bank would like to diversify into S&P 500 stocks. The old fashion
way of achieving the desired objectives would be for each party to sell the
stocks they do not want, and reinvest the proceeds in the stocks they do want.
Such an approach is very expensive in terms of commissions. A much cheaper
alternative is for each party to keep their own portfolio intact, and arrange between
themselves an equity swap.
The swap agreement might dictate the following terms. For every percentage
point that the NASDAQ stock index rises over the course of the year,
Capital Bank will pay Back Bay Investment Management $1 million. Simultaneously,
for every percentage point that the S&P 500 rises over the course of
the year, Back Bay will pay Capital $1 million. Thus, if the NASDAQ index
rises 15% and the S&P 500 rises 11%, there will be a net payment of $4 million
from Capital to Back Bay. If in the following year the NASDAQ index rises
23% and the S&P 500 rises 29%, Back Bay will pay Capital $6 million on net.
The equity swap is illustrated in Exhibit 13.5.
In this equity swap, the "notional principal" is $100 million—that is, the
payments equal a base of $100 million times the indexes' respective returns.
The net effect of the swap is to essentially convert $100 million of Back Bay's
Standard & Poor's stocks into $100 million of NASDAQ stocks. Simultaneously,
$100 million of Capital Bank's NASDAQ stocks will now perform as if they
were $100 million of Standard & Poor's 500 stocks. Both sides keep their assets
parked where they were, but they swap exposures on the notional principal.
Some arithmetic will prove the point that Back Bay's portfolio will now
perform as if it were invested in NASDAQ stocks instead of S&P stocks. If
Back Bay did in fact own $100 million of NASDAQ stocks, by the end of the
first year, after the 15% rise in NASDAQ stocks, this portfolio would have
EXHIBIT 13.5 An equity swap.
Back Bay
Investment
Management
Capital Bank
Returns on $100 million of
NASDAQ stock index
Returns on $100 million of
S&P 500 stock index
Financial Management of Risks 449
grown to be worth $115 million. But Back Bay owns $100 million of S&P
stocks, and has a position in an equity swap. The $100 million of S&P stocks
grows to $111 million after the 11% S&P rise in the first year. The swap, however,
pays Back Bay $4 million at the end of the first year. Thus, at the end of
the first year, Back Bay does have $115 million in total portfolio value. Verify,
that the total value of Capital Bank's portfolio at the end of the first year will
be $111 million, just as if it had invested $100 million in S&P stocks.
Since the notional principal remains fixed at $100 million, the swap will
continue to convert $100 million of Back Bay's S&P stocks into $100 million of
NASDAQ stocks, and visa versa for Capital Bank. Total portfolio performance
in subsequent years depends on how the swap proceeds are reinvested by
each party.
Interest Rate Swaps
The most common type of swap is an interest rate swap. The typical, or "plainvanilla"
interest rate swap, is a "fixed for f loating swap," whereby cash flows
depend on the movement of variable interest rates. For example, consider two
firms Michel/Shaked Manufacturing (M) and Healing Heart Hospital (H). The
swap agreement might specify that M pay H a fixed 10% per year on a notional
principal of $100 million, and H pays to M the prime rate, as quoted in the
Wall Street Journal, times $100 million. Settlement might be once per year.
The prime rate quoted at the beginning of each year will determine the cash
flow paid at the end. Thus, if at first the prime rate is 12%, H will pay M $2
million at the end of the first year. If by the end of the first year the prime rate
has fallen to 7%, at the end of the second year M will pay H $3 million. And so
the swap continues for a specified number of years. H will benefit if rates fall;
M will benefit if rates rise. This interest rate swap is depicted in Exhibit 13.6.
Examples of Hedging Interest Rate
Exposure with a Swap
The Keating Computer Company assembles and markets computer hardware
systems. In the past several years Keating Computer has been one of the fastest
EXHIBIT 13.6 An interest rate swap.
Back Bay
Investment
Management
Capital Bank
Variable interest rate ×
$100 million
Fixed 10% interest rate ×
$100 million
450 Planning and Forecasting
growing computer hardware companies. They borrowed extensively to finance
this growth. Currently on the books is a very large long-term variable rate loan.
Also on the books is a sizable amount of short-term debt. The managers of
Keating Computer have observed that they are dangerously exposed to interest
rate risk. If rates should rise, they will have to pay more in debt service on the
variable rate loan, and they will face higher interest rates when they roll over
their short-term debt. The company is currently profitable, but they worry that
rising interest rates can wipe out that profit. Since the company is planning an
equity offering in coming years, management is very concerned about the
prospect of reporting any losses over the near term.
One solution to Keating Computer's problem would be to refinance at
fixed interest rates. The transaction costs of refinancing, however, are sizable,
and the rates currently offered on long-term debt are not favorable. Entering
an interest rate swap is a better hedging strategy. The company should enter as
the fixed rate payer, which means they would be the variable rate receiver. As
interest rates rise, the company will make money on the swap, offsetting the
higher payments they must make on their own debt. Since swaps are over-thecounter
instruments, the company can tailor the terms of the swap so that the
hedge will be in force for the exact number of years it is needed. Moreover, the
notional principal can be tailored so that the money received when rates rise is
closely matched to the new higher debt service obligations.
Another Example
Kayman Savings and Loan holds most of its assets in the form of long-term
mortgages, mortgage backed securities, and 30-year Treasury bonds. The liabilities
of Kayman Savings are mostly short-term certificates of deposits.
Kayman has also sold some short-term commercial paper of its own. Stephen
Kayman, the president of Kayman Savings, suddenly realizes that they are in
the same precarious predicament as that of many savings and loans (S&Ls) that
went bust in the 1980s. Long-term fixed income instruments are more sensitive
to interest rates than short-term instruments. When interest rates rise, both
long-term and short-term instruments fall in value, but the long-term instruments
fall much more. Consequently, if interest rates should rise, the market
value of the S&L's assets will fall farther than the market value of its liabilities.
When this happens, the S&L's equity will be wiped out. The bank will be
bankrupt. Even if government auditors do not shut down the S&L, the institution
will experience cash flow problems. The relatively low fixed interest revenue
from the long-term assets will not be enough to keep up with the rising
interest expenses of the short-term liabilities. What can Kayman do to protect
against the risk of rising interest rates?
The predicament faced by Kayman Savings is known as a "duration gap."
The duration of the assets is greater than the duration of the liabilities. As
rates rise, equity vanishes. Kayman Savings needs a hedge that will pay off
when rates rise. Entering an interest rate swap as the fixed payer can close the
Financial Management of Risks 451
duration gap. The swap will grow in value as rates rise, offsetting the equity
losses. Again, the size, timing, and other terms of the interest rate swap can be
tailored to meet the particular needs of Kayman Savings.
HOW TO CHOOSE THE APPROPRIATE HEDGE
We have now examined forwards, futures, call options, put options, and swaps.
We have observed how these instruments can be used to hedge in a wide variety
of risky scenarios. How does one choose which of these instruments to use
in a particular situation? When is a future better than a forward? When should
an option be used instead of a future? Should interest rate exposure be hedged
with bond futures or swaps? The following steps will provide some guidance.
The first task in implementing a hedge strategy is to identify the natural
exposures that the firm faces. Does the firm gain or lose when interest rates
rise? Does it gain or lose as the dollar appreciates? Is a falling wheat price good
news or bad news for the company? What about oil prices and stock prices?
How about foreign stock and bond prices? Is the company exposed, and if so,
which direction causes a loss?
Clearly the answers to these questions vary from firm to firm. The bakers
benefited from falling wheat prices while the farmers suffered. Rising interest
rates might hurt a firm that has variable rate debt, but might help a
pension fund that is about to invest in bonds. A rising dollar benefits U.S. importers
but hurts U.S. exporters. The first step in risk management is to identify
the exposures.
Once the exposures are identified, one should narrow the search for an
appropriate hedge to the set of derivatives that compensate the firm when the
adverse scenario is realized. For example, an airline that purchases jet fuel will
see higher costs when the price of oil rises. The airline should look for derivatives
that pay off when oil prices rise. Thus, the airline should consider a long
position in an oil future, or a long oil forward, or an oil call option. A bank that
suffers losses when interest rates rise should consider a short position in a bond
future or forward, bond put options, or the fixed-payer side of an interest rate
swap. An exporter that expects to receive Mexican pesos, might wish to go
short in peso futures or forwards, or buy peso puts.
The next step is to choose from among futures, forwards, options, and
swaps. This is perhaps the trickiest part of the analysis. To guide the selection,
it is helpful to categorize the risks and the instruments as either symmetric or
asymmetric. Futures, forwards, and swaps are symmetric hedging instruments,
in that they pay off money if prices move in one direction, but incur
losses if prices move in the opposite direction. Options, on the other hand, are
asymmetric hedging instruments. They pay off money if prices move in one direction,
yet result in no cash outf lows if prices should move the other way. A
symmetric risk is one in which the firm is hurt if underlying prices move one
way but benefits if prices move in the opposite direction. An asymmetric risk
452 Planning and Forecasting
is one in which the firm is hurt if prices move in one direction, but the firm
does not benefit appreciably if the price moves in the other direction. For example,
a firm that exports to Japan and receives payment in yen benefits when
the value of the yen rises, but is hurt when the yen falls in value. This foreign
exchange risk is thus symmetric. The symmetric foreign exchange risk can be
eliminated most completely with a symmetric instrument such as a future or
forward, not an option.
A portfolio manager invested in stocks also faces a symmetric risk. He
benefits if stock prices rise, and loses money if stock prices fall. The portfolio
manager, however, might wish to modify the exposure in an asymmetric way,
insuring against losses on the downside while maintaining the potential for
upside appreciation. An asymmetric instrument, a put option, would be the appropriate
hedge instrument in this case, since an asymmetric instrument converts
a symmetric risk into an asymmetric exposure.
An automobile leasing company is an example of a commercial venture
that faces an asymmetric risk. If interest rates rise, the firm's interest expenses
rise. If the firm tries to offset these higher costs by charging higher prices to
customers, the firm will lose business. However, if interest rates fall, buying an
automobile on credit becomes a more attractive substitute for leasing unless
the leasing company also lowers its prices. Thus, the leasing company suffers
when rates rise, but does not benefit when rates fall. An asymmetric hedge,
such as a bond put option would be the best choice of instrument in this case.
The bond put option will pay off when rates rise, but will not require a cash
outflow when rates fall.
The key to choosing between symmetric and asymmetric instruments is
to first identify the nature of the risk that is faced, and then choose the type of
instrument which will modify the risk appropriately. A symmetric risk can best
be eliminated with a symmetric instrument. An asymmetric risk can best be
eliminated with an asymmetric instrument. A symmetric risk can be turned
into an asymmetric exposure with an asymmetric instrument.
Finally, the last step is to choose whether the instruments should be of
the exchange-traded or over-the-counter variety. Forwards and swaps are overthe-
counter instruments; futures are exchange-traded instruments. Options are
generally exchange-traded, but they can also be bought over the counter.
Exchange-traded instruments are standardized, and are thus liquid and entail
low transaction costs. But since they are standardized, they may not perfectly
suit the risk exposure the firm wishes to hedge. Over-the-counter instruments
can be custom tailored, but they are therefore less liquid and more expensive
in terms of transaction costs. The firm must weigh the costs and benefits of
liquidity, differences in transaction costs, and custom fit. The correct choice
depends on the particular hedging situation.
A couple of examples will illustrate the process of putting all the factors
together to pick the best suited hedge. A U.S. manufacturing firm owns a production
facility in Canada. Rent and wages are paid in Canadian dollars. Consequently,
if the Canadian dollar rises in value, the wages and rent translated
Financial Management of Risks 453
into U.S. dollars would become more expensive. If the Canadian dollar falls,
the expenses in terms of U.S. dollars decline. Thus, the exposure is symmetric.
If the firm wishes to completely eliminate the exposure, a symmetric instrument
is called for, ruling out options. The firm should go long in Canadian dollar
futures or forwards, since either of these instruments will provide positive
cash flows when the Canadian dollar is rising. An exchange-traded Canadian
dollar futures contract is available. The commission on the forward is greater
than the commission on the futures, but the futures contract covers slightly
more Canadian dollars than the firm wishes to hedge, and the timing does not
exactly correspond to the timing of wage and rent payments. An over-thecounter
forward contract could be constructed so that cash f lows are synchronized
with wage and rent payments. After weighing the two alternatives, the
managers decide that the benefit from lower commissions on the futures contract
outweighs the disadvantage of the futures' slight mismatch in the hedge.
They go long in Canadian dollar futures.
The same manufacturing firm has many customers in Venezuela. If the
Venezuelan currency (the bolivar) falls in value, the U.S. dollar value of the
revenue will fall. If the Venezuelan currency rises in value, the dollar revenue
will rise. Thus, the risk is symmetric, and so the list of hedging candidates is
narrowed to futures and forwards. The firm benefits from a rise in the bolivar,
and loses when the bolivar falls. Thus, the firm should go short in bolivar futures
or forwards, so that a cash flow will be received when the bolivar falls.
No bolivar futures contracts are available on exchanges, so the firm must go
short in over-the-counter Venezuelan bolivar forwards.
A producer of copper wire purchases large amounts of copper as a raw
material. When copper prices rise, the firm must either absorb the higher expenses,
or raise the price of copper wire. Raising the price of wire, however,
causes customers to cut back on purchases, and so the firm is stuck with unsold
inventory. When copper prices fall, alternatively, competitors lower their
prices and so the firm must also lower its price in order to sell its output. Consequently,
the firm's profits suffer when copper prices rise, but profits do not
increase when copper prices fall. Management would like to increase production
capacity, but it is difficult to forecast how much the firm can sell, given recent
copper price f luctuations. With current levels of raw copper inventory,
management believes that raw copper prices can rise as much as 10% without
significantly impacting the firm's bottom line. What is the appropriate hedge?
Clearly, the firm faces an asymmetric risk. The firm is hurt when copper
prices rise, but does not benefit when the price falls. An option will best
mitigate the risk. Since the firm is hurt when copper prices rise, a call option
that pays off when copper prices rise is the best choice. Since the firm can
tolerate a 10% rise in copper prices without suffering significant losses, an
out-of-the-money copper call option that begins to pay off only when copper
prices rise more than 10% is ideal. Exchange-traded copper call options exist,
and so due to their greater liquidity and lower transaction costs, they would
be the best choice.
454 Planning and Forecasting
A cellular communications firm has sold a six-year variable rate bond,
where the interest payments are tied to the London Interbank Offered Rate
(LIBOR). When LIBOR rises, so too do the company's interest payments.
When LIBOR falls, the firm's interest payments fall. The company's interest
payments are due twice a year, on the last days of February and August. The
firm raised $160 million this way. With competition holding cellular telephone
rates down, the firm worries that an increase in interest rates can wipe out all
profits. What is the appropriate hedge instrument?
The interest rate exposure is symmetric, ruling out options. The firm
needs an instrument that will pay it money when interest rates rise. Thus, the
firm should go short in either bond futures or forwards, or the firm should be
the fixed-rate payer in an interest rate swap. Since the cash f lows that the firm
is trying to hedge do not conform to those of any exchange-traded future, the
correct choice is narrowed to the over-the-counter instruments—a forward or
a swap. The firm must hedge twelve interest rate payments, two per year for six
years. Forwards are generally constructed to provide one payment only. Swaps
are designed to hedge multiple payments over longer terms. Thus, entering a
six-year interest rate swap as the fixed payer is the ideal hedge in this situation.
SUMMARY AND FINAL RECOMMENDATIONS
This chapter has presented the basics of risk management using derivatives. By
separating an asset's value from its exposure, derivatives allow firms to exchange
exposures without exchanging the underlying assets. It is much more
economical to transfer exposures, rather than assets, and thus derivatives have
greatly facilitated risk management. Derivatives are indeed powerful risk management
tools, but in the wrong hands they can be dangerous and destructive.
It is essential that managers fully understand how much and under what conditions
derivatives will provide positive cash f lows or require cash outf lows. If it
is not absolutely clear when and how much the cash flows will be, do not enter
the contract. Managers should strive to identify the nature, magnitude, and
size of their risk exposures. They can then match those exposures with countervailing
positions in derivatives. Managers should never forget that their job
is to preserve value by reducing risk. The temptation to speculate should be
avoided. Don't be greedy.
FOR FURTHER READING
Abken, Peter, and Steven Feinstein, "Covered Call Options: A Proposal to Ease Less
Developed Country Debt," in Financial Derivatives: New Instruments and
Their Uses (Atlanta: Federal Reserve Bank of Atlanta, 1994).
Bernstein, Peter, Against the Gods: The Remarkable Story of Risk (New York: John
Wiley, 1998).
Financial Management of Risks 455
Bodie, Zvi, and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-Hall,
2000).
Chance, Don M., An Introduction to Derivatives (New York: Dryden Press, 1998).
Chew, Lillian, Managing Derivative Risks: The Use and Abuse of Leverage (New
York: John Wiley, 1996).
Daigler, Robert T., Financial Futures and Options Markets: Concepts and Strategies
(New York: HarperCollins, 1994).
Dunbar, Nicholas, Inventing Money: The Story of Long-Term Capital Management
and the Legends Behind It (New York: John Wiley, 2001).
Fraser, Andrew, "Top Banks Plan Bailout for Fund," Associated Press, September 24,
1998.
, "Fed Key Player in Rescue of Floundering Hedge Fund," Associated Press,
September 25, 1998.
Hull, John C., Options, Futures, and Other Derivative Securities (Upper Saddle
River, NJ: Prentice-Hall, 2000).
Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital
Management (New York: Random House, 2000).
Various authors, "Managing Risks," special report in Business Week, October 31,
1994, 86–104.
NOTES
1. Zvi Bodie and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-
Hall, 2000) deserve credit for this perspective on risk management techniques.
2. Fischer Black, who helped invent the model, passed away prior to recognition
from the Nobel committee.
3. All data referring to equity positions, assets under management, exposure,
and profits and losses in this section come from Roger Lowenstein, When Genius
Failed: The Rise and Fall of Long-Term Capital Management (New York: Random
House, 2000).
PART THREE
MAKING KEY
STRATEGIC DECISIONS
459
14 GOING PUBLIC
Stephen M. Honig
SETTING THE STAGE
It is June 2000, and recent MIT graduate John Dough and his friend, business
school graduate Mary Manager, decide to pursue a software idea that Dough
has conceptualized. Dough believes that he can design a relational database
that will more tightly store financial information and more quickly access that
information than anything now on the market.
Dough and Manager take their meager savings accounts and $20,000
of credit card advances and form Dough.com Inc., a Delaware corporation.
Dough sits down at his computer and begins to program Dough-Ware.
Mary successfully approaches five business school acquaintances; each
invests $4,000 and each is issued 4% of the company's stock.
By the spring of 2001, Dough has a working initial version of Dough-
Ware available for testing at the sites of potential clients. The company is completely
out of funds, and is without the necessary liquidity to negotiate for the
test sites, install the software, and work with prospective clients. Dough and
Manager have been networking at venture capital forums, and are able to induce
five "angel" investors, wealthy individuals with a history of investing
in emerging technology companies, to invest an aggregate of $250,000. By June
2001, each of Dough and Manager now owns 30% of their company; each of
the original five investors owns 3%; the new angel investors have received a
25% common stock interest. With this new money and with modest interim
payments from the first "beta site," or test customers, the company begins installation
and testing of its software.
460 Making Key Strategic Decisions
By June 2002 the company has refined its software into a salable product
for which Dough believes there is a significant market. However, in order to
produce, customize and install the software, and in order to broadly market,
the company needs significant new investment. All prior financing, and the
meager proceeds from the test installations, are virtually exhausted. The company
is fortunate enough to induce a venture capital investor, Vulture Partners,
to invest $1 million but there is a significant cost:
• Vulture Partners insists on receiving 50% of the equity in the form of
convertible preferred stock that will participate in the proceeds of the
sale of the company in preference to all the other stockholders, who hold
only common stock.
• Vulture Partner's preferred stock will convert into common stock upon
any public offering.
• Vulture Partners gets two board of directors seats.
• Vulture Partners insists upon a substantial increase in personnel in order
to aggressively address the market place; John Dough is given the title of
"chief scientific officer"; Mary Manager is made vice president; they hire
a chief operating officer who formerly was a senior vice president at a
large software firm, a chief financial officer from one of the big five accounting
firms, and a sales manager with experience at Mega-Soft, the
largest software development firm in the country.
The new team, properly financed, goes off to sell Dough-Ware and is fabulously
successful.
It is one year later, in the spring of 2002, and everyone involved in management,
including John Dough and Mary Manager, agrees that substantial additional
capital is needed. It looks as though the company can reach $100
million in sales next year and have a 10% market penetration, but that's going
to take an awful lot of money, something like $40 million. This money will be
necessary to further refine the product, increase the engineering capacity to
customize the product, and enter into sales efforts so as to speed market penetration.
The directors hope that a direct approach to customers will enable the
company to decrease its dependence on Big Deal Corporation, a large software
company which has marketed Dough-Ware in exchange for a substantial commission.
The directors call a board meeting for the end of June 2003 to discuss
their options.
THE THREE OPTIONS
Dough and Manager have understood from various board members that there
are three primary sources for financing company growth: raising additional
money on a private basis as in the past; raising money through an initial public
Going Public 461
offering (IPO); or merging with a strategic partner (such as Big Deal Corporation),
which might pay a high price to acquire Dough-Ware and add it to its stable
of software products offered by its existing sales force.
Dough and Manager precede the board meeting by visiting with corporate
attorney Stanley Sharp, who explains the difference between selling stock
privately and selling stock in an IPO.
Both the United States government and all of the states substantively
regulate the offer and sale of securities within their borders. The offer and
sale of securities federally is regulated by the Securities and Exchange Commission
(SEC) under authority granted by the Securities Act of 1933. Each
state also has its own similar statute, administered by various state agencies;
these state statutes collectively are referred to as "Blue Sky Laws." It is necessary
to satisfy both federal and state law in order for Dough.com Inc. to sell
shares of stock.
Whether shares of stock are sold privately or publicly, all of these laws at
a minimum require full disclosure of material information. This means that in
both private and public transactions the company typically must prepare an offering
document which explains its business, finances, and the risks of investment.
In a private offering, this booklet is often called a private placement
memorandum (PPM); in an offering to the public, this booklet is called a
"prospectus."
The big difference, Attorney Sharp continues, between public and private
sale of securities has to do with whether the transaction by which those
securities are sold is "registered" with government authorities. Registration is
the process by which the offering document is filed with and reviewed by
such authorities. In a private transaction or "private placement," there is little
or no involvement of either the federal or state governments. A private
placement generally is effected to a limited number of investors who, because
of their small number or because of their financial resources or sophistication
in making investments, do not trigger the registration requirements of federal
or state law. Attorney Sharp explains that in a $40 million private placement,
it is likely that the securities will be sold to sophisticated venture
capital investors who qualify as "accredited investors" under Regulation D of
the General Rules and Regulations of the SEC, which by its terms exempts
such sale from the federal registration requirement. Further, in many such
transactions compliance with the federal law automatically will constitute
compliance with state laws.
An IPO involves selling securities in smaller minimum investments, to a
greater number of people who need not meet any standard of sophistication or
financial resources. These people must receive a prospectus which has been reviewed
by the SEC, and in order to obtain clearance to finally utilize that
prospectus in the sale of their securities, the company will have to undergo a
"going public" process that is liable to take at least four months of management's
time and attention.
462 Making Key Strategic Decisions
THE BOARD OF DIRECTORS MEETING
The board of directors of Dough.com Inc. meets with its various advisers to
determine how to raise the necessary capital to promote the development of
Dough-Ware. Every possible solution has its advocates.
Some directors want to raise the money through a private placement of
securities from venture capital firms, believing that going public is too time
consuming, involves too much expense (upward of 10% of the proceeds typically
will be absorbed in selling commission and out-of-pocket expenses), and
that the underwriters (the investment bankers who will sell the IPO to the
public investors) will attempt to value the shares at less than their true value so
that the public investors will see the price rise upon conclusion of the offering.
An investment banker on the board suggests that the shares could be privately
placed by selling an additional 20% of the company's common stock for
$40 million, effectively valuing the company as it sits today (a "pre-money" valuation)
at $160 million.
The representative from Vulture Partners has yet another strategy. He
suggests that the company not raise the additional funds now, but push the current
version of their product out the door and work on building volume and
profitability for the next six months; then, the company can go public at a valuation
which is 30 times the company's projected pretax earnings, which would
value the company at $300 million pre-money. In conjunction with the IPO,
Vulture Partners then would sell half of its own original shares, realizing a
multimillion dollar profit while still retaining a substantial equity position.
Dough and Manager do not want to wait to raise money; they see the most
important thing as capturing market share before competitors overtake the advantage
that struggling Dough.com Inc. now enjoys. Company management
does not care whether Vulture Partners is able to sell any equity interest at this
time; they have been investors for only one year, and management does not feel
that Vulture's rush to liquidity is appropriate. But some of the other early investors,
the original group of five friends and the angel investors, also are
intrigued with the possibility of selling some of their shares.
The investment banker warns that in an IPO, it is sometimes a negative if
too many shares are sold by existing stockholders and not by the company itself;
new investors like to invest their money in the enterprise and help it grow, not
into the pockets of prior investors, and too many sales by previous investors indicate
a lack of confidence in the future.
Some of the management team wants the company acquired by Big Deal
Corporation Management, which is experienced in working with larger corporations,
sees an acquisition by a strategic acquirer as increasing the value of
their existing stock options, and believes that through their existing close contacts
with Big Deal Corporation's management they will be able to structure
attractive personal compensation packages. They point out that, whether capital
is raised publicly or privately, there is far greater risk of failure if
Dough.com Inc. goes it alone, as compared to joining forces with an existing
Going Public 463
multibillion dollar entity like Big Deal Corporation. Besides, if the key to success
is to hit the market fast with Dough-Ware, teaming up with Big Deal Corporation
is the fastest way to achieve that goal.
The investment banker says that if the desire is to sell to a strategic partner
such as Big Deal Corporation, or anyone else who can pay a high price
quickly and assist in the marketing of Dough-Ware, his investment banking
firm will be pleased to handle the proposed sale of the company and could
shop potential strategic acquirers and find the best price.
Through the afternoon, the conversation works itself toward a consensus
to effect an immediate public offering. Certainly the prospect of more rapid
ultimate profit which would result from a prompt IPO is intriguing to all:
Vulture Partners and the other prior investors; management; and John Dough
and Mary Manager as founders. All are intrigued with the advantages that
being a public entity can bring:
• Relative ease of raising additional capital for expansion in the future.
• Ability to obtain debt financing at reasonable rates (not now available due
to lack of hard asset collateral or proven cash flow).
• An ability of existing stockholders to partially cash out their investments
at a profit.
• The ability to attract employees in a highly competitive technology marketplace
by reason of public equity incentives.
• The ability to easily acquire related software companies and to make payment
for such acquisitions through the issuance of additional shares of
company stock.
Near the end of the meeting, the investment banker turns to Dough,
Manager, and the entire executive team and says that he feels compelled to
share with them some of the risks and problems, both short term and long
term, that they will encounter in going public. Effecting an IPO, and living
with the reality of being a public company thereafter, is not all a bed of roses.
For example:
• At this particularly crucial time in the marketing of the Dough-Ware product,
significant attention will be diverted from the operation of the business
into the process of going public and in preparation of the prospectus.
• The full disclosure that will be required in the prospectus will cause the
disclosure in detail of the company's business strategy and perhaps some
of its trade secrets, and will reveal the terms of its contracts with Big
Deal Corporation, and with some of its customers and suppliers.
• Any transactions between the company and its affiliates (its officers, directors,
significant stockholders, and their relatives, and companies they
own) must be disclosed.
• The cost of an IPO is significant; it is likely that investment banking firms
will be retained as underwriters and will take 7% of the gross proceeds
464 Making Key Strategic Decisions
right off the top, although this is an expense that will not be incurred unless
the offering is successful; certain other significant expenses, particularly
legal fees, accounting fees, printing fees, filing fees, and miscellaneous
out of pocket fees, must be paid even if the transaction is not successful.
Expenses in this size of proposed IPO could approximate $1 million.
• Once the company is public, it will be subject to public scrutiny, must
make periodic filings with the SEC, and will incur an overhead in dealing
with the public which does not now exist.
• There will be public pressure to achieve short-term growth on sales and
profitability so as to sustain and advance the stock price, and these pressures
will affect strategic decisions made by management which might
otherwise be based on a long-range product-driven strategy.
• Management and the directors can incur personal liability in connection
with a public offering, if it is ultimately determined that the prospectus is
materially false or misleading, causing a decline in the value of investor
shares (although certain protections from this risk can be obtained by the
company's purchase of directors and officers [D&O] insurance).
The vote is taken. With some trepidation, the board decides to attempt
a public offering, or IPO, of its shares of common stock as quickly as possible.
A "team" of two directors and three members of management is established to
pursue that result.
THE PROCESS OF GOING PUBLIC
While it is possible for the company to sell its shares directly to the public
through a variety of mechanisms including direct offerings over the Internet,
the company wants to proceed in a more traditional fashion and retain one or
more investment bankers to serve as lead or "managing" underwriters for the
public offering of its common stock. Through the contacts of the investment
banker on the board, and the contacts of Vulture Partners, the team interviews
several investment banking firms.
The entire process of going public is supervised by the managing underwriters
who will head the syndicate of other investment banking firms which
will sell the shares of common stock to the public.
An underwriter is either a distributor or sales agent for the shares, depending
upon the type of underwriting which is undertaken. A "firm" commitment
underwriting means that the underwriters agree, as a group, that if the
public offering occurs, the underwriters will themselves purchase all the
shares of stock and resell those shares to the public. Consequently, in the theoretical
event that an insufficient public market develops for the shares, the underwriters
themselves will end up owning the shares of stock as investors. As a
practical matter, it is an exceedingly rare event that the underwriters cannot
resell the shares after an IPO is effected.
Going Public 465
The other kind of underwriting is a "best efforts" underwriting. This is,
literally speaking, not an underwriting at all. The investment bankers agree, as
agents of the company, to sell such number of shares for which they can actually
find buyers. Such an underwriting may be "all or none" which means
that the underwriters must find buyers for all of the shares, or a "minimummaximum"
offering (which may close if the underwriters find purchasers for a
specified minimum number of shares). Most established underwriters only undertake
"firm" underwritings, and are entitled to receive somewhat greater
compensation under the rules of the National Association of Securities Dealers,
Inc. (which regulates underwriter compensation) in consideration of undertaking
a firm deal. The underwriters, even in a firm underwriting, are not
required to purchase the shares until the very last moment and retain certain
abilities to abort the transaction; consequently, the practical difference to the
company between these two kinds of underwritings is slight, although much
may be made of it in the marketplace.
The prospective managing underwriters all propose to do the same thing:
organize the entire process, establish a timetable, and assign tasks to the various
players; review the company's drafts of its filing with the SEC (which
consists of a "registration statement" in two parts, the longest part being the
"prospectus" which describes the company and its prospects and risks, and the
shorter part being a Part II which contains other technical information); organize
and conduct several meetings of the going public team, focused on performing
"due diligence" (an examination of the company to make sure that all
material facts are uncovered and disclosed), and on reviewing in detail the
contents of the prospectus to make sure that there is no inaccuracy or material
omission; gather other investment banking firms as part of a syndicate of underwriters
or selling group so as to achieve a broader distribution of the shares;
and find buyers for the shares.
The team considers several factors in discussions with prospective managing
underwriters:
• The value that each underwriter is willing to place on the company, and
the discount that the underwriters propose in making company shares attractive
for public purchase.
• The recent track record of the underwriter, based both on general reputation
and on that underwriter's success in closing similar transactions.
• Whether the underwriter has been able to structure prior IPOs so that
there was a sufficient "aftermarket" for the shares, preventing the price
from collapsing.
• The experience of other companies which have gone public through
that underwriter, as gathered from conversations with CEOs of those
companies.
• The degree to which the underwriter seems capable of placing some of
the shares in the hands of larger "institutional" purchasers, so as to provide
some stability in the stockholdings of the company.
466 Making Key Strategic Decisions
• The ability of the underwriter to distribute the stock on a broad enough
geographical basis that all constituencies having an interest in the company
have an opportunity to participate in the public offering.
• Whether the underwriter employs well-known securities analysts within
the company's industry, whose views are valued within the investment
community.
Finally, the team selects two investment-banking firms as managing underwriters.
A Letter of Intent, outlining the terms of the proposed public offering,
is then prepared and signed by the company. Among other matters, this
Letter of Intent will obligate the company to pay certain expenses of the underwriter,
whether or not the IPO is successful.
One of the managing underwriters takes the lead in organizing the IPO
process. First, a date is fixed for an "all hands organizational meeting." This
important meeting will be attended by the managing underwriters, the lawyers
for the underwriters, the company management, the lawyers for the company,
and the certified public accountants who will prepare the SEC-specified financial
statements. At the organizational meeting:
• It is decided that shares of voting common stock will be sold; it is expected
that Vulture Partners will convert its preferred stock into common
stock effective upon the public offering.
• All parties are assigned specific responsibilities with specific deadlines.
• A timetable for the offering is established, generally encompassing a 12-
to 16-week period from the date of the organizational meeting to a closing
of the public offering.
• The parties discuss the selection of a financial printer, and the company
later will interview and negotiate price with a printer who is experienced
in printing SEC filings and causing those filings to be effected electronically
through the SEC's electronic filing system (called EDGAR).
• The managing underwriters present a "due diligence checklist" which is a
list of numerous facts to be gathered and documents to be produced by
the company; it is the task of the underwriters to perform "due diligence"
to make sure that all facts are uncovered. The diligence process is outlined
and materials for the checklist are contained in the NASD's "Due
Diligence Examination Outline," annexed to this chapter as Appendix A.
• The participants discuss the addition of "antitakeover provisions" to the
corporate structure of the company; when a company becomes publicly
held, there is the possibility that third parties might attempt to obtain a
controlling financial interest or voting interest. The underwriters are of
the view that certain antitakeover provisions are inappropriate, as they
limit the likelihood of a legitimate takeover of the company at a high
price and therefore work against the interest of the stockholders. Management
expresses an interest in taking reasonable steps to preserve current
control. Antitakeover provisions may include: staggering the board of
directors so that all directors cannot be replaced at once; limiting
Going Public 467
the rights of stockholders to call special stockholder meetings; limiting
the rights of stockholders to amend the company's bylaws; eliminating
the right to remove directors except for cause; establishing voting mechanisms
which do not permit the purchaser of shares immediately to affect
the control of the company; and the adoption of complicated stockholder
protection plans, called "poison pills," that dilute the equity interest of
any unfriendly future significant stockholder.
• There is discussion concerning the number of shares to be offered, the
percentage of the company to be offered, the general range of share pricing,
and whether the company's shares will be listed for trading over an
exchange or quoted through the facilities of NASDAQ (National Association
of Securities Dealers' Automated Quotation System). It is decided
that approximately 10% of the shares to be sold in the IPO will belong to
Vulture Partners and other original investors in the company.
• The underwriters ask for the option to purchase from the company, for
resale to the public a short time after the closing of the IPO, an additional
number of shares of common stock. These shares, typically not in excess
of 15% of the shares sold in an IPO, are an "overallotment" to permit the
co-managing underwriters to cover short positions in the company's stock
which they may have created immediately after the IPO closing in an effort
to stabilize the stock price. These shares are sometimes referred to as
"the green shoe," named after a securities offering which allegedly first
utilized this technique.
• There is a discussion of "lockup agreements." The underwriters will require
that existing stockholders contract that for some period following
the IPO (most typically 180 days), they will not sell any shares; this prohibition
permits the underwriters to "stabilize" or create an equilibrium
in the price of the shares, and eliminates the perception that the insiders
are "bailing out." Conversely, the underwriters may be asked to include a
reasonable number of shares for sale by prior investors.
• Management asks to set up a "directed share program" by which friends
of the company, such as key suppliers and business partners, will be given
an opportunity to preferentially subscribe for shares; generally underwriters
seek to limit these programs to 5% of the total offering.
• The parties discuss the inclusion of online "e-brokers" as part of the underwriter
distribution group, in order to address the growing appetite of
online purchasers in technology-related IPOs.
The organizational meeting sets off a time of hectic effort by management,
accountants, and attorneys. Some staff is delegated to filling the due
diligence checklist. The bulk of the more visible effort is directed, however,
toward the preparation of the registration statement, which includes the
prospectus.
The company and its attorneys are charged with the task of preparing a
first draft of this registration statement. The contents of the registration statement
are rigorously specified by the forms and rules promulgated by the SEC.
468 Making Key Strategic Decisions
One of the tasks of the organizational meeting is to determine which SEC
"Form" will be utilized in going public. The SEC has promulgated two additional
forms, Form SB-1 and Form SB-2, for certain small businesses. The financial
statements for such forms are less rigorous than for Form S-1 and
require only one year of audited balance sheet and two years of audited income
statements, statements of cash f lows, and statements of stockholders' equity.
However, because of a combination of limitation on amount of capital to
be raised and value of the company at the commencement of the process, at
the organizational meeting it is determined that SEC Form S-1 must be utilized;
the accountants will be required to prepare two years of audited balance
sheets and three years of audited income statements, cash f lows, and stockholders'
equity. (Appendix B is Securities and Exchange Commission Form
S-1, the most typical registration form for an IPO.)
Although audited information is required for only three years in Form
S-1, the accountants also will have to put together the results of operations for
a five-year comparative period (if available). Since 2001 the company has received
an audit of its financial statements, but results of operations for the initial
year 2000 were prepared on a review basis only. The accountants will have
to go back and apply audit standards to this period. Since the objectives of an
audit are to obtain and evaluate evidence to corroborate management's assertions
regarding its financial statements, and to express an opinion on those
financial statements, the "review" of the operating numbers will be an insufficient
basis for the issuance of an audit opinion. But since Mary Manager was
assiduous in financial record keeping and since the certified public accountants
are familiar with the company's financial records and financial statements,
the accountants will be able to complete the audit procedure at the
same time that they are preparing the Form S-1 financial information and supporting
schedules in the format required by the SEC.
In preparing the registration statement, the company, the underwriters,
the accountants, and the attorneys are guided by specific instructions from the
SEC. The textual content of the registration statement is controlled by SEC
Regulation S-K; the accounting content is regulated by SEC Regulation S-X.
These regulations and related pronouncements contained in the General Rules
and Regulations of the SEC, may be accessed through the SEC Web site, and
are made available to companies undergoing the IPO process through a series
of publications provided without additional charge by most financial printers.
The process of drafting the prospectus is made more complicated by efforts
of the SEC to clarify communication between the company and its potential
public investors. Since October 1998, the SEC has required that the
prospectus be drafted in "plain English" pursuant to the provisions of Rule 421
of the SEC's General Rules and Regulations. The entire prospectus is to be
written in clear, concise, and understandable English using short sentences and
paragraphs, bullet lists, and descriptive headings without either technical or
legal jargon. The company will struggle to describe the technicalities of its
business in language that will be clear and understandable to an intelligent but
Going Public 469
non-technologically oriented reader. The lawyers will struggle in similar fashion
to convey technical information concerning the terms of the offering.
Special plain-English rules apply to the front and back cover pages, to the
summary contained in the front of the prospectus, and to the section of "risk
factors." Risk factors are a constant feature of IPO prospectuses, and are designed
fully to apprise the potential investor of all pitfalls that the company
might encounter and which might cause it to falter. These risk factors generally
relate to the newness and lack of financing and operating history of the company,
the experience level of management, rapid technological change for the
marketplace in which the company proposes to compete, and the superior resources
of the competition. These vital pages are the ones likely to be read most
carefully by the investing public, and must be reviewed particularly to make
sure that sentences are short, that the active voice is utilized, that concrete
everyday words are employed, and that complex information is contained in
tables or otherwise graphically depicted.
There will be several drafting meetings in the six to eight weeks between
the organizational meeting and the filing of the first draft of a registration
statement with the SEC. During these lengthy meetings, each word of the
prospectus will be reviewed and considered, some on-the-spot rewriting will
occur, and other sections will be designated for later rewrite. Much attention
will be directed to the description of the company's business, and to the
"MD&A" (management's detailed discussion and analysis of its financial operations,
liquidity, and capital requirements for the past three years, as well as for
the foreseeable future, if known). When all parties are confident that the description
is accurate, the "preliminary prospectus" will be filed as part of the
registration statement.
Contemporaneously, filings also must be made with the regulatory agencies
of each state in which the IPO will be offered; state practice varies as to
the degree of substantive review that state regulators will give to a registration
statement, and in the past the severity of state review was more stringent than
SEC review; some states involved themselves in approving or disapproving the
substance of an offering ("merit review"), while SEC review typically is restricted
to ensuring the adequacy and completeness of the description of the
company and the attendant risks of investment.
In the case of the company, a decision has been made to apply for the
immediate right to have the shares issued in the IPO quoted for trading on
NASDAQ. By law, when IPO shares will be quoted on NASDAQ or listed on
a national securities exchange, the states' right to insist on separate registration
and review is preempted.
Now everyone waits for the SEC staff to provide comments and ask questions
in a written "comment letter." It is not typical to print and distribute to
the public the first filing of the preliminary prospectus, in part because no one
is quite sure whether the SEC will have significant comments or request significant
corrections and in part because often the managing underwriters are
not ready to effect such a distribution. During the three to four weeks that it
470 Making Key Strategic Decisions
typically takes for the SEC to provide both accounting and business comments
on the prospectus, several things will be occurring:
• The company's accountants will work on updating financials, so they will
be "fresh" (i.e., within 135 days of filing) for the anticipated amendments
to the registration statement.
• The company will be careful in its public utterances and in the contents of
its Web site, to avoid the improper direct or implicit promotion of the
company's stock; during this waiting period generally the only writing
that may be utilized to actually offer company stock for sale is the
prospectus itself, and no generally ancillary writing and no inconsistent
oral presentations can be made.
• The comanaging underwriters will form a syndicate of additional underwriters
who will agree to purchase a certain number of the IPO shares.
These underwriters in turn will deal with the lowest tier of distribution,
the "selected securities dealers" whose securities customers ultimately
will be asked to purchase the shares.
• The managing underwriters will have filed with the National Association
of Securities Dealers Inc. (NASD) the following: the registration statement,
their underwriting agreement with the company, the agreement
among the underwriters themselves, and the agreement between the underwriters
and those "selected securities dealers." The NASD regulates
compensation of underwriters, and must review the offering to declare
that the consideration to be paid by the company to the underwriters is
fair and reasonable.
• The company will prepare the information necessary to permit the company's
common stock to be quoted over the NASDAQ, on completion of
the IPO.
When the SEC staff issues its comment letter, a f lurry of rewriting results
in an amended registration statement, which is combined with updated financial
statements and refiled with the SEC as promptly as possible. Typically,
this version of the prospectus is then printed in large numbers and distributed
by the underwriters to the investment community. This distributed prospectus
is typically referred to as the "red herring." Until 1996, the SEC required that
the cover of a preliminary prospectus, which was being distributed, bear in red
ink a legend which advised that the prospectus was subject to change and that
the SEC had not finally approved the offering. Under current practice, language
to similar effect is required on the front cover and on occasion may be
printed in red ink, but it need not be.
At this juncture, the underwriters together with key company management
embark on a "road show," which is a key element in the marketing of an
IPO. For a couple of weeks, the managing underwriters and management crisscross
the United States, and sometimes travel overseas, to hold brief meetings
with underwriters, brokers, securities analysts, and significant investors to
Going Public 471
present the company, discuss and answer questions concerning the prospectus,
and make the company story palpable to the people whose support is essential
to sell the offering. Management typically makes a highly orchestrated half
hour presentation, supported by a PowerPoint or similar screen presentation.
Because the company is still in the waiting period and (generally) only the
prospectus can be utilized as a written presentation of the company's
prospects, no written materials are distributed. The managing underwriters
had booked two and a half weeks of in-person meetings, mostly at breakfast
and lunch time when securities professionals and significant investors are most
available, in cities all across the United States, with a brief two-day trip to
London.
Perhaps the fastest evolving and most confused aspect of the going public
process is the road show procedures, in light of technological advances. Road
show sessions are now permitted to be accessed online with the Internet, and
the SEC and the underwriting community is grappling with the ground rules
for such access. At present, there are no general rules and regulations as to the
types of potential investors who may participant in an Internet road show, although
the trend seems to be toward opening road show participation to increasingly
less sophisticated investors. It is quite possible that this trend will
continue so as to open road shows to all interested parties, and if Internet road
shows are open to everyone, then the in-person road show seemingly could also
be fully attended. The attorneys for the underwriters have written to the SEC
and obtained specific permission to permit the Internet streaming of several of
the United States road shows to selected retail investors who are securities customers
of the underwriting syndicate, which investors will be given a password
to a Web site in order to participate. Because of the prohibition against utilizing
any writing other than the prospectus during this "cooling off " period, Internet
participants will be prohibited from downloading the PowerPoint
presentation which will be made by the company management.
Throughout this period, the underwriters gather indications of interest
for the purchase of stock. They also receive feedback as to the proposed range
of pricing, which ref lects the market value that will be placed on the company
and will be ref lected in the per share price. In dialogue with the team, and
with approval of the board of directors, just prior to final clearance from the
SEC the managing underwriters fix the per share price at which company
common stock will be sold in the IPO.
Meanwhile, the SEC staff has reviewed the amended prospectus, and has
been satisfied with the response it has received to questions it has addressed to
management and to the accountants. It has indicated that the IPO can proceed.
Pursuant to SEC practice, the underwriters may now file a final registration
statement (with fresh financials if needed), which for the first time
will contain the actual per share purchase price, the aggregate proceeds to the
company and to selling stockholders, and the specific dollar amounts for the
underwriter discount (the commission that the underwriters will receive on
the sale of the shares). This "pricing amendment" by SEC regulation will take
472 Making Key Strategic Decisions
effect in 20 days, but in practice the company requests and the SEC will grant
"acceleration," which permits the immediate offering of the stock pursuant
to the final prospectus. The prospectus is printed in large numbers for distribution
to investors, without the "red herring" legend on the front cover which
had indicated that the prospectus was subject to change. The prospectus is
now final.
At the same time that the company's registration statement under the Securities
Act of 1933 has become effective, permitting the initial sale of the
company's stock, the SEC also has permitted to become effective a filing made
by the company under the Securities Exchange Act of 1934, which statute establishes
the rules for subsequent trading of the shares on the part of the purchasers
who obtain company stock in the IPO.
It is only at this time that the company and the two managing underwriters
will sign the underwriting agreement by which the underwriters agree to
purchase the company's shares. The agreement had been filed as an exhibit
with the registration statement and had been approved by the NASD, but until
the SEC has granted its approval of the registration statement the underwriters
have not been contractually bound to purchase the shares. Even now, in the
brief period of time it will take for the underwriters to effect the going public
transaction, the underwriting agreement contains a series of "market out" provisions
which permit the underwriters, over the next few days, to decline to
move forward with the IPO in the event material and unexpected changes
occur in the financial markets.
The underwriters and the selected dealers now are entitled to accept payment
for the shares, and they sell the company's common stock to various institutional
and individual investors. Approximately one week later, a closing under
the underwriting agreement occurs. Before the underwriters will close, they
will require a series of assurances from the company and its advisers with respect
to the continuing accuracy of the contents of the registration statement.
Officers of the company will deliver certifications as to the accuracy of facts,
the attorneys for the company will give formal legal opinions with respect to
legal matters and the absence of their awareness of contrary material facts, and
the accountants will deliver a "comfort letter," which sets forth the degree of
diligence utilized by the accountants, the materials which the accountants have
reviewed, and the conclusion that nothing has come to the attention of the accountants
to indicate that the financial statements are improperly prepared or
erroneous. An example of a comfort letter approved by the American Institute of
Certified Public Accountants Inc. is attached to this chapter as Appendix C.
At the closing, the company receives $33 million from the underwriters in
exchange for its stock. Vulture Partners and certain other stockholders, who
sold their shares along with the shares issued by the company, receive $4.2 million.
The underwriters retain $2.8 million, or a 7% commission. Out of its proceeds,
the company pays many additional substantial expenses: several hundred
thousand dollars to each of its lawyers, its accountants, and its financial
printer, as well as the legal fees and expenses of the underwriters' attorneys.
Going Public 473
Dough.com Inc. now is a publicly held company with a couple of thousand
shareholders spread throughout the United States and Britain.
THE MORNING AFTER
Although the infusion of over $30 million of net capital in the company is of
major significance, the life of the company in public mode has drastically
changed. The company's executives and directors have taken on both new roles
and serious potential liabilities. The company itself has become obligated to
feed the public's earnings appetite, and the requirements of the regulatory authorities
for a continuous stream of accurate information.
As a publicly held company with shares quoted on NASDAQ and registered
under the Securities Exchange Act of 1934, both the company and its executives
have further become responsible for the filing of very specific and
complex reporting forms.
The company itself must keep the public informed by filing within 90
days of each fiscal year-end, on Form 10-K, an extensive discussion of the company's
business and financial condition. Much like a prospectus, the Form 10-K
contains a description of the business, properties, and legal proceedings involving
the company, an MD&A (management's discussion and analysis of financial
condition and results of operations) for the three prior years, three years of
audited financial statements, and a variety of other information about the company's
stock, the company's management, and (typically although not specifically
required by regulation) an ongoing and updated list of risk factors.
Less comprehensive but equally required by regulation, the company
must file within 45 days of the end of each of its fiscal quarters (except for the
year-end) a quarterly report of its financial condition on Form 10-Q, and furthermore
must file periodic reports on Form 8-K within several days after the
occurrence of significant events, such as a change of control, the acquisition or
disposition of significant assets, a change in the auditors, or a resignation of directors
because of disagreement.
The company will be required by NASDAQ to provide a written annual report
with audited financial statements to all of its stockholders. Corporate practice
will require the corporation to hold an annual meeting of its stockholders,
generally within two or three months of the release of the annual report on
Form 10-K, which will contain the financial statements for the prior year.
Now that the company's stock is widely held by a couple of thousand people
in diverse locations, it is necessary for management to seek written voting
authorization, through signature and return of a proxy card, by which stockholders
authorize designated members of management to vote the shares of
such investors for the election of directors and for any other action to be taken
at the annual meeting. Proxy regulations of the SEC will require that the company
send extensive written information (a "proxy statement") to each stockholder
in advance of the annual meeting, and in connection with management's
474 Making Key Strategic Decisions
solicitation of proxies for the voting of shares. The SEC requires filing of this
proxy statement and all related information at the same time they are sent to
stockholders; in the event significant action beyond the typical election of directors
is to be voted on at the annual meeting, the SEC requires advance filing
of proxy materials so that the SEC staff can review and comment on such
materials.
The company will have to consider whether it wishes to attempt to conduct
its annual meeting online. While substantive state law controls whether a
corporation can accept electronically sent proxies or electronically sent direct
votes, the desire on the part of companies to communicate more completely
with its stockholders will likely push the company to spend more and more
time in producing online annual meetings.
Now that the company is public, the company and its management can have
personal liability if materially incorrect information about the company falls into
the public domain. Indeed, it is the purpose of the various formal SEC filings to
make sure that accurate current information is disseminated. But often events
arise which call for public disclosure on the part of the company, and if the information
contained in such disclosure is both material and not previously contained
in an SEC filing or other public announcement, then under SEC
Regulation FD the company must make sure that contemporaneously with the
making of such private disclosure there is also a broad public dissemination.
The annual meeting presents particular problems in the control of company
information. Company officers answering questions at the annual meeting
will have to stick to a recitation of previously announced material facts; in the
event a decision is made to release previously nonpublic material information,
or if such information inadvertently is provided, SEC regulations require
prompt broad dissemination through filing of Form 8-K and through appropriate
press releases to the public. In connection with its annual meeting, management
may be briefed by attorneys and PR consultants as to how to answer
questions from the f loor concerning company operations and finances.
Indeed, separate and apart from its annual meeting, the company must
generate some specific policies on the handling of material nonpublic information.
Dough.com has already placed an ad in the newspaper for a director of investor
relations, to coordinate the need of company investors for accurate
information about the company. It is likely that this function within the company
will grow over time and indeed likely that an outside public relations firm,
experienced in the public relations and disclosure issues of public entities, will
be retained. The company should anticipate adopting a constant policy of
broadly disseminating public press releases about new products, and material
developments in the company.
Particular problems arise in connection with dealing with rumors that
may circulate in the public domain. The company may decide that it will systematically
offer "no comment" with respect to questions about certain kinds
of rumors or misinformation (whether raised at an annual meeting or at other
times). Such a policy is difficult to sustain; once adopted it must be followed
Going Public 475
rigorously, and if in the past the company had a practice of discussing such
matters, then it cannot state "no comment" in a particular case. Additionally,
rules of most Exchanges and of the NASDAQ require a company affirmatively
to correct, through its own public disclosure, materially inaccurate and misleading
rumors which circulate in the marketplace through third parties regardless
of whatever legal ground rules may exist.
The investor relations and legal advisers to the company also will now
have to pay attention to the contents of the Web site, which in the past might
have contained overly enthusiastic reports about the company, its potential
profitability and the functionality of its products. Contents of the Web site can
constitute false and misleading information upon which investors may rely to
their detriment, and financial losses incurred by investors based on erroneous
or dated Web site information can be recovered by lawsuit against the company
and its management.
In forming a public disclosure policy, the company will work closely with
legal counsel. Many of its pronouncements will contain language approved by
the Private Securities Litigation Reform Act of 1995 so as to establish a socalled
"safe harbor" for forward-looking statements. A company and its management
will be insulated from liability in connection with any statement
which later proves to be inaccurate, provided the statement is believed to be
true when made and provided it is disclosed clearly that the anticipated future
event is dependent on certain variables.
The company now must deal with the common practice of announcing
quarterly earnings, generally by a conference call with securities analysts (securities
professionals who follow the company stock and write about the stock
in research reports and publications). Although quarterly financial information
must be filed in the Form 10-Q within 45 days of the end of the first three fiscal
quarters (or included in the annual Form 10-K within 90 days of the end of
each fiscal year), it is not unusual for a company to announce its earnings by
conference call or perhaps online as soon as determined. It is also during such
earnings announcements that management is sometimes induced to speculate
as to earning trends, and such speculation must be made carefully if it is to be
protected by the "safe harbor" for forward-looking statements. The SEC is actively
involved in regulating the announcement of earnings in such a private
forum. The practice of releasing this information only to selected securities
professionals has been criticized as fundamentally unfair to the broad investing
public, and regulatory changes in this practice are likely in the near future.
Now that the company is public, management will be expected to announce
its projected sales and profits; produce results that are reasonably consistent
with its projections; adjust those projections in midquarter if it appears
that they will prove to be materially erroneous; answer questions of securities
analysts in such a way that the information which is provided is both accurate
and does not materially disclose previously unknown facts; and manage the enterprise
strategically with an eye toward quarter-to-quarter financial progress.
The morning after the IPO closing, John Dough has already learned that there
476 Making Key Strategic Decisions
will be a monthly management meeting designed to control his budget and to
narrow areas of research into the development of products with short test cycles
so as to drive forward current earnings.
John Dough and Mary Manager meet for coffee a few weeks later. Each
has sold a modest number of shares as part of the IPO. John has purchased a
small sailboat, and Mary has made a down payment on a ski house. On paper,
each is worth millions of dollars, although the remaining balance of their
shares cannot now be resold because of the lockup for 180 days, and thereafter
can be resold only pursuant to specific SEC regulations because they are "affiliates"
of an issuer of publicly traded securities.
They have to be careful what they say to reporters, investors, and securities
analysts. They even have to be careful about what they say casually in conversation
with friends and relatives, lest they inadvertently leak nonpublic
information which results in illegal insider trading profits. Someone who accidentally
"tips" or leaks material information to someone who improperly profits
from it is personally liable for that act.
Within 10 days of the IPO, Mary and John had filed with the SEC their
personal report on Form 3, disclosing the amount of company stock that each
owns of record and beneficially. Mary reminds John that these forms will have
to be updated periodically by filing other forms, Forms 4 and 5, with the SEC
whenever there is a material change in ownership. Section 16(b) of the Securities
Exchange Act of 1934 will also require John and Mary to forfeit any profit
they make in so-called "short swing trading"; the law requires automatic disgorgement
of any profit made by corporate insiders who both buy and sell securities
of their company within six calendar months as an automatic
disincentive to trading by insiders based on their possible possession of material
inside information.
If John and Mary do go to sell their shares, they will always possess much
more information than the investing public. How can they protect themselves
against a claim that they abused that information by, for example, selling just
before the price of the stock fell based on poor earnings or excessive warranty
claims? They may be able to sell their shares of stock only in prespecified time
"windows" which follow immediately and brief ly after the systematic announcement
of public information by the company, such as immediately following
the filing of SEC Form 10-K or SEC Form 10-Q. Alternately, they may
adopt a preexisting Sales Plan under SEC Rule 10b5-1, which operates like a
doomsday machine: The stockholder who wishes to trade in shares of stock of
his or her company will set up in advance a program for purchasing or selling
stock on a certain date or at a certain price, and then the brokerage firm will
effect those transactions without the insider making any specific buy or sell decisions
at the point in time that the transaction actually occurs.
Finally, John and Mary must avoid acting together in the purchase, sale or
voting of stock, or joining together with others in that regard; the mere formation
of such a "group" with respect to the stock of the company, if involving
persons owning 5% or more of the company's stock, will trigger a requirement
that such event be reported by the filing of a Form 13D with the SEC.
Going Public 477
John and Mary agree that they are richer and have the opportunity to aggressively
develop and directly market Dough-Ware, which is the reason they
started Dough.com Inc. in the first place. But they are in some ways more personally
restricted. They're sitting in the coffee shop, also agreeing that it is exciting
and gratifying to be thought of as winners in the "new economy."
Then, glancing around, they lower their voices, because they want to
make sure that no one can overhear their conversation.
FOR FURTHER READING
Arkebauer, James B., and Ron Schultz, Going Public: Everything You Need to Know to
Take Your Company Public, Including Internet Direct Public Offerings
(Chicago: Dearborn Trade, 1998).
Blowers, Stephen C., Peter H. Griffith, and Thomas L. Milan, The Ernst & Young
Guide to the IPO Value Journey (New York: John Wiley, 1999).
Bloomenthal, Harold S., and Holme Roberts & Owen, Going Public Handbook
(St. Paul, MN: West Group Securities Law Series, 2001).
Farnham, Brian, Bill Daugherty, and Jonas Steinman, Codename Bulldog: How
Iwon.com Went from the Idea to IPO (New York, John Wiley, 2000).
Harmon, Steve, Zero Gravity: Riding Venture Capital from High-Tech Start-up to
Breakout IPO (Princeton, NJ: Bloomberg Press, 1999).
Lipman, Frederick D., The Complete Going Public Handbook: Everything You
Need to Know to Turn a Private Enterprise into a Publicly Traded Company
(Roseville, CA: Prima Publishing, 2000).
Taulli, Tom, Investing in IPOs: New Paths to Profit with Initial Public Offerings
(Princeton, NJ: Bloomberg Press, 1999).
INTERNET LINKS
www.sec.gov The SEC Web site, links all SEC forms,
regulations, and filings made by companies
under EDGAR.
www.nasdaq.com/about Provides a going public summary, with
/going_public.stm discussion of fairness in underwriting
compensation. This site is maintained
by NASDAQ.
www.nyse.com and www.amex.com Descriptive listing of IPO shares on
the New York and American Stock Exchanges,
through sites maintained by
the exchanges themselves.
www.iporesources.org/ipopage.html List and link a wide variety of related
and www.emergencepub.com Web sites.
/IPO07.going.publicwebs.htm
478 Making Key Strategic Decisions
APPENDIX A
DUE DILIGENCE EXAMINATION OUTLINE
The goal of due diligence is to understand fully
the business of the issuer, to identify the risks
and problems it will face, and to assure that the
registration statement is complete and accurate.
Thoughtful analysis concerning the particular
issuer as well as the experience, knowledge and
care of the underwriters and their counsel in
this process represent the critical ingredients of
due diligence. A checklist of topics and
procedures merely serve as an aid in the due
diligence process when used in conjunction
with thoughtful analysis and the review of
applicable registration forms, rules and guides
promulgated by the SEC.
The SEC and NASD Regulation both have
acknowledged that attempts to define or
standardize the elements of the underwriters'
due diligence obligations have not been
successful. The appropriate due diligence
process will depend on the nature of the issuer,
the level of the risk involved in the offering, and
the investment banker's knowledge of and
relationship with the issuer.
Checklists of the items to be covered in a due
diligence investigation can be useful tools. It is
not possible, however, to develop a checklist that
will cover all issues or all offerings. Due diligence
is not a mechanical process. The use or absence
of use of a checklist does not indicate the quality
of due diligence. Conversely, deviation from any
checklist that is used does not taint a due
diligence review any more than the following of
a checklist validates such a review.
In view of the above, the following outline should
not be considered a definitive statement of, or a
standard recommended by, NASD Regulation
regarding the due diligence issues and procedures
that would be required or appropriate in any
particular initial public offering.
I. Before Commitment Is Made to Establish
Investment Banking Relationship with
Prospective Investment Banking Client
(the "Company")
A. Staffing the Review
1. Assign personnel who have particular
competence in the business in which
the issuer is engaged.
2. Consider retaining outside
consultants to analyze the technology
employed by the Company and others
in the Company's industry.
B. Assessing Integrity of Management
1. Inquire of appropriate parties
whether the corporation is being run
by the type of persons with whom the
investment banker would wish to be
associated.
2. Determine whether any of the
Company's officers, directors, or
principal shareholders have been
charged or convicted of any charges
involving fraud, embezzlement,
insider trading, or any other matter
concerning dishonesty.
Going Public 479
C. Review of Industry
1. Examine prospectuses, Form 10-Ks,
and annual reports prepared by other
corporations in the industry.
2. Examine research reports on major
corporations in the industry as well as
reports on the industry itself.
3. Become familiar with applicable
regulations governing the industry.
4. Study the accounting practices
followed in the industry, including
any differences in accounting practices
followed by different companies.
5. Determine financial ratios of the
industry as a whole.
6. Become acquainted with new
developments in the industry by
examining trade publications.
7. Determine the industry size and
growth rate.
8. Assess whether the industry is subject
to cyclical influences.
9. Determine whether seasonality of
demand affects the industry.
10. Determine the stage of the industry in
the industry life cycle (e.g., growth,
maturity).
11. Evaluate short-term and long-term
prospects for the industry.
II. After Commitment Is Made to Establish
Investment Banking Relationship
A. Submission of Questionnaire
to Officers and Directors
The specific information to be sought
includes:
1. Relationship to underwriters.
2. Voting arrangements.
3. Transactions with the companies.
4. Past and present occupations.
5. Record and beneficial ownership of
the stock.
6. Compensation, direct and indirect.
7. Principal shareholders.
8. Knowledge of pending or threatened
litigation.
B. Submission of Request
for Company Documents
1. Regarding legal status.
a. Charter documents (articles of incorporation
and bylaws) and all
amendments.
b. Minute books for meetings of
directors, shareholders, executive
committee, stock option committee
and the like for the past five years.
c. Copies of applications for permits to
issue stock permits, and exemption
notices.
d. Specimen stock certificates.
e. Copies of voting trust and voting
agreements.
f. Documents previously filed with the
SEC, including prospectuses, Form 10,
10-K, 9-K, 8-K, proxy statements, and
supplementary sales literature.
g. Contracts or arrangements restricting
the transferability of shares.
h. Shareholders' list indicating names,
ownership, and how shares are held.
i. Licenses to conduct business.
j. Foreign qualifications, if any.
k. All documents filed with any state
agency affecting corporate status,
including annual reports.
480 Making Key Strategic Decisions
2. Regarding the Company's business.
a. Promissory notes (except immaterial
routine notes from persons, other than
officers, directors, or 10 percent
shareholders), loan agreements, trust
deeds, indentures and all relevant
correspondence regarding same.
b. Financial statements and tax returns
for the past five years.
c. Stock option agreements, profit
sharing and pension plans, supplementary
information booklets.
d. Annual reports.
e. Advertising materials, brochures, and
other sales literature.
f. Leases and/or grant deeds.
g. Description of plants and
properties.
h. Agreements with officers, directors,
shareholders, or promoters (e.g.,
employment agreements,
indemnification agreements).
i. Documents of agreements with
affiliates (e.g., lease, purchase
agreement, license, covenant not to
compete, etc.), insiders and other
related parties, and if affiliate is other
than a natural person (e.g., trust,
estate, partnership, joint venture,
corporation) court orders, agreements,
stock book, and other documents
necessary to establish precise nature of
affiliation and terms thereof.
j. All materials contracts.
k. Copies of licenses, permits,
governmental approvals, quality
ratings, franchises, patents, copyrights,
trademark and service mark
registrations, trade secret agreements
and any opinions of counsel related
thereto.
l. Distribution or agency agreements.
m. Consignment agreements.
n. List of major customers and suppliers,
copies of their existing agreements,
and copies of correspondence for the
past year.
o. All documents relating to any
complaints, investigations, claims,
hearings, litigation, adjudications, or
proceedings by or against the
Company, including copies of the
material pleading.
p. All documents relating to issuance of
stock, including offering documents
and documents relating to reliance on
securities registration exemptions and
any related litigation action or
proceeding.
q. Business plans (past five years).
r. All written documents relating to
employment policies and practices.
s. All correspondence between the
Company and legal counsel regarding
responses to requests for auditors
information (for five years).
t. Copies of any pleading or other
documents relating to any litigation,
action, or proceeding related to any of
the Company's affiliates, officers,
directors, or beneficial owners of 10
percent or more of stock.
u. All insurance documents.
v. Affirmative action plans.
w. Any other documents that are material
to the Company.
Going Public 481
C. Review of Basic Corporate Documents
1. After gaining an understanding of the
industry, examine specific Company
documents filed with the SEC during the
past five years, including:
a. Form 10-K.
b. Form 8-K.
c. Form 10-Q.
d. Registration statements and private
offering memoranda relating to the
sale of securities and any
e. Proxy statements for:
1) Annual meetings,
2) Acquisitions, and
3) Other transactions requiring a
shareholder vote.
2. Examine document and other
communications sent to the shareholders
during the past five years, including:
a. Annual reports and quarterly reports,
with particular attention to the
president's letter, which may provide
insight into any major problems faced
by the corporation.
b. Follow-up reports on annual
meetings.
c. Shareholder letters.
3. Examine public documents on the
Company.
a. News clippings.
b. Press releases.
c. Documents on file.
d. NEXIS computer searches.
e. Recent private placement
memoranda and written rating agency
presentation.
4. Evaluate restrictive covenants.
a. Examine indentures and loan
agreements.
b. Consider the effect such covenants
might have on the Company's
operations and prospective financing.
D. Analysis of the Company and Its Industry
1. Company analysis.
a. Compare the Company's prior
business plan and financial plan with
the actual results obtained.
b. Determine the Company's principal
product lines. If the Company's
principal products are newly developed,
it may be desirable to retain an
independent consultant who can advise
on the technology, the feasibility of the
product, and its potential market.
c. Examine the demographic and
geographic markets in which the
company sells its products.
d. Compile a list of principal customers
by products.
e. Obtain samples of marketing and sales
literature used for various products.
f. Determine the mechanism for distribution
of company products or
services, i.e., wholesale and
retail distributors, personal service,
or Internet.
g. Assess the technology position of the
company.
h. Compile a list of trademarks, trade
names, and service marks and assess
the protection obtained for such marks
and names.
i. Obtain copies of permits for conduct of
business, including licenses, franchises,
concessions, and distributorship
agreements.
482 Making Key Strategic Decisions
2. Strategic analysis.
a. What are the Company's long-term
goals?
b. On what basis does the Company
measure its performance?
c. What strengths does the Company
intend to exploit to be successful in its
industry?
d. What weaknesses does the Company
have in the industry and what does it
intend to do to overcome such
weaknesses?
e. What are the current market opportunities
and how does the Company
plan to exploit such opportunities?
f. What are the risks that the Company
faces in the industry? What is the
likelihood that such risks will come to
fruition? What would be the
consequence to the Company if the
risks came to fruition?
g. What are the Company's business
strategies for success in the industry?
3. Financial analysis.
a. Compare basic financial ratios of the
Company to the industry average.
(1) Debt to equity ratios.
(2) Liquidity ratios.
(a) Current ratio (Current
assets/current liabilities).
(b) Quick ratio (Current assets
minus inventory/current
liabilities).
(c) Earnings/fixed charges.
(d) Price/earnings ratios.
(3) Asset utilization ratios.
(a) Sales turnover.
(b) Total assets turnover.
(4) Profitability ratios.
(a) Return on assets.
(b) Return on equity.
(5) Price-earnings ratios.
4. Prepare a written memorandum setting
forth questions to be asked of
management and areas to be explored in
greater depth.
E. Visits to Principal Facilities
1. If the Company is a manufacturing
concern, visit one or more of its principal
plants. Inspect the facilities to become
acquainted with the Company's products
and the manner in which they are
produced.
2. If the Company is not a manufacturing
concern, visit one or more of the
Company's offices to obtain an overview
of the Company's day-to-day operations.
3. Does it appear the facilities are being fully
utilized?
F. Meetings with Principal Officers (after
reviewing the registration statement but
before engaging in a line-by-line discussion
of the document)
1. Hold individual meetings with executive
officers responsible for significant aspects
of the Company's business.
a. Prepare a list of questions in advance to
focus the discussions.
(1) How would you assess the flexibility
of the production facilities?
(2) Do you anticipate advances in
production techniques and, if so, is
the Company prepared to make
such advances?
Going Public 483
(3) Does the Company have any
continuing obligations in connection
with sales, such as an ongoing
maintenance and repair obligation or
a requirement to finance purchases
by customers?
(4) How do you assess the quality and
quantity of resources allocated by the
Company to research and
development?
(5) What are your financial projections?
(6) Have results met past projections?
(7) How do you assess the gross profit
margin trends in your various
product lines?
(8) How do you feel about the level of
sales for each of the Company's
product lines?
(9) How do you assess labor relations?
Have there been any work stoppages
and, if so, how have you dealt with
them?
(10) What is the Company's overall
advertising and marketing plan?
(11) What is the Company's acquisition
policy? Explain the Company's recent
acquisitions, if any.
(12) For what does the Company plan to
use the proceeds of the public
offering?
(13) How would you assess the inventory
turnover?
(14) Have there been any delays in new
product introduction?
(15) Has the Company changed
accounting or legal representation
within the last five years? If so, why?
(16) Has the Company lost any major
customer, supplier or distributor
within the last five years?
If so, why?
(17) Are any of the existing shareholders
antagonistic toward the current
management of the Company? If
so, please explain.
b. During the course of the interviews,
ask the same questions of different
corporate officials to evaluate the
answers received and to obtain
different perspectives on potential
problems.
2. Hold at least one meeting with the
Company's chief executive officer (CEO).
a. Ask the CEO to review the broad
aspects of the Company's strategic and
operational goals and its plan to
achieve those goals.
b. Ask the CEO for his or her personal
assessment of the Company's strengths
and weaknesses.
(1) This interview should be as far
reaching as circumstances warrant.
(2) It is essential to listen critically to
the CEO's comments.
3. Based on the meetings, assess the
competence of the officers of the
Company.
a. Are the administrators organized and
knowledgeable?
b. Are the financial officers skilled?
c. Are the technical personnel wellqualified?
d. Is the management structure such that
it can adjust to the Company's growth
beyond the current stages of operation?
484 Making Key Strategic Decisions
G. Meetings with Company's
Accountants (Out of the Presence
of the Company's Officials)
Questions to Ask:
1. How would you assess the Company's
internal controls?
2. Are there any unusual accounting
issues in regard to the Company or the
industry?
3. Are reserves adequate?
4. How would you assess the Company's
aged-analysis of accounts receivable?
5. Do you note any unusual fluctuations
in inventory?
6. Is the Company's method of revenue
recognition in line with industry
practice and applicable accounting
principles?
7. How do you assess the Company's
segment reporting?
8. From your dealings with the
Company's accounting and financial
personnel, how would you assess their
capability?
H. Meeting with Company's Counsel
Questions to Ask:
1. How would you assess the pending
litigation and contingent liabilities of
the Company?
2. How would you assess the pending
administration and regulatory
proceedings that the Company is facing?
3. How would you assess the status of the
Company's proprietary information
and intellectual property, including any
copyrights, trademarks, service marks
and trade secrets?
I. Meetings with Other Third Parties
1. Suppliers/creditors/distributors. Does the
Company pay its bills/debts in a timely
manner?
2. Competitors and customers.
a. What is the company's reputation?
b. How would you rate management's
reputation?
c. What risks are present in the Company
and its industry?
d. How would you rate the quality of the
Company's products and services?
J. Legal Review
1. Review of basic corporate documents.
a. Articles of incorporation.
(1) Obtain copies of the articles of
incorporation, including any
restated articles and amendments.
(2) Determine whether all of these
items were certified by the Secretary
of State (by whatever name known)
of the state in which the company is
incorporated.
(3) Determine whether the purposes
clause of the articles is broad
enough under the applicable law to
include all actions previously taken
and presently being contemplated.
(4) List the dates of all amendments
and summarize changes.
(5) Were such amendments validly
authorized by the shareholders?
(6) Is the name as specified in the
Charter the same as used by the
Company?
(7) Do the powers of the Company
suggest any restrictions?
(8) Is the authorized capital sufficient?
Going Public 485
(9) Verify the description of the Company's
equity stock.
(10) Do the articles provide for preemptive
rights?
(11) Does the authorized number of
directors conform to the minutes?
(12) Do the articles provide for the accessibility
of shares?
(13) Do the articles provide for restrictions
on issuance of shares?
(14) What is the county of the principal
place of business?
(15) Do the articles provide for indemnification
of officers and directors?
b. Bylaws.
(1) Obtain copies of the bylaws, including
all amendments certified by the
corporate secretary.
(2) Review for powers of officers, roles of
committees, powers to amend, restrictions
on actions, and other governing
provisions.
c. Minutes.
(1) Obtain minutes of all meetings of
directors, committees of directors and
shareholders, including copies of any
written notices, waivers of notices, and
written consents to action without a
meeting, all for the past five years.
(2) Has the Company regularly held its
annual meeting of shareholders? If not,
explain the circumstances. If not, were
notices duly given or waivers obtained?
If notices or waivers were properly
obtained, indicate whether such waivers
were actually signed before or during
the meetings, or whether they were
executed after the meetings.
(3) Indicate whether the Company
holds regular periodic meetings of
its directors.
(4) What is the normal frequency of
such meetings?
(5) Were notices duly given or waivers
obtained with respect to these
meetings? If so, indicate whether
such waivers were actually signed
before or during the meetings, or
whether they were executed after
the meetings.
(6) If a meeting was not held, were
resolutions adopted pursuant to
proper unanimous written consent?
(7) Prepare a summary of the minutes
for review by the underwriters.
d. Meetings.
(1) Indicate the date and place for
meetings, both for directors and
shareholders, as provided in the
bylaws or articles of the
corporation.
(2) What were the actual locations of
the last three shareholders'
meetings?
(3) What were the actual locations of
the last two directors' meetings?
e. Executive committee meetings.
(1) If the Company has an executive
committee, does it hold regular
periodic meetings?
(2) If so, are minutes regularly
prepared?
(3) If such minutes are prepared, is
such preparation under the
direction or approval of the office
of general counsel?
486 Making Key Strategic Decisions
(4) If no meetings are held, are
resolutions properly adopted
pursuant to unanimous written
consent?
f. Directors' and shareholders'
meetings/minutes.
(1) How are the corporate minutes
and/or unanimous written
consents kept? If the minutes or
consents are kept looseleaf, are the
pages consecutively numbered?
(2) Are previous minutes of meetings
properly signed? Who signs the
minutes?
(3) Do all previous minutes reflect the
presence of a quorum and the
names of those in attendance?
(4) Do all previous minutes indicate
the approval of previous minutes?
(5) Do all previous minutes indicate
the time and place of the holding
of the meeting?
(6) Do all previous minutes indicate
that either waivers were properly
executed or notices properly given
for the meeting?
g. Voting trust agreements.
(1) Obtain copies of any voting
trust agreements, or
shareholders' or similar
agreement, and lists of the
shares covered.
(2) Do such agreements terminate by
virtue of the offering?
h. Minute books and stock records.
(1) Where are the minute books of the
Company physically kept?
(2) Where are the stock record books
of the Company physically kept?
(3) Who is the stock transfer agent for
the Company? (Indicate the
transfer agent's complete address.)
i. Annual reports.
(1) Obtain copies of any document
sent to shareholders, including the
Company's annual reports,
quarterly reports, following reports
on annual meetings and
shareholder letters and press
releases sent within the last three
years.
j. Proxy statements.
(1) Obtain copies of any proxy
statements of the Company for
annual meetings, acquisitions or
other transactions requiring a
shareholder vote within the last
five years.
(2) Obtain copies of the form of proxy
used for the last annual meetings.
k. Annual certified audits.
(1) Obtain copies of the annual
certified audits of the Company for
the last three years, if any, unless
contained in the annual report.
(2) Has there been any change in the
accountants?
l. Election procedures.
(1) Do election procedures for
directors, as used by the Company,
comply with all applicable laws and
regulations, including the
Company's bylaws?
(2) Have directors been unanimously
elected?
m. Concurrent director/officer status.
(1) Was any person who was both a
director and an officer present at
Going Public 487
the meeting at which his or her salary
was set?
(2) Was such person counted as part of the
quorum for such a meeting or did that
person sign a unanimous written consent
for same?
(3) If an affirmative answer is given to
either (1) or (2), does such action create
a legal problem under the applicable
law?
n. Power of board of directors.
Is it the Company's policy to get the board
of directors' approval for:
(1) Changes in reserves?
(2) Changes in surplus accounts?
(3) Declaration of dividends?
(4) Election of officers?
(5) The setting of officers' salaries and/
or bonuses?
(6) Amendments to the by-laws of the
corporations?
(7) The granting of powers of attorney?
o. Policy-making authority of the board of
directors.
(1) As a practical matter, does the
Company get the board of directors'
approval for all major policy decisions?
(2) If not, how much leeway does the board
of directors give the Company's
management in the area?
p. Indemnification.
(1) Obtain copies of any insurance policies
or other agreements, other than the
bylaws of the articles of incorporation,
which provide for the indemnification
of any officer, director, shareholder,
employee, or other agent of the
company.
(2) Is the indemnification agreement or
policy authorized by applicable
jurisdiction?
(3) Is any indemnification in the
bylaws consonant with law in the
applicable jurisdiction?
q. Rights of the various classes of stock.
(1) State the voting rights of the
various classes of stocks.
(2) Are any dividends on preferred
stock presently in arrears? If so,
indicate any additional preferences
that come into being because of the
arrearage.
(3) Indicate any potential voting right,
other than noted in Section II.J.1.b.
above, held by holders of preferred,
convertibles, debentures, bonds,
etc., that become effective on the
happening of contingent events
(such as failure to pay dividends or
make payments).
r. Dividends and other distributions
(1) Indicate the Company's dividend
record on common stock for the
past five years.
(2) Indicate any other distribution of
property to shareholders by the
Company over the past five years.
(3) Has the Company ever paid a
dividend or made another distribution
to shareholders without
meeting an earned surplus or other
test under applicable state law to
cover it? If so, explain.
s. Pension plans/profit sharing
plans/stock option plans.
488 Making Key Strategic Decisions
(1) Obtain copies of (i) all pension plans,
(ii) all profit sharing plans, and (iii)
all stock option plans.
(2) If the Company has a pension plan,
indicate the date on which there last
was a compliance with the Federal
Pension Plan Disclosure Act.
(Compliance is obtained by giving a
printed copy of the plan to the
employees covered thereby.)
t. Reports filed with governmental agencies.
(1) Review all material reports filed with
any governmental agency (state or
federal) during the last 12 months.
(2) Indicate whether the narrative in all
reports filed with any governmental
agency, as well as the Company's
annual report, is checked for accuracy
by the office of general counsel.
u. Related parties.
(1) Does the Company do business with
which any officer or director, including
spouses and other close relatives, has
an interest?
v. Insurance.
(1) Is the Company self-insured?
(2) If so, to what extent?
(3) Indicate the insurance coverage of the
Company, giving the name of the
carrier and the policy numbers of
each type of coverage.
w. License to do business.
(1) Indicate the states in which the
Company does business.
(2) Obtain copies of certificate of good
standing to determine if the
Company is properly licensed in each
state it is doing business.
(3) Is the Company licensed to
do business in any states in which it
presently is not doing business? If
so, indicate the tax consequences
for each jurisdiction.
x. Corporate opportunity doctrine
compliance.
(1) Indicate any possible violation of
the corporate opportunity doctrine
known to the Company's counsel.
y. Contingent liabilities.
(1) List all material contingent
liabilities of the Company not
otherwise set forth in this audit.
2. Documents regarding securities.
a. Stock options/stock purchases/
stock bonuses.
(1) Obtain all forms of stock option
plans, stock purchase plans, and
stock bonus plans, and all forms of
stock option agreements, or escrow
agreements that have been or may
be used under any such plan, as
well as all other documents relating
to the issuance of securities by the
Company, including other purchase
agreements, registration rights
agreements, and offering circulars.
b. Sources of capital.
(1) List each issue of stock, bonds,
debentures, options, warrants, other
convertibles, etc., indicating the
amount, the authorized amount,
and the applicable permit or registration
of each (both state and
federal), and if there is no permit
and/or registration, state the
claimed state and Federal
exemption.
Going Public 489
(2) List the states where such securities
described in Section J.2.a., above,
were issued and state the date of
blue-sky authorization. If no such
authorization, give the applicable
exemption.
(3) Indicate the date of each federal
registration, if any, and the term
for which registered.
(4) Obtain copies of any agreements
pursuant to which such securities
were issued (e.g., stock option
plans, underwriting agreements,
placement agreements, bond
indentures, etc.).
(5) Do any such agreements provide
for registration rights? If so,
describe.
(6) Obtain copies of all applications
for permits, private placement
memoranda and registration
statements.
c. Payments for stock.
(1) Do the Company's records indicate
all of its outstanding stock was
properly issued for value?
(2) Is any of the Company's stock not
fully paid? If so, explain; do statutes,
articles and by-laws permit?
d. Stock issuance/transfer restrictions.
(1) Do all issuance and transfers
comply with any rights of first
refusal, preemptive rights, or other
restrictions contained in the
articles, bylaws or other
documents, such as placement
agreements?
3. Review of material contracts.
a. Various material contracts.
(1) Obtain bank lines of credit
agreements, including any
amendments, renewal letters,
notices, default waivers, etc.
(2) Obtain other outstanding loan
agreements, guarantees, indentures,
or agreements with respect to
indebtedness.
(3) Obtain all outstanding material
leases for real and personal
property.
(4) Obtain material contracts with
suppliers and customers.
(5) Obtain any model sales contracts,
license agreements, and dealer
agreements used by the Company.
(6) Obtain agreements for loans and
any other agreements (including
consulting and employment
contracts) for officers, directors, or
employees, whether or not now
outstanding.
(7) Obtain schedule for all insurance
policies in force covering property
of the Company and any other
insurance policies, such as "key
man" policies or products liability
policies.
(8) Obtain partnership or joint venture
agreements.
(9) Obtain copies of any bonus plans,
retirement plans, pension plans,
deferred compensation plans, profit
sharing and management incentive
agreements.
b. Mortgages, notes payable, and
other liabilities.
(1) List all mortgages (including deeds
of trust) of the Company on which
490 Making Key Strategic Decisions
the anticipation is that final payment
will not be made within the 36
months of the date of this
examination.
(2) Indicate whether such mortgages
overlap any other security interest
given by the Company.
(3) List all notes and other liabilities in
excess of $5,000.
c. Reports on dividends.
(1) Does the Company make reports
(both federal and/or state) on
dividends paid to its shareholders?
(2) If so, give the date of the last such
report.
d. Corporate negotiable insurance.
(1) Indicate each institution in which the
Company has authorized its agents to
execute negotiable instruments,
showing the authorized agents, their
titles, and the limit of their authority.
(2) For each of the authorizations,
indicate the date of the corporate
resolution authorizing the signature.
e. Authority of corporate agent.
(1) Is a notice of limit of agent's
authority given to each new account
with which the Company does
business?
(2) If not, what steps are taken to ensure
that each agent of the Company does
not exceed his/her authority?
f. Business outside the United States.
(1) If the Company does any business
outside the United States, determine
whether or not any activities of the
Company might reasonably be
construed as a violation of any
statutory or regulating limitation on
doing business with specified
nations or limitation on certain
trading, such as trading in gold and
foreign exchange.
(2) What steps have been taken to
ensure that the Company does not
violate any prohibitions concerning
transactions between designated
foreign companies or concerning
transfer with respect to securities
registered in the name of
designated nationals, as well as
importation of and dealing on
certain classes of merchandise?
(3) List all corporations incorporated
in a foreign country in which the
Company owns 10 percent or more
of the capital stock, and for each
such corporation indicate (i) any
outstanding powers of attorney (ii)
any guarantees undertaken (iii) any
liabilities created, and (iv) and
contract commitments undertaken.
g. Prepaid items.
(1) List all prepaid items on the
Company's book of assets when
such prepayments exceed $100,000
and will continue in excess of this
amount for more than 12 months.
h. Bad debts.
(1) Indicate the percentage of accounts
receivable that became bad debts in
each of the last three years.
(2) Ascertain trends regarding
bad debts.
i. Security interests.
(1) What security interest, if any, is
typically used to secure open
accounts?
Going Public 491
(2) Are such security devices properly
perfected?
(3) In how many states does the Company
presently have perfected security
interest?
(4) What steps are taken to ensure
the timely filing of continuation
statements required under Article 9 of
the Uniform Commercial Code?
j. Warehousing.
(1) Does the Company, as either buyer or
seller, utilize the facilities of on-premises
warehousing for financing purposes?
(2) Does the Company, as either buyer or
seller, utilize warehouse receipts in
financing?
k. Labor contracts.
(1) List all labor contracts to which the
Company is a signer, indicating the
bargaining unit covered, the union, the
termination date, and a general
statement of the company's relationship
with the union, indicating specifically
any major problem areas.
(2) If there are material problems, obtain
copies of each labor contract.
l. Individual employment contracts.
(1) Does the Company have any individual
employees with a written employment
contract?
(2) If so, obtain copies of all forms used for
employment contracts (including forms
of contracts used for executives).
m.Minimum wage compliance.
(1) Is the Company considered to be
engaged in interstate commerce?
(2) Are any employees or employees of
subcontractors working on the
premises currently being paid less
than the applicable minimum wage
per hour? If so, what justification
can be given for a lower rate of pay?
(3) Are any employees covered by a
state minimum wage law requiring
the payment of more than the
federal minimum wage per hour? If
so, indicate with appropriate
citation the state law, the bargaining
units covered, and any other
pertinent information.
(4) Is overtime paid? If not, explain
when it is not paid.
n. Child labor.
(1) Does the Company employ any
person under eighteen years of age
on a permanent basis?
(2) What safeguards are taken to ensure
that the Company does not violate
either the federal or state "Child
Labor Act"?
o. Compliance with fair labor standards.
(1) Has any governmental agency
checked the Company within the
last three years in regard to
compliance with the fair labor
standard act or other litigation
regarding employees?
(2) If so, indicate the approximate date
and result of the investigation.
p. Compliance with antidiscrimination
statutes.
(1) Does the Company have procedures
to assure compliance with antidiscriminatory
statutes relating to age,
sex, and race; and does it keep
adequate records to demonstrate
compliance (e.g., application forms,
492 Making Key Strategic Decisions
records of employees, and work
assignments, etc.)?
(2) Does the company, in fact, have an
age limit cutoff beyond which
general hiring is not done? If so, what
is the age limit?
(3) What steps have been taken to ensure
the compliance by the Company with
federal statutes prohibiting age
discrimination in hiring?
q. Salary withholding information.
(1) Does the Company maintain an upto-
date file of Form W-4
(withholding information) for each
employee?
(2) Has the Company failed to comply
with withholding requirements?
r. Worker's compensation.
(1) Does the Company maintain the
worker compensation insurance
required by the state on each
employee?
(2) If not, explain.
s. Other. Assess compliance with state and
Federal laws related to the environment,
occupational health and safety, and
antitrust/unfair trade practice
regulations.
t. Material payments on contracts.
(1) List all contracts, presently in force,
on which the Company, directly or
indirectly, is bound, that will not be
completed within 24 months, and
each that involves payments (or
performance of services or delivery
of goods) to or by the Company of a
material account.
(2) Make a schedule of all leases for
real and personal property
requiring payment of a material
amount.
u. Contract forms and significant
provisions.
(1) Do the contract forms presently in
use by the Company meet the
requirements of the Uniform
Commercial Code?
(2) What precautions are taken to
ensure that, upon acceptance,
additional terms are not inserted by
the other party and made part of
the agreement?
(3) Obtain copies of all significant
contract forms utilized by the
Company.
(4) Are any required anti-discrimination
provisions included?
v. Current breaches of material
agreements.
(1) If any party is presently in breach of
any material agreement with the
Company, indicate:
(i) The default,
(ii) The contract penalty for the
breach, if any,
(iii) What action presently is
being taken and
(iv) What action is being
contemplated.
(2) Does the Company take action in
the event of breaches by others?
w. Sales of the Company's products.
(1) Indicate how the Company's sales
are made (i.e., through sales agents,
distributors, independent
contractors, etc.).
Going Public 493
(2) Indicate the authority each type of
selling agent possesses.
(3) If sales agents have limited authority,
what steps are taken to publish this
authority to those with whom the
agent deals?
(4) If independent contractors are used,
are they permitted to set prices? Are
they given a sales quota? Are they
truly independent contractors?
x. Identification of agents.
(1) List the titles and positions of those
who, under a reasonable interpretation
of the statutory and case law of
the jurisdiction in which they sell for
the Company, could be considered
agents of the Company.
(2) Do any such agents act through
contractual relationships?
y. Sales forms.
(1) Does the Company have sales forms
that are considered to be offers
tendered for acceptance by the
purchaser, or
(2) Does the Company have forms that
are considered offers to the Company
when executed by a purchaser? If the
latter is used, is acceptance accomplished
at the home office or by the
agent in the field?
z. Direct sales.
(1) List those jurisdictions in which
direct sales are made by the
Company.
(2) List those jurisdictions in which
direct sales are made through an
independent contractor or
distributor.
(3) List those jurisdictions in which
direct sales are made only via
communications in interstate
commerce.
aa. Trade associations.
(1) Indicate whether the Company is a
member of any trade association(s).
(2) List all such organizations with
which the Company has
any contract.
(3) Indicate the relationship between
the Company and such organizations.
(4) Indicate whether any of the organizations
above listed have been investigated
by any state or federal group,
either administrative, judicial, or
legislative, for possible anti-trust
violations during the last five years.
(5) If so, explain in detail the outcome
of the investigation and what
impact, if any, this had on the
Company.
bb. Material transactions with insiders
and affiliates.
(1) Obtain material of any material
transactions within the last five
fiscal years with any insider (i.e.,
any director, officer or substantial
owner of the Company's securities)
or any associate of, or entity
affiliated with, an insider.
4. Regulation and litigation.
a. Various items relating to regulation
litigation.
(1) Obtain all letters sent to the
Company's independent auditors in
connection with its audits for the
past five fiscal years, including
"litigation letters."
494 Making Key Strategic Decisions
(2) Obtain copies of letters from the
auditors to the Company regarding its
internal management controls.
(3) Obtain active litigation files for
material litigation, including letters
asserting claims, complaints,
answers, etc.
(4) Obtain any settlement documents for
material litigation.
(5) Obtain any decrees, orders, or
judgments of courts or governmental
agencies.
(6) Obtain information regarding any
material litigation to which the
Company is a party or in which it may
become involved.
(7) Obtain audited financial statements
(five years).
(8) Obtain recent forward-looking
budgets for the next two fiscal years
prepared on a monthly basis (if
available).
(9) Obtain recent five-year projections
(if available).
b. Pricing policies.
(1) Does the Company, in its pricing
policies, follow an industrial leader?
(2) If so, which competitor does the
Company follow as leader?
(3) If not, how are the Company's
pricing policies determined?
c. Compliance with building codes.
(1) Is the Company in compliance with
all building codes (or other similar
local governmental codes) that are
applicable to it?
(2) If not, explain.
(3) Indicate the approximate date of the
last time the Company's facilities
were checked by local governmental
authorities for possible violations
of local governmental codes, and
indicate the results of such
investigation.
(4) If any of the Company's facilities
are borderline, indicate any
remedial steps that should be
undertaken at this time.
(5) List any warnings that the
Company has received within the
past three years for the violation of
any local governmental codes.
(6) List the date and amounts of fines,
if any, paid to any local governmental
authority for violation of
local codes, other than the traffic
code, paid by the Company during
the last three years.
d. Contract defaults.
(1) Is the Company presently in
default under any contractual
arrangement?
(2) If so, explain the default and
indicate the penalties arising out of
such default.
e. Liens.
(1) List all liens presently in force
against the Company's property,
both real and personal.
(2) Have any actions been taken in
respect to any such liens?
f. Legal action.
(1) List all legal actions presently
pending or known to be
contemplated in which the
Company might have an
involvement.
Going Public 495
(2) Ascertain the identity of legal
counsel representing the Company
in such matters.
g. Assignment of patents, trademarks,
and copyrights.
(1) Obtain the form used in which
employees assign to the Company
any patent, trademark, and/or
copyright that might arise from
inventions discovered while
working for the Company, together
with a list of the employees who
have signed the contract. If a form
is not used, should it be?
(2) Does the Company have
nondisclosure agreements with
employees?
h. Surety bonds.
(1) Indicate those employees (by title
or position) who are presently
covered by a fidelity or other
surety bonds.
(2) What are the amounts of any
such bonds?
i. Charitable contributions.
(1) Indicate the number and amount
of charitable contributions made
by the Company in each of the
last two years in the following
categories: (i) religious,
(ii) educational, (iii) other.
(2) Does the Company have any policy
regarding employee charitable
contributions?
j. Lobbying activities/political campaigns
(1) Indicate whether the Company is
engaged in any lobbying activities
or political campaigns and, if so,
to what extent, and at what
financial cost.
(2) Does the Company retain any
lobbying firms?
k. Tax compliance.
(1) Does the Company file all required
tax reports?
(2) If not, explain.
(3) How long are tax records kept?
(4) Does the Company have its tax
records reviewed periodically for
compliance with tax laws?
(5) How often are the tax reports
reviewed and by whom?
(6) Does the Company utilize tax
counsel in the planning phase of
transactions?
(7) If so, is tax advice rendered by
house counsel or outside counsel?
(8) How are audits by governmental
tax authorities conducted?
l. Year 2000 compliance.
(1) Assess the affect on the company of
its compliance with the Year 2000
transition, taking into account the
costs, potential disruptions of
productivity, potential liabilities
related to company products or
services, and compliance by
suppliers.
m. Subsidiary information.
(1) Identify the Company's
subsidiaries.
(2) Where material, provide the
information above with respect to
each subsidiary of the Company.
496 Making Key Strategic Decisions
K. Review Officers' and Directors'
Questionnaire
1. Obtain from the Company's counsel
the "officers' and directors' questionnaire"
to gather information on the
Company's officers and directors,
their remuneration and employee
benefits, and material transactions
that they have had with the
Company.
2. Compare the information disclosed
in the questionnaire with the
disclosure required by the applicable
registration form, especially in regard
to:
a. Insider transactions and loans.
b. NASD Regulation affiliations.
c. Litigation.
d. Cheap stock.
e. Stock ownership.
L. Check of Order Backlogs
1. Compare oral purchase orders or
oral changes to written purchase
orders.
2. Do cancellation provisions exist in
standard purchase orders, including
any penalties for cancellation?
3. Are there indications that
outstanding offers may be "soft," or
subject to cancellation?
M. Detailed Review of Draft of
Registration Statement
1. Read the draft of the registration
statement carefully for content.
2. Read the draft of the registration
statement a second time against:
a. The items of the applicable form
(e.g., Form S-1, Form S-2, Form
S-3, Form S-18) and
b. Regulation S-K (to the extent
covered by the applicable form).
(1) Item 501-Forepart of Registration
Statement and Outside Front
Cover Page of Prospectus.
(2) Item 502-Inside Front and
Outside Back Cover Pages of
Prospectus.
(3) Item 503-Summary Information,
Risk Factors, and Ratio of
Earnings to Fixed Charges.
(4) Item 504-Use of Proceeds.
(5) Item 505-Determination of
Offering Price.
(6) Item 506-Dilution.
(7) Item 507-Selling Security
Holders.
(8) Item 508-Plan of Distribution.
(9) Item 509-Interests of Named
Experts.
(10) Item 510-Disclosure of
Commission Position on
Indemnification for Securities Act
Liabilities.
(11) Item 511-Other Expenses of
Issuance and Distribution.
(12) Item 512-Undertakings.
3. Review the registration statement on a
line-by-line basis with appropriate
individuals, including:
a. Officers of the Company responsible
for preparing the registration
statement.
Going Public 497
b. The Company's counsel.
c. Representative of the Company's
certified public accountants.
4. Based on the information elicited
through discussions with various
individuals, encourage that the
registration statement be revised in an
effort to improve upon
its disclosure.
5. After a revised draft of the registration
statement is available, see that it is
distributed to all directors and key
officials.
6. Review the Company's procedures for
collecting and evaluating comments
on the registration statement from
those persons to whom it has been
furnished.
N. Review of Other Documents
1. Review documents not previously
furnished, including those of a
confidential nature that the Company
would prefer not to be taken from its
offices, including:
a. Five-year plans.
b. Financial forecasts.
c. Budgets.
d. Periodic reports by operating units
to senior management or the board
of directors.
e. Letters of comment received by the
Company in connection with prior
registration statements.
f. At least the most recent
management letter prepared by the
accountants in connection with
their audit.
O. Review During Negotiation of Underwriting
Agreement
1. During negotiations on representations
and warranties in the underwriting
agreement, be sensitive to potential
problems that arise and may need to be
disclosed in the registration statement.
2. Review legal counsel's summary of the
Company's minutes.
III. Summary Analysis
A. Prior to effectiveness of registration
statement, prepare a memorandum
summarizing the due diligence investigation,
including the dates of any visits to principal
facilities, meetings with management, and
registration statement review sessions.
B. Have this memorandum reviewed by counsel
for the underwriters.
SOURCE: The NASDAQ Stock Market, Inc.
498 Making Key Strategic Decisions
APPENDIX B
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM S-1
REGISTRATION STATEMENT UNDER THE
SECURITIES ACT OF 1933
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of incorporation or organization)
(Primary Standard Industrial Classification Code Number)
(I.R.S. Employer Identification Number)
(Address, including zip code, and telephone number, including area
code, of registrant's principal executive offices)
(Name, address, including zip code, and telephone number,
including area code, of agent for service)
(Approximate date of commencement of proposed sale to the public)
If any of the securities being registered on this Form are to be offered on a delayed
or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box:
If this Form is filed to register additional securities for an offering pursuant to
Rule 462(b) under the Securities Act, please check the following box and list
the Securities Act registration statement number of the earlier effective registration
statement for the same offering. .
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under
the Securities Act, check the following box and list the Securities Act registration
statement number of the earlier effective registration statement for the
same offering.
Going Public 499
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under
the Securities Act, check the following box and list the Securities Act registration
statement number of the earlier effective registration statement for the
same offering.
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box.
Calculation of Registration Fee
Note: Specific details relating to the fee calculation shall be furnished in notes
to the table, including references to provisions of Rule 457 (§ 230.457 of this
chapter) relied upon, if the basis of the calculation is not otherwise evident
from the information presented in the table. If the filing fee is calculated pursuant
to Rule 457(o) under the Securities Act, only the title of the class of securities
to be registered, the proposed maximum aggregate offering price for
that class of securities, and the amount of registration fee need to appear in the
Calculation of Registration Fee table. Any difference between the dollar
amount of securities registered for such offerings and the dollar amount of securities
sold may be carried forward on a future registration statement pursuant
to Rule 429 under the Securities Act.
GENERAL INSTRUCTIONS
I. Eligibility Requirements for Use of Form S-1
This Form shall be used for the registration under the Securities Act of 1933
("Securities Act") of securities of all registrants for which no other form is authorized
or prescribed, except that this Form shall not be used for securities of
foreign governments or political subdivisions thereof.
II. Application of General Rules and Regulations
A. Attention is directed to the General Rules and Regulations under the Securities
Act, particularly those comprising Regulation C (17 CFR 230.400 to
230.494) thereunder. That Regulation contains general requirements regarding
the preparation and filing of the registration statement.
B. Attention is directed to Regulation S-K (17 CFR Part 229) for the requirements
applicable to the content of the nonfinancial statement portions of
registration statements under the Securities Act. Where this Form directs the
Title of Each
Class of
Securities to
Be Registered
Amount to Be
Registered
Proposed
Maximum
Offering Price
per Unit
Proposed
Maximum
Aggregate
Offering Price
Amount
of Registration
Fee
500 Making Key Strategic Decisions
registrant to furnish information required by Regulation S-K and the item of
Regulation S-K so provides, information need only be furnished to the extent
appropriate.
III. Exchange Offers
If any of the securities being registered are to be offered in exchange for securities
of any other issuer, the prospectus shall also include the information
which would be required by item 11 if the securities of such other issuer were
registered on this Form. There shall also be included the information concerning
such securities of such other issuer which would be called for by Item 9 if
such securities were being registered. In connection with this instruction, reference
is made to Rule 409.
IV. Roll-up Transactions
If the securities to be registered on this Form will be issued in a roll-up transaction
as defined in Item 901(c) of Regulation S-K (17 CFR 229.901(c)), attention
is directed to the requirements of Form S-4 applicable to roll-up
transactions, including, but not limited to, General Instruction I.
V. Registration of Additional Securities
With respect to the registration of additional securities for an offering pursuant
to Rule 462(b) under the Securities Act, the registrant may file a registration
statement consisting only of the following: the facing page; a statement
that the contents of the earlier registration statement, identified by file
number, are incorporated by reference; required opinions and consents; the
signature page; and any price-related information omitted from the earlier registration
statement in reliance on Rule 430A that the registrant chooses to include
in the new registration statement. The information contained in such a
Rule 462(b) registration statement shall be deemed to be a part of the earlier
registration statement as of the date of effectiveness of the Rule 462(b) registration
statement. Any opinion or consent required in the Rule 462(b) registration
statement may be incorporated by reference from the earlier registration
statement with respect to the offering, if: (i) such opinion or consent expressly
provides for such incorporation; and (ii) such opinion relates to the securities
registered pursuant to Rule 462(b). See Rule 411(c) and Rule 439(b) under the
Securities Act.
PART I—INFORMATION REQUIRED IN PROSPECTUS
Item 1. Forepart of the Registration Statement and Outside Front
Cover Page of Prospectus.
Set forth in the forepart of the registration statement and on the outside
front cover page of the prospectus the information required by Item 501 of
Regulation S-K (§ 229.501 of this chapter).
Going Public 501
Item 2. Inside Front and Outside Back Cover Pages of Prospectus.
Set forth on the inside front cover page of the prospectus or, where permitted,
on the outside back cover page, the information required by Item 502
of Regulation S-K (§ 229.502 of this chapter).
Item 3. Summary Information, Risk Factors, and Ratio of Earnings
to Fixed Charges.
Furnish the information required by Item 503 of Regulation S-K
(§ 229.503 of this chapter).
Item 4. Use of Proceeds.
Furnish the information required by Item 504 of Regulation S-K
(§ 229.504 of this chapter).
Item 5. Determination of Offering Price.
Furnish the information required by Item 505 of Regulation S-K
(§ 229.505 of this chapter).
Item 6. Dilution.
Furnish the information required by Item 506 of Regulation S-K
(§ 229.506 of this chapter).
Item 7. Selling Security Holders.
Furnish the information required by Item 507 of Regulation S-K
(§ 229.507 of this chapter).
Item 8. Plan of Distribution.
Furnish the information required by Item 508 of Regulation S-K
(§ 229.508 of this chapter).
Item 9. Description of Securities to Be Registered.
Furnish the information required by Item 202 of Regulation S-K
(§ 229.202 of this chapter).
Item 10. Interests of Named Experts and Counsel.
Furnish the information required by Item 509 of Regulation S-K
(§ 229.509 of this chapter).
Item 11. Information with Respect to the Registrant.
Furnish the following information with respect to the registrant:
(a) Information required by Item 101 of Regulation S-K (§ 229.101 of
this chapter), description of business;
(b) Information required by Item 102 of Regulation S-K (§ 229.102 of
this chapter), description of property;
(c) Information required by Item 103 of Regulation S-K (§ 229.103 of
this chapter), legal proceedings;
502 Making Key Strategic Decisions
(d) Where common equity securities are being offered, information required
by Item 201 of Regulation S-K (§ 229.201 of this chapter),
market price of and dividends on the registrant's common equity
and related stockholder matters;
(e) Financial statements meeting the requirements of Regulation S-X
(17 CFT Part 210) (Schedules required under Regulation S-X shall
be filed as "Financial Statement Schedules" pursuant to Item 15,
Exhibits and Financial Statement Schedules, of this Form), as well
as any financial information required by Rule 3-05 and Article 11 of
Regulation S-X;
(f ) Information required by Item 301 of Regulation S-K (§ 229.301 of
this chapter), selected financial data;
(g) Information required by Item 302 of Regulation S-K (§ 229.302 of
this chapter), supplementary financial information;
(h) Information required by Item 303 of Regulation S-K (§ 229.303 of
this chapter), management's discussion and analysis of financial condition
and results of operations;
(i) Information required by Item 304 of Regulation S-K (§ 229.304 of
this chapter), changes in and disagreements with accountants on accounting
and financial disclosures;
(j) Information required by Item 305 of Regulation S-K (§ 229.305 of
this chapter), quantitative and qualitative disclosures about market
risk;
(k) Information required by Item 401 of Regulation S-K (§ 229.401 of
this chapter), directors and executive officers;
(l) Information required by Item 402 of Regulation S-K (§ 229.402 of
this chapter), executive compensation;
(m) Information required by Item 403 of Regulation S-K (§ 229.403 of
this chapter), security ownership of certain beneficial owners and
management; and
(n) Information required by Item 404 of Regulation S-K (§ 229.404 of
this chapter), certain relationships and related transactions.
Item 12. Disclosure of Commission Position on Indemnification for
Securities Act Liabilities.
Furnish the information required by Item 510 of Regulation S-K
(§ 229.510 of this chapter).
PART II—INFORMATION NOT REQUIRED IN PROSPECTUS
Item 13. Other Expenses of Issuance and Distributions.
Furnish the information required by Item 511 of Regulation S-K
(§ 229.511 of this chapter).
Going Public 503
Item 14. Indemnification of Directors and Officers.
Furnish the information required by Item 702 of Regulation S-K
(§ 229.702 of this chapter).
Item 15. Recent Sales of Unregistered Securities.
Furnish the information required by Item 701 of Regulation S-K
(§ 229.701 of this chapter).
Item 16. Exhibits and Financial Statement Schedules.
(a) Subject to the rules regarding incorporation by reference, furnish
the exhibits as required by Item 601 of Regulation S-K (§ 229.601
of this chapter).
(b) Furnish the financial statement schedules required by Regulation
S-X (17 CFR Part 210) and Item 11(3) of this Form. These schedules
shall be lettered or numbered in the manner described for exhibits
in paragraph (a).
Item 17. Undertakings.
Furnish the undertakings required by Item 512 of Regulation S-K
(§ 229.512 of this chapter).
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the registrant
has duly caused this registration statement to be signed on its behalf by the
undersigned, thereunto duly authorized in the City of , State
of , on , 20 .
(Registrant)
By (Signature and Title)
Pursuant to the requirements of the Securities Act of 1933, this registration
statement has been signed by the following persons in the capacities and on the
dates indicated.
(Signature)
(Title)
(Date)
504 Making Key Strategic Decisions
Instructions.
1. The registration statement shall be signed by the registrant, its principal
executive officer or officers, its principal financial officer, its controller
or principal accounting officer, and by at least a majority of the board of
directors or persons performing similar functions. If the registrant is a
foreign person, the registration statement shall also be signed by its authorized
representative in the United States. Where the registrant is a
limited partnership, the registration statement shall be signed by a majority
of the board of directors of any corporate general partner signing the
registration statement.
2. The name of each person who signs the registration statement shall be
typed or printed beneath his or her signature. Any person who occupies
more than one of the specified positions shall indicate each capacity in
which he or she signs the registration statement. Attention is directed to
Rule 402 concerning manual signatures and to Item 601 of Regulation S-K
concerning signatures pursuant to powers of attorney.
Going Public 505
APPENDIX C
COMFORT LETTER
AICPA Professional Standards
(Updated as of January 1, 2000)
Copyright c 2000, American Institute of Certified Public Accountants Inc.
[Note: dating throughout, in 1900s]
1. The contents of comfort letters vary, depending on the extent of the information
in the registration statement and the wishes of the underwriter or
other requesting party. Shelf registration statements may have several closing
dates and different underwriters. Descriptions of procedures and findings
regarding interim financial statements, tables, statistics, or other
financial information that is incorporated by reference from previous 1934
Act filings may have to be repeated in several comfort letters. To avoid restating
these descriptions in each comfort letter, accountants may initially
issue the comments in a format (such as an appendix) that can be referred
to in, and attached to, subsequently issued comfort letters.
Example A: Typical Comfort Letter
2. A typical comfort letter includes—
a. A statement regarding the independence of the accountants (paragraphs
.31 and .32).
b. An opinion regarding whether the audited financial statements and financial
statement schedules included (incorporated by reference) in the
registration statement comply as to form in all material respects with
the applicable accounting requirements of the Act and related rules and
regulations adopted by the SEC (paragraphs .33 and .34).
c. Negative assurance on whether—
(1) The unaudited condensed interim financial information included
(incorporated by reference) in the registration statement (paragraph
.37) complies as to form in all material respects with the applicable
accounting requirements of the Act and the related rules
and regulations adopted by the SEC.
(2) Any material modifications should be made to the unaudited condensed
consolidated financial statements included (incorporated
by reference) in the registration statement for them to be in conformity
with generally accepted accounting principles.
d. Negative assurance on whether, during a specified period following
the date of the latest financial statements in the registration statement
and prospectus, there has been any change in capital stock, increase in
506 Making Key Strategic Decisions
long-term debt, or any decrease in other specified financial statement
items (paragraphs .45 through .53).
Example A is a letter covering all these items. Letters that cover some of
the items may be developed by omitting inapplicable portions of example A.
Example A assumes the following circumstances. The prospectus (Part I
of the registration statement) includes audited consolidated balance sheets as
of December 31, 19X5 and 19X4, and audited consolidated statements of income,
retained earnings (stockholders' equity), and cash f lows for each of the
three years in the period ended December 31, 19X5. Part I also includes an
unaudited condensed consolidated balance sheet as of March 31, 19X6, and
unaudited condensed consolidated statements of income, retained earnings
(stockholders' equity), and cash flows for the three-month periods ended
March 31, 19X6 and 19X5, reviewed in accordance with section 722 but not
previously reported on by the accountants. Part II of the registration statement
includes audited consolidated financial statement schedules for the three years
ended December 31, 19X5. The cutoff date is June 23, 19X6, and the letter is
dated June 28, 19X6. The effective date is June 28, 19X6.
Each of the comments in the letter is in response to a requirement of the
underwriting agreement. For purposes of example A, the income statement
items of the current interim period are to be compared with those of the corresponding
period of the preceding year.
June 28, 19X6
[Addressee]
Dear Sirs:
We have audited the consolidated balance sheets of The Blank Company
Inc. (the company) and subsidiaries as of December 31, 19X5 and 19X4, and the
consolidated statements of income, retained earnings (stockholders' equity),
and cash f lows for each of the three years in the period ended December 31,
19X5, and the related financial statement schedules all included in the registration
statement (no. 33-00000) on Form S-1 filed by the company under the
Securities Act of 1933 (the Act); our reports with respect thereto are also included
in that registration statement. The registration statement, as amended
on June 28, 19X6, is herein referred to as the registration statement. In connection
with the registration statement—
1. We are independent certified public accountants with respect to the
company within the meaning of the Act and the applicable rules and regulations
thereunder adopted by the SEC.
2. In our opinion [include the phrase "except as disclosed in the registration
statement," if applicable], the consolidated financial statements and
financial statement schedules audited by us and included in the registration
statement comply as to form in all material respects with the applicable
Going Public 507
accounting requirements of the Act and the related rules and regulations
adopted by the SEC.
3. We have not audited any financial statements of the company as of any
date or for any period subsequent to December 31, 19X5; although we have
conducted an audit for the year ended December 31, 19X5, the purpose (and
therefore the scope) of the audit was to enable us to express our opinion on the
consolidated financial statements as of December 31, 19X5, and for the year
then ended, but not on the financial statements for any interim period within
that year. Therefore, we are unable to and do not express any opinion on the
unaudited condensed consolidated balance sheet as of March 31, 19X6, and the
unaudited condensed consolidated statements of income, retained earnings
(stockholders' equity), and cash flows for the three-month periods ended
March 31, 19X6 and 19X5, included in the registration statement, or on the financial
position, results of operations, or cash f lows as of any date or for any
period subsequent to December 31, 19X5.
4. For purposes of this letter we have read the 19X6 minutes of meetings
of the stockholders, the board of directors, and [include other appropriate
committees, if any] of the company and its subsidiaries as set forth in the
minute books at June 23, 19X6, officials of the company having advised us that
the minutes of all such meetings through that date were set forth therein; we
have carried out other procedures to June 23, 19X6, as follows (our work did
not extend to the period from June 24, 19X6, to June 28, 19X6, inclusive):
a. With respect to the three-month periods ended March 31, 19X6
and 19X5, we have—
(1) Performed the procedures specified by the American Institute
of Certified Public Accountants for a review of interim financial information
as described in SAS No. 71, Interim Financial Information,
on the unaudited condensed consolidated balance sheet as of
March 31, 19X6, and unaudited condensed consolidated statements
of income, retained earnings (stockholders' equity), and cash flows
for the three-month periods ended March 31, 19X6 and 19X5, included
in the registration statement.
(2) Inquired of certain officials of the company who have responsibility
for financial and accounting matters whether the unaudited
condensed consolidated financial statements referred to in a(1) comply
as to form in all material respects with the applicable accounting
requirements of the Act and the related rules and regulations
adopted by the SEC.
b. With respect to the period from April 1, 19X6, to May 31, 19X6, we
have—
(1) Read the unaudited consolidated financial statements of the
company and subsidiaries for April and May of both 19X5 and 19X6
508 Making Key Strategic Decisions
furnished us by the company, officials of the company having advised
us that no such financial statements as of any date or for any
period subsequent to May 31, 19X6, were available.
(2) Inquired of certain officials of the company who have responsibility
for financial and accounting matters whether the unaudited
consolidated financial statements referred to in b(1) are stated on a
basis substantially consistent with that of the audited consolidated
financial statements included in the registration statement.
The foregoing procedures do not constitute an audit conducted in accordance
with generally accepted auditing standards. Also, they would not necessarily
reveal matters of significance with respect to the comments in the
following paragraph. Accordingly, we make no representations regarding the
sufficiency of the foregoing procedures for your purposes.
5. Nothing came to our attention as a result of the foregoing procedures,
however, that caused us to believe that—
a. (1) Any material modifications should be made to the unaudited
condensed consolidated financial statements described in 4a(1), included
in the registration statement, for them to be in conformity
with generally accepted accounting principles.
(2) The unaudited condensed consolidated financial statements described
in 4a(1) do not comply as to form in all material respects
with the applicable accounting requirements of the Act and the related
rules and regulations adopted by the SEC.
b. (1) At May 31, 19X6, there was any change in the capital stock, increase
in long-term debt, or decrease in consolidated net current assets
or stockholders' equity of the consolidated companies as
compared with amounts shown in the March 31, 19X6, unaudited
condensed consolidated balance sheet included in the registration
statement, or
(2) for the period from April 1, 19X6, to May 31, 19X6, there were
any decreases, as compared to the corresponding period in the preceding
year, in consolidated net sales or in the total or per-share
amounts of income before extraordinary items or of net income, except
in all instances for changes, increases, or decreases that the registration
statement discloses have occurred or may occur.
6. As mentioned in 4b, company officials have advised us that no consolidated
financial statements as of any date or for any period subsequent to
May 31, 19X6, are available; accordingly, the procedures carried out by us with
respect to changes in financial statement items after May 31, 19X6, have, of necessity,
been even more limited than those with respect to the periods referred
to in 4. We have inquired of certain officials of the company who have responsibility
for financial and accounting matters whether
Going Public 509
(a) at June 23, 19X6, there was any change in the capital stock, increase
in long-term debt, or any decreases in consolidated net current assets or
stockholders' equity of the consolidated companies as compared with
amounts shown on the March 31, 19X6, unaudited condensed consolidated
balance sheet included in the registration statement or
(b) for the period from April 1, 19X6, to June 23, 19X6, there were any
decreases, as compared with the corresponding period in the preceding
year, in consolidated net sales or in the total or per-share amounts
of income before extraordinary items or of net income. On the basis of
these inquiries and our reading of the minutes as described in 4, nothing
came to our attention that caused us to believe that there was any
such change, increase, or decrease, except in all instances for changes,
increases, or decreases that the registration statement discloses have
occurred or may occur.
7. This letter is solely for the information of the addressees and to assist
the underwriters in conducting and documenting their investigation of the affairs
of the company in connection with the offering of the securities covered
by the registration statement, and it is not to be used, circulated, quoted, or otherwise
referred to within or without the underwriting group for any purpose,
including but not limited to the registration, purchase, or sale of securities, nor
is it to be filed with or referred to in whole or in part in the registration statement
or any other document, except that reference may be made to it in the underwriting
agreement or in any list of closing documents pertaining to the
offering of the securities covered by the registration statement.
510
15 THE BOARD
OF DIRECTORS
Charles A. Anderson
Robert N. Anthony
This chapter describes the nature and function of the board of directors,
which has the ultimate responsibility for governing a corporation. It describes
the board's activities in normal meetings, in strategy meetings, and in special
situations, and it describes the work of three important board committees: the
compensation committee, the audit committee, and the finance committee.
We focus on large corporations whose stock is listed on a securities exchange.
These corporations must conform to regulations of the Securities and
Exchange Commission. Most of the discussion is also relevant to boards of
smaller corporations.
WHY HAVE A BOARD OF DIRECTORS?
Every corporation is required by law to have a board of directors. The board's
legal function is to govern the corporation's affairs. However, in a small corporation
in which the chief executive officer (CEO) is also the controlling shareholder,
the CEO actually governs and the board acts primarily as an adviser.
When a corporation grows to a size where it needs outside capital, it may
go public by selling shares of stock (as explained in Chapter 14), and the board
then represents the interests of these shareholders. The shareholders, who are
the owners of the corporation, have a say in the way their company is run.
They expect to receive regular, reliable reports on the company's operations.
If the company is profitable, they probably expect to receive dividends. If the
The Board of Directors 511
company has problems, the owners need to know about these problems so that
they can take any necessary remedial action.
A corporation may have many shareholders; American Telephone & Telegraph
Corporation has 2.6 million. Individual shareholders obviously can't govern
the company directly; moreover, most of them are engaged in their own
pursuits and will not give much, if any, time to governance. They elect people
to act for them. This is the board of directors.
SIZE AND COMPOSITION OF THE BOARD
The typical board has about 11 members. Some boards, especially those in
banks, are much larger. Large boards must delegate much of their work to an
executive committee for overall matters and to several committees for specific
topics.
Most board members typically are "outside directors"; that is, they are
not employees of the corporation. At one time, most board members were "inside
directors," and this is still the case in a few boards. The trend toward outside
directors results from the shareholders' recognition that the board should
have a significant degree of independence from the company's management.
The board is responsible for selecting, appraising, and compensating management.
If the board and management are the same people, the board can hardly
perform its governance role in an objective manner.
Many outside board members are CEOs or senior officers of other corporations
(but not competitors). Other outsiders are lawyers, bankers, physicians
(on health-care boards), scientists and engineers (on high-tech boards), retired
government officials, and academics. A few people are professional board
members; that is, their principal occupation is serving on boards. The number
of female and minority board members has increased substantially in recent
years. The CEO and perhaps one or two senior members of management typically
are members of the board.
Board members are compensated. Generally, they receive an annual retainer
plus a fee for meetings attended. In addition, many companies offer
some form of stock compensation and retirement benefits. According to a
Conference Board survey, the median basic annual compensation in manufacturing
companies for 1999 (not including stock components) was $35,000.
When the value of the stock component was added, compensation totaled
$46,000.
Board members are elected at the annual meeting of shareholders. The
shareholders almost always elect the slate proposed by the incumbent board;
thus, as a practical matter, the board is self-perpetuating. The process of selecting
candidates for filling board vacancies is an important board function.
Many have staggered terms; that is, one-third of the board members are
elected each year for a three-year term. This practice is intended to make it
more difficult for corporate raiders to obtain control of the company.
512 Making Key Strategic Decisions
BOARD MEMBER RESPONSIBILITIES
In the following sections, we describe the specific activities for which the
board is responsible. In this section, we describe the responsibilities of individual
board members.
Board members must not personally buy stock or sell their own stock immediately
after they learn of important developments at board meetings or
other activities. Examples of relevant developments include current estimates
of earnings, change in dividend policy, a decision to acquire another company
or to buy back stock, and changes in senior management. The Securities and
Exchange Commission and rules of the stock exchanges impose an "earnings
blackout" period of one or two days in which such trading is prohibited.
Board members and management must not disclose any of these events to
a selected group of interested parties. For example, they must not make a telephone
conference call to a selected group, send an Internet message to them, or
disclose information at a meeting of such a group. When this information is disclosed,
it must be made available at the same time to the general public. These
rules were significantly tightened in 1999 and 2000 by SEC Regulation FD.
RELATION TO THE CHIEF EXECUTIVE OFFICER
Their titles indicate that the board of directors "directs" and the chief executive
officer "executes" the board's directions, but these terms are not an accurate
description of the roles of these two parties. In the majority of companies,
the chief executive officer is also the board's chairman and is the principal architect
of policies. Executing these policies is indeed a primary responsibility.
The CEO is truly the "chief."
The board selects the CEO and, therefore, wants to give the CEO its full
support. The CEO is accountable to the board and may be terminated if the
board decides that the individual's performance was unsatisfactory.
The appropriate relationship is one of trust. The board must believe that
the CEO is completely trustworthy, provides the board with all the information
it wants and needs, withholds nothing, and doesn't slant arguments to support
a preconceived position. The CEO, in turn, must believe that he or she has
the full support of the board.
Appraising the CEO
A board's major responsibility is to appraise the CEO. If performance is below
expectations, there are two possible explanations: (1) The CEO is to blame, or
(2) extraneous inf luences are responsible. In most cases, both factors are involved,
and the directors have the extraordinarily difficult job of judging their
relative importance. If they conclude that the CEO has made an incorrect decision,
they may suggest a different course of action. More likely, however, they
The Board of Directors 513
may say nothing and mentally file the incident for future reference in evaluating
the CEO. The Business Roundtable, a group of CEOs of leading companies,
succinctly described the directors' role vis-a-vis the CEO as "challenging, yet
supportive and positive."
An important function of board meetings, conversations, and even social
occasions is to give the directors a basis for continuously appraising the CEO.
Directors usually cannot make constructive suggestions on the details of current
operations. Occasionally, they may call attention to a matter that should be
investigated. Primarily, however, they listen carefully to what the CEO says
and do their best to judge whether things are going satisfactorily and, if not,
where the responsibility lies.
The directors want the CEO to be frank and to give an accurate analysis
of the company's status and prospects; concealing bad news is one of the worst
sins a CEO can commit. Nevertheless, human nature is such that directors cannot
expect the CEO to be completely objective. Incipient problems may go
away, and making them known, even in the relative privacy of the boardroom,
may cause unnecessary alarm. Directors, therefore, are on the alert for indications
of significant problems. In many well-publicized bankruptcies of public
companies, the directors were significantly responsible; they did not identify
or act on the problem soon enough.
Louis B. Cabot, former chairman of the board of Cabot Corporation, had
a frustrating experience with the ill-fated Penn Central Corporation. He joined
the Penn Central board about a year before the company went under. From the
outset, he was disturbed by management's unwillingness to furnish the information
about performance that he felt he needed. A few months after joining
the board, he wrote the CEO a letter that contains the following succinct description
of the director's role:
I believe directors should not be the managers of a business, but they should ensure
the excellence of its management's performance. To do this, they have to
measure that performance against agreed-upon yardsticks.
The Next CEO
The board cannot tell beforehand whether a candidate will make a good CEO.
The best indicator is how well the individual performs in his or her current job.
In most instances, therefore, the board looks to senior executives with proven
track records as candidates for the CEO position. One of the most important
responsibilities that a board assigns to a CEO is to develop a succession plan
for the company's senior managers. The purpose of such a plan is to identify
potential CEO candidates, provide them with opportunities for growth, and
groom them for higher level positions. The board participates actively in this
process by meeting with the CEO (usually once a year) in a meeting devoted
largely to reviewing the senior management. Typical questions asked are: How
is a key executive performing? What is his or her potential? Who are potential
successors for the CEO, now and in the future?
514 Making Key Strategic Decisions
At one company the authors are familiar with, the chairman and CEO
held an annual meeting of the outside directors to discuss succession. He referred
to it as the "truck meeting" because he always started with the question,
"Suppose I am run over by a truck tomorrow. What will you do?" At this meeting,
two, and sometimes three, managers were identified as potential CEOs.
Individuals were added to or eliminated from the list and their relative ranking
changed. When this process works properly, an agreed upon CEO candidate is
available in an emergency, and a person who will take over from a retiring
CEO in normal succession is identified.
If boards fail to deal effectively with succession, they may be forced to go
outside the company for a new CEO. Under most circumstances, this increases
the risk that the CEO will not succeed since chances for a successful succession
are usually better when the CEO position is filled by a proven executive
from within the organization. In some cases, an organization may need a "shaking
up" and the board may elect to go outside for a CEO who can give the organization
new life.
NORMAL BOARD MEETINGS
Most boards meet eight, nine, or ten times a year. Some meet only quarterly,
and a few meet every month. The typical meeting lasts two to three hours, but
it may go considerably longer if contentious issues arise.
Premeeting Material
Prior to the meeting, board members are sent an agenda and a packet of material
on topics to be discussed. This homework usually requires several hours of
work. Directors may query the CEO, in person or by a phone call before the
meeting, on matters that require clarification.
Current Situation and Outlook
The first substantive topic on a meeting's agenda usually is a discussion of current
information about the company and its outlook. The CEO leads this discussion,
perhaps delegating part of it to another senior officer. Much of the
information is financial—that is, condensed income statements for each division
or for groups of division, corporate expenses, and key balance sheet items,
such as inventory and receivable amounts. There are three ways to present this
financial information:
1. Compare management's current estimate of performance for the whole
year with budgeted performance for the year. What is the current estimate
of how the company will perform for the whole year? This is the
most important type of information. However, it is also the most sensitive,
and many CEOs do not circulate it prior to the meeting.
The Board of Directors 515
2. Compare actual performance with budgeted performance for the current
period and for the year to date. Because the actual numbers are firm,
they provide a more objective basis for analysis than the current estimate
for the whole year.
3. Compare actual current performance with performance for the same period
last year. A carefully prepared budget incorporates changes in the
business and the economy that have occurred since the prior year, and
this is a more meaningful basis for comparison than last year's numbers.
If, however, the budgeted amounts, particularly the estimate of revenue,
are highly uncertain, the numbers for last year provide a firmer foundation
for comparison.
Variances between actual and budgeted performance are discussed. Are
unfavorable variances temporary? If not, what steps will be taken to eliminate
them, or, if they result from unforeseen outside forces, what adjustments in the
company's operations will be made?
By reviewing the company's financial performance and raising questions
or making suggestions to management, directors form judgments regarding the
company's affairs. Preparing and presenting to the board a report on the company's
performance is an important discipline for management.
Other Actions
Next, a number of proposed actions are submitted for board approval. Many
of these recommendations come to the full board from committees that have
discussed the topics in meetings held prior to the board meeting; these are
described later in this chapter. Questions may be raised about the recommendations,
but usually they are requests for clarification. Board members
rely on committee members to explore these matters thoroughly; there is not
enough time to do so in the full board meeting. Unless new information surfaces,
these recommendations typically are approved.
The board also deals with a number of routine items. These include requests
for approval of capital projects, of signature authority for various
banking connections, of exceptions to pension plans, and of certain types of
contracts. Except for large capital projects, these items are usually referred to
as "boilerplate." In most cases, they come to the board because state law, corporate
bylaws, or written policy requires board action. They are approved with
little discussion, sometimes en bloc, despite the fact that the minutes may state
for each of them, "After a full discussion, a motion to adopt the recommendation
was duly made and seconded, and the motion was approved."
Education
A division manager, assisted by senior associates, may report on the activities
of the division. This is an educational experience for the directors. (Some
516 Making Key Strategic Decisions
board meetings may be held at company plants or other facilities; this also is a
valuable educational device.)
The meeting itself and the informal activities that usually are associated
with it are also educational. Directors have an opportunity to appraise both
company officials and their own colleagues. Judgments about these individuals
may be valuable if the board is required at some time to deal with a crisis
situation.
Setting Standards
Partly through written policy statements, but primarily through their attitudes,
directors communicate to management the standards that they believe
should govern the organization's actions. There are two general types of standards;
they might be labeled economic standards and ethical standards, although
neither term is precisely correct.
With respect to economic standards, the directors communicate the overall
goals they believe the company should attain: the relative importance of
sales growth, earnings per share and return on investment, and the specific
numbers that they believe to be attainable. The board also indicates the relative
importance of short-run versus long-run performance. In the final analysis,
board members generally rely on management's recommendations, but the
enthusiasm, or lack of enthusiasm, with which they support a given recommendation
conveys an important message to management.
Ethical standards are nebulous. Written policy statements are always impeccably
virtuous, but directors' actual expectations are revealed in the way
they react to specific ethical problems. How does the company deal with its female
and minority employees? What happens to an employee who has a drinking
problem? Does the company have a policy concerning support for the
communities in which it operates? These and many other issues are loaded
with ethics, and the manner in which the board reacts to them establishes the
real policy, regardless of what is in a written statement.
It is easy to rely on counsel's answer to the question, Must we report this
unpleasant development to the Securities and Exchange Commission? The answer
depends on the legal interpretation of the regulations. It is much more difficult
for the directors to agree, and to convey to management, that certain
policies or practices, although perhaps within the letter of the law, should not be
allowed or sanctioned. Examples include environmental considerations, employment
practices in Third World countries, and involvement in political issues.
STRATEGY
A company should have a set of strategies that are well thought out and clearly
understood by all managers. Strategies include the industry in which the company
has decided to operate, its product lines within this industry, the price
The Board of Directors 517
and quality position of these products, the targeted customers and markets
(local, regional, national, international), the company's distribution channels
(direct sales, dealers, distributors), marketing policies (advertising, sales promotion),
manufacturing policies (in-house production, plant locations, outside
sourcing), financial policies (balance among borrowing, equity financing, retained
earnings), and others.
The board usually does not have the knowledge necessary to initiate a
strategy or to decide among alternative strategies. It must rely on management
to take the initiative, make the necessary analyses, and bring its recommendations
to the board. What the board can and should do is described by Kenneth
R. Andrews in The Concept of Corporate Strategy.1 He writes, as a summary,
A responsible and effective board should require of its management a unique
and durable corporate strategy, review it periodically for its validity, use it as
the reference point for all other board decisions, and share with management
the risks associated with its adoption.
While it is unrealistic to expect directors to formulate strategies, they
should satisfy themselves that management has a sound process for developing
them. The strategy is probably acceptable if:
• It is based on careful analysis by people who are in the best position to
evaluate it, rather than on an inspiration accepted without study.
• The reasoning seems sensible.
• No significant information has been omitted from the analysis.
• The results expected from the strategy are clearly set forth so that actual
accomplishment can be compared with them.
Strategy Meetings
As a basis for considering strategic plans, many companies arrange a meeting at
which directors, together with senior managers, spend one, two, or three days
discussing where the company should be headed. In order to minimize distractions
and provide an opportunity for informal discussion and ref lection, these
meetings are often held at a retreat that is distant from the corporate offices.
While company practices differ widely, it is not uncommon for meetings devoted
primarily to strategic issues to be held every year or two.
The primary purpose of a strategy meeting is for management to explain
current and planned strategies and the rationales for them. The explanations
provide useful information to the directors. The quality of the rationale for the
strategies indicates the competence of senior management and the managers of
the divisions concerned. Thus, the strategies provide additional insight about
the abilities of the CEO and the participants who may be CEO candidates.
Once adopted, a corporate strategy must be adhered to. Management
brings to the board for decision and approval many matters that may impact a
company's strategy—major capital expenditures, acquisitions, divestitures, and
518 Making Key Strategic Decisions
financing proposals. The board ensures that these proposals are consistent with
the adopted strategy. If they are not, the company can drift off course and may
get into serious trouble.
DEALING WITH MAJOR CRISES
In addition to its regular activities, a board occasionally must deal with crises.
These usually arise unexpectedly and require special board meetings. We describe
two of these: terminating the CEO and dealing with takeover attempts.
Terminating the CEO
There are times when a board must replace the CEO. Failure to act in time is
a major criticism of some boards. Although such criticism may be justified one
should recognize that it is much easier for an outside observer to criticize than
to be in the shoes of the directors who are faced with this decision.
The decision to replace a CEO is subjective and usually emotional. Sometimes
there are compelling reasons for taking action—for example, when the
CEO is becoming an alcoholic or when his or her corporate performance has
dramatically deteriorated. In most instances, however, the case is not so clear.
Earnings may not have kept pace with industry leaders because the board discouraged
management from assuming additional debt that would have enabled
the company to expand. Or perhaps the board supported a major acquisition
that did not work out. In such instances, it is not obvious that the CEO is primarily
at fault.
There are, however, several important signals that can alert a board to
question the CEO's capabilities:
• Loss of confidence in the CEO. If a significant number of directors have
lost confidence in, or no longer trust, the CEO, the individual should be
replaced.
• Continuing deterioration in corporate results. Earnings may be significantly
below industry norms or below the budget without an adequate explanation.
The board must act before it is too late.
• Organizational instability. A CEO who consistently has problems retaining
qualified senior executives probably should be replaced.
These problems are especially serious in the many new companies springing
up in information technology industries. In these industries, change is
rapid, competition is severe, there are no track records on which to base judgment,
and stock prices may change by huge percentages in a few days, ref lecting
changes in investors' opinions about the company's outlook.
It is one thing for board members to begin to doubt the CEO's capabilities,
but it is quite another thing for them to demonstrate the courage and
The Board of Directors 519
consensus needed to take action. The CEO and the directors usually have
worked together for some time; they are good, perhaps close, friends. For the
CEO, dismissal is a catastrophic event. Taking action that will probably destroy
the career of a business associate is a difficult decision.
Replacing the CEO precipitates a crisis, not only for the board but also for
the entire organization. When it happens, the board must be prepared to announce
a successor and to deal with the problems inherent in the transfer of executive
authority. Such action puts a major burden on the outside directors.
Nevertheless, this is their responsibility to the shareholders and to the other
constituencies of the corporation.
For example, in early 2000, Jill E. Barad, CEO of Mattel Inc. the world's
largest toy manufacturer "resigned." Ms. Barad built one of Mattel's f lagship
products, the Barbie doll, from $250 million in annual sales in the mid-1980s to
$1.7 billion in 1999. In the late 1980s, Barbie's growth slowed, and Ms. Barad
turned to acquisitions. Unfortunately, several acquisitions failed to live up to
expectations. A loss of $82 million was recorded for 1999, and Mattel's stock
price dropped from a high of $45 in 1998 to a low of $11 in early 2000. The
board acted, and Ms. Barad "resigned." Apparently the board decided that
there was no suitable successor within the company. They selected Robert
Eckel, formerly CEO of Kraft Foods to be the new CEO.
The turnover of CEOs of major corporations seems to be accelerating in
the twenty-first century. Mr. William Rollinick, a Mattel board member and former
acting chairman, observed that when a chief executive stumbles, "there's
zero forgiveness. You screw up and you're dead." The investing community puts
boards under considerable pressure to act when things appear to be going wrong.
Sarah Telsik, executive director of the Council of Institutional Investors, which
represents 110 pension funds with more than $1.5 trillion in assets, believes that
underperforming CEOs were not losing their jobs fast enough.
Too fast or too slow? A board should decide what is in the long-term best
interests of the company and its stockholders. In some instances, immediate
pressures should be resisted in favor of long-term considerations. In other
cases, the board should "bite the bullet." The decision is not easy.
Unfriendly Takeover Attempts
Another crisis event is the hostile, or unfriendly, takeover attempt. Board decisions
vital to the company's future—even its continued existence—must be
made in circumstances in which emotions are high, vested interests are at
stake, and advice is often conf licting. The business press reports daily the dramatic
developments of offers and counteroffers, tactics, and strategies as each
side in the struggle seeks to gain an advantage. Boards and management spend
much time preparing offensive and defensive plans.
One of the problems in takeover situations is that the board, which represents
the shareholders, may have interests that differ from those of management.
In most successful unfriendly takeovers, the senior managers of the
520 Making Key Strategic Decisions
target company lose their jobs. A common accusation, therefore, is that management
resists takeovers in order to entrench itself, even though the deal
would result in a handsome gain for the shareholders.
In these situations, directors must exercise great care in making a decision
that is in the shareholders' interests. This is not always easy to determine.
What is the intrinsic value of the corporation? What is the real value of the
"junk bonds" being offered to the shareholders? What consideration, if any,
should the directors give to the interests of other parties—employees, communities,
suppliers, and customers?
In an unfriendly takeover attempt, the directors of the target company
must rely on legal advice since takeovers inevitably lead to lawsuits. The board
also depends on expert advice from investment banks about the value of the
company and the true value of offers to acquire it.
In practice, when a hostile takeover is initiated, the target company's
lawyers, investment bankers, accountants, and other advisers, together with
the board and management, become involved in a hectic struggle that can last
for weeks or months. It is a sixteen-hour-day, seven-day-week effort; nearly
everything else yields to the intense preoccupation with survival or striking the
best possible deal.
BOARD COMMITTEES
Much of the board's work is done in committees. They meet before board
meetings, hear reports, and prepare summaries and recommendations for full
board action. In this section, we describe the activities of the three committees—
compensation, audit, and finance—that deal with finance and accounting
matters.
COMPENSATION COMMITTEE
The board determines the compensation of the CEO and the other principal
corporate officers. In many boards, a compensation committee, composed of
outside board members, analyzes what compensation should be and makes its
recommendations to the full board.
The SEC requires that a section of the proxy statement, issued prior to
the annual meeting of shareholders, must describe the work of the compensation
committee, the decisions on compensating senior executives, reasons for
the decision, their compensation for the past three years, and comparisons with
other companies in the industry.
CEO Compensation
When the board sets the CEO's compensation, it is establishing a compensation
standard for managers throughout the company. Their compensation is integrally
The Board of Directors 521
related to the CEO's and this, therefore, is the single most important compensation
decision the board must make.
In most instances this decision is not easy. Most CEOs are ambitious and
competitive, and compensation is their report card. Since proxy statements disclose
the compensation of all CEOs of public companies, each CEO is able to
see just where he or she stands in relation to others. Virtually every CEO would
like to stand higher on that list.
Compensation committees consider three principal factors. The CEO's
compensation should: (1) be related to performance, (2) be competitive, and
(3) provide motivation. Compensation includes not only salary but also
perquisites and, in most companies, long-term incentive arrangements, such as
stock options or performance-share plans. These plans, however, are far from
perfect, and compensation committees constantly struggle to find new
arrangements or formulas in an effort to relate compensation more closely
to performance.
Performance
The CEO's compensation should be related to performance. Superior performance
should be rewarded with high compensation, while poor performance,
if it does not warrant dismissal, should at least result in decreases or minimal
increases in compensation.
There is justification for the claim that in some companies top-executive
compensation continues to climb without regard to performance. The problem
is complex. In theory, the CEO should be rewarded for increasing the shareowner's
wealth over the long term. Although this is a splendid generalization,
the criterion is hard to measure, especially on a year-to-year basis.
Competitive Range
Compensation committees look at the CEO's compensation relative to that of
competitors. They can be sure that their CEO has this information and is likely
to be unhappy if the compensation is perceived as unfair or not competitive.
There are many sources for salary information. They include proxy statements
from similar organizations and published surveys. Some consulting organizations
specialize in executive compensation; they provide data and advice
on these matters. In the end and with all of the information at hand, the committee
makes its judgment as to where in the competitive spectrum they want
the CEO's compensation to fall.
Motivation
Compensation committees ask themselves, How can we structure a compensation
package that motivates the CEO to do what the board expects? If the
company has a plan to move aggressively and take unusual risks in the near
term, with the possibility of significant long-term payoff, the committee can
522 Making Key Strategic Decisions
structure a compensation plan for the CEO that will reward that kind of behavior.
For example, the CEO might have a multiyear contract that provides assurance
of employment during the high-risk phase, as well as a long-term stock
option plan. At the other extreme, a mature company might be interested in
moderate growth but steady dividends. The compensation committee might
then structure a plan weighted heavily toward a fixed salary, reviewed annually,
with only modest incentive features.
There are many types of compensation arrangements: base salary reviewed
annually, base salary plus annual discretionary bonus, base salary
with bonus based on a formula, stock option plans, performance share plans,
and multiyear incentive plans. Benefits play an important part in CEO compensation
arrangements, especially retirement programs. Each plan has its
own motivational features, and the compensation committee attempts to
structure a plan that provides the motivation for the CEO that the board
wants to generate.
Compensation Reviews
In addition to deciding the CEO's compensation, the committee also determines
compensation for the other senior executives—that is, corporate officers
and others whose salary is above a stated level. The review process usually
takes place at a meeting that brings together the compensation committee, the
CEO, and the staff officer concerned with compensation and personnel
policies.
At this meeting the CEO describes the compensation history of, and
makes a recommendation for, each executive. Usually, a few of the recommendations
are discussed, and a few changes may be made. For the most part, however,
the committee accepts the CEO's recommendations. Nevertheless, the
review process is important. It enables the compensation committee to be sure
that the CEO is following sensible guidelines and consistent policies and is not
playing favorites. It also serves to remind the CEO that recommendations to
the committee must be justified.
Board Remuneration
The compensation committee also recommends compensation arrangements
for the board members. Obviously, this is a delicate matter because the board
is disbursing company funds (actually shareholder funds) to its members.
Directors' compensation is disclosed on the annual proxy statement. Most
companies would like to see their directors "respectably" compensated and,
while compensation usually is not the compelling reason for holding a directorship,
directors want to feel that they are being compensated on a competitive
basis. On the other hand, most directors want to feel that their compensation is
not excessive and that they will never be criticized for compensating themselves
improperly.
The Board of Directors 523
Much survey information is available on board retainer fees, board meeting
fees, and compensation for committee chairs to help reach a balanced level
of compensation.
AUDIT COMMITTEE
The audit committee is responsible for ensuring that the company's published
financial statements are presented fairly in conformance with generally accepted
accounting principles (GAAP), and that the company's internal control
system is effective. Furthermore, the audit committee deals with important
cases of alleged misconduct by employees, including violations of the company's
code of ethics. It also ratifies the selection of the company's external auditor.
All companies listed on major stock exchanges are required to have audit
committees, and most other corporations have them. The SEC requires at least
three members of the audit committee to be "financial literate or to become financial
literate within a reasonable period of time."2
Responsibility
Although the full board can delegate certain functions to the audit committee,
this delegation does not relieve individual board members of their responsibility
for governance. In its 1967 decision in the BarChris case, the federal court
emphasized this fact:3
Section 11 [of the Securities Act of 1933] imposes liability in the first instance
upon a director, no matter how new he is. . . . He is presumed to know his responsibility
when he became a director. He can escape liability only by using
that reasonable care to investigate the facts which a prudent man would employ
in the management of his own property.
Directors have directors' and officers' (D&O) insurance, but this only
partially protects them against loss from lawsuits claiming that they acted improperly.
Recent decisions suggest that courts are increasingly willing to examine
directors' decisions. For example, the shareholders of Oxford Health Care
sued the company for misleading financial statements. Oxford's stock price
thereupon fell by 50%, a $14 billion drop in market value. The company reportedly
agreed to settle the case for $2.83 billion. In the 1990s, there were
more than 100 fraud actions annually against SEC firms and many more against
smaller firms.
Audit committee members walk a tightrope. On one hand, they want to
support the CEO—the person whom the board itself selected. On the other
hand, they have a clear responsibility to uncover and act on management inadequacies.
If they do not, the entire board of directors is subject to criticism
at the very least and imprisonment at worst. Their task is neither easy
nor pleasant.
524 Making Key Strategic Decisions
Published Financial Statements
The audit committee does not conduct audits; it relies on two other groups to
do this. One is the outside auditor, a firm of certified public accountants. All
listed companies are required to have their financial statements examined by
an outside auditor, and most other corporations do so in order to satisfy the requirements
of banks and other lenders. The other group is the company's internal
audit staff, a group of employees whose head reports to a senior officer,
usually the CEO or chief financial officer (CFO).
Selection of Auditors
Ordinarily, management recommends that the current auditing firm be appointed
for another year and that its proposed audit scope and fee schedule be
adopted. After some questioning, the audit committee usually recommends approval.
The recommendation is submitted to shareholders in the annual meeting.
Occasionally, the audit committee gives more than routine consideration
to this topic.
There may be advantages to changing auditors, even when the relationship
between the audit firm and the company has been satisfactory for several
years. One advantage is that the process of requesting bids from other firms
may cause the current firm to think carefully about its proposed fees. However,
the public may perceive that a change in outside auditors indicates that
the superseded firm would not go along with a practice that the company
wanted. The SEC requires that when a new auditing firm is appointed, the reason
for making the change must be reported on its Form 8-K. Also, because a
new firm's initial task of learning about the company requires management
time, management may be reluctant to recommend a change.
Public accounting firms often perform various types of consulting engagements
for the company: developing new accounting and control systems,
analyzing proposed pension plans, and analyzing proposed acquisitions. Fees
for this work may exceed the fees for audit work. The SEC and the stock exchanges
have strict rules that prohibit a public accounting firm from conducting
an audit if it has consulting engagements with the corporation that might
affect the objectivity of the audit. Some auditing firms have responded to
these rules by setting up a separate firm to conduct these engagements.
The Audit Opinion
In its opinion letter, the public accounting firm emphasizes the fact that management,
not the auditor, is responsible for the financial statements. Almost all
companies receive a "clean opinion"; that is, the auditor states that the financial
statements "present fairly, in all material respects" the financial status and
performance of the company in accordance with GAAP. Note that this statement
says neither that the statements are 100% accurate nor whether different
The Board of Directors 525
numbers would have been more fair.4 The audit committee's task is to decide
whether the directors should concur with the outside auditor's opinion and, occasionally,
to resolve differences when auditors are unwilling to give a clean
opinion on the numbers that management proposes.
Management has some latitude in deciding the amounts to be reported,
especially the amount of earnings. Since managers are human beings, it is
reasonable to expect them to report performance in a favorable light. Examples
of this tendency, discussed next, are: (1) accelerating revenue, (2) smoothing
earnings, (3) reporting unfavorable developments, and (4) the "big bath."
Much of the discussion of these topics is complicated by differences in the
meaning of "materiality." The SEC has tried to lessen the reliance on materiality
by publishing detailed descriptions of what the term means.
Accelerating Revenue
A company may go to great lengths to count revenues actually earned in future
periods as revenues in the current period, even though this decreases the next
period's revenues. The following example illustrates:
The SEC sued two executives of Sirena Apparel Group for misleading revenue
estimates for the quarter ended March 31, 1999. They instructed employees
daily to set back the computer clock that entered the dates on invoices until a
satisfactory revenue amount was recorded. Invoices dated from April 12, 1999,
were set back.5
Not all attempts to accelerate revenue recognition are improper. There
are documented stories of managers who personally worked around the clock
at year-end, packing goods in containers for shipment. This enabled them to
count the value of the packed goods as revenue in the year that was about to
end. Counting goods that actually were shipped as revenue is legitimate.
Smoothing Earnings
There is a widespread belief (not necessarily supported by the facts) that ideal
performance is a steady growth in earnings, certainly from year to year, and
desirably from quarter to quarter. Within the latitude permitted by GAAP,
therefore, management may wish to smooth reported earnings—that is, to
move reported income from what otherwise would be a highly profitable period
to a less profitable period. The principal techniques for doing this are to
vary the adjustments for inventory amounts and bad debts, and estimated returns,
allowances, and warranties.
The audit committee, therefore, pays considerable attention to the way
these adjustments and allowances are calculated and to the resulting accounts
receivable, inventory, and accrued liability amounts. Changes in the reserve
percentages from one year to the next are suspect. The audit committee tolerates
a certain amount of smoothing, within limits. Indeed, it may not be aware
526 Making Key Strategic Decisions
that smoothing has occurred. Outside these limits, however, the committee is
obligated to make sure that the reserves and accrual calculations are reasonable.
Management may also recommend terminology that does not affect net
income but does affect income from operating activities. Examples are earnings
before marketing costs, cash earnings per share, earnings before losses on
new products, and pro forma earnings. None of these terms is permitted in
GAAP; they appear in press releases and speeches.
Reporting Unfavorable Developments
The Securities and Exchange Commission requires that its Form 8-K report be
filed promptly whenever an unusual material event that affects the financial
statements becomes known. The principal concern is with the bottom line, the
amount of reported earnings. Management, understandably, may be inclined
not to report events that might (or might not) have an unfavorable impact on
earnings. These include the probable bankruptcy of an important customer, an
important inventory shortage, a reported cash shortage that might (or might
not) turn out to be a bookkeeping error, a possibly defective product that could
lead to huge returns or to product liability suits, possible safety or environmental
violations, an allegation of misdeeds by a corporate officer, the departure
of a senior manager, or a lawsuit that might (or might not) be well founded.
It is human nature to hope that borderline situations will not actually have a
material impact on the company's earnings.
Furthermore, publicizing some of these situations may harm the company
unnecessarily. Disclosing a significant legal filing against the company is necessary,
but disclosing the amount that the company thinks it might lose in such
litigation, in a report that the plaintiff can read, would be foolish.
In any event, the audit committee should be kept fully informed about all
events that might eventually require filing a Form 8-K. One might think that
the CEO would welcome the opportunity to inform the board of these events
because this shifts the responsibility for disclosure to the board. But managers,
like most human beings, prefer not to talk about bad news if there are reasonable
grounds for waiting a while.
Occasionally, a manager may attempt to "cook the books," that is, to produce
favorable accounting results by making entries that are not in accordance
with GAAP. The audit committee must rely on the auditors (or occasionally on
a whistle-blower) to detect these situations.
The Big Bath
A new CEO may "take a big bath"; that is, the accounting department may be required
to write off or write down assets in the year he or she takes over, thereby
reducing the amount of costs that remain to be charged off in future periods.
This increases the reported earnings in the periods for which the new management
is responsible. Since the situation that led to the replacement of the former
The Board of Directors 527
manager may justify some charge-offs, and since the directors don't want to disagree
with the new chief executive officer during the honeymoon period, this
tactic is sometimes tolerated. If the inf lated earnings lead to extraordinarily
high bonuses in future years, the board may regret its failure to act.
Audit Committee Activities
In probing for the possible existence of any of the situations described above,
the audit committee takes two approaches. First, it asks probing questions of
management: Why has the receivables-reserve percentage changed? What is
the rationale for a large write-off of assets?
Then, and much more important, the committee asks similar questions of
the outside auditors. The audit committee usually meets privately with the
outside auditors and tells them, in effect, "If you have any doubts about the
numbers, or if you have reason to believe that management has withheld material
information, let us know. If you don't inform us, the facts will almost certainly
come to light later on. When they do, you will be fired."
A more polite way of probing is to ask the following: "Is there anything
more you should tell us? What were your largest areas of concern? What were
the most important matters, if any, on which you and management differed?
Did the accounting treatment of certain events differ from general practice in
the industry? If so, what was the rationale for the difference? How do you rate
the professional competence of the finance and accounting staff?"
Usually, these questions are raised orally. Because the auditors know from
past experience what to expect, they come prepared to answer them. Some
audit committees provide their questions in writing prior to the meeting.
Although cases of improper disclosure make headlines, they occur in only
a tiny fraction of 1% of listed companies. Most such incidents ref lect poorly on
the work of the board of directors and its audit committee. Increasingly, the
courts penalize such boards for their laxity. Directors are aware of the fact
that when serious misdeeds surface, the CEO often leaves the company, but
the directors must stay with the ship, enduring public criticism and the blot on
their professional reputation. Their lives will be much more pleasant in the
long run if they act promptly.
Quarterly Reports
In addition to the annual financial statements, the SEC requires companies to file
a quarterly summary of key financial data on Form 10-Q. Because the timing of
the release of this report usually does not coincide with an audit committee
meeting, most audit committees do not review it. Instead, they ask the CEO to
inform the committee chair if there is an unusual situation that affects the quarterly
numbers. The chair then decides either to permit the report to be published
as proposed or, if the topic seems sufficiently important, to have the committee
meet in a telephone conference call or an e-mail exchange to discuss it.
528 Making Key Strategic Decisions
Internal Control
In addition to its opinion on the financial statements, the outside auditing firm
writes a "management letter." This letter lists possible weaknesses in the company's
control system that have come to the auditor's attention, together with
recommendations for correcting them. (In the boilerplate preceding this list,
the auditor disclaims responsibility for a complete analysis of the system. The
listed items are only those that the firm happened to uncover.) Internal auditors
also write reports on the subject.
Audit committees follow up on these reports by asking management to
respond to the criticisms. If management disagrees with the recommended
course of action, its rationale is considered and is either accepted or rejected.
If action is required, the committee keeps the item on its agenda until it is satisfied
that the matter has been addressed.
If an especially serious problem is uncovered, the committee may engage
its public accounting firm or another firm to make a special study. If the problem
involves ethical or legal improprieties, the committee may engage an outside
law firm. As soon as material problems are identified, they must be
reported promptly to the SEC on Form 8-K.
The audit committee has a difficult problem with internal audit reports.
In the course of a year, a moderate size staff may write 100 or more reports.
Many of them are too trivial to warrant the committee's attention. (One of the
authors participated in an audit committee meeting of a multibillion dollar
company in which 15 minutes were spent discussing a recommendation to
improve the computer system that was expected to save $24,000 annually.)
Drawing a line between important reports and trivial ones is difficult, however.
A rule of thumb, such as, "Tell us about the dozen most important matters,"
may be used, but what if the thirteenth matter also warrants the
committee's attention?
In its private meeting with the head of internal audit, the audit committee
assures itself that the CEO has given the internal audit staff complete freedom
to do its work. The committee also makes it clear that the head of internal
audit has direct access to the audit committee chair if a situation that warrants
immediate board attention is uncovered. The internal auditor normally would
report the matter in question to his or her superior first, but the auditor's
primary obligation is to the audit committee. The committee, in turn, should
guarantee, as well as it can, that the internal auditor will be fully protected
against possible retaliation.
Internal Audit Organization
The audit committee also considers the adequacy of the internal audit organization.
Is it large enough? Does it have the proper level of competence? For example,
do the auditors know how to audit the latest computer systems? In many
companies, the internal audit organization is a training ground where promising
The Board of Directors 529
accountants are groomed for controllership. The audit committee may find it
useful to get acquainted with the internal audit staff, as a basis for judging
future candidates for the controller organization.
When campaigns to reduce overhead are undertaken, the internal audit
staff may be cut more than is healthy for the organization. The audit committee
questions such cuts and gets an opinion from the outside auditing firm. However,
because internal auditors do much of the verifying that otherwise would be
done by external auditors, at a much lower cost per hour, external auditors may
not have an unbiased view of the proper size of the internal audit organization.
FINANCE COMMITTEE
The board is responsible to the shareholders for monitoring the corporation's
financial health and assuring that its financial viability is maintained. The finance
committee makes recommendations on these matters. (Nevertheless, as
emphasized earlier, the full board cannot escape its ultimate responsibility for
making sound decisions on important matters.)
The committee's agenda includes analyses of proposed capital and operating
budgets and regular reviews of the company's financial performance as reported
on the income statement, and its financial condition as reported on the
balance sheet. The committee reviews the estimated financial requirements
over the next several years and looks at how these requirements will be met. It
also recommends the amount of quarterly dividends. The finance committee
(or a separate pension committee) reviews matters of the pension fund as well
as those of the fund for paying health-care and other post-employment benefits.
It reviews the policies that determine the annual contribution to these
funds and the performance of the firm or firms that invest them.
This section describes aspects of these matters that are dealt with at the
board of directors level. Reviews of performance and status are described in
Chapters 1 and 2. The budget preparation process is described in Chapter 6.
Financial policies are discussed in Chapters 9 through 13.
In some companies, the functions described here are divided among three
committees, for budget, finance, and pension, and the names may be different.
Our purpose is to describe what committees do, regardless of their titles.
Analysis of Financial Policies
Financial policies are recommended by management. Tools of analysis are increasingly
sophisticated. Using these tools to evaluate risk and return is the responsibility
of management, not the finance committee. These tools help to
quantify risk, but they are not a substitute for a definite policy on risk. An attitude
toward risk is a personal matter, and the finance committee should recognize
it as such. Each CEO has a personal attitude toward risk, and so does each
individual director.
530 Making Key Strategic Decisions
The committee's responsibility is to probe management's rationales for its
policies and thereby assure itself that management has thought them through
and that the policies are within acceptable limits.
Dividend Declaration
One financial policy specifically for the board to decide is the declaration of
dividends. Dividends are paid only if the company declares them; this declaration
usually is made quarterly.
Some companies regularly distribute a large fraction of earnings, while
others retain a large fraction (or all) within the corporation. Although generous
dividends may suit shareholders in the short run, they can deprive the corporation
of resources it needs to grow and thereby penalize shareholders in the long
run. Conversely, if a large fraction of earnings is retained, shareholders may be
deprived of the opportunity to make profitable alternative investments of
their own. Thus, the finance committee must balance the interests of the corporation
with the interests of individual shareholders.
Some boards take a simplistic approach to dividends: "Always pay out X%
of earnings," or "Increase dividends each year, no matter what." Both statements
are acceptable guidelines, but neither is more than a guide. In some
industries, a certain payout ratio is regarded as normal, and a company that departs
substantially from industry practice may lose favor with investors. Good
evidence suggests that a record of increasing dividends over time, or at least a
record of stable dividends, is well regarded by investors. By contrast, an erratic
dividend pattern is generally undesirable; it creates uncertainty for investors.
Dividend policy warrants careful analysis. The principal factors that the
board considers are:
• What are the company's financial needs? These needs depend on how fast
the company wants to grow and how capable it is of growing. Or, as is the
case with some companies, what is needed to preserve the company during
a period of adversity?
• How does the company want to finance its requirements for funds? It can
meet its needs by retaining earnings, issuing debt, issuing equity, or some
combination of these. Each source of funds has its own cost and its own
degree of risk.
• What return does the company expect to earn on shareholder equity, and
what degree of risk is it willing to assume in order to achieve this objective?
The trade-off between risk and return will determine the appropriate
type of financing and thus inf luence the extent to which earnings
should be retained or paid out in dividends.
These are complex questions. Moreover, the factors involved in arriving
at answers to them interact with one another. Consider the example of Cisco
Systems:
The Board of Directors 531
Cisco was founded in 1984 and shipped its first product in 1985. The company
grew rapidly. In 2000 it was a world leader in networking for the Internet, with
sales of $18.9 billion and net income of $2.7 billion. The following statement is
included in the company's 2000 Annual Report. "The Company has never paid
cash dividends on its common stock and has no present plans to do so." Cisco retained
all of its earnings to help finance its growth and used its stock to acquire
other companies, which it integrated into its operations.
Cisco's dividend policy is typical of high-growth technology companies
that need resources to grow but find raising equity in the financial markets expensive
because they have no financial "track record" for new ventures.
Many successful companies have quite different dividend and financing
policies from Cisco's. Many public utility companies, for example, have long,
unbroken records of stable dividends that are a relatively high percentage of
earnings, ranging from 50% to 90%. Even during the Depression in the 1930s
many of these companies maintained their regular dividends, although dividends
exceeded earnings in some periods.
The contrast between Cisco Systems and public utility companies indicates
the extent to which dividend policy depends on an individual company's
circumstances and needs. It also highlights the relationships between dividend
policy, the company's need for financing, and the methods that it selects in
order to meet its financial requirements.
Pension Funds
The finance committee considers two aspects of pension fund policy: (1) the
amount required to be added to the fund and (2) the investment of the fund.
Size of the Pension Fund
Most corporate pension plans are defined benefit plans. In deciding the size of
the fund required to make benefit payments to retirees, directors tend to rely
heavily on the opinion of an actuary. The actuary calculates the necessary size
of the fund using information about the size and demographic characteristics
of the covered employees, facts about the provisions of the plan, and assumptions
about the fund's return on investment and probable wage and salary increases
over time. (With available software, the company can make the same
calculation.)
There is no way of knowing, however, how reasonable are two key assumptions:
the future return on investment and the future wage and salary
payments on which the pensions are based. Since the actuarial calculations depend
on the accuracy of these assumptions, the calculations should not be
taken as gospel. Both of these variables are roughly related to the future rate of
inf lation, and the spread between them should remain roughly constant. That
is, when one variable changes by one percentage point, the other variable also
is likely to change by one percentage point.
532 Making Key Strategic Decisions
Pension Fund Investments
The most conservative practice is to invest the pension fund in annuities or in
bonds whose maturities match the anticipated pension payments. Such a policy
is said to "lock in" the ability to make payments. This works out satisfactorily for
employees who have already retired, but not for employees who are currently
working. If the latter group's compensation increases at a faster rate than is assumed
in the actuarial calculations, or if the plan itself is sweetened, the fixed
return will turn out to be inadequate. Under a defined benefit plan, there is no
sure way to guarantee that the cash will be available when it is needed. In any
event, with such a conservative policy, the company gives up the opportunity to
earn the usually greater return from an investment in equities.
Most companies hire one or more banks or investment firms to manage
their pension funds. Voluminous data are available on the past performance of
these managers. However, an excellent past record is no guarantee of excellent
future performance. A firm is a collection of individuals. Investment performance
is partly a function of the individuals doing the investing, and the performance
record may change when these individuals leave or lose their skills.
For many years, when it was managed by Peter Lynch, the Magellan Fund was
the most successful of all mutual funds. After Mr. Lynch left, the fund's performance
was not so huge (but was still above average). Performance is also
partly a matter of luck.
Some companies divide the pension fund among several managers, periodically
compare their performance, and replace the one with the poorest
record. This may spread the risk somewhat, but it does not guarantee optimum
performance. Luck and the individual who manages the fund continue to be
dominant factors. It is a fact that some managers are better than others. The finance
committee watches performance carefully. It is cautious about making
changes based primarily on short-run performance, but it does so promptly
when it is convinced that a better manager has been identified.
The finance committee also decides on asset allocation investment policies:
how much in equities, how much in fixed income securities, how much in
real property, how much in new ventures, how much in overseas securities, and
the maximum percentage in a single company or industry.
Companies must also provide for costs of health-care and other benefits
of employees who have not yet retired. The problems of estimating these costs
are similar to those for pension funds, but with the additional complication that
healthcare costs continue to increase at an unpredictable rate.
SUMMARY
In doing its job, the board accepts certain responsibilities. It should:
• Actively support the CEO, both within the organization and to outside
parties, as long as the individual's performance is judged to be generally
satisfactory.
The Board of Directors 533
• Discuss proposed major changes in the company's strategy and direction,
major financing proposals, and other crucial issues, usually as proposed by
the CEO.
• Formulate major policies regarding ethical or public responsibility matters,
convey to the organization its expectation that the policies will be
adhered to, and ensure that policy violations are not tolerated.
• Ensure, if feasible, that the CEO has identified a successor and is grooming
that person for the job.
• Require the CEO to explain the rationale behind operating budgets,
major capital expenditures, acquisitions, divestments, dividends, personnel
matters, and similar important plans. Accept these proposals if they
are consistent with the company's strategy and the explanation is reasonable.
Otherwise, require additional information.
• Analyze reports on the company's performance, raise questions to highlight
areas of possible concern, and suggest possible actions to improve
performance, always with the understanding that the CEO, not the
board, is responsible for performance.
• Assure that financial information furnished to shareholders and other outside
parties fairly presents the financial performance and status of the
company. Assure that internal controls are satisfactory.
• Replace the CEO promptly if the board concludes the executive's performance
is and will continue to be unsatisfactory.
• Participate actively in decisions to elect or appoint directors.
• Decide on policies relating to the compensation of senior management,
including bonuses, incentives, and perquisites. Determine the compensation
of the CEO. Review recommendations of the CEO and ratify the
compensation of other executives.
FOR FURTHER READING
American Bar Association Committee on Continuing Professional Education, Corporate
Governance Institute: ALI-ABA Course of Study Materials (Philadelphia,
PA: American Law Institute, 2000).
, Corporate Director's Guidebook (Chicago, IL: ABA, 1994).
American Law Institute-American Bar Association, Current Issues in Corporate
Governance: ALI-ABA Course of Study Materials (Philadelphia, PA: ALI-ABA,
1996).
American Society of Corporate Secretaries, Current Board Practices (New York:
ASCS, 2000).
Anderson, Charles A., and Robert N. Anthony, The New Corporate Directors (New
York: John Wiley, 1986).
Bawley, Dan, Corporate Governance and Accountability: What Role for the Regulator,
Director, and Auditor? (Westport, CT: Quorum, 1999).
534 Making Key Strategic Decisions
Berenbeim, Ronald, The Corporate Board: A Growing Role in Strategic Assessment
(New York: Conference Board, 1996).
Bureau of National Affairs, Corporate Governance Manual (Washington, DC:
Author, 1998).
Cagney, Lawrence K., Compensation Committees (Washington, DC: Bureau of National
Affairs, 1998).
Cohen, Stephen S., and Gavin Boyd, eds., Corporate Governance and Globalization:
Long Range Planning Issues (Northampton, MA: Edward Elgar, 2000).
Davies, Adrian, A Strategic Approach to Corporate Governance (Brookfield, VT:
Gower, 1999).
Donaldson, Gordon, and Jay W. Lorsch, Decision Making at the Top (New York: Basic
Books, 1983).
Ernst & Young, Compensation Committees: Fulfilling Your Responsibilities in the
1990s (New York: Ernst & Young, 1995).
Harvard Business Review on Corporate Governance (Boston: Harvard Business
School, 2000).
Investor Responsibility Research Center, Global Corporate Governance: Codes, Reports,
and Legislation (Washington, DC: Author, 1999).
Iskander, Magdi R., and Nadereh Chamlou, Corporate Governance: A Framework for
Implementation (Washington, DC: World Bank, 2000).
Keasey, Kevin, and Mike Wright, eds., Corporate Governance: Responsibilities,
Risks, and Remuneration (New York: John Wiley, 1997).
Knepper, William E., and Dan A. Bailey, Liability of Corporate Officers and Directors,
6th ed. (Charlottesville, VA: Michie, 1998).
Lorsch, Jay W., Pawns or Potentates: The Reality of America's Corporate Boards
(Boston: Harvard Business School, 1984).
Mace, Myles L., Directors: Myth and Reality, rev. ed. (Boston: Division of Research,
Harvard Business School, 1984).
Montgomery, Jason, Corporate Governance Guidelines: An Analysis of Corporate
Governance Guidelines at S&P 500 Corporations (Washington, DC: Investor
Responsibility Research Center, 2000).
National Association of Corporate Directors, The Role of the Board in Corporate
Strategy (Washington, DC: NACD, 2000).
, Report of the NACD Blue Ribbon Commission on Director Professionalism
(Washington, DC: NACD, 1996).
Oliver, Caroline, ed., The Policy Governance Fieldbook: Practical Lessons, Tips, and
Tools from the Experience of Real-Word Boards (San Francisco: Jossey-Bass, 1999).
Patterson, D. Jeanne, The Link between Corporate Governance and Performance:
Year 2000 Update (New York: Conference Board, 2000).
Stoner, James A. F., R. Edward Freeman, and Daniel R. Gilbert, Jr., Management,
6th ed. (London: Prentice-Hall International, 1995).
Vancil, Richard F., Passing the Baton: Managing the Process of CEO Succession
(Boston: Harvard Business School Press, 1987).
Varallo, Gregory V., and Daniel A. Dreisbach, Corporate Governance in the 1990s:
New Challenges and Evolving Standards (Chicago, IL: American Bar Association,
1996).
The Board of Directors 535
Ward, Ralph D., Improving Corporate Boards: The Boardroom Insider Guidebook
(New York: John Wiley, 2000).
, 21st Century Corporate Board (New York: John Wiley, 1997).
Weidenbaum, Murray L., The Evolving Corporate Board (St. Louis: Center for the
Study of American Business, Washington University, 1994).
NOTES
1. Kenneth R. Andrews, The Concept of Corporate Strategy (Homewood, IL:
Dow-Jones Irwin, 1980).
2. SEC Release 34-41982.
3. Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968).
4. If the auditing firm cannot make this statement, it states that it is unable to
give any opinion. In these circumstances, the stock exchanges immediately suspend
trading in the company's stock.
5. Investors Relation Business. Press release October 9, 2000.
536
16
INFORMATION
TECHNOLOGY
AND THE FIRM
Theodore Grossman
INTRODUCTION
The personal use of information technology was discussed in an earlier chapter.
This chapter will discuss the firm's use of information technology.
Of all the chapters in this book, the two dealing with information technology
will have the shortest half-life. Because of the constant flow of new
technology, what is written about today will have changed somewhat by tomorrow.
This chapter presents a snapshot of how technology is used today in industry
finance and accounting. By the time you compare your experiences with
the contents of this chapter, some of the information will no longer be applicable.
Change means progress. Unfortunately, many companies will not have
adapted; consequently, they will have lost opportunity and threatened their
own futures.
HISTORICAL PERSPECTIVE
To understand the present and future of information technology, it is important
to understand its past. In the 1960s and 1970s, most companies' information
systems were enclosed in the "glass house." If you entered any company
that had its own computer, it was located behind a glass wall with a security
system that allowed only those with access rights to enter the facility. One
computer controlled all of a company's data processing functions. Referred to
as a host centric environment, the computer was initially used for accounting
purposes—accounts payable, accounts receivable, order entry, payroll, and
so on. In the late 1970s and 1980s, most companies purchased in-house
Information Technology and the Firm 537
computer systems and stopped outsourcing their data processing. Recognizing
the power and potential of information technology, companies directed the
use of their technology toward operations, marketing, and sales; and they created
a new executive position, Chief Information Officer (CIO), to oversee
this process.
In the 1980s, many companies gradually changed from host centric to distributed
computing. Instead of processing all of the information on one large,
mainframe computer, companies positioned minicomputers to act as processors
for departments or special applications. The minicomputers were, in many
cases, networked together to share data. Databases became distributed, with
data residing in different locations, yet accessible to all the machines in the
network.
The personal computer had the greatest impact on the organization. It
brought true distributed processing. Now everybody had their own computer,
capable of performing feats that, until then, were only available on the company's
mainframe computer. This created both opportunities and headaches
for the company, some of which will be addressed in the section on controls. As
companies entered the 1990s, these computers were networked, forging the
opportunity to share data and resources, as well as to work in cooperative
groups. In the mid-1990s, these networks were further enhanced through connection
to larger, wide area networks (WANs) and to the ultimate WAN, the
Internet. Companies are doing what was unthinkable just a couple of years ago.
They are allowing their customers and their suppliers direct connection into
their own computers. New technology is being introduced every day, and new
terms are creeping into our language (Internet, intranet, extranet, etc.). It is
from this perspective that we start by looking at computer hardware.
HARDWARE
Most of the early computers were large, mainframe computers. Usually manufactured
by IBM, they were powerful batch processing machines. Large numbers
of documents (e.g., invoices or orders) were entered into the computer
and then processed, producing various reports and special documents, such as
checks or accounts receivable statements.
Technology was an extremely unfriendly territory. In many companies,
millions of lines of software were written to run on this mainframe technology.
Generally speaking, these machines were programmed in a language called
COBOL and used an operating system that was proprietary for that hardware.
Not only was it difficult to run programs on more than one manufacturer's
computer, but, because there were slight differences in the configurations and
operating systems, it was difficult to run the same software on different computers,
even if they were produced by the same manufacturer.
In the 1980s, technology evolved from proprietary operating systems
to minicomputers with open systems. These were the first open systems,
538 Making Key Strategic Decisions
computers that functioned using the UNIX operating system. While, in the
1970s, Bell Labs actually developed UNIX as an operating system for scientific
applications, it later became an accepted standard for commercial applications.
Platform independent, the operating system and its associated applications could
run on a variety of manufacturers' computers, creating both opportunities for
users and competition within the computer industry. Users were no longer inexorably
tied to one manufacturer. UNIX became the standard as companies
moved into the 1990s. However, standards changed rapidly in the nineties, and
UNIX has lost ground due to the development of client server technology.
In the early 1990s, technologists predicted the demise of the mainframe.
IBM's stock declined sharply as the market realized that the company's chief
source of margin was headed toward extinction. However, the mainframe has
reinvented itself as a super server, and, while it has been replaced for some of
the processing load, the mainframe and IBM are still positioned to occupy
important roles in the future.
Server technology is heading toward a design in which processors are built
around multiple, smaller processors, all operating in parallel. Referred
to as symmetrical multiprocessors (SMPs), there are between two and eight
processors in a unit. SMPs are made available by a range of manufacturers and
operating systems, and they provide processor power typically not available in a
uniprocessor. Faced with the demanding environment of multiple, simultaneous
queries from databases that exceed hundreds of gigabytes, processors with massively
parallel processors, or MPPs, are being utilized more and more. MPPs
are processors that have hundreds of smaller processors within one unit. The
goal of SMPs and MPPs is to split the processing load among the processors.
In a typical factory in the 1800s, one motor usually powered all of the
machinery, to which it was connected by a series of gears, belts, and pulleys.
Today, that is no longer the case, as each machine has its own motor or, in some
cases, multiple, specialized motors. For example, the automobile's main motor
is the engine, but there are also many other motors that perform such tasks as
opening and closing windows, raising and lowering the radio antenna, and powering
the windshield wipers. Computers are the firm's motors, and like motors,
they, too, have evolved. Initially, firms used a host centric mainframe, one
large computer; today, they are using many computers to perform both specialized
and general functions.
In the early 1990s, Xerox's prestigious Palo Alto Research Center introduced
"ubiquitous computing," a model that it feels ref lects the way companies
and their employees will work in the future. In ubiquitous computing, each
worker will have available differing quantities of three different size computers:
20 to 50 Post-it note size portable computers, three or four computers the
size of a writing tablet, and one computer the size of a six-foot-by-six-foot
white board. All of the computers will work together by communicating to a
network through, in most cases, wireless connections.
The progress of chip technology has been highly predictable. In the early
1960s, Gordon Moore, the inventor of the modern CPU at Intel, developed
Information Technology and the Firm 539
Moore's Law, which predicts that the density of the components on a computer
chip will double every 18 to 24 months, thereby doubling the chip's processing
power. This hypothesis has proven to be very accurate. Exhibit 16.1
shows the growth of the various Intel CPU chips that have powered the personal
computer and many other machines. As can be seen, the PC's power has
just about doubled every 18 to 24 months.
This growth can be seen more dramatically when the graph is plotted
logarithmically, as in Exhibit 16.2.
EXHIBIT 16.1 Moore's Law—charting the power of the growth of
the PC.
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
Year
MIPS (millions of instructions
per second)
0
100
200
300
400
500
600
700
800
900
1000
EXHIBIT 16.2 Moore's Law—charting the growth of the PC
(logarithmically).
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
Year
MIPS (millions of instructions
per second)
0.1
1.0
10.0
100.0
1000.0
540 Making Key Strategic Decisions
SOFTWARE
Exhibit 16.3 represents the information systems paradigm. Operational control
systems, which run the company's day-to-day operations, are typically used by
the lowest level of the organization, are run on a scheduled basis, and usually
contain large volumes of input data, output reports, and information. These
systems might be accounts payable, accounts receivable, payroll, order entry,
or inventory control.
Decision support systems are generally used by middle-level managers to
supply them with information that they can use to make decisions. Usually run
on an ad hoc basis and involving small amounts of data, budgets, exception reporting,
cash-f low forecasting, accounts receivable dunning reports, "what if "
analyses, audit analysis reports, and variance analyses are examples of these
decision support systems. Many of the newer applications packages come with
facilities for managers without any programming knowledge to create their
own decision reports.
Strategic information systems are used by senior management to make decisions
on corporate strategy. For example, a retail company might use demographic
census data, along with a computerized geographical mapping system,
to evaluate the most appropriate locations at which it should open new stores. A
manufacturing company, given its demands for both skilled and unskilled
labor, might use a similar method to determine the optimal location for a
new plant.
While most older hardware has given way to newer computers, most companies
use a combination of newly acquired and older, self-developed software.
The latter was developed over a period of years, perhaps 20 or more, using
COBOL, which, until the early 1990s, was the standard programming language
in business applications. Today, many companies' mission critical systems still
EXHIBIT 16.3 Types of information systems.
Operational control
systems
Decision support
systems
Strategic
information
systems
Information Technology and the Firm 541
run on mainframe technology, using programs written in COBOL; in fact,
there are billions of lines of COBOL programming code still functional in U.S.
business.
These "legacy" systems have become a major issue for many, though, and
were the key issue behind the Y2K problem. In many instances, they have
grown like patchwork quilts, as they have been written and modified by programmers
who are no longer with their firms. More often than not, documentation
of these changes and enhancements is not available, and the guidelines
for many of these software applications no longer exist. Replacing these applications
is cost prohibitive, and the distraction to the organization caused by the
need to retrain workers would be tremendous.
Nonetheless, as a result of the Y2K problem, many of these systems were
replaced, but large volumes of them were merely patched to allow for the millennium
change. These systems will eventually have to be replaced. If history
is a lesson, many of these systems will not be replaced, though, until it is too
late. In any event, the business community should not face the singular deadline
it faced at the end of 1999.
Today, most programmers write in C++, C, or fourth-generation programming
languages. C++ is an object oriented programming language; object oriented
languages provide the programmer with a facility to create a programming
object or module that may be reused in many applications. Fourth-generation
programming languages are usually provided with sophisticated relational database
systems. These database systems provide high-level tools and programming
languages that allow programmers to create applications quickly without having
to concern themselves with the physical and logical structure of the data. Oracle,
Informix, Sybase, and Progress are some of the more popular relational
database package companies.
INTERNET TECHNOLOGY
Nothing has impacted technology and society in the past 10 years more than
the Internet. When Bill Clinton was inaugurated in January 1993, there were
50 pages on the Internet. Today, there are more than 200 billion pages. The underlying
technology behind the Internet has its roots in a project begun by the
U.S. government in the early 1970s. The network was originally developed by a
consortium of research colleges and universities and the federal government
that was looking for a way to share research data and provide a secure means of
communicating and for backing up defense facilities. The original network was
called ARPANET. ARPANET was sponsored by the Department of Defense's
Advanced Research and Planning Agency (ARPA). It was replaced in the 1980s
by the current network, which was originally not very user friendly and was
used mostly by techies. The Internet's popularity exploded with the development
of the World Wide Web and the necessary software programs that made
it much more user friendly to explore.
542 Making Key Strategic Decisions
The Internet works on a set of software standards the first of which,
TCP/IP, was developed in the 1970s. The entire theory behind the Internet
and TCP/IP, which enables computers to speak to each other over the Internet,
was to create a network that had no central controller. The Internet is unlike
a string of Christmas lights, where if one light in the series goes out the
rest of the lights stop functioning. Rather, if one computer in the network is
disabled, the rest of the network continues to perform.
Each computer in the Internet has an Internet, or IP, address. Similar to
one's postal address, it consists of a series of numbers (e.g., 155.48.178.21),
and it tells the network where to leave your e-mail, and data. When you access
an Internet site through its URL (e.g., www.babson.edu), a series of
computers on the Internet, called domain name servers (DNS), convert the
URL to an IP address. When an e-mail, message, or data is sent to someone
over the Internet, it is broken into a series of packets. These packets, similar
to postcards, contain the IP address of the sender, the IP address of the
recipient, the packet number of the message (e.g., 12 of 36), and the data
itself. These packets may travel many different routes along the Internet.
Frequently, packets belonging to the same message do not travel the same
route. The receiving computer then reassembles these packets into a complete
message.
The second standard that makes the Internet work is HTML, or Hypertext
Markup Language. This language allows data to be displayed on the
user's screen. It also allows a user to click on an Internet link and jump to a
new page on the Internet. While HTML remains the underlying programming
language for the World Wide Web, there are many more user-friendly
software packages, like FrontPage 2000, that help create HTML code. Moreover,
HTML, while powerful in its own right, is not dynamic and has its limitations.
Therefore, languages such as JavaScript, Java, and Pearl, which create
animation, perform calculations, create dynamic Web pages, and access and
update databases with information on the host's Web server, were developed
to complement HTML. Using a Web browser (e.g., Netscape Navigator or
Microsoft's Internet Explorer), the computer converts the HTML or other
programming languages into the information that the users see on their computer
monitors.
Internet technology has radically changed the manner in which corporate
information systems process their data. In the early and mid-1990s, corporate information
systems used distributed processing techniques. Using this method,
some of the processing would take place on the central computer (the server)
and the rest on the users' (the clients') computers—hence, the term clientserver
computing. Many companies implemented applications using this technology,
which ensured that processing power was utilized at both ends and that
systems were scalable. The problem with client-server processing was that different
computers (even within the IBM-compatible PC family) used different
drivers and required tweaking to make the systems work properly. Also, if the
software needed to be changed at the client end, and there were many clients
Information Technology and the Firm 543
(some companies have thousands of PC clients), maintaining the software for all
of those clients could be a nightmare. Even with specialized tools developed for
that purpose, it never quite worked perfectly.
As companies recognized the opportunity to send data over the Internet,
whether for their customers or their employees, they started to migrate all of
their applications to a browser interface. This change has required companies
to rethink where the locus of their processing will occur. Prior to the 1990s,
companies' networks were host-centric, where all of their processing was conducted
using one large mainframe. In the early 1990s, companies began using
client-server architecture. Today, with the current browser technology and the
Internet, the locus has shifted back to a host-centric environment. The difference,
though, is that the browser on the users' computers is used to display and
capture data, and the data processing actually occurs back at the central host
on a series of specialized servers, not on one large mainframe computer. The
only program users need is a standard browser, which solves the incompatibility
problem presented by distributed data processing. No specialized software
is stored on the users' computers.
Internet technology was largely responsible for many of the productivity
enhancements of the 1990s. Intel's microprocessors, Sun and Hewlett Packard's
servers, CISCO's communications hardware, and Microsoft's Windows operating
systems have all facilitated this evolution. While Windows is the predominant
client operating system, most servers operate on Windows NT or 2000,
UNIX or LINUX operating systems.
TODAY'S APPLICATION SYSTEMS
In the 1970s and 1980s, application software systems were stand-alone. There
was little sharing of data, leading to the frequent redundancy of information.
For example, in older systems, there might have been vendor data files for both
inventory and accounts payable, resulting in the possibility of multiple versions
of the truth. Each of the files may have contained address information, yet
each of the addresses may have been different for the same vendor. Today,
however, software applications are integrated across functional applications
(accounts payable, accounts receivable, marketing, sales, manufacturing, etc.).
Database systems contain only one vendor data location, which all systems utilize.
These changes in software architecture better ref lect the integration of
functions that has occurred within most companies.
Accounting systems, while used primarily for accounting data, also provide
a source of data for sales and marketing. While retail stores' point of sale
cash registers are used as a repository for cash and to account for it, they are
also the source of data for inventory, sales, and customer marketing. For example,
some major retailers ask their customers for their zip codes when point of
sale transactions are entered, and that data is shared by all of the companies'
major applications.
544 Making Key Strategic Decisions
Accounts receivable systems serve two purposes. On one hand, they allow
the company to control an important asset, their accounts receivable. Also, the
availability of credit enables customers to buy items, both commercial and retail,
that they otherwise would not be able to buy if they had to pay in cash.
Credit card companies, which make their money from the transaction fees and
the interest charges, understand this function well. Frequently, they reevaluate
the spending and credit patterns of their client base and award increased credit
limits to their customers. Their goal is to encourage their customers to buy
more, without necessarily paying off their balance any sooner than necessary.
Information systems make it possible for the companies to both control and
promote their products, which in this case are credit card transactions.
These examples of horizontally integrated systems, as well as the understanding
of the strategic and competitive uses of information technology,
demonstrate where industry is headed.
ACCOUNTING INFORMATION SYSTEMS
As mentioned earlier, computer-based accounting systems were, for most companies,
the first computerized applications. As the years progressed, these systems
have become integrated and consist of the following modules:
• Accounts Payable.
• Order Entry and Invoicing.
• Accounts Receivable.
• Purchase Order Management and Replenishment.
• Inventory Control.
• Human Resource Management.
• Payroll.
• Fixed Assets.
• General Ledger and Financial Statements.
Whereas in past years some of these modules were acquired and others were
self-developed, today most companies purchase packaged software.
In the 1980s, "shrink-wrapped" software was developed and introduced.
Lotus Corporation, along with other companies, was a pioneer, selling software
like its 1-2-3 application in shrink-wrapped packages. The software was accompanied
by sufficient documentation and available telephone support to ensure
that even companies with limited technical expertise could manage their own
destinies.
There are a host of software packages that will satisfy the needs of companies
of all sizes. Smaller companies can find software selections that run on
personal computers and networks, are integrated, and satisfy most of the companies'
requirements. Quicken and Computer Associates have offerings that
Information Technology and the Firm 545
provide most of the necessary functional modules for small and medium size
companies, respectively. The more advanced packages, like Macola and Acc-
Pac, are equipped with interfaces to bar-code scanners and scales, which, together,
track inventory and work in process and weigh packages as they are
shipped, producing not only invoices but also shipping documents for most of
the popular freight companies such as FedEx and UPS. These packages range
in price from $100 for the entire suite of accounting applications for the smallest
packages to approximately $800 per module for the larger packages, which,
of course, have more robust features. While some of the smaller packages are
available through computer stores and software retailers, the larger packages
are acquired through independent software vendors (ISV), who, for a consulting
fee, will sell, install, and service the software. The practice of using third
party ISVs began in the 1980s, when large hardware and software manufacturers
realized that they were incapable of servicing all of the smaller companies
that would be installing their products, many of whom required a lot of handholding.
Consequently, a cottage industry of distributors and value added dealers
developed, in which companies earn profits on the sale of hardware and
software and the ensuing consulting services.
Larger companies are following a trend toward large, integrated packages
from companies like SAP and Oracle. These packages integrate not only the accounting
functions but also the manufacturing, warehousing, sales, marketing,
and distribution functions. These systems are referred to as enterprise resource
planning (ERP) systems. Many of these ERP systems, available from
companies such as SAP, Oracle, and BAAN, also interface with Web applications
to enable electronic commerce transactions. SAP has spawned an entire
industry of consulting companies that assist large companies in implementing
its software, a process that may take several years to complete. As in any software
implementation, one must always factor into the timetable the process's
cost and the distraction it causes the organization. In today's lean business environment,
people have little extra time for new tasks. Implementing a major
new system or, for that matter, any system, requires a major time and effort
commitment.
INFORMATION TECHNOLOGY IN
BANKING AND FINANCE
The financial services industry is the leading industry in its use of information
technology. As shown in Exhibit 16.4, according to a survey conducted in 1999
by the Computer Sciences Corporation, this sector has spent 5.0% of its annual
revenue on IT, almost more than double that of any other industry, except the
technology driven telecommunications industry.
This graph also illustrates how integral a role real-time information plays
in the financial services industry, whether it be for accessing stock quotes or
processing bank deposits. The industry has become a transaction processing
546 Making Key Strategic Decisions
industry that is information dependent. Very little real money is ever touched.
Rather, all transactions, from stock purchases to the direct deposit of workers'
checks, are processed electronically. Information technology has paved the way
for innovations like the NASDAQ trading system, in which, unlike the New York
Stock Exchange (NYSE), all of the trades are conducted totally electronically.
NETWORKS AND COMMUNICATIONS
It is becoming increasingly common in industry to create virtual wide area networks
using multiple, interconnected local area networks. These networks also
connect the older mainframe and midrange computers that industry uses for its
older legacy systems to the client terminals on the users' desks. Exhibit 16.5 is
a model of a typical company's wide area network, and it demonstrates how all
of the older technology interconnects with the newer local area networks and
the Internet.
In the early 1990s, there were numerous, competing network operating
systems and protocols. While Novell and its NetWare software holds the largest
market share, Microsoft's Windows NT is becoming the network operating system
of choice, and, because of the Internet's overwhelming success, TCP/IP is
rapidly becoming the standard communications protocol. Remember, though,
success is very fragile in the world of information technology. Today's standard
can easily become yesterday's news. If you are always prepared for change,
then you will not be surprised by it.
EXHIBIT 16.4 Information technology budgets by industry.
Financial services
Percentage of revenue
Health care
Aerospace/defense
Manufacturing
Chemicals
Retail
Telecommunications
Consumer goods
Utilities
Oil/energy
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Information Technology and the Firm 547
Electronic Data Interchange (EDI) allows companies to communicate and
conduct electronic commerce from one computer to another. EDI is one of the
industry's growing uses for data communications, and many companies are using
it to send purchase orders to their suppliers, thereby lessening the time it takes
for purchase orders to be mailed and then entered and processed by the suppliers.
Inventories are lowered by speeding up the turnaround time of ordering
and receiving goods and materials. On the f lip side, many suppliers use EDI to
send their customers advance ship notifications (ASN), advising them of what
has been shipped so that they can prepare their warehouses for the goods and
EXHIBIT 16.5 Model of wide area network (local area network and
Internet connection using open communications
protocol, c. 1997).
Server
Minicomputer
Mainframe
Internet
(TCP/IP)
Router
Server
Minicomputer
Mainframe
Client
Client
(e.g., branch office)
Key:
= Processing capacity (e.g., the ability to run program code)
TCP/IP = Transmission Control Protocol/Internet Protocol
Local
area
network
(TCP/IP)
548 Making Key Strategic Decisions
materials. Lastly, some companies use EDI to transmit their invoices and then
to receive the subsequent payments. While industries use different versions of
EDI in different ways, their goals are always the same: minimize the processing
time and lower inventory costs and overhead expenses. An industry organization
in Washington, D.C., developed and maintains a standard format that dictates
how all transactions are sent, ensuring that all companies that wish to implement
EDI can be assured that all vendors' and customers' computers will understand
each others' transactions, without requiring any custom programming.
EDI, while still used quite extensively, has been eclipsed by electronic commerce,
which will be discussed later in this chapter.
The 1990s has also seen the advent of virtual organizations. Virtual organizations
are formed when companies join together to create products or enterprises
that they could not have created individually. In most cases,
information technology allows companies to create these partnerships and
share information as if they were one company. Using communications and
groupware products like Lotus Notes, the partners can share information with
each other about their individual progress to ensure the best possible success.
This will be discussed further in the section on IT strategy.
DATABASE
The following scenario depicts what information systems looked like prior to
the use of database management systems. Imagine a physical office in which
each person has his or her own file cabinet. The information in the file cabinets
belongs to the people whose desks are closest to them. They decide what information
will be in their file cabinets and how it will be organized. For example,
sales might refer to gross sales in one worker 's cabinet and net sales in another's.
Yet, the discrepancy would be unimportant, because there was actually
very little sharing of data.
Database management systems assume that information is a corporate
asset to be shared by all workers in the enterprise. Database technology, therefore,
allows a company to have one integrated location for the storage of all
company data. These systems create a standard vocabulary, or data dictionary,
by which all references are consistent (e.g., sales always means net sales). They
also enable each user to have her own individual view of the data as if the information
were still in the file cabinet next to her desk. Users need not concern
themselves with the physical location or physical order of the data either. Database
management systems are capable of presenting the data as necessary. In
fact, with distributed databases, the data does not even have to reside in the
same location or computer. It can be spread around the world if necessary.
Database systems are sufficiently intelligent and can find the data and process
it as if it were located directly on the user's personal computer.
Most of the software that was developed in the earlier years relied on data
structures called f lat files. While some companies utilized database technology
Information Technology and the Firm 549
to store information, those database management systems were, in many cases,
unwieldy and very expensive to both acquire and maintain. They were usually
hierarchical or network database systems that, alone, cost in excess of $200,000
and frequently required special database administrators just to constantly finetune
the system.
Today's database technology is based on a relational model, and, on a very
simplistic basis, it resembles a spreadsheet. In a relational database, there are a
series of tables or files. Similar to a spreadsheet table, each table has columns
with attributes and rows of data. The difference is that there is only one table
in a spreadsheet, whereas there can be an almost unlimited number of tables in
a database. In addition, there is a practical limit to the size of a spreadsheet,
but databases can contain thousands of columns and millions of rows of data.
In addition, databases also allow users to relate or connect tables that share
common columns of data.
Exhibit 16.6 is an example of a very simple portion of a payroll application.
There are two different tables. The employee table contains data about
each of the company's employees: name, address, marital status, number of dependents,
and so on. The pay table contains data about every time each of the
employees is paid: their gross payroll, social security taxes, federal withholding,
state tax, and so forth.
First, notice the common column between the two tables, the employee
number. This column enables the database management system to relate the
two tables. It allows the system, for example, to print a payroll journal that has
both the weekly payroll information from the pay table and to access the employees'
names from the employee table. Why not combine all the data into one
table? Not only would the employees' names, social security numbers, and
other information appear multiple times, requiring the unnecessary use of data
storage, but also multiple versions of the truth might occur. If one of the employees
should happen to change his name or address (if address were included
in the employee table), the database would show one name for part of the year
and another for the rest of the year. Redundant data creates opportunities for
data corruption; just because data is changed in one table, that same data is not
necessarily changed in all tables. Prudent systems design eliminates data field
duplications wherever possible.
DATE WAREHOUSE
Data warehousing attempts to reconcile and live with past applications software,
while still benefiting from today's newer technology. As mentioned
earlier, industry is rife with older legacy systems that are currently cost prohibitive
to replace. Most of these older systems are mission critical operational
control systems (see Exhibit 16.3) and satisfy most of the operational needs
of the company. However, they are built on technology that cannot support
the kinds of decision support tools that management requires. Many of these
550
EXHIBIT 16.6 Database example.
EMPLOYEE TABLE
Social Date of Hourly
Employee Security Marital Number of Date of Date of Date of Last or
Number First Name Initial Last Name Number Status Dependents Birth Hire Termination Pay Raise Pay-Rate Salary
1 Mary E Smith 123456789 M 4 4/1/63 7/21/91 9/1/96 8.505 H
2 Tom T Day 234567890 M 3 3/2/55 11/15/91 1/15/96 750.000 S
3 Harry F Jones 345678901 S 1 11/30/71 1/15/92 9/24/96 11/6/94 12.500 H
4 Sally D Kraft 456789012 S 0 10/5/65 3/6/92 3/5/96 14.755 H
5 Charlie Malt 567890123 S 1 6/6/80 6/2/93 6/17/96 900.000 S
6 John K Free 678901234 M 5 8/5/49 11/1/94 12/15/95 17.500 H
PAY TABLE
Number of Number of Social Federal
Employee Regular Overtime Security Medicare Withholding Check
Number Date Hours Hours Gross Payroll Tax Tax Tax Net Pay Number
1 1/7/96 40.0 4.0 391.23 24.26 5.67 101.1642534 21.52 238.62 1
2 1/7/96 40.0 0.0 750.00 46.50 10.88 193.935 41.25 457.44 2
3 1/7/96 40.0 0.0 500.00 31.00 7.25 129.29 27.50 304.96 3
4 1/7/96 40.0 4.0 678.73 42.08 9.84 175.5060034 37.33 413.97 4
5 1/7/96 40.0 0.0 900.00 55.80 13.05 232.722 49.50 548.93 5
6 1/7/96 40.0 2.5 765.63 47.47 11.10 197.9753125 42.11 466.97 6
1 1/14/96 40.0 12.0 493.29 30.58 7.15 127.5549282 27.13 300.87 7
2 1/14/96 40.0 0.0 750.00 46.50 10.88 193.935 41.25 457.44 8
3 1/14/96 40.0 8.0 650.00 40.30 9.43 168.077 35.75 396.45 9
4 1/14/96 40.0 7.9 765.05 47.43 11.09 197.8257886 42.08 466.62 10
5 1/14/96 40.0 0.0 900.00 55.80 13.05 232.722 49.50 548.93 11
6 1/14/96 40.0 0.0 700.00 43.40 10.15 181.006 38.50 426.94 12
1 1/21/96 40.0 0.0 340.20 21.09 4.93 87.968916 18.71 207.49 13
2 1/21/96 40.0 0.0 750.00 46.50 10.88 193.935 41.25 457.44 14
3 1/21/96 40.0 2.4 545.00 33.79 7.90 140.9261 29.98 332.41 15
4 1/21/96 40.0 6.7 738.49 45.79 10.71 190.9581624 40.62 450.42 16
5 1/21/96 40.0 0.0 900.00 55.80 13.05 232.722 49.50 548.93 17
6 1/21/96 40.0 5.0 831.25 51.54 12.05 214.944625 45.72 507.00 18
Information Technology and the Firm 551
systems use older file structures or obsolete database management systems and
are almost incapable of accessing and manipulating data.
As an alternative to replacing these systems, data warehousing provides a
state of the art database management system that is fed data from the older
legacy systems. However, data does get duplicated, which can potentially cause
a synchronization problem between the data in the warehouse and the data in
the older legacy systems. Consequently, IT management must put stringent
controls in place. Still, the benefits outweigh the potential problems, for the
data warehouse comes with all of the high tech tools that will enable management
to create a plethora of queries and reports. Most of the newer Decision
Support Tools and Executive Information Systems, which will be discussed
later, require a storage capability similar to the data warehouse.
CONTROLS
Because the initial software applications that were developed in the 1960s and
1970s were accounting oriented, data processing, which is what information
technology was then called, typically reported to the Chief Financial Officer,
creating a control atmosphere consistent with accounting controls. A central
group of trained data entry operators was responsible for entering and verifying
data. Access to the "glass house" was restricted, and in some cases access to
the data entry and report distribution areas was also restricted. Because everything
was self-contained, control was not a major issue.
In the late seventies and early eighties, online terminals began appearing
on users' desks, outside of the glass house, allowing them access to data. Initially,
these terminals were used for information inquiry. Yet, even this limited
function was tightly controlled by strict software access control and password
protection. While workers were getting additional capabilities, they were also
creating opportunities for lapses in control. This was just the beginning of the
Trojan horse. Eventually, data entry moved out of the glass house to the warehouse
receiving dock to be used for inventory receipts; the order entry desk to
be used for new orders; the purchasing department to be used for purchase
orders; and, in the case of retailing, on to the sales f loor for point of sale processing.
No longer were trained data-entry operators responsible for the quality
of the data; others were responsible for entering data, and it was just an
ancillary part of their job, for which they were not necessarily even trained.
The control environment was breaking down, and the introduction of the
personal computer only complicated the issue. No longer was control centralized.
While access to data could be controlled, control over the use of data and
the content of reports was lost. For example, two people could each issue a report
on sales, and the numbers could easily be different. Yet, both reports
could be accurate. How is this possible? Simple. One of the reports may have
been about gross sales and the other about net sales, or one may have been
based on data through Friday and the other on data through Saturday.
552 Making Key Strategic Decisions
When all programming was controlled by a small professional group, control
was much easier. Because today's spreadsheet programs are user friendly,
however, and software does not require programming knowledge, everybody is
his or her own programmer. Thus, it is difficult to control the consistency of
the information that is being distributed.
The problems only become more complicated. Now companies allow their
business partners, vendors, and even outsiders to access their computers, using
the Internet and EDI. Data is interchanged and moneys are exchanged electronically
often without paper backup. While technology can prevent most
unauthorized access to data, as recent history has shown, even the U.S. Defense
Department has not successfully prevented the best hackers from accessing
its computers and wreaking havoc. What was relatively simple to
control before 1990 is now a nightmare. Accountants, systems professionals,
and auditors must remain forever vigilant against both inadvertent and intentional
unauthorized use and abuse of company data.
INFORMATION TECHNOLOGY STRATEGY
How do companies decide how to invest their IT money? What projects get
funded? Which projects are of higher priority? IT strategy is not created in a
vacuum. Rather, like all of the other operational departments within a corporation,
IT must support the direction and goals of the company. The Chief Information
Officer's job is to educate the rest of senior management about IT's
ability to create opportunities for the company and help it move in directions
that make sense.
IT architecture is developed to support the IT and corporate strategy. If
additional networks, workstations, or data warehouses are required, they are
either acquired or developed.
In the late 1980s and early 1990s, Wal-Mart adopted an everyday low
pricing strategy. To accomplish this goal, Wal-Mart needed to change the manner
in which it both conducted business with its suppliers and managed the inbound
logistics, warehousing, and distribution of merchandise to its stores. It
needed to abolish warehousing as much as possible and quicken the process by
which stores ordered and received merchandise. Also, Wal-Mart needed to
eliminate any unnecessary inventory in stores and allow stores to order merchandise
only as needed. Lastly, lags in its distribution centers needed to be
prevented, enabling goods to be received from their suppliers and immediately
shipped to stores.
As a result, Wal-Mart designed a systems and technology infrastructure
that, through EDI, enables the stores to order goods, as needed, from their
suppliers. Moreover, Wal-Mart permits manufacturers to access computerized
sales information directly from its computers, which, in turn, allows them
to gauge Wal-Mart's demand and then stage production to match it. Wal-Mart
effectively shifted the burden of warehousing merchandise from its own
Information Technology and the Firm 553
warehouses to the vendors, eliminating the costs of both warehouse maintenance
and surplus inventory. The distribution centers were automated, allowing
cross docking, whereby goods being received for specific stores were
immediately sent to the shipping area designated for those stores, thus putting
an end to all time lags.
Wal-Mart now has the lowest cost of inbound logistics in its industry. Its
selling G&A is 6% below its nearest competitor, enabling it to be the most
aggressive retailer in its industry. Wal-Mart aligned its IT strategy and infrastructure
to support the company's overall strategy. IT was the agent for
change. Without the newer information technologies, none of the newer strategies
and directions could have been successful.
JUSTIFYING THE COST OF
INFORMATION TECHNOLOGY
Should companies take that giant leap of faith and invest millions of dollars in
new machines and software? Can we measure the return on a company's investment
in technology?
These are questions that, for years, have concerned professional technology
managers. Today, information technology consumes an increasing share of companies'
budgets. While we cannot live with the cost of technology, ultimately, we
cannot live without the technology. Thus, when every new version of the personal
computer chip or Windows hits the market, companies must decide
whether it is a worthwhile investment. Everyone wants the latest and greatest
technology, and they assume that, with it, workers will be more productive.
While IT is the medium for change, its costs and soft benefits are difficult
to measure. As technology gets disbursed throughout a company, it becomes
increasingly difficult to track costs. As workers become their own
administrative assistants, each company must determine whether its workers
are more or less productive when they type their own documents and prepare
their own presentations. These are many of the issues that companies are facing
now and will be in the future as they struggle with new IT investments.
INTERNET/ INTRANET/EXTRANET
The Internet, intranets, and extranets provide companies with a plethora of
opportunities to find new ways of transacting business. An alternative to some
of the older technology, an intranet, a subsystem of the Internet, was developed
in 1996 to allow employees from within a company to access data in the
company's system. A "firewall" prevents outsiders from accessing any data
that a company wishes to keep confidential. An intranet refers to those systems
that are inside the firewall. Employees have the access authority to break
through the firewall and access information, even though they might be using
554 Making Key Strategic Decisions
a computer outside of the company. Remember, the Internet is just one large
party line on which everybody is sending around data.
One manufacturing company provides an intranet facility for its employees
to learn about their health, life and disability insurance, and educational
benefits. The system allows them to sign up for these programs and, in the frequently
asked questions (FAQs) section, to inquire about some of the most
common issues specific to the programs. When online, employees can also access
and sign up for a list of in-house training courses, read an employee
newsletter, and check the current price of the company's publicly traded stock.
An extranet is a version of the intranet that allows external users to access
data inside of the firewall. For example, part of Wal-Mart's ordering and logistics
system allows its vendors and suppliers to access Wal-Mart's store sales
data directly from Wal-Mart's computer systems. If these transactions occurred
over the Internet, they would be referred to as extranet transactions.
ELECTRONIC COMMERCE
Electronic commerce is changing the entire landscape in how business is
transacted. While most consumers think just about business to consumer
(B2C) e-commerce, the greatest potential lies in business-to-business (B2B)
e-commerce. International Data Corporation estimates that B2C e-commerce
will generate $300 billion annually by 2004, but B2B e-commerce will generate
$2.2 trillion annually by 2004. Most of the focus of the investor community
during 1999 and 2000 was on the B2C space, with millions of dollars made and
lost as a result of people not understanding the business model. Most of the
money raised in venture capital was used for advertising to gain brand recognition,
whereas very little was invested in infrastructure. As a result, the B2C
landscape is littered with the corpses of failed ventures. Those that have survived
are spending money on the traditional back office functions that brick
and mortar retailers have developed over the years.
All the while, bricks-and-mortar retailers have been experimenting in
selling on the Internet and have adopted a hybrid model for doing so. Customers
are able to order over the Internet, but they can also return merchandise
to traditional stores. The Internet can also make a significant difference
when products, such as music and software, can be ordered—and delivered—
electronically.
These new opportunities create new challenges for those involved in the
operations, accounting, and finance of these virtual-marketplace companies.
The order is being not only processed electronically but also shipped automatically,
sometimes from a third party's fulfillment center. Also, the payment
is being processed electronically. The electronic payment, usually through a
third-party clearance house, must conform to various security standards in
order to protect credit card information that is transmitted over the Web. Frequently,
the company selling the goods never receives the credit card number
Information Technology and the Firm 555
of the consumer, only an authorization number from the credit card clearance
house. The tracking of the merchandise, as well as the payment, not to mention
the processes for handling customer returns and credits, will present significant
angst for the auditors and controllers of these firms.
Nonetheless, the financial services industry has embraced e-commerce
and now offers most of its products over the Internet. Online services include,
among others, the purchase of stocks and bonds, online mortgages, and life
insurance and online banking. Because they are nontangible, these products
and services lend themselves well to e-commerce. The Internet works well in
many cases, because, while it is not delivering the product itself, it is delivering
information about the product, often in levels of detail and consistency that
were never available in the physical world.
As noted earlier, the real action is and will be in B2B e-commerce. Companies
of every shape and size are realizing the opportunities for both ordering
and selling their products over the Internet. Businesses are or will be using the
Internet for both the purchasing of direct and indirect materials and MRO
(maintenance, repair, and operations). General Electric runs its own auction
site on which suppliers bid to provide GE's operating divisions with millions
of dollars of materials per day. Their private e-auction is squeezing hundreds of
millions of dollars out of purchases annually and opening their purchasing to
many new vendors. Some companies, such as W. W. Grainger, long known as a
supplier of MRO materials through its network of physical distribution centers,
have established a giant Internet presence for the sale of MRO materials
called Total MRO. They are attempting to supply any nondirect material a
company could use, including office equipment and supplies.
Other marketplaces have been created to offer products for specific industries
(vertical marketplaces) or across industries (horizontal marketplaces).
These marketplaces provide not just buying opportunities, but selling opportunities
as well. Many utilize auctions or reverse auctions. Hundreds of millions
of dollars are or will be changing hands on a daily basis, totally electronically.
As per legislation passed by the U.S. government in 2000, it is now possible to
electronically sign purchase commitments and contracts over the Internet.
Some companies are using their Internet site to process orders, create and
price custom configurations (similar to what Dell Computer is doing on its
site), track orders, and assist with customer service. Some industries are creating
their own marketplaces for the cooperative purchase of goods and services.
The most notable of these marketplaces, Covisint, is an online auto parts
exchange created by major automobile manufacturers Ford, GM, and Daimler-
Chrysler. There are multitudes of B2B marketplaces and exchanges. Some are
vertical, servicing specific industries like Metalsite.com for the steel industry,
retailexchange.com for the retail industry, or paperexchange.com for the paper
industry. Others are horizontal marketplaces, like staples.com or wwgrainger
.com. There are also some hybrid models, like Verticalnet.com, that address
multiple industries. Companies like Ariba and Commerce One provide the
necessary software that facilitates these marketplaces and exchanges.
556 Making Key Strategic Decisions
APPLICATION SERVICE PROVIDERS (ASPS)
ASPs are companies that provide hosted access to software applications like
Microsoft Office and ERP systems. In effect, a company rents the application
while the data is processed on the ASP's computer. Companies typically pay a
per-user fee along with a cost-per-storage unit and access-time unit. This cost
structure is similar to a model from the 1960s and 1970s, when computers
were very expensive and companies used service bureaus to process their data.
The difference today is that much of the data is accessed over high speed data
lines or over the Internet. The downside of using an ASP is that the user is
placing its destiny in another company's hands and is dependant on its security
and financial health. The upside is that users are not responsible for purchasing
the application, maintaining it, and having to provide the computer power to
process the data.
WEB HOSTING
While many companies host their own Web site, others prefer to contract that
job out to other companies. These companies provide the communications
lines, Web servers, data backup, and, in some cases, Web design and maintenance
services. Companies that choose to outsource their Web hosting are also
protecting their main network from security breeches. However, they are still
placing a great deal of their data on the Web hosting company's computer,
which is still subject to security hackers. Many large companies such as Earthlink,
AT&T, Qwest, along with many smaller companies, provide Web hosting
services. These companies provide speed, reliability, and cost advantages,
along with redundancy and technical service.
DECISION SUPPORT SYSTEMS/EXECUTIVE
INFORMATION SYSTEMS
A class of software that is used mostly by middle-level and senior executives to
make decisions, this software combines many of the features of traditional exception
reporting with the graphical display tools available in spreadsheets. It
allows users to make their own inquiries into large volumes of data, stored in
databases or data warehouses, and provides for drill down reporting, or "slice
and dice" analysis.
Typically, most data in a database or data warehouse is three dimensional
and looks something like a Rubic's cube. Consider a database model for a chain
of 300 retail stores. The first dimension may be the company's merchandise;
the second dimension may be its store locations; and the third dimension may
represent different points in time. An executive might examine the men's department
sales. Not satisfied with the results, she might then probe to learn
557
EXHIBIT 16.7 Example of options screen for a decision support system.
558
EXHIBIT 16.8 Example of output from a decision support system.
Information Technology and the Firm 559
what categories of items sold better than others. After finding an underperforming
category, she may check how different groups or districts of stores
performed for that category. Knowing how each store performed, she might explode
down, looking at individual items, and compare their performance to
that of a prior week or year. This process is like taking the Rubic's cube and
continually rotating the levels, looking at each of the cube's faces. Each face of
each small cube represents data for a piece of merchandise for a store for a period
of time. That is why this process is referred to as "slice and dice." You can
slice and turn the data any which way you desire. The data can also be viewed
and sorted in a tabular or graphical mode. The same theory applies whether
the database contains retailing data, stock market data, or accounting data. Exhibits
16.7 and 16.8 show examples of a decision support system's output. The
output was created by Pilot Software's executive information system.
ADVANCED TECHNOLOGY
Many new technologies are on the horizon, two of which are database mining
and intelligent agents. Both address the issue of information overload. In the
1970s, the average database was perhaps 100 megabytes (millions of bytes) in
size. In the 1980s, databases were typically 20 gigabytes (billions of bytes).
Now, databases are in the terabytes (trillions of bytes). Wal-Mart has a data
warehouse that exceeds 100 terabytes. With all that data, it is difficult for a
user to know where to look. It is not the question that the user knows to ask
that is necessarily important, but, rather, the question that the user does not
know to ask that will come back to haunt him.
These new technologies examine entire databases, scanning them for any
data that does not fit the business's model and identifying any data that the
user needs to examine further. These data mining techniques can be used successfully
in many industries. For example, auditors might use them to scan
client transaction detail to look for transactions that do not conform to company
policies, and stock analysts can use them to scan data on stock prices and
company earnings over a period of time in order to look for opportunities.
CONCLUSION
The world of business has changed dramatically in the past 10 years. What was
unimaginable then is ordinary today. Product life-cycle times have decreased
from years to months. New technology is being introduced every day. An Internet
year is equal to three or four calendar months. The manager who is comfortable
with and understands the practical implications of technology will be
one of the first to succeed. Imagination and creativity are vital. Don't be afraid
of change. Understand it, and embrace it.
560 Making Key Strategic Decisions
FOR FURTHER READING
Amor, Daniel, The E-business (R)Evolution (Upper Saddle River, NJ: Prentice-Hall,
2000).
Frenzel, Carroll, Management of Information Technology, 3rd ed. (Danvers, MA:
Boyd & Fraser, 1999).
Fried, Louis, Managing Information Technology in Turbulent Times (New York: John
Wiley, 1995).
Kanter, Jerry, Information Literacy (Wellesley, MA: Babson Press, 1996).
Kanter, Jerry, Information Technology for Business Managers (New York: McGraw-
Hill, 1998).
Kalakota, R., and M. Robinson, E-Business 2.0 (Boston: Addison-Wesley, 2000).
Nickerson, Robert, Business and Information Systems, 2nd ed. (Upper Saddle River,
NJ: Prentice-Hall, 2001).
Pearlson, Keri, Managing and Using Information Systems (New York: John Wiley,
2001).
Reynolds, George, Information Systems for Managers (St. Paul, MN: West, 1995).
Turban, E., E. McLean, and J. Wetherbe, Information Technology for Management,
2nd ed. (New York: John Wiley, 2001).
Turban, E., J. Lee, D. King, and H. M. Chung, Electronic Commerce—A Managerial
Perspective (Upper Saddle River, NJ: Prentice-Hall, 2001).
INTERESTING WEB SITES
www.ariba.com ARIBA
www.baan.com BAAN
www.commerceone.com Commerce One
www.esri.com ESRI
www.greatplains.com Great Plains Software
www.intel.com Intel
www.intuit.com INTUIT
www.macola.com Macola Software
www.microsoft.com Microsoft
www.microstrategy.com Microstrategy
www.oracle.com ORACLE
www.retailexchange.com Retail Exchange
www.sap.com SAP
www.staples.com Staples
www.sun.com Sun Microsystems
www.verticalnet.com VerticalNet
www.wwgrainger.com W. W. Grainger
561
17
PROFITABLE
GROWTH BY
ACQUISITION
Richard T. Bliss
The subject of this chapter is growth by acquisition; few other business transactions
receive more scrutiny in both the popular and academic presses. There are
several reasons for this attention. One is the sweeping nature of the deals, which
typically result in major upheaval and job losses up to the highest levels of the
organizations. A second is the sheer magnitude of the deals—the recently announced
merger between Time-Warner and AOL, worth more than $150 billion,
exceeds the annual GDP of 85% of the world's nations! Thirdly, the
products involved are known to billions around the globe. Daimler-Benz, Coca
Cola, and Louis Vuitton are just a few of the world-renowned brand names recently
involved in merger and acquisition (M&A) transactions. Finally, the personalities
and plots in M&A deals are worthy of any novelist or Hollywood
scriptwriter. The 1988 acquisition of Nabisco Foods by RJR Tobacco—at that
time the largest deal ever, at $25 billion—was the subject of a New York Times
best-seller and a popular film, both called Barbarians at the Gate. Since then,
there have been numerous other best-selling books and movies based on real
and fictional M&A deals.
In spite of this publicity and the huge amounts of money involved, it is important
to remember that M&A transactions are similar to any other corporate
investment, that is, they involve uncertainty and the fundamental tradeoff between
risk and return. To lose sight of this simple fact or to succumb to the
emotion and frenetic pace of M&A deal-making activities is a sure path to an
unsuccessful result. Our goal in this chapter is to identify the potential pitfalls
you may face and to create a road map for a successful corporate M&A strategy.
562 Making Key Strategic Decisions
We review the historical evidence and discuss some of the characteristics of
both unsuccessful and successful deals. The importance of value creation is
highlighted, and we present simple analytical tools that can be used to evaluate
the potential of any merger or acquisition. Practical aspects of initiating and
structuring M&A transactions are presented and the issues critical to the successful
implementation of a new acquisition are brief ly described. It is important
to understand that there are many legal and financial intricacies involved
in most M&A transactions. Our objective here is not to explain each of these in
detail, since there are professional accountants, lawyers, and consultants available
for that. Instead, we hope to provide valuable and concise information for
busy financial managers so that they can design and implement an effective
M&A strategy.
DEFINITIONS AND BACKGROUND
Before examining the historical evidence on acquisitions, we need to define
some terminology. An acquisition is one form of a takeover, which is loosely defined
as the transfer of control of a firm from one group of shareholders to another.
In this context, control comes with the ability to elect a majority of the
board of directors. The firm seeking control is called the bidder and the one
that surrenders control the target. Other forms of takeovers include proxy contests
and going private, but the focus of this chapter is takeover via acquisition.
As we can see, acquisitions may occur in several ways. In a merger, the
target is absorbed by the bidder and the target's original shareholders receive
shares of the bidder. In a consolidation, the firms involved become parts of an
entirely new firm, with the bidder usually retaining control of the new entity.
All original shareholders hold shares in the new firm after the deal. The two
transactions have different implications for shareholders, as the following examples
make clear.
Example 1 There has recently been a wave of takeover activity in the
stuffed animal industry. Griffin's Giraffes Inc. (GGI) has agreed to merge
Takeover
Acquisition
Proxy contest
Going private
Merger or consolidation
Stock acquisition
Asset acquisition
Profitable Growth by Acquisition 563
with Hayley's Hippos Inc. (HHI). GGI offers one of its shares for three shares
of HHI. When the transaction is completed, HHI shares will no longer exist.
The original HHI stockholders own GGI shares equal in number to one-third
of their original HHI holdings. GGI's original shareholders are unaffected by
the transaction, except to have their ownership stake diluted by the newly issued
shares.
Example 2 Kristen's Kangaroos Inc. (KKI) wishes to take over the operations
of Michael's Manatees Inc. (MMI) and Brandon's Baboons Inc. (BBI). Rather
than giving its shares to the owners of MMI and BBI, KKI decides to establish
a new firm, Safari Ventures Inc. (SVI). After this consolidation, shareholders of
the three original companies (KKI, MMI, and BBI) will hold shares in the new
firm (SVI), with KKI having the controlling interest. The three original firms
cease to exist.
Another method of acquisition involves the direct purchase of shares,
either with cash, shares of the acquirer, or some combination of the two. These
stock acquisitions may be negotiated with the mangers of the target firm or by
appealing directly to its shareholders, often via a newspaper advertisement.
The latter transaction is called a tender offer, which typically occur after negotiations
with the target firm's management have failed. Finally, an acquisition
can be effected by the purchase of the target's assets. Asset acquisitions are
sometimes done to escape the liabilities (real or contingent) of the target firm
or to avoid having to negotiate with minority shareholders. The downside is
that the legal process of transferring assets may be expensive.
Acquisitions can be categorized based on the level of economic activity
involved according to the following:
• Horizontal: The target and bidder in a horizontal merger are involved in
the same type of business activity and industry. These mergers typically
result in market consolidation, that is, more market share for the combined
firm. Because of this, they are subject to extra antitrust scrutiny.
The pending acquisition of USAir by United Airlines is an example of a
horizontal merger (see p. 564). Because the combined entity would be the
world's largest airline and have a dominant market share in the United
States, the Justice Department has demanded that certain assets and
routes be divested before approval for the deal will be granted.
• Vertical: A vertical merger involves firms that are at different levels of
the supply chain in the same industry. For example, stand-alone Internet
service provider/portal AOL functions primarily as a distribution channel.
Its pending merger with Time Warner will allow AOL to move up the
home entertainment industry supply chain and control content in the
form of Time Warner's music and video libraries.
• Conglomerate: In a conglomerate merger, the target and bidder firms are
not related. These were popular in the 1960s and seventies but are rare
564 Making Key Strategic Decisions
today. An auto manufacturer acquiring an ice cream producer would be
an example.
Armed with a basic understanding of the types of acquisitions and how
they occur, we now turn our attention to the track record of M&A transactions.
Be forewarned that it is spotty at best and that many practitioners, analysts, and
academics believe that the odds are stacked against acquirers. We do not say this
to dissuade anyone from pursuing an acquisition strategy, but rather to highlight
the fact that without careful planning, there is little chance of success.
THE TRACK RECORD OF MERGERS AND ACQUISITIONS
There has been tremendous growth in the number and dollar value of M&A
transactions over the last two decades (see Exhibit 17.1). In 1998, the total annual
value of completed transactions exceeded one trillion dollars for the first
time in history. The number of deals fell in 1999, but larger deals resulted in a
total deal value of almost $1.5 trillion. Exhibit 17.2 lists the largest deal for
each of the years between 1990 and 2000.
While the data in Exhibits 17.1 and 17.2 focus on large transactions, the
growth trend for all M&A deals is similar. And in 1999, for the first time in
history, there were more deals done abroad than in the United States. By any
SOURCE: The Wall Street Journal, December 20, 2000.
Profitable Growth by Acquisition 565
measure, the 1990s was an increasingly acquisitive decade around the world.
This explosion in deal making might lead one to assume that mergers and acquisitions
are an easy way for corporate managers to create value for their
shareholders. To assess this, we now examine the empirical evidence on mergers
and acquisitions. Let's begin with the wealth of academic studies that analyze
M&A performance.1
M&A activity has been the focus of volumes of academic research over
the last 40 years. The evidence is mixed, but we can draw several clear conclusions
from the data. We break our discussion into two pieces: short-term
EXHIBIT 17.1 M&A activity, 1981–1999.a
aData is for deals valued at at least $5 million and involving one U.S. company.
SOURCE: Mergers & Acquisitions, September 2000.
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999
Year
Number of deals
Value (billions)
Number of deals (left axis)
Total value (right axis)
0
2,000
4,000
6,000
8,000
10,000
12,000
0
200
400
600
800
1,000
1,200
1,400
1,600
EXHIBIT 17.2 A decade of megadeals.
Price
Year Bidder Target (billions)
1990 Time Inc. Warner Communications $ 12.6
1991 AT&T Corp. NCR Corp. 7.5
1992 BankAmerica Corp. Security Pacific Corp. 4.2
1993 Merck & Co. Medco Containment Services 6.2
1994 AT&T Corp. McCaw Cellular Inc. 18.9
1995 AirTouch Communications US West Inc. 13.5
1996 Walt Disney Co. Capital Cities/ABC Inc. 18.9
1997 Bell Atlantic Corp. NYNEX Corp. 21.3
1998 Travelers Group Inc. Citicorp 72.6
1999 Exxon Corp. Mobil Corp. 78.9
2000 America Online Inc. Time Warner Inc. 156.0
SOURCE: Mergers & Acquisitions, September 2000.
566 Making Key Strategic Decisions
and long-term M&A performance. The short-term is a narrow window, typically
three to five days, around the merger announcement. Long-term studies
examine postmerger performance two to five years after the transaction is
completed.
We can offer three unambiguous conclusions about the short-term financial
impact of M&A transactions:
1. Shareholders of the target firms do very well, with average premiums between
30% and 40%.
2. Returns to bidders have fallen over time as the market for corporate control
becomes more competitive; recent evidence finds bidder returns indistinguishable
from zero or even slightly negative.
3. The combined return of the target and the bidder, that is, the measure of
overall value creation, was slightly positive.
However, these results are highly variable depending on the specific samples
and time periods analyzed. The findings on the long-term performance of
mergers and acquisitions are not any more consistent or encouraging. Agrawal
et al. report "shareholders of acquiring firms experience a wealth loss of about
10% over the five years following the merger completion."2 Other studies' conclusions
range from underperformance to findings of no abnormal postmerger
performance. The strongest conclusions offered by Weston et al. are that, "It is
likely, therefore, that value is created by M&As," and that, "Some mergers
perform well, others do not."3 So much for the brilliance of the academy! This
level of confidence hardly seems to justify the frenetic pace of merger activity
chronicled in Exhibits 17.1 and 17.2.
If the academic literature seems ambivalent about judging the financial
wisdom of M&A decisions, the popular business press shows no such hesitancy.
In a 1995 special report, Business Week carefully analyzed 150 recent deals
valued at $500 million or more and reported "about half destroyed shareholder
wealth" and "another third contributed only marginally to it." The article's last
paragraph makes it clear that this is not a benign finding and places the blame
squarely on corporate CEOs.
All this indicates that many large-company CEOs are making multibilliondollar
decisions about the future of their companies, employees, and shareholders
in part by the seat of their pants. When things go wrong, as the
evidence demonstrates that they often do, these decisions create unnecessary
tumult, losses, and heartache. While there clearly is a role for thoughtful and
well-conceived mergers in American business, all too many don't meet that
description.
Moreover, in merging and acquiring mindlessly and f lamboyantly, dealmakers
may be eroding the nation's growth prospects and global competitiveness.
Dollars that are wasted needlessly on mergers that don't work might
better be spent on research and new-product development. And in view of the
growing number of corporate divorces, it's clear that the best strategy for most
would-be marriage partners is never to march to the altar at all.4
Profitable Growth by Acquisition 567
A 1996 survey of 150 companies by the Economist Intelligence Unit in London
found that 70% of all acquisitions failed to meet the expectations of the initiator.
Coopers and Lybrand studied the postmerger performance of 125 companies
and reported that 66% were financially unsuccessful.
We now turn our attention to several specific M&A transactions. While
unscientific, this approach is more informative and certainly more interesting
than reviewing academic research. We purposely focus on failed deals in an attempt
to learn where the acquirers went wrong. In the next section, we examine
the acquisition strategy and policies of Cisco Systems, the acquirer ranked
No. 1 in a recent survey of corporate M&A practices.
As you read about these dismal transactions, can you speculate on the reasons
for failure? On their faces, they seemed like strategically sound transactions.
While one might question AT&T's push into personal computers, the
other two deals were simple horizontal mergers, that is, an extension of the existing
business into new product lines or geographic markets. In hindsight,
each deal failed for different reasons, but there are some common issues. The
lessons learned are critical for all managers considering growth by acquisition.
We now examine these colossal failures in more detail.
Analysts believe that the merger between AT&T and NCR failed due to
managerial hubris, overpayment, and a poor understanding of NCR's products
and markets. A clash between the two firms' cultures proved to be the final
nail in the coffin. In 1990 AT&T's research division, Bell Labs, was one of the
worlds premier laboratories. With seven Nobel prizes and countless patents to
its name, it was where the transistor and the UNIX operating system had been
invented. AT&T's executives mistakenly believed that this research prowess
Disaster Deal No. 1
Between 1985 and 1990, AT&T's computer operations lost approximately $2
billion. The huge conglomerate seemed unable to compete effectively against
the likes of Compaq, Hewlett Packard and Sun Microsystems. They decided to
buy rather than build and settled on NCR, a profitable, Ohio-based personal
computer (PC) manufacturer with 1990 revenues of $6 billion. NCR did not
want to be purchased and this was made clear in a letter from CEO Chuck
Exley to AT&T CEO Robert Allen: "We simply will not place in jeopardy the
important values we are creating at NCR in order to bail out AT&T's failed
strategy." OUCH! However, after a bitter takeover fight—and an increase of
$1.4 billion in the offer price (raising the premium paid to more than
100%!)—AT&T acquired NCR in September 1991 for $7.5 billion.
Aftermath: In 1996, after operating losses exceeding $2 billion and a $2.4 billion
write-off, AT&T spun-off NCR in a transaction valued at about $4 billion,
approximately half of what it had paid to acquire NCR less than five years
before.
568 Making Key Strategic Decisions
and $20 billion of annual long-distance telephone revenues, along with the
NCR acquisition, would guarantee the company's success in the PC business.
They were confident enough to increase their original offer price by $1.4 billion.
The problem was that by this time, PCs had become a commodity and
were being assembled at low-cost around the world using off-the-shelf components.
Unlike the microprocessor and software innovations of Intel and Microsoft,
AT&T's research skills held little profit potential for the PC business.
AT&T hoped to use NCR's global operations to expand their core telecom
business. But NCR's strengths were in developed countries, whereas the
fastest-growing markets for communications equipment were in developing
third-world regions. And in many companies, the computer and telephone systems
were procured and managed separately. Thus, the anticipated synergies
never materialized.
Finally, the two companies had very different cultures. NCR was tightly
controlled from the top while AT&T was less hierarchical and more politically
correct. When AT&T executive Jerre Stead took over at NCR in 1993, he
billed himself as the "head coach," passed out T-shirts, and told all of the employees
they were "empowered." This did not go over well in the conservative
environment at NCR, and by 1994, only 5 of 33 top NCR managers remained
with the company.
Disaster Deal No. 2
Throughout 1994, Quaker Oats Co. was rumored to be a takeover target. It was
relatively small ($6 billion in revenue) and its diverse product lines could be
easily broken up and sold piecemeal. In November, Quaker announced an
agreement to buy iced-tea and fruit-drink maker Snapple Beverage Corp. for
$1.7 billion, or $14 per share. CEO William Smithburg dismissed the 10%
drop in Quaker 's stock price, arguing "We think the healthy, good-for-you
beverage categories are going to continue to grow." The hope was that Quaker
could replicate the success of its national-brand exercise drink Gatorade,
which held an extraordinary 88% market share.
Snapple, which had 27% of the ready-to-drink tea segment was distributed
mainly through smaller retail outlets and relied on offbeat advertising
and a "natural" image to drive sales. Only about 20% of sales were from supermarkets
where Quaker 's strength could be used to expand sales of Snapple's
drinks.
Aftermath: In April 1997, Quaker announced it would sell Snapple for
$300 million to Triarc Cos. Quaker takes a $1.4 billion write-off and the sale
price is less than 20% of what Quaker paid for Snapple less than three years
earlier. Analysts estimated the company also incurred cash losses of approximately
$100 million over the same period. Ending a 30-year career with the
company, CEO Smithburg "retires" two weeks later at age 58.
Profitable Growth by Acquisition 569
What doomed the Quaker-Snapple deal? One factor was haste. Quaker
was so worried about becoming a takeover target in the rapidly consolidating
food industry that it ignored evidence of slowing growth and decreasing profitability
at Snapple. The market's concern was ref lected in Quaker's stock price
drop of 10% on the acquisition announcement. In spite of this, Quaker's managers
proceeded, pushing the deal through on the promise that Snapple would
be the beverage industry's next Gatorade. This claim unfortunately ignored the
realities on the ground: Snapple had onerous contracts with its bottlers, fading
marketing programs, and a distribution system that could not support a national
brand. There was also a major difference between Snapple's quirky, offbeat
corporate culture and the more structured environment at Quaker.
Most importantly, Quaker failed to account for the possible entrance of
Coca Cola and Pepsi into the ready-to-drink tea segment—and there were few
barriers to entry—which ultimately increased competition and killed margins.
Disaster Deal No. 3
The 1998 $130 billion megamerger between German luxury carmaker Daimler-
Benz and the #3 U.S. automobile company, Chrysler Corporation, was universally
hailed as a strategic coup for the two firms. An official at a rival firm
simply said "This looks like a brilliant move on Mercedes-Benz's part."* The
stock market agreed as the two companies' shares rose by a combined $8.6 billion
at the announcement. A 6.4% increase in Daimler-Benz's share price accounted
for $3.7 billion of this total. The source of this value creation was
simple: There was very little overlap in the two companies' product lines or geographic
strengths. "The issue that excites the market is the global reach," said
Stephen Reitman, European auto analyst for Merrill Lynch in London.* Daimler
had less than 1% market share in the U.S., and Chrysler 's market share in
Europe was equally miniscule. There would also be numerous cost-saving opportunities
in design, procurement, and manufacturing.
The deal was billed as a true partnership, and the new firm would keep
operational headquarters in both Stuttgart and Detroit and have "co-CEOs"
for three years after the merger. In addition, each firm would elect half of the
directors.
Aftermath: By the end of 2000, the new DaimlerChrysler 's share price
had fallen more than 60% from its post merger high. Its market capitalization
of $39 billion was 20% less than Daimler-Benz's alone before the merger! All
of Chrysler 's top U.S. executives had quit or been fired, and the company's
third-quarter loss was an astounding $512 million. As if all of this weren't bad
enough, DaimlerChrysler 's third-largest shareholder, Kirk Kekorian, was suing
the company for $9 billion, alleging fraud when they announced the 1998 deal
as a "merger of equals."
* "Auto Bond: Chrysler Approves Deal With Daimler-Benz," The Wall Street Journal,
May 7, 1998.
570 Making Key Strategic Decisions
In this case, Quaker's management was guilty of two mistakes: failure to analyze
Snapple's products, markets, and competition correctly and overconfidence
in their ability to deal with the problems. Either way, their lapses cost
Quaker's shareholders billions.
Although the jury is still out on the Daimler-Chrysler merger, analysts already
have assigned at least some of the blame. There were culture issues from
the start, and it quickly became apparent that co-CEOs were not the way to
manage a $130 billion global giant. Chrysler CEO Robert Eaton left quietly at
the beginning of 2000 and there were other departures of high-level American
executives. Morale suffered as employees in the U.S. realized that the "merger
of equals" was taking on a distinctive German f lavor and in November 2000,
the last remaining Chrysler executive, U.S. president James Holden, was fired.
Rather than deal with these issues head-on, Daimler CEO Jergen
Schremp took a hands-off approach as Chrysler's operations slowly spiraled
downward. The company lost several top designers, delaying new product introductions
and leaving Chrysler with an aging line of cars at a time when its
competitors were firing on all cylinders. The delay in merging operations
meant cost savings were smaller than anticipated as were the benefits from
sharing technology. Finally, analysts suggested that Daimler paid top dollar for
Chrysler at a time when the automobile industry in the U.S. was riding a wave
of unprecedented economic prosperity. As car sales began to sag at the end of
2000, all three U.S. manufacturers were facing excess capacity and offering
huge incentives to move vehicles. This was not the ideal environment for
quickly restructuring Chrysler's troubled operations and Daimler was facing a
35% drop in projected operating profit between 1998 and 2001.
Conclusions: These three case studies highlight some of the difficulties
firms face in achieving profitable growth through acquisitions. Managerial
hubris and a competitive market make it easy to overestimate the merger 's
benefits and therefore overpay. A deal that makes sense strategically can still
be a financial failure if the price paid for the target is too high. This is especially
a problem when economic conditions are good and high stock prices
make it easy to justify almost any valuation if the bidder 's managers and directors
really want to do a deal. Shrewd managers can sell deals that make little
strategic sense to unsuspecting shareholders and then ignore signals from the
market that the deal is not a good one.
The previous examples make it clear that it is easy to overstate the benefits
that will come after the transaction is completed. Whatever their source,
these benefits are elusive, expensive to find and implement, and subject to attack
by competitors and economic conditions. Managers considering an acquisition
should be conservative in their estimates of benefits and generous in the
amount of time budgeted to achieve these benefits. The best way to accurately
estimate the benefits of the merger is to have a thorough understanding of the
target's products, markets, and competition. This takes time and can only come
from careful due diligence, which must be conducted using a disciplined
Profitable Growth by Acquisition 571
approach that fights the tendency for managers to become emotionally attached
to a deal. In spite of the time pressures inherent in any merger transaction,
this is truly a situation where "haste makes waste."
A common factor in each of these transactions—and one often overlooked
by managers and researchers in finance and accounting—is culture. Two types
of culture can come into play in an acquisition. One is corporate or industry
culture and the second is national culture, which is a factor in cross-border
deals. If the target is in a different industry than the bidder, a careful analysis
of the cultural differences between them is essential. Culture is especially
critical in industries where the main assets being acquired are expertise or intellectual
capital. Failure to successfully merge cultures in such industries can
be particularly problematic because key employees will depart for better working
conditions. The attempted 1998 merger between Computer Associates
(CA) and Computer Science Corporation (CSC) ultimately failed when CA realized
that their mishandling of the negotiations and their insensitivity to the
culture at CSC would cause many of CSC's consultants to quit the merged
company. We will discuss the keys to successful implementation of mergers
later in the chapter. In the next section we examine the acquisition strategy of
Cisco Systems Inc. We do this to make it clear that there are ways to increase
your chances of success when planning and implementing an M&A strategy.
ANATOMY OF A SUCCESSFUL ACQUIRER:
THE CASE OF CISCO SYSTEMS INC.
Cisco Systems Inc., the Silicon Valley-based networking giant, is one of the
world's most successful corporations. Revenues for the fiscal year ending July
2000 were up an incredible 55% to $18.9 billion, while net income grew to $3.9
billion, resulting in a healthy 21% net profit margin. Even more impressive was
its 10th consecutive quarter of accelerating sales growth, culminating in a 61%
sales increase for the last quarter. At $356 billion, Cisco's market capitalization
trailed only General Electric Company. What is behind such phenomenal results?
Beginning in 1993, Cisco has acquired 51 companies, 21 of them in the
12-month period ending March of 2000. Not every one of these deals has been
a winner, and certainly some elements of Cisco's strategy are unique to the
high-technology industry. However, in a recent survey of corporate M&A policies
Cisco was ranked number 1 in the world, and there are lessons for any potential
acquirer in its practices.5
We will focus on two aspects of Cisco's acquisition strategy: the competitive
and economic forces behind it and how new acquisitions are merged into
the corporate fold. The strategic imperative behind Cisco's acquisition spree is
simple. Each year the company gets 30% to 50% of its revenue from products
that it did not sell 12 months before. Technological change means that Cisco
cannot internally develop all of the products its customers need. They have
two choices; to limit their offerings or to buy the products and technology they
572 Making Key Strategic Decisions
can't or choose not to develop. In this case, the strategy is driven by their customer's
demands and by the realities of the industry. Once CEO John Chambers
and Cisco's board made rapid growth a priority, an effective M&A plan
was the only way to accomplish this goal. To minimize risk, Cisco often begins
with a small investment to get a better look at a potential acquisition and to assess
it products, customers, and culture. Finally, Cisco often looks for private
and pre-IPO companies to avoid lengthy negotiations and publicity.
Cisco's 1999 acquisition of fiber-optic equipment maker Cerent Corporation
is a good example of this strategy. Cisco purchased a 9% stake in Cerent in
1998 as a hedge against what analysts viewed as Cisco's lack of fiber-optic expertise.
Through this small investment, Cisco CEO John Chambers got to
know Cerent's top executive, Carl Russo. He quickly realized that they had
both come up through the high-tech ranks as equipment salesmen and had
built their companies around highly motivated and aggressive sales teams. Cerent's
266 employees included a 100-member sales team that had assembled a
rapidly growing customer base. Cerent also favored sparse offices—a Cisco
trademark—and Mr. Russo managed the company from an eight-foot square
cubicle. All of these factors gave Cisco important insights into Cerent's
strengths and corporate culture.
When Mr. Chambers felt comfortable that Cerent could successfully become
part of Cisco, he personally negotiated the $7 billion purchase price for
the remaining 91% stake with Mr. Russo. The discussions took a total of two
and a half hours over three days. When the deal was announced on August 25,
1999, the second—and arguably the most important—phase of Cisco's acquisition
strategy kicked in. Over the years, including an occasional failure, Cisco
had developed a finely tuned implementation plan for new acquisitions. The
plan has three main pieces:
1. Don't forget the customer.
2. Salespeople are critical.
3. The small things garner loyalty.
There is often a customer backlash to merger announcements because
customers' perception of products and brands may have changed. In the recent
spate of pharmaceutical industry mergers, only those firms that avoided pairing
up experienced substantial sales growth. As part of the external environment,
customers are easy to ignore in the short term when the tendency is to
focus on the internal aspects of the implementation. This is a big mistake. To
allay customer fears, in the weeks after Cerent was acquired, Mr. Russo and his
top sales executive attended the annual Cisco sales convention meeting and
Mr. Chambers joined sales calls to several of Cerent's main customers.
This lesson did not come cheaply. When Cisco acquired StrataCom in
1996, it immediately reduced the commission schedule of StrataCom's sales
force and reassigned several key accounts to Cisco salespeople. Within a few
months, a third of StrataCom's sales team had quit, sales fell drastically, and
Cisco had to scramble to retain customers. In the Cerent implementation, the
Profitable Growth by Acquisition 573
sales forces of the two companies remained independent and Cerent's salespeople
received pay increases of 15% to 20% to bring them in line with Cisco's
compensation practices. As a result, there was little turnover and sales grew.
Cisco executives realized early on that the strategic rationale for an acquisition
and their grand plans for the future meant little to the target's midand
low-level employees. They had more basic concerns like job retention and
changes in their day-to-day activities. Cisco had also learned that quickly winning
over these employees—and keeping them focused on their jobs—was critical
to a successful implementation. This process begins weeks before the deal
is done, as the Cisco transition team works to map each employee at the target
into a Cisco job. As each Cerent employee left the meeting where the acquisition
was announced, they were given an information packet on Cisco, telephone
and e-mail contacts for Cisco executives, and a chart comparing the
vacation, medical, and retirement benefits of the two companies. There were
follow-up sessions over the next several days to answer any lingering questions.
Cisco also agreed to honor several aspects of Cerent's personnel policies that
were more generous than their own, such as providing more-generous expense
allowances and permitting previously promised sabbaticals to be taken. Cisco
understood that these are relatively small items in the larger context of a successful
and timely transition.
When the merger was actually completed, Cerent employees had new IDs
and business cards within days. By the following week, the e-mail and voicemail
systems had been converted to Cisco's standards and all of Cerent's computer
systems were updated. By the end of September, one month after the
acquisition announcement, the new employee mapping had been implemented.
Most employees kept their original jobs and bosses; about 30 were reassigned
because they had positions that overlapped directly with Cisco workers. Overall,
there was little turnover.
This example highlights some of the factors important to developing and
implementing a successful acquisition strategy. However, all companies are not
like Cisco, and what works for them may not guarantee you a winning acquisition
plan. Cisco is fortunate to be in a rapidly growing industry in continuous
need of new technologies and products. It also has the benefit of a high stock
market valuation, which makes its shares valuable currency for making acquisitions.
At the same time, the keys to successful implementation discussed previously—
that is, concern for the customer, taking care of salespeople, and
understanding what creates employee loyalty—are universal and must be part
of any acquisition strategy. In the next section we look more closely at the question
of value creation in M&A decisions.
CREATING VALUE IN MERGERS
AND ACQUISITIONS
We have already presented the dubious historical evidence on the financial
performance of mergers and acquisitions. This record makes it clear that a
574 Making Key Strategic Decisions
significant number destroy shareholder value, some spectacularly. In this section,
we more closely examine the issue of value creation, focusing on its
sources in mergers and acquisitions. We begin the discussion with an assumption
that the objective of managers in initiating these transactions is to increase
the wealth of the bidder's shareholders. We will ignore the reality that managers
may have personal agendas and ulterior motives for pursuing mergers and
acquisitions, even those harmful to their shareholders. A discussion of these issues
is beyond the scope of this chapter.6
To be very clear, recall the source of all value for holders of corporate equity.
Stock prices are a function of two things: expected future cash f lows and
the risk of those f lows. These cash flows may come as dividends, share price
increases, or some combination of the two, but the important thing to understand
is that changes in share prices simply ref lect the market's expectations
about future cash flows or their risk—nothing more and nothing less. If investors
believe a company's cash f lows in the future will be smaller or riskier,
ceteris paribus, the share price will decline. If the expectation is for larger or
less risky cash f lows, the share price goes up. Thus, when we talk about M&A
decisions creating value, there can only be two sources of that value: more cash
f low or less risk. Our discussion focuses primarily on the former.
Consider two independent firms, A and B, with respective values VA and
VB. Assume that the managers of firm A feel that the acquisition of firm B, that
is, the creation of a merged firm AB, would create value. That is, they believe
VAB > VA + VB. The difference between the two sides of this equation, VAB − (VA
+ VB), is the incremental value created by the acquisition, sometimes called the
synergy. That is,
Clearly, positive synergy would be a prerequisite to going forward with the acquisition.
In practice, things are a bit more complicated for two reasons: the
costs of an acquisition and the target premium. The acquisition process carries
significant direct costs for lawyers, consultants, and accountants. There is also
the indirect cost caused by the distraction of the bidder's executives from their
day-to-day operation of the existing business. Finally, the data presented in the
section on mergers and acquisitions shows that target shareholders in acquisitions
typically receive a 30% to 40% premium over market price. Some transactions
have smaller premiums, but in almost all cases, the acquirer pays a
price above the pre-acquisition market value. All of these costs can be factored
into the evaluation as follows:
Example 3 Midland Motorcycles Inc. is considering the acquisition of Scotus
Scooters. Midland's current market capitalization is $10 million, while Scotus
has a market capitalization of $2 million. The executives at Midland feel the
combined firm would be worth $14 million due to synergies. Current takeover
premiums average 35% and the total cost of the acquisition is estimated at $1.5
million. Should Midland proceed with the deal?
Net advantage of merging = V Merger costs Premium (2) AB A B [ − (V + V )]− −
Synergy (1) AB A B = V − (V + V )
Profitable Growth by Acquisition 575
The deal would destroy $200,000 of value. Note that this is in spite of the fact
that there are $2 million of positive synergies created by the acquisition. The
reality is that this synergy is more than offset by the costs of the transaction
and the premium paid for the target, a typical problem in acquisitions. For example,
consider Coca-Cola's recent interest in Quaker Oats, which Coke CEO
Douglas Daft felt "fit perfectly into Coke's strategy of boosting growth by increasing
its share of non-carbonated drinks."7 Even Coke's directors felt that
the strategic rationale behind the transaction was sound. But the deal was
ultimately rejected because of the price. Warren Buffett, a major Coca-Cola
shareholder, said "Giving up 10% of the Coca-Cola Company was just too much
for what we would get."8
Note that the bracketed term in equation 2 is just the synergy as defined
in equation 1. Where does this synergy or incremental value originate? From
above, we know that value can only come from two places—increased cash
f lows or reduced risk. In this case, the synergy can be computed as follows:
where ÄCFt is the incremental cash f low in period t, and r is the appropriate
risk-adjusted discount rate. The total synergy is just the present value of all future
incremental cash flows. Equation 3 makes it clear that changes in future
cash f lows or their risk are at the root of any M&A synergies. Before considering
how a merger might impact cash f lows, recall how they are computed:
With this in mind, we can look more closely at potential sources of incremental
cash flows—and therefore, value—in acquisitions. We focus on the following
three areas:
1. Incremental revenue.
2. Cost reductions.
3. Tax savings.
Incremental Revenue More revenue for the combined firm can come from
marketing gains, strategic benefits, or market power. Increased revenue
through marketing gains result from improvements in advertising, distribution
or product offerings. For example, when Citicorp and Travelers Inc. announced
their merger in 1998, incremental revenue was a key factor:
Incremental Revenues
− Incremental Costs
− Incremental Taxes
− Incremental Investment in New Working Capital
− Incremental Investment in Fixed Assets
= Incremental Cash Flow
Synergy = (3)
( + ) =
∞ Ó ÄCF
r
t
t t 1 0
Net advantage of merging =[14 − ($10 + $2)]− $1.5 − (35%× $2) = −$0.2 million
576 Making Key Strategic Decisions
"Finally, there is the central justification of the deal: cross-selling each other 's
products, mainly to retail customers. Over the next two years, Citigroup ought
to be able to generate $600 million more in earnings because of cross-selling."9
After acquiring Miller Brewing Company in 1970, Philip Morris used its marketing
and advertising strength to move Miller from the number 7 to the number
2 U.S. beer maker by 1977.
Some acquisitions provide strategic benefits that act as insurance against
or options on future changes in the competitive environment. As genetic research
has advanced, pharmaceutical firms have used acquisitions to ensure
they participate in the commercial potential offered by this new technology.
The 1998 acquisition of SmithKline Beecham PLC by Glaxo Wellcome PLC
was motivated by Glaxo's fear of missing out on this revolution in the industry.
SmithKline had entered the genetic research field in 1993 by investing $125
million in Human Genome Sciences, a Rockville, Maryland, biotechnology
company created to commercialize new gene-hunting techniques.
Finally, the acquisition of a competitor may increase market share and
allow the merged firm to charge higher prices. By itself, this motive is not valid
justification for initiating a merger, and any deal done solely to garner monopolistic
power would be challenged by global regulators on antitrust grounds.
However, market power may be a by-product of a merger done for other reasons.
American Airline's potential bid for USAir, while launched primarily to
thwart a similar attempt by its competition, would also have implications for
market power in the industry.
American is particularly worried about the prospect of USAir falling into
United's hands. Nabbing the carrier for itself would give American coveted
slots at Chicago's O'Hare, New York's LaGuardia, and Washington's National
Airport.10
Cost Reductions Improved efficiency from cost savings is one of the most
often cited reasons for mergers. This is especially true in the banking industry,
as the recent merger between J.P. Morgan and Chase Manhattan makes clear.
The key to executing the merger, say analysts, will be how quickly Chase can
trim its expenses. It plans to save $500 million through job cuts, $500 million by
consolidating the processing systems of the two institutions and $500 million
by selling off excess real estate. In London, for example, the two banks have 21
buildings, and they won't need all of them.11
In total, there is an estimated $1.5 billion of annual savings. The link between
this and value creation is easy for investors to understand and the benefits from
cost reductions are relatively easy to quantify. These benefits can come from
economies of scale, vertical integration, complementary resources, and the
elimination of inefficient management.
Economies of scale result when a certain percentage increase in output
results in a smaller increase in total costs, resulting in reduced average cost. It
Profitable Growth by Acquisition 577
doesn't matter whether this increased output is generated internally or acquired
externally. When the firm grows to its "optimal" size, average costs are
minimized and no further benefits are possible. There are many potential
sources of economies of scale in acquisitions, the most common being the ability
to spread fixed overhead, such as corporate headquarters expenses, executive
salaries, and the operating costs of central computing systems, over
additional output.
Vertical integration acquisitions can reduce costs by removing supplier
volatility, by reducing inventory costs, or by gaining control of a distribution
network. Such benefits can come in any industry and for firms of all sizes.
Waste Systems International, a regional trash hauler in the United States, acquired
41 collection and disposal operations between October 1996 and July
1999 with the goal of enhancing profitability.
The business model is fairly straightforward. Waste Systems aims to own the
garbage trucks that pick up the trash at curbside, the transfer stations that consolidate
the trash, and the landfills where it's ultimately buried. Such vertical
integration is seen as crucial for success in the waste business. Owning landfill
space gives a trash company control over its single biggest cost, disposal fees,
and, equally important, produces substantial economies of scale.12
One firm may acquire another to better utilize its existing resources. A chain
of ski retailers might combine with golf or tennis equipment stores to better
utilize warehouse and store space. These types of transactions are typical in
industries with seasonal or very volatile revenue and earnings patterns.
Personnel reductions are often used to reduce costs after an acquisition.
The savings can come from two sources, one being the elimination of redundancies
and the second the replacement of inefficient managers. When firms combine,
there may be overlapping functions, such as payroll, accounts payable, and
information systems. By moving some or all of the acquired firm's functions to
the bidder, significant cost savings may be possible. In the second case, the target
firm managers may actually be making decisions that limit or destroy firm
value. By acquiring the firm and replacing them with managers who will take
value-maximizing actions, or at least cease the ones that destroy value, the bidder
can effect positive changes.
The U.S. oil industry in the late 1970s provides an excellent example of
this. Excess production, structural changes in the industry, and macroeconomic
factors resulted in declining oil prices and high interest rates. Exploration
and development costs were higher than selling prices and companies
were losing money on each barrel of oil they discovered, extracted, and refined.
The industry needed to downsize, but most oil company executives were
unwilling to take such action and as a result, continued to destroy shareholder
value. T. Boone Pickens of Mesa Petroleum was one of the few industry participants
who not only understood these trends, but was also willing to act. By acquiring
several other oil companies and reducing their exploration spending,
Pickens created significant wealth for his and the target's shareholders.13
578 Making Key Strategic Decisions
Tax Savings Corporations in the U.S. pay billions each year in corporate income
taxes. M&A activity may create tax savings that would not be possible absent
the transaction. While acquisitions made solely to reduce taxes would be
disallowed, substantial value may result from tax savings in deals initiated for
valid business purposes. We consider the following three ways that tax incentives
may motivate acquisition activity:
1. Unused operating losses.
2. Excess debt capacity.
3. Disposition of excess cash.
Operating losses can reduce taxes paid, provided that the firm has operating
profits in the same period to offset. If this is not the case, the operating losses
can be used to claim refunds for taxes paid in the three previous years or carried
forward for 15 years. In all cases, the tax savings are worth less than if
they were earned today due to the time value of money.
Example 4 Consider two firms, A and B, and two possible states of the economy,
boom and bust with the following outcomes:
Firm A Firm B
Boom Bust Boom Bust
Taxable income $1,000 $(500) $(500) $1,000
Taxes (at 40%) (400) 0 0 (400)
Net income $ 600 $(500) $(500) $ 600
Notice that for each possible outcome, the firms together pay $400 of
taxes. In this case, operating losses do not reduce taxes for the individual firms.
Now consider the impact of an acquisition of firm B by firm A.
Firm A/B
Boom Bust
Taxable income $500 $500
Taxes (at 40%) (200) (200)
Net income $300 $300
The taxes paid have fallen by 50% to $200 under either scenario. This is
incremental cash f low that must be considered when assessing the acquisition's
impact on value creation. This calculation must be done with two caveats.
Firstly, only cash f lows over and above what the independent firms would ultimately
save in taxes should be included and secondly, the tax savings cannot be
the main purpose of the acquisition.
Interest payments on corporate debt are tax deductible and can generate
significant tax savings. Basic capital structure theory predicts that firms will
issue debt until its additional tax benefits are offset by the increased likelihood
Profitable Growth by Acquisition 579
of financial distress. Because most acquisitions provide some degree of diversification,
that is, they reduce the variability of profits for the merged firms,
they can also reduce the probability of financial distress. This diversification
effect is illustrated in the previous example, where the postmerger net income
is constant. The result is a higher debt-to-equity ratio, more interest payments,
lower taxes, and value creation.
Many firms are in the enviable position of generating substantial operating
cash f lows and over time, large cash surpluses. At the end of 1999, for example,
Microsoft and Intel held a combined $29 billion in cash and short-term
investments. Firms can distribute these funds to shareholders via a dividend or
through a stock repurchase. However, both of these options have tax consequences.
Dividends create substantial tax liabilities for many shareholders and
a stock repurchase, while generating lower taxes due to capital gains provisions
cannot be executed solely to avoid tax payments. A third option is to use the excess
cash to acquire another company. This strategy would solve the surplus
funds "problem" and carry tax benefits as no tax is paid on dividends paid from
the acquired to the acquiring firms. Again, the acquisition must have a business
rationale beyond just saving taxes.
The following example summarizes the sources of value discussed in
this section and illustrates how we might assess value creation in a potential
acquisition.
Example 5 MC Enterprises Inc. manufactures and markets value-priced digital
speakers and headphones. The firm has excellent engineering and design
staffs and has won numerous awards from High Fidelity magazine for its most
recent wireless bookshelf speakers. MC wants to enter the market for personal
computer (PC) speakers, but does not want to develop its own line of new products
from scratch. MC has three million outstanding shares trading at $30/share.
Digerati Inc. is a small manufacturer of high-end speakers for PCs, best
known for the technical sophistication of its products. However, the firm has
not been well managed financially and has had recent production problems,
leading to a string of quarterly losses. The stock recently hit a three-year low of
$6.25 per share with two million outstanding shares.
MC's executives feel that Digerati is an attractive acquisition candidate
that would provide them with quick access to the PC market. They believe an
acquisition would generate incremental after-tax cash f low from three sources.
1. Revenue enhancement: MC believes that Digerati's technical expertise
will allow it to expand their current product line to include high-end
speakers for home theater equipment. They estimate these products
could generate incremental annual cash flow of $1.25 million. Because
this is a risky undertaking, the appropriate discount rate is 20%.
2. Operating efficiencies: MC is currently operating at full capacity with
significant overtime. Digerati has unused production capacity and could
easily adapt their equipment to produce MC's products. The estimated
580 Making Key Strategic Decisions
annual cash f low savings would be $1.5 million. MC's financial analysts
are reasonably certain these results can be achieved and suggest a 15%
discount rate.
3. Tax savings: MC can use Digerati's recent operating losses to reduce its
tax liability. Their tax accountant estimates $750,000 per year in cash savings
for each of the next four years. Because these values are easy to estimate
and relatively safe cash f lows, they are discounted at 10%. The
values of MC and Digerati premerger are computed as follows:
Number of
Company Shares Price/Share Market Value
MC Enterprises 3,000,000 $30.00 $90 million
Digerati Inc. 2,000,000 6.25 12.5 million
Assume that MC pays a 50% premium to acquire Digerati and that the
costs of the acquisition total $3 million. What is the expected impact of the
transaction on MC's share price?
Solution: We first compute the total value created by each of the incremental
cash f lows:
Annual Cash Discount
Source Flow Rate Value
Revenue enhancement $1.25 million 20% $ 6.25 million
Operating efficiencies 1.5 million 15 10.0 million
Tax savings $750,000 10 2.38 million
Total Value = $18.63 million
The total value created by the acquisition is $18.63 million. A 50% premium
would give $6.25 million of this incremental value to Digerati's shareholders.
After $3 million of acquisition costs, $9.38 million remains for MC's
three million shareholders. Thus, each share should increase by $3.13 ($9.38
million divided by the 3 million shares outstanding) to $33.13.
Note that the solution to Example 5 assumes the market knows about and
accepts the value creation estimates described. Investors will often discount
management's estimates of value creation, believing them to be overly optimistic
or doubting the timetable for their realization. In practice, estimating
the synergistic cash flows and the appropriate discount rates is the analyst's
most difficult task.
Summary The sole motivation for initiating a merger or acquisition should
be increased wealth for the acquirer's shareholders. We know from the empirical
evidence presented in section III that many transactions fail to meet
this simple requirement. The main point of this section is that value can only
come from one source—incremental future cash f lows or reduced risk. If we
can estimate these parameters in the future, we can measure the acquisition's
Profitable Growth by Acquisition 581
synergy, or potential for value creation. For the deal to benefit the acquirer's
shareholders, management must do two things. The first is to pay a premium
that is less than the potential synergy. Many acquisitions that make strategic
sense and generate positive synergies fail financially simply because the bidder
overpays for the target. The second task for the acquirer's management is
to implement the steps needed after the transaction is completed to realize
the deal's potential for value creation. This is a major challenge and is
discussed further in section VII. In the next section we brief ly present some
of the key issues managers should consider when initiating and structuring
acquisitions.
SOME PRACTICAL CONSIDERATIONS
In this section, we brief ly discuss the following issues you may encounter in developing
and executing a successful M&A strategy:
• Identifying candidates.
• Cash versus stock deals.
• Pooling versus purchase accounting.
• Tax considerations.
• Antitrust concerns.
• Cross-border deals.
This is not meant to be a comprehensive presentation of these topics. Rather,
the important aspects of each are described with the focus on how they can inf
luence cash f lows and synergy. The goal is to make sure that you are at least
aware of how each item might affect your strategy and the potential for value
creation.
Identifying and Screening Candidates
Bidders must first identify an industry or market segment they will target. This
process should be part of a larger strategic plan for the company. The next step
is to develop a screening process to rank the potential acquisitions in the industry
and to eliminate those that do not meet the requirements. This first screen
is typically done based on size, geographic area, and product mix. Each of the
target's product lines should be assessed to see how they relate to (a) the bidder's
existing target market, (b) markets that might be of interest to the bidder,
and (c) markets that are of no interest to the bidder. Keep in mind that
undesirable product lines may be sold.
It is also important to evaluate the current ownership and corporate governance
structure of the target. If public, how dispersed is share ownership
and who are the majority stockholders? What types of takeover defenses are in
582 Making Key Strategic Decisions
place and have there been previous acquisition attempts? If so, how have they
fared? For a private company, there should be some attempt to discern how
likely the owners are to sell. Information about the recent performance of the
firm or the financial health of the owners may provide some insight.
The original list of potential acquisitions can be shortened considerably
by using these criteria. The companies on this shortened list should be first analyzed
assuming they would remain as a stand-alone business after the acquisition.
This analysis should go beyond just financial performance and might
include the following criteria:14
Other popular tools for this analysis include SWOT (strengths, weaknesses,
opportunities, and threats) analysis, the Porter's Five Forces model,
and gap analysis. Once this process is completed, the potential synergies of
the deal should be assessed using the approach presented in the previous section.
The result will be a list of potential acquisitions ranked by both their potential
as stand-alone companies and the synergies that would result from a
combination.
Cash versus Stock Deals
The choice of using cash or shares of stock to finance an acquisition is an important
one. In making it, the following factors should be considered:
1. Risk-sharing: In a cash deal, the target firm shareholders take the money
and have no continued interest in the firm. If the acquirer is able to create
significant value after the merger, these gains will go only to its shareholders.
In a stock deal, the target shareholders retain ownership in the new
firm and therefore share in the risk of the transaction. Stock deals with
Microsoft or Cisco in the 1990s made many target-firm shareholders
wealthy as the share prices of these two firms soared. Chrysler Corporation
Future Performance Forecast
Growth prospects
Future margin
Future cash flows
Potential risk areas
Key Strengths/Weaknesses
Products and brands
Technology
Assets
Management
Distribution
Industry Position
Cost structure versus competition
Position in supply chain
Financial Performance
Profit growth
Profit margins
Cash flow
Leverage
Asset turnover
Return on equity
Business Performance
Market share
Product development
Geographic coverage
Research and assets
Employees
Profitable Growth by Acquisition 583
stockholders on the other hand, have seen the postmerger value of the
Daimler-Benz shares they received fall by 60%.
2. Overvaluation: An increase in the acquirer's stock price, especially for
technology firms, may leave its shares overvalued historically and even in
the opinion of management. In this case, the acquirer can get more value
using shares for the acquisition rather than cash. However, investors may
anticipate this and view the stock acquisition as a signal that the acquirer's
shares are overpriced.
3. Taxes: In a cash deal, the target firm's shareholders will owe capital gains
taxes on the proceeds. By exchanging shares, the transaction is tax-free (at
least until the target firm stockholders choose to sell their newly acquired
shares of the bidder). Taxes may be an important consideration in deals
where the target is private or has a few large shareholders, as Example 6
makes clear.
Often firms will make offers using a combination of stock and cash. In a study
of large mergers between 1992 and 1998, only 22% of the deals were cash-only.
Stock only (60%) and combination cash and stock (18%) accounted for the vast
majority of the deals.15 This contrasts with the 1980s when many deals were
cash offers financed by the issuance of junk bonds. The acquirer's financial advisor
or investment banker can help sort through these factors to maximize the
gains to shareholders.
Example 6 Sarni Inc. began operations 10 years ago as an excavating company.
Jack Sarni, the principal and sole shareholder, purchased equipment (a
truck and bulldozer) at that time for $40,000. The equipment had a six-year
useful life and has been depreciated to a book value of zero. However, the machinery
has been well maintained and because of inf lation, has a current market
value of $90,000. The business has no other assets and no debt.
Pave-Rite Inc. makes an offer to acquire Sarni for $90,000. If the deal is
a cash deal, Jack Sarni will immediately owe tax on $50,000, the difference between
the $90,000 he receives and his initial investment of $40,000. If he instead
accepts shares of Pave-Rite Inc. worth $90,000 in a tax-free acquisition,
there is no immediate tax liability. He will only owe tax if and when he sells the
Pave-Rite shares. Of course in this latter case, Sarni assumes the risk that
Pave-Rite's shares may fall in value.
Purchase versus Pooling Accounting
The purchase method requires the acquiring corporation to allocate the purchase
price to the assets and liabilities it acquires. All identifiable assets and
liabilities are assigned a value equal to their fair market value at the date of acquisition.
The difference between the sum of these fair market values and the
purchase price paid is called goodwill. Goodwill appears on the acquirer's
books as an intangible asset and is amortized, or written off as a noncash
584 Making Key Strategic Decisions
expense for book purposes over a period of not more than 40 years. The amortization
of purchased goodwill is deductible for tax purposes and is taken over
15 years.
Under the pooling of interests method, the assets of the two firms are
combined, or pooled, at their historic book values. There is no revaluation of
assets to ref lect market value and there is no creation of goodwill. Because of
this, there is no reduction in net income due to goodwill amortization. This
method requires that the acquired firm's shareholders maintain an equity
stake in the surviving company and is therefore used primarily in acquisitions
for stock.
Weston and Johnson report that 52% of the 364 acquisitions they analyzed
used pooling and 48% used purchase accounting.16 To illustrate the difference
between the two methods of accounting for an acquisition, we offer a simple
example.
Example 7 Consider the following predeal balance sheets for B.B. Lean Inc.
and Dead End Inc., both clothing retailers:
B.B. Lean Inc. ($ millions) Dead End Inc. ($ millions)
Cash $ 6 Equity $28 Cash $ 3 Equity $12
Land 22 Land 0
Building 0 Building 9
Total $28 $28 Total $12 $12
Now assume that B.B. Lean offers to purchase Dead End for $18 million
worth of its stock and elects to use the purchase method of accounting. Assume
further that Dead End's building has appreciated and has a current market
value of $12 million. B.B. Lean's balance sheet after the deal appears as
follows:
B.B. Lean Inc. ($ millions)
Purchase Method
Cash $ 9 Equity $46
Land 22
Building 12
Goodwill 3
Total $46 $46
Note that the acquired building has been written up to ref lect its market
value of $12 million and that the difference between the acquisition price ($18
million) and the market value of the assets acquired ($15 million) is booked as
goodwill. Lean's equity has increased by the $18 million of new shares it issued
to pay for the deal.
Now assume that the same transaction occurs, this time using the pooling
method.
Profitable Growth by Acquisition 585
B.B. Lean Inc. ($ millions)
Pooling Method
Cash $ 9 Equity $40
Land 22
Building 9
Goodwill 0
Total $40 $40
Under the pooling method, there is no goodwill and the acquired assets
are put on B.B. Lean's balance sheet at their book value.
Entire volumes have been written on the accounting treatment of acquisitions
and this is a very complex and dynamic issue. In fact, as this chapter is
being written, accounting-rule makers in the United States were proposing to
eliminate the pooling of interests method of accounting for acquisitions. Because
of this, it is important to get timely, expert advice on these issues from
competent professionals.
Tax Issues
Taxes were discussed brief ly in the paragraph comparing cash and stock deals.
In a tax-free transaction, the acquired assets are maintained at their historical
levels and target firm shareholders don't pay taxes until they sell the shares received
in the transaction. To qualify as a tax-free deal, there must be a valid
business purpose for the acquisition and the bidder must continue to operate
the acquired business. In a taxable transaction, the assets and liabilities acquired
are marked up to ref lect current market values and target firm shareholders
are liable for capital gains taxes on the shares they sell.
In most cases, selling shareholders would prefer a tax-free deal. In the
study by Weston and Johnson (1999), 65% of the transactions were nontaxable.
However, there are situations where a taxable transaction may be preferred. If
the target has few shareholders with other tax losses, their gain on the deal can
be used to offset these losses. A taxable deal might also be optimal if the tax
savings from the additional depreciation and amortization outweigh the capital
gains taxes. In this case, the savings could be split between the target and bidder
shareholders (at the expense of the government). Again, it is important to
get current, expert advice from knowledgeable tax accountants when structuring
any transaction.
Antitrust Concerns
Regulators around the world routinely review M&A transactions and have the
power to disallow deals if they feel they are anti-competitive or will give the
merged firm too much market power. More likely than an outright rejection
are provisions that require the deal's participants to modify their strategic
586 Making Key Strategic Decisions
plan or to divest certain assets. These concessions can have important implications
for margins and ultimately cash flow and shareholder value. For example,
in approving the recent megamerger between AOL and Time Warner, the U.S.
Federal Trade Commission (FTC) imposed strict provisions on the new company
with respect to network access by competing internet service providers.
The goal of this is to increase competition, which will ultimately reduce
AOL/Time Warner's margins and future cash f lows.
The basis for antitrust laws in the U.S. is found in the Sherman Act of
1890, the Clayton Act of 1914, and the Hart-Scott-Rodino Act of 1976. Regulators
assess market share concentration within the context of the economics of
the industry. Factors such as ease of entry for competitors and the potential for
collusion on pricing and production levels are also considered. In the end, antitrust
enforcement is an inexact science that can have a major impact on M&A
activity. When assessing potential acquisition candidates, the potential for regulatory
challenges—and an estimate of the valuation impact of likely remedies—
must be considered in the screening and ranking process.
Cross-Border Deals
In 1999, for the first time in history, there were more acquisitions of foreign
companies (10,413) than U.S. companies (7,243). The U.S. deals were larger
on average, totaling $1.2 trillion versus $980 billion for the foreign transactions.
17 By any measure, the level of international M&A activity is increasing
as the globalization of product and financial markets continues. All of the issues
discussed in this chapter apply to cross-border deals, in some cases with
significant added complexities, which are discussed brief ly next.
Each country has its own legal, accounting, and economic systems. This
means that tax and antitrust rules may vary greatly from U.S. standards. While
there is a move to standardized financial reporting via generally accepted accounting
principles (GAAP) or international accounting standards (IAS), there
is still great variability in the frequency and reliability of accounting data
around the world. The problem is that developing nations, which offer some of
the best acquisition opportunities, have the most problems.
Doing M&A transactions across borders brings additional risks that have
not been previously discussed. These include currency exchange risk, political
risk, and the additional risk of national cultural differences. If a company is
going to execute an effective international M&A strategy, all of these must be
identified and quantified, because they can have a significant impact on synergies
and the implementation timetable. It is critical for a bidder to get capable
financial and legal advisors in each country it is considering acquisitions.
SUCCESSFUL POSTMERGER IMPLEMENTATION
The section on mergers and acquisitions makes it clear that most acquisitions
fail to meet the expectations of corporate managers and shareholders. This
Profitable Growth by Acquisition 587
dismal record is attributable to various causes, including ill-conceived acquisition
strategies, poor target selection, overpayment, and failed implementation.
In a study of 45 Forbes 500 firms, Smolowitz and Hillyer ask senior executives
to rate a list of reasons for the poor performance record of acquisitions.18 The
following were the five most frequently ranked factors:
1. Cultural incompatibility.
2. Clashing management styles and egos.
3. Inability to implement change.
4. Poor forecasting.
5. Excessive optimism with regard to synergy.
The last two are premerger problems, but the first three occur in the postmerger
transition process. Deloitte & Touche Consulting estimates that 60% of
mergers fail largely because of integration approach. Managers must understand
that the acquisition closing dinner marks the end of one stage of the
transaction and the beginning of the process that will determine the deal's ultimate
success or failure. In this section, we brief ly discuss the following key
components of a successful implementation plan:
• Expect chaos and a loss of productivity.
• Create a detailed plan before the deal closes.
• First, keep your executives happy.
• Speed and communication are essential.
• Focus managerial resources on the sources of synergy.
• Culture, culture, culture.
The process of merging two firms creates havoc at every level of the organization.
The moment the first rumors of a possible acquisition begin, an air
of uncertainty and anxiety permeates the company. The first casualty in this
environment is productivity, which grinds to a halt as the gossip network takes
over. While the executives debate grand, strategic issues, the employees are
concerned with more basic issues and need to know several key things about
their new employers, their compensation and their careers before productivity
will resume. Managers must understand that this "me first" attitude is human
nature and must be addressed—especially in transactions where the most important
assets are people.
The first step in any postmerger implementation must be a detailed
plan. We saw how Cisco "maps" the future of every employee in a soon-to-beacquired
firm. For those continuing on, their new position and duties within
Cisco are clearly defined from the beginning. The employees that will be relocated
or terminated are also identified and a separate plan for handling
them is created. Relocation and severance packages must be generous to signal
retained workers that their new employer is ethical and fair. The second
reason for a detailed plan is that it allows transition costs to be accurately estimated.
The costs to reconfigure, relocate, retrain, and sever employees
588 Making Key Strategic Decisions
must be budgeted as they can have a significant impact on postmerger cash
f lows.
The detailed plan must start at the highest levels of the organization. If
executives from the two firms are going to lead the transition, they must be
confident of their future roles and comfortable with their compensation plans.
In the Daimler-Benz-Chrysler deal, there was a good deal of animosity between
executives as the German managers watched their American counterparts
walk away with multimillion-dollar payoffs from their Chrysler stock
options while simultaneously receiving equity in the newly merged firm. A fair
incentive system must be in place at the corporation's executive suite before
any implementation plan begins.
Once the key managers have been identified, retained, and given the
proper incentives, they must carry the vision of the merger to the rest of the
organization. To combat the productivity problems discussed above, managers
have two critical weapons, speed and communication. Remember that the
enemy from the employee's perspective is uncertainty, and absent timely information
from above, they will usually assume the worst. Executives must move
quickly to convey the vision for the merged entity and to assure key employees
of their role in executing this vision.
While all employees should be part of this process, those that deal with
the firms' customers should receive special attention. We saw how Cisco moves
quickly to retain key salespeople and reassure important customers that the
merger will only improve product offerings and services. In contrast, the 1997
merger between Franklin Planner and Covey Systems failed to heed this advice.
Combining sales forces was seen as a key source of synergy, but the company
was unsuccessful in merging the two compensation programs.
Divisions were especially strong within the company's 1,700-person sales force,
which marketed its seminars and training sessions. Former Covey salespeople
got higher bonuses than Franklin staffers. Covey employees also kept their free
medical coverage, while Franklin's had to pay part of their premiums.19
This situation created such sniping by sales reps on both sides that productivity
plunged.
The implementation plan must focus management resources on those areas
at the root of the deal's synergies. If value is going to be created, it will only be
by executing on those aspects of the deal that were the original rationale for
merging. Without a plan, it is too easy for managers to get bogged down in details
of the implementation that have little marginal impact on shareholder
wealth. In the failed AT&T-NCR merger, the hoped-for technological synergies
between telecommunications and computers never materialized as managers
worried more about creating a team environment.
In many cases, the disappointing performance of mergers can be traced
to a failure to account for cultural differences between organizations. These
differences can be based in corporate culture or national culture in the case of
cross-border deals. In many transactions, both corporate and national cultural
Profitable Growth by Acquisition 589
differences are present. Because they are difficult to measure and to some extent
intangible, cultural differences are often ignored in the pre-acquisition
due diligence. This is unfortunate since they can ultimately be the most costly
aspect of the implementation process. In mergers where the firms have similar
cultures, the rapid combination of the two organizations can actually be easier.
However, where there are large cultural differences, executives should consider
keeping the entities separate for some time period. This allows each to
operate comfortably within its own culture while at the same time learning to
appreciate the strengths and weaknesses of the cultural differences between
the organizations. Such an arrangement may delay the realization of certain
synergies but, in the end, is the most rationale plan. The key is that culture can
have a huge impact on value (both positive and negative), and therefore needs
to be part of the planning process from the very beginning—even before any
acquisition offer is made.
To ensure success, the postmerger implementation process must be carefully
planned and executed. Even when this is done, there will undoubtedly be
surprises and unanticipated problems. However, a well-thought-out plan should
minimize their negative impact. The most important parts of the plan are
speed and communication, which are critical weapons in the fight against successful
implementation's main enemies—uncertainty, anxiety, and an inevitable
drop in productivity. A plan conceived and implemented swiftly by
the firms' executives, with their full and active leadership, improves the
chances for a successful transition. As always, we urge acquirers to seek the advice
of knowledgeable experts on the implementation process.
SUMMARY AND CONCLUSIONS
Mergers and acquisitions are a popular way for firms to grow, and as economic
globalization continues, there is every reason to believe their size and frequency
will increase. However, it is not that case that profitable growth by acquisition
is easy. The empirical data presented in this chapter makes it clear
that corporate combinations have historically failed to meet the operational
and financial expectations of the acquiring firm's managers and shareholders.
While target firm shareholders typically earn 30% to 40% premiums, M&A
transactions do not create value on average for the acquirer's stockholders.
This information should make it clear that a carefully designed acquisition
strategy, realistic estimates of the potential synergies, and an efficient implementation
plan are critical if the historical odds are to be overcome.
Managers must understand that the only source of incremental value in
corporate mergers and acquisitions is incremental future cash f lows or reduced
risk. These cash f lows can come from increased revenues, reduced costs, or tax
savings. The sum of the potential value created from these incremental cash
f lows is called synergy. For a deal to be successful financially the premium
paid and the costs of the transaction must be less than the deal's total synergy.
590 Making Key Strategic Decisions
Only then will the bidder's shareholders see their wealth increase. This sounds
simple, but in a competitive market for corporate control, there must be a relatively
unique relationship between the bidder and the target that other firms
cannot easily match. The market must perceive the target as worth more as
part of your firm than alone or with some other firm.
There are many practical details that potentially impact the creation of
value in M&A transactions. These include the choice of payment (cash vs.
stock), the accounting method (purchase or pooling), tax considerations, and
antitrust concerns. Each of these may affect future cash flows and synergies
and therefore must be part of the premerger due diligence process. We describe
brief ly how each factor can impact value creation, but refer potential
bidders to investment bankers, professional accountants, tax experts, and attorneys
for the most timely and customized advice.
The final and most important part of the process is the postmerger implementation
plan. Managers often focus on completing the transaction, which is
unfortunate, since the transition to a single organization is where the keys to
value creation lie. A detailed implementation plan must be developed before
the transaction closes and communicated quickly and effectively to employees
by the firm's new leadership. The plan must focus on the roots of synergy in
the deal to ensure the successful creation of the anticipated shareholder value.
In deals where there are major cultural differences, special attention must be
paid to smoothly integrating these differences. Failure to do so can doom an
otherwise sound transaction.
In the end, profitable growth by acquisition is possible but difficult. The
market for corporate control is competitive and it is easy for bidders to overestimate
potential synergies and therefore overpay for acquisitions. To avoid this,
managers must develop and stick to an acquisition plan that makes strategic
and financial sense. Only then can they hope to overcome history, human
nature, and the odds against successfully creating shareholder value through
mergers and acquisitions. Our hope is that this chapter provides the basic information
needed to embark on such a course.
FOR FURTHER READING
Morosini, Piero, Managing Cultural Differences (New York: Elsevier, 1997). A comprehensive
discussion of culture's role in mergers and other corporate alliances.
The focus is on cross-border deals, but the strategies for effective implementation
can be used by all.
Sirower, Mark L., The Synergy Trap: How Companies Lose the Acquisition Game
(New York: Free Press, 1997). Focuses on assessing the potential for synergies
and value creation in mergers.
Vlasic, Bill, and Bradley A. Stertz, Taken for a Ride: How Daimler-Benz Drove Off with
Chrysler (New York: HarperCollins, 2000). A fascinating behind-the-scenes look
Profitable Growth by Acquisition 591
at the Daimler-Benz-Chrysler deal. Clearly shows the roles of culture, human
nature, and managerial hubris in M&A transactions.
Weston, J. Fred, Kwang S. Chung, and Juan A. Siu, Takeovers, Restructuring, and
Corporate Governance (Upper Saddle River, NJ: Prentice-Hall, 1998). An excellent
reference for developing and implementing an effective M&A strategy.
INTERNET LINKS
www.cnnfn.cnn.com/news/deals Up-to-date stories on deals, all free
information
www.stern.nyu.edu/∼adamodar Academic site with numerous
quantitative examples and spreadsheets
that can be used to value potential
synergies
www.mergerstat.com Comprehensive source of M&A data;
some good free information
www.webmergers.com Good reports on M&A activity of
internet companies
NOTES
1. For a concise summary of and more detail on empirical tests of M&A performance
see chapter 7 of J. Fred Weston, Kwang S. Chung, and Juan A. Siu, Takeovers,
Restructuring, and Corporate Governance (Upper Saddle River, NJ: Prentice-Hall,
1998).
2. Anup Agrawal, Jeffrey F. Jaffe, and Gershon N. Mandelker, "The Post-
Merger Performance of Acquiring Firsms: A Re-examination of an Anomaly," Journal
of Finance 47 (September 1992): 1605–1621.
3. Weston, Chung, and Siu, 133, 140.
4. Business Week, October 30, 1995.
5. Merger & Acquisition Integration Excellence (Chapel Hill, NC: Best Practices,
2000).
6. For a more thorough discussion of this topic, see Weston, Chung, and Siu,
chapter 5.
7. The Wall Street Journal, November 30, 2000, B4.
8. Ibid.
9. Business Week, April 20, 1998, 37.
10. Business Week, October 16, 1995, 38.
11. The Wall Street Journal, September 21, 2000, C22.
12. The Wall Street Journal/New England, July 28, 1999, NE3.
13. See Harvard Business School case #285053, Gulf Oil Corp—Takeover, for a
complete discussion of this value creation.
592 Making Key Strategic Decisions
14. Adapted from Brian Coyle, Mergers and Acquisitions (Chicago: Glenlake,
2000), 32.
15. J. Fred Weston and Brian Johnson, "What It Takes for a Deal to Win Stock
Market Approval," Mergers and Acquisition 34, no. 2 (September/October 1999): 45.
16. Weston and Johnson, 45.
17. "M&A Time Line," Mergers & Acquisitions, 35(8) (September 2000): 30.
18. Ira Smolowitz and Clayton Hillyer, Working Paper, 1996, Bureau of Business
Research, American International College, Springfield, MA.
19. Business Week, November 8, 1999, 125.
593
18 BUSINESS
VALUATION
Michael A. Crain
It has been said that determining the value of an investment in a closely held
business is similar to analyzing securities of public companies. The theories are
similar and not overly complex on the surface. There are even Web sites that
proclaim to be able to value a private business. But like so many things in the
business world, the devil is in the details. The valuation of a closely held business
depends on many variables. While the theories of valuation are not overly
complicated, the accuracy of the valuation result is only as good as the variables
that go into it. The valuation of closely held businesses is often complicated
because of the limitations of the underlying information and the way
private businesses are operated. Unlike public companies, private businesses
often do not have complete and accurate information available. Dollar for dollar,
the time to accurately value most profitable private companies is out of
proportion to the analysis of public-company securities. This is illustrated in
the following case study that demonstrates the financial theories of business
valuation and the level of information needed for an accurate result.
For the past 20 years, Bob has owned and operated a manufacturing business
that has grown significantly since its inception. Bob is approaching 60 years of
age and his children do not appear capable of taking over the company. He is
contemplating the future of the business at a time when he would like to slow
down. One of his options is selling his business. Bob's company, ACME Manufacturing
Inc. is a manufacturer of certain types of adhesives and sealants and
has revenues of approximately $50 million. It has six manufacturing locations
throughout the country. Bob owns 100% of the company's common stock. He
does not know what the company is worth, nor does he know how its value
594 Making Key Strategic Decisions
would be determined. Bob asked his certified public accountant (CPA) about
valuing the business. The CPA tells him that it would be most appropriate to
engage someone who specializes in business valuations. After interviewing several
candidates, Bob hires Victoria to appraise his business. The valuation date
is December 31, 2000, and the standard of value is fair market value. Victoria
explains the appraisal process and the scope of her work.
THREE APPROACHES TO VALUE
Victoria tells Bob that the value of a business is determined by considering
three approaches.
1. Income approach.
2. Market approach.
3. Asset (or cost) approach.
The income approach is a general way of determining the value using a
method to convert anticipated financial benefits, such as cash f lows, into a
present single amount. This approach is based on the concept that the value of
something is its expected future benefits expressed in present value dollars. (A
simple example of present value is that a dollar received a year from now is
worth less than a dollar today.)
The market approach is a general way of determining a value comparing
the asset to similar assets that have been sold. For example, real estate appraisals
using the market approach rely on the sales prices of comparable properties.
In business valuation, it is sometimes possible to locate similar businesses
that have sold and are appropriate to use as guidelines in the appraisal.
The asset approach is a general way of determining the value based on the
individual values of the assets of that business less its liabilities. The company's
balance sheet serves as a starting point for this approach. The proper application
requires that all of the business's assets be identified. Often, the balance
sheet prepared in accordance with general accepted accounting principals
does not include assets that have been created within the company such as
goodwill and other intangible assets. Once all the company assets and liabilities
have been identified, each one is valued separately.
DIFFERENT TYPES OF BUYERS
Victoria explains to Bob that buyers have different motives for acquiring businesses
and they may be willing to pay different prices for the same business.
Most buyer motives can be grouped into these categories:
• Financial buyers. These buyers are primarily motivated by getting an appropriate
rate of return on their investment. Financial buyers generally
have a much broader range of investment alternatives than other types of
Business Valuation 595
buyers. Also, financial buyers often have an exit strategy to sell their investment
at some time in the future. They usually pay fair market value
(defined next).
• Strategic/investment buyers. These buyers probably already know the
company or already operate in its industry. Therefore, the number of
strategic buyers for a particular business is typically more limited than
the market of financial buyers. A strategic buyer is usually looking at integrating
its operations with the purchased business. Most of these buyers
will pay a price that ref lects certain synergies that are not readily available
to financial buyers. This price is called investment value, which is
different than fair market value.
The smallest of businesses, sometimes called "mom and pop businesses,"
often have two other groups of buyers—lifestyle buyers and buyers of employment.
A lifestyle buyer is looking to acquire a business that gives him or her a
desired lifestyle (e.g., a motel in the mountains). Another group of buyers of
small businesses is primarily motivated to provide employment for the buyer
and/or the family.
Among strategic and financial buyers, strategic buyers will usually pay a
higher price because of the anticipated synergies between the two businesses.
After explaining the different types of buyers to Bob, Victoria discusses
how it applies to ACME. Obviously, Bob would like to obtain the highest price
possible if he sold his business. However, Victoria has no way to foresee who
that buyer may be or that buyer's strategic motives for buying ACME. Therefore,
she is going to determine what a financial buyer would likely pay—the
company's "fair market value." Practically, determining the fair market value
will assist Bob in establishing a target minimum price to accept when selling
ACME. If Bob can locate a particular strategic buyer who would pay a strategic
price (or investment value), he will try to obtain a higher price.
Bob asks Victoria to explain fair market value and how it differs from investment
value. She tells him that fair market value is defined as "the price, expressed
in terms of cash equivalents, at which property would change hands
between a hypothetical willing and able buyer and a hypothetical willing and
able seller, acting at arm's length in an open and unrestricted market, when
neither is under compulsion to buy or sell and when both have reasonable
knowledge of the relevant facts."1 Fair market value contemplates what the
"market" will pay. Investment value is the price a specific investor would pay
based on individual requirements and expectations. It frequently ref lects a
higher price for the unique synergies between the buyer and company.
AN OVERVIEW OF THE BUSINESS
VALUATION PROCESS
Victoria explains to Bob that a complete business appraisal is both a quantitative
and qualitative process involving a risk and investment return analysis. A
596 Making Key Strategic Decisions
complete valuation is more than simply analyzing the historic financial statements
of the business and then making future projections. Valuations that give
the most accurate results consider qualitative matters such as technology
changes, the company's competition, and its customers. In addition, other areas
that are considered are macro-environment issues such as the industry and the
national and local economic factors that affect the particular business. A complete
business valuation will consider the following areas:
• Analysis of the company.
• Industry analysis.
• Economic analysis.
• Analysis of the company's financial statements.
• Application of the appropriate valuation methodologies.
• Application of any appropriate valuation discounts or premiums.
A large part of valuing a business is the assessment of the investment risk
of buying and owning the business. A buyer of the business assumes the risk
that he or she will actually receive the anticipated economic benefits. Of
course, there is no guarantee of actually receiving the projected income. A
fundamental concept in business valuation is the risk-reward relationship in
making any kind of investment. Rational individuals and companies make investment
decisions regularly by comparing the risk of an investment to the
anticipated rewards. For example, a certificate of deposit from a bank that is
guaranteed from default may have a rate of return (interest) of 5%. This investment
has little or no risk. Investments in large public company (large-cap)
stocks have traditionally returned an average of 10% to 12% per year over the
long term. Small public company (small-cap) stocks have average historical
rates of return in the 15% to 20% range over the long term. These three types
of investments illustrate the risk-reward relationship investors have in making
decisions. Buying large-cap stocks instead of a certificate of deposit carries
more risk and, thus, the market rewards the investor with a higher rate of return.
Small-cap stocks over the long term have been more risky than large
company stocks and have rewarded investors even more with higher returns.
Simplistically, the valuation of a closely held business considers the risk of an
investment in the company and compares it to alternative forms of investments.
Victoria further explains that valuation concepts are founded in several
economic principles. The first is the principle of alternatives that states that
each person has alternatives to completing a particular transaction. In the preceding
example, the individual has the alternatives of investing funds in a bank
certificate of deposit, large-cap stocks, or small-cap stocks. Investing in a business
is yet another alternative. The second economic principle in valuation is
the principle of substitution. This states that the value of something tends to
be determined by the cost of acquiring an equally desirable substitute. For example,
if a new restaurant offers steak on its menu, it will likely have a price
similar to other restaurants selling steak (all things being equal). The first
Business Valuation 597
restaurant will probably not sell very many steaks if the price is double what
the customer could buy at another restaurant. Likewise, a potential purchaser
of a business is not likely to pay significantly more than the price he or she can
purchase a similar business.
In business valuation, we must remember that buyers/investors have many
places to invest their money and they will generally not pay significantly more
for a business than the price of comparable investments. Thus, a business valuation
will generally benchmark the profitable private company against alternative
investments. This involves an analysis of the risk of those investments as
well as those of the business being valued.
INDUSTRY ANALYSIS
ACME operates in the adhesive and sealant industry. The U.S. government's
Standard Industrial Classification (SIC) is number 2891. Victoria researches this
industry and finds that the segment consists of approximately 1,100 U.S. establishments
primarily engaged in manufacturing industrial and household adhesives,
glues, caulking compounds, sealants, and linoleum, tile, and rubber
cements. The annual sales in this industry segment are $16.9 billion, and the industry
employs roughly 36,000 people. Also, the industry has grown at an average
annual compound rate of 6.7% over the past 10 years. Victoria finds that this
industry segment is a large growing global segment. However, the U.S. portion is
highly fragmented and a significant majority of the industry participants are
small and regional companies. It is expected that the industry will consolidate as
companies seek to enhance operating efficiencies and new product development,
sales and marketing, distribution, production, and administrative overhead.
Victoria concludes that the industry outlook is positive in revenue and
earnings expectations but moderated by the level of competition from numerous,
smaller companies selling similar products.
THE FUNDAMENTAL POSITION OF THE COMPANY
During Victoria's management interview, she discovers that Bob founded
ACME 20 years ago. The company's history has been one of relative success. It
started in a small garage and grew by expanding the number of products and
its customer base. Over the years, ACME acquired new facilities, not only in its
hometown but in other cities as well. The company's growth was primarily
funded by reinvesting its profits and with long-term financing when purchasing
real estate. During the past five years, ACME's sales increased from $34 million
to $50 million. ACME currently expects to expand its manufacturing capacity
by adding equipment to the existing locations.
Victoria's investigation into ACME's competitors reveals competition
from numerous companies, many of which are small, privately held businesses.
598 Making Key Strategic Decisions
She also finds that ACME's customers are retail distributors of its products
and the company does not have any significant customer concentration.
Generally, relationships with customers have been long term.
The company currently has numerous products in the adhesives and
sealants area. ACME has several trademarks and several products that are well
recognized as well as ACME's name. Victoria determines through her research
that the risk of product obsolescence or replacements by new products is a
minimal risk to ACME.
ACME has conducted research and development activities and the costs
range from $250,000 to $500,000 per year over the past five years. Management
does not expect any significant product developments in the near future.
Victoria's financial analysis examines the dividend paying capacity of
ACME. Because the company is closely held, special analysis of the compensation
paid to family members and perquisites is necessary. Victoria determines
that officers' compensation, shareholder distributions, and perquisites over the
past five years have been as follows:
Officers' Compensation, Perquisites,
and Shareholder Distributions
Year $ Million
2000 $7.7
1999 5.5
1998 8.2
1997 6.3
1996 6.5
Closely held businesses are frequently operated to minimize taxable income.
Publicly held companies, in contrast, are operated to maximize earnings
for the benefit of the shareholders and public markets. A financial analysis of a
closely held company should make adjustments so that revenues and expenses
are "normalized." In this particular case, Victoria determines the amount of
economic benefits the family members took from the business and compares
that with the market compensation for others employed in similar positions.
The difference between the two amounts is actually an economic benefit or
dividend (profit) flowing to ACME's owner. Victoria's analysis strives to identify
the actual profitability of the business enterprise even though it is different
from what is reported on the income statement.
ACME has approximately 240 employees at its six locations. The three top
individuals in management are family members including Bob. Should the
company be sold, it is unlikely that the three family members would remain in
the business.
Summary of Positive and Negative
Fundamental Factors
As a result of Victoria's preceding analysis of ACME's fundamental position,
she identifies the following key positive and negative factors for the company.
Business Valuation 599
Positive
ACME has been in existence for 20 years.
ACME has a long-term history of growing sales and profits.
ACME owns several trademarks for products that are well known.
ACME has diversification in the number of its manufacturing locations.
ACME's industry outlook is moderately positive.
The demand for ACME's products is expected to continue.
Negative
ACME is highly dependent on the three family members who hold the
top management positions.
ACME's products face significant competition and are regionalized.
FINANCIAL STATEMENT ANALYSIS
An analysis of a company's historic financial statements is important (unless it
is a start-up business), as the past is usually relevant to estimating future business
operations. If a company has had high growth in recent years, that may indicate
significant growth potential in the future. If past earnings have been
volatile, this is an indication of increased financial risk for a buyer of the business.
While an analysis of the financial statements is important, the process
does not stop with looking at the company's past performance. The ultimate
goal of the quantitative analysis is estimating the future profitability of the
business since that is what a prospective buyer is looking to receive. Future
earnings may or may not be similar to the past.
Balance Sheet Analysis
Victoria prepares Exhibit 18.1 that presents ACME's historic balance sheets in
condensed form for the most recent five years. She finds that total assets grew
an average of 15% per year over the five years and a similar amount in the most
recent year. The current assets consist primarily of accounts receivable and inventory.
Fixed assets primarily consist of land, buildings, and improvements,
machinery and equipment, factory construction in progress, and transportation
equipment. As of the most recent year's end, ACME's depreciable fixed assets
were depreciated to 69% of their original costs.
The most recent year ref lects unamortized intangible assets, consisting
primarily of goodwill (that had been recorded in accordance with generally
accepted accounting principles) in connection with ACME's acquisition of a
manufacturing facility.
Current liabilities consist of accounts payable and the amounts due within
the next 12 months on promissory notes and obligations under capital leases.
ACME is moderately leveraged. During the past five years, ACME's interest
bearing debt (both current and noncurrent portions) increased from $6.6
600
EXHIBIT 18.1 ACME Manufacturing Inc.: Summary of condensed balance sheets 1996 –2000.
($million) Growth Rates
2000 1999 1998 1997 1996 1996–2000 1999–2000
Assets
Current assets $11.69 $11.56 $12.37 $ 9.43 $ 9.17 6.3% 1.1%
Fixed assets, net 13.87 10.36 9.37 7.65 6.79 19.5 33.9
Other assets 3.17 3.00 3.25 1.12 0.62 50.4 5.5
Total assets $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3%
Liabilities and Equity
Current liabilities $11.50 $ 6.41 $ 8.78 $ 4.34 $ 4.94 23.5% 79.4%
Long-term liabilities 5.83 7.26 7.78 4.85 4.96 4.1 −19.7
Total liabilities 17.33 13.67 16.56 9.19 9.90 15.0 26.8%
Equity 11.39 11.25 8.42 9.01 6.69 14.2 1.3
Total liabilities and equity $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3%
Common Size
2000 1999 1998 1997 1996
Assets
Current assets 40.7% 46.4% 49.5% 51.8% 55.3%
Fixed assets, net 48.3 41.6 37.5 42.0 41.0
Other assets 11.0 12.0 13.0 6.1 3.7
Total assets 100.0% 100.0% 100.0% 100.0% 100.0%
Liabilities and Equity
Current liabilities 40.1% 25.7% 35.1% 23.9% 29.8%
Long-term liabilities 20.3 29.1 31.2 26.6 29.9
Total liabilities 60.3 54.9 66.3 50.5 59.7
Equity 39.7 45.1 33.7 49.5 40.3
Total liabilities and equity 100.0% 100.0% 100.0% 100.0% 100.0%
Business Valuation 601
million to $10.4 million. Debt consists of real estate mortgage notes, term
loans, a revolving line of credit, and obligations under capital leases.
Over the past five years, the shareholder equity increased from $6.7 million
to $11.4 million. Shareholder equity decreased slightly as a percentage of
total liabilities and equity over the past five years.
Income Statement Analysis
Victoria also prepares Exhibit 18.2 that presents ACME's historic income
statements in condensed form for the past five years. She also prepares Exhibit
18.3, which is a graph of ACME's annual revenues for the previous five years.
It graphically shows the revenue amounts from Exhibit 18.2 and more clearly
shows the revenue growth trend. The company had a compounded annual
growth rate in revenues of 11.1% during the previous five years and 3.5% for
the most recent year. ACME's revenue growth rate over the past five years was
substantially higher than the 5.6% revenue growth reported by the chemical
products industry.
Cost of goods sold as a percentage of revenues f luctuated between 66.6%
and 69.9% over the past five years. Operating expenses, exclusive of officers'
compensation, ranged from 9.8% to 11.8%. The overall trend is up.
ACME reported consistent profitability during the past five years. In
1996, income before officers' compensation and taxes was $6.5 million ($4.31 +
$2.23). For 2000, it increased to $8.7 million ($5.29 + $3.38).
Ratio Analysis
Victoria also prepares Exhibit 18.4 that presents various financial operating
ratios of ACME for the past five years. The liquidity ratios indicate the ability
of ACME to meet current obligations as they come due. The current ratio
decreased from 1.9 to 1.0 during the five-year period. Working capital also decreased
from $4.2 million to $190,000 during the same five-year period. These
indicate the company has a greater risk in being able to pay its bills.
The activity ratios indicate how effectively a company is utilizing its assets.
The average number of days in ACME's accounts receivable was similar
over the past five years at approximately 50 days. However, the average number
of days inventory remained at the plant before being sold decreased from
58 days to 47 days. The average number of days of accounts payable was similar
during the five-year period at 48 days.
The coverage ratios indicate a company's ability to pay debt service. The
number of times interest was earned, as measured by earnings before interest
and taxes (EBIT) divided by interest expense, decreased from 8 to 7 times.
The leverage ratios generally indicate a company's vulnerability to business
downturns. Highly leverage firms are more vulnerable to business downturns
than those with lower debt-to-worth positions. ACME's debt to tangible
worth increased in the past five years from 1.5 to 1.8. Fixed assets to tangible
worth increased from 1.0 to 1.5.
602
EXHIBIT 18.2 ACME Manufacturing Inc.: Summary of condensed income statements 1996 –2000.
($million) Growth Rates
2000 1999 1998 1997 1996 1996–2000 1999–2000
Revenues $50.29 $48.59 $40.85 $37.94 $33.02 11.1% 3.5%
Cost of goods sold 34.80 33.95 28.45 25.25 22.63 11.4 2.5
Gross profit 15.49 14.64 12.39 12.69 10.39 10.5 5.7
Operating expenses 5.95 5.58 4.34 3.72 3.31 15.8 6.7
Officers' compensation 3.38 2.86 3.53 3.03 2.23 11.1 18.4
Operating EBITDA 6.15 6.20 4.52 5.94 4.86 6.0 −0.9
Depreciation and amortization 0.31 0.22 0.10 0.05 0.07 44.9 42.3
Operating income (EBIT) 5.84 5.99 4.42 5.89 4.79 5.1 −2.5
Miscellaneous (income) (0.30) (0.25) (0.19) (0.18) (0.12) 26.1 17.1
Interest expense 0.84 0.74 0.55 0.47 0.59 9.0 12.6
Pretax income 5.29 5.49 4.06 5.60 4.31 5.3 −3.6
Less: Income taxes* — — — — — N/A N/A
Net income $ 5.29 $ 5.49 $ 4.06 $ 5.60 $ 4.31 5.3% −3.6%
Common Size
2000 1999 1998 1997 1996
Revenues 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 69.2 69.9 69.6 66.6 68.5
Gross profit 30.8 30.1 30.3 33.4 31.5
Operating expenses 11.8 11.5 10.6 9.8 10.0
Officers' compensation 6.7 5.9 8.6 8.0 6.8
Operating EBITDA 12.2 12.8 11.1 15.7 14.7
Depreciation and amortization 0.6 0.5 0.2 0.1 0.2
Operating income (EBIT) 11.6 12.3 10.8 15.5 14.5
Miscellaneous (income) −0.6 −0.5 −0.5 −0.5 −0.4
Interest expense 1.7 1.5 1.3 1.2 1.8
Pretax income 10.5 11.3 9.9 14.8 13.1
Less: Income taxes* 0.0 0.0 0.0 0.0 0.0
Net income 10.5% 11.3% 9.9% 14.8% 13.1%
* ACME is an S
corporation for tax purposes and taxable income is passed through to the shareholder. Thus, the corporation does not pay income taxes.
Business Valuation 603
The profitability ratios ref lect the returns earned by ACME and assist in
evaluating management performance. ACME has been consistently profitable
in each of the past five years. The earnings before taxes to tangible worth f luctuated
between 55% and 66%. Officers' compensation ranged from $2.2 million
to $3.6 million during the five years and was $3.4 million in the most
recent year.
EXHIBIT 18.3 ACME Manufacturing Inc.: Revenue growth 1996 –2000.
Year
Dollars (millions)
Revenues
1996 1997 1998 1999 2000
$-
10
20
30
40
50
60
EXHIBIT 18.4 ACME Manufacturing Inc.: Ratio analysis 1996 –2000.
2000 1999 1998 1997 1996
Liquidity ratios:
Current ratio 1.0 1.8 1.4 2.2 1.9
Quick ratio 0.6 1.1 0.9 1.3 1.1
Activity ratios:
Revenue/accounts receivable 7.3 7.5 7.0 7.8 7.2
Days' receivable 49.8 48.6 52.4 46.9 50.4
COS/inventory 7.8 7.6 6.4 7.2 6.3
Days' inventory 46.6 47.8 57.2 50.5 58.1
COS/payables 7.6 9.4 4.9 7.4 7.6
Days' payables 47.7 39.0 73.9 49.2 48.0
Revenue/working capital 274.2 9.4 11.4 7.5 7.8
Coverage/leverage ratios:
EBIT/interest 7.3 8.4 8.4 13.0 8.3
Fixed assets/tangible worth 1.5 1.1 1.5 0.9 1.0
Debt /tangible worth 1.8 1.5 2.6 1.0 1.5
Profitability & operating ratios:
EBT/tangible worth 55.4% 58.8% 63.4% 62.8% 65.5%
EBT/total assets 18.4% 22.1% 16.2% 30.8% 26.0%
Revenue/fixed assets 3.6 4.7 4.4 5.0 4.9
Revenue/total assets 1.8 2.0 1.6 2.1 2.0
604 Making Key Strategic Decisions
COMPARISON TO INDUSTRY AVERAGES
Victoria also compares ACME's key financial ratios to peer companies. The
main differences between ACME and other companies of similar size in the
same industry are as follows:
• ACME's liquidity is significantly less than other companies in the group.
Similar companies had a ratio of 1.6 while ACME had a current ratio of
1.0. This is likely due to ACME having a significant portion of its financing
due within twelve months as opposed to longer term financing.
• The average number of days in accounts payable for ACME is 48 days and
is significantly more than the peer group at 32 days. This is likely due to
the company taking longer to pay its expenses related to raw materials and
inventory than that of its peer group because of low working capital.
• The times interest earned measure for ACME is significantly higher than
its peer group. The company had a measure of 7.3 as compared to its
peers at 4.0. This is likely due to ACME having a higher profit margin
than its peers.
• ACME is significantly more leveraged than its peer group. Its measure of
debt to tangible worth is 1.8 as compared to its peers at 1.2. Also, the
company's measure of fixed assets to tangible worth is 1.5 as compared to
its peers at 0.5. This assessment is related to the company having a higher
level of fixed assets as compared to its tangible worth.
• ACME is more profitable than its peers. The measure of earnings before
taxes to total assets was 18%, as compared to its peers' 12%. Additionally,
ACME's earnings before taxes to tangible worth was 55% as compared to
its peers at 22%. This is due to ACME's profit margin of 11%, as compared
to its peers at 5%.
The purpose of the this part of Victoria's analysis is to assess the risk factors
of owning this business as compared to an investment in the average peer
company. As previously discussed in this chapter, investors have options of
where to place their capital and rational investors require a higher reward (in
the form of returns) for investments with higher risks.
APPRAISAL OF FAIR MARKET VALUE
Victoria tells Bob that the shares of ACME are closely held securities and there
is no ready market for their sale. The three general approaches available for the
valuation of private business interests were discussed earlier in this chapter.
Victoria considers all relevant valuation approaches and methods and ultimately
relies on two approaches to estimate the value of ACME's common
stock—a market approach and an income approach. She rejects the asset approach
because the premise of value is a going concern and the company has no
Business Valuation 605
intention to liquidate the assets. In addition, this approach does not clearly ref
lect the value of the business resulting from its earnings potential.
Debt-Free Analysis
She further explains to Bob that there are two ways to value the equity (stock)
of a private business under the income approach. The first is the direct equity
methodology. Under this approach a company's net income or cash f low is the
basis to determine the value of the company's stock. This methodology either
capitalizes net income or net cash flow, or it determines the present value of a
series of future cash f lows.
The second is the debt-free methodology (or invested capital methodology).
How much or how little a company is leveraged can have a significant impact
on the value of the company's stock. If a specific company has too little
leverage or too much leverage as compared to an ideal blend of debt and equity
capital, the direct equity methodology may result in a distorted valuation.
A company's invested capital represents all of its sources of capital to
fund the business—capital from investors (equity) and lenders (debt). When
we say the value of a "business," it often has a different meaning from the
value of the corporation's equity. This concept is illustrated below.
When we say the value of a "business" or "company," we are often referring
to the value of the overall capital (the debt and equity capital equals the
total assets). Many sales transactions are structured only to transfer the assets
of a business and it is up to the buyer to raise capital from investors and/or
lenders. (In an asset sale, the seller would be responsible for paying off the existing
debt, usually upon the receipt of the sales proceeds.) When the objective
is to value only the equity, debt is subtracted from the value of the total assets.
This is the underlying model of the debt-free methodology. First, the total assets
are valued based on the company's cash flow without regard to servicing
the debt. Second, if the equity is being valued, then the company's debt is subtracted
from the value of the assets.
The direct equity methodology determines the value of the equity by
using the net cash f low after the company services its debt, which results in a
=
Value of assets
Value of
overall capital structure
Debt
Equity
606 Making Key Strategic Decisions
lower cash flow. Then a discount rate or capitalization rate (multiple) is applied.
The result is the value of the company's equity. The direct equity and
debt-free methodologies are summarized below:
COST OF CAPITAL
Bob asks Victoria to explain the cost of capital. She says that when a business
owner or prospective buyer is raising capital, debt capital is less expensive than
equity capital. Debt capital represents those monies borrowed from a lender,
such as a bank, to fund the business. The lender expects a return on its investment
in the form of interest. From a financial prospective, interest expense on
the debt is called the cost of debt. Therefore, the business pays interest, or the
cost of debt, which is often near the prime lending rate. ACME's cost of debt
that it pays in interest is 9%. However, since ACME can take a tax deduction
for the interest expense, its actual cost of debt capital is 5.4% (9% interest cost
less 40% in reduced taxes). For every $100 ACME pays in interest expense to
the bank, its income tax obligation is lowered by $40 because interest is a business
expense that lowers taxable income. Thus, ACME's after-tax interest expense
is $60 ($100 minus $40 in reduced taxes).
In order for a business to raise equity capital (selling stock to investors), it
expects to provide the shareholders a rate of return. As previously discussed,
stocks of large public companies have had average returns of 10% to 12% per
year to the shareholders over an extended time period. Small public company
stocks have traditionally yielded 15% to 20% to shareholders. Since closely held
companies are frequently more risky than small public companies, most private
businesses must offer a rate of return to shareholders exceeding the returns of
small public stocks. Let's say that a closely held business is raising capital by
selling stock. The return a company expects to give its investors (stockholders)
in order to attract their capital is called the company's cost of equity.
Therefore, a company has a cost of debt capital and a cost of equity capital.
Combined, they are referred to as a company's cost of capital. The cost of debt is
less than the cost of equity as illustrated above. Management of a business can
Direct Equity Methodology Debt-Free Methodology
Net income or net cash f low to equity
holders (defined later)
Net cash flow to holders of total invested
capital (defined later)
Apply discount rate or capitalization
rate on a cost of equity basis (discussed
later)
Apply discount rate or capitalization
rate on a weighted average cost of
capital basis (discussed later)
Results in value of company's equity Results in value of company's invested
capital (debt and equity)
Subtract value of debt capital to arrive
at the value of the company's equity
Business Valuation 607
maximize the shareholders' returns by using a blend of debt financing (less expensive)
and equity capital (more expensive). Say that a prospective buyer of a
business must raise $10 million to acquire the company. If it raised the entire $10
million from the sale of stock, it would have to pay those shareholders a rate of return
of, say, 20%. Or, it could raise a portion of the $10 million by borrowing
from a bank at, say, an after-tax interest cost of 5%. Obviously, the cost of debt is
significantly less than the cost of equity. If management borrows $5 million from
the bank and raises another $5 million through the sale of stock, its overall cost of
capital is significantly lower than if the company raised the entire $10 million
from the sale of stock. This comparison is presented below:
Blended Capital Structure of Debt and Equity
Weighted
Average
Type of Amount Cost of Cost of
Capital ($ million) Percent Capital Capital
Debt $ 5 50% 5% (after-tax) 2.5%
Equity 5 50 20 10.0
Debt and Equity 10 100 N/A 12.5
No Debt in Capital Structure
Type of Amount Cost of
Capital ($ million) Percent Capital
Equity $10 100% 20%
The above illustrates that with the proper blending of debt and equity
capital, management can decrease its overall cost of capital from 20% to
12.5%. This has the effect of increasing the shareholders' rate of return. It also
has a positive effect on the value of the company's stock.
(This concept of different returns for different types of capital and the
respective weightings is called the band of investment methodology when used
in real estate appraisals.)
The relevance of all this to business valuation is that if a particular company
does not already have the proper blend of debt and equity capital, a
valuation may be performed and have an incorrect result unless a more sophisticated
debt-free analysis is done. The direct equity methodology does not
take into account an optimal blend of debt and equity (unless the business already
happens to have it). Consequently, the result of a valuation using the direct
equity methodology may result in an incorrect value. However, if the
business already has an appropriate blend of capital, the direct equity method
is a simpler valuation methodology and produces a correct value result. In addition,
buyers of smaller private companies do not necessarily take capital
structure into account when making purchase decisions, so a debt-free analysis
may not be necessary for these companies to determine fair market value.
Victoria's research indicates that ACME does not have the ideal capital
structure. Therefore, she concludes that a debt-free methodology is necessary to
608 Making Key Strategic Decisions
arrive at a proper value of ACME. This methodology determines the earnings
of ACME without regard to its debt service. Thus, net income on a debtfree
basis will be higher than the company's net income, which typically
includes interest expense. The resulting higher value using the debt-free
methodology is not only for equity holders but also debt holders. This combined
value of equity and debt is known as the market value of invested capital
(MVIC). Once the value of ACME's MVIC is determined, then the value of
debt capital is subtracted resulting in the value of ACME's equity. Victoria
summarizes this concept for Bob. The debt-free methodology results initially
in the combined value of equity and debt (total invested capital) of the business.
Interest bearing debt is then subtracted to determine the value of the
company's equity. This methodology is more complicated but it is frequently
necessary to obtain a correct valuation when the business's debt and equity
blend is not optimal.
ADJUSTMENTS TO EARNINGS
FOR VALUATION PURPOSES
As previously mentioned, financial statements of private companies sometimes
do not ref lect the true profitability. Victoria tells Bob that valuation adjustments
to the financial statements are sometimes necessary.
These adjustments fall into two categories. The first type of adjustment is
the elimination of unusual or nonrecurring items. These adjustments eliminate
the effect of past events that are not expected to occur again in the future,
such as a profit center that has been eliminated, legal expenses that were incurred
to defend an extraordinary lawsuit, or a nonrecurring capital gain from
the sale of an asset. A buyer of the business does not expect these items to
recur in the future and, therefore, they are eliminated. The second type of adjustment
are the economic adjustments. These include adjustments to expenses
that are not ref lected at their market values, such as the officers' compensation
being paid at an above-market amount, the company's rent expense being
paid on a shareholder-owned building at an amount different than market rent,
or the shareholder's extra perquisites being expensed by the business. In addition,
some closely held businesses fail to report all of their revenues and these
amounts should be considered in the adjustments. Any expenses related to nonoperating
assets (e.g., a ski condominium) would also be eliminated.
After the valuator identifies the adjustments, the reported earnings of
the company are modified to ref lect the economic earnings of the business on
an ongoing basis.
In the case of ACME, Victoria determines that officers' compensation actually
being paid is in excess of the amount the business would need to pay by replacing
the family members. Thus, officers' compensation expense is reduced to
the market level and earnings increased accordingly. In addition, Bob owns some
of the factory locations personally. Victoria also determines that ACME is not
Business Valuation 609
paying market rents to Bob, and she makes the corresponding adjustment to rent
expense. As ref lected in Exhibit 18.2, ACME has elected to be treated as an
S corporation for income tax purposes. Thus, ACME does not pay income taxes
since the income is reported on Bob's personal income tax return. Bob pays the
income taxes instead of the corporation. Victoria determines that the most likely
buyer of ACME would be a large corporation that would not be able to maintain
ACME's S corporation tax status. (The most likely buyer is a C corporation that
pays its own taxes.) Therefore, Victoria makes an economic adjustment to
ACME's pro forma income statement to include income tax expense. The aftertax
income is what a typical buyer expects to earn from purchasing this business.
After these adjustments are made on a pro forma income statement, the result
indicates ACME's true profitability to a typical buyer of the business.
Once Victoria determines ACME's actual earnings base, she continues
her appraisal by applying the most appropriate valuation methodologies for the
business.
INCOME APPROACH: DISCOUNTED
CASH FLOW METHOD
As previously discussed, the income approach is based on the concept that the
value of an asset today represents its perceived future benefits discounted to
present value. Victoria uses the discounted cash flow (DCF) methodology in
her valuation. This method forecasts ACME's cash f lows into the future and
discounts them to their present value. In addition, this method assumes that
ACME will be sold at some point in the future and the owner will receive the
sales proceeds at that time. The estimated future sales price, also know as the
residual value (or terminal value), is also discounted back to present value. The
sum of the present values of future cash f lows and the residual value are added
together to determine the value of ACME. This concept is summarized here:
This methodology can be applied to different forms of earnings—net income,
cash f low to equity holders, or debt-free cash flow. Many business valuators
prefer to use cash flows as the earnings base rather than net income
because it is cash f low that is available for shareholder distributions. As previously
discussed, cash flows may be determined after the inclusion of debt costs
(referred to as equity net cash f low) or on a debt-free basis (referred to as invested
capital net cash f low). The formulas for these types of cash f lows are
presented below. The use of either type of cash f low is valid when the appropriate
discount rate is applied in the DCF model.
Discounted Cash Flow Valuation Method (simplified)
Annual future cash flows, discounted to present value
Future residual value of the company, discounted to present value
Value (today)
+
=
610 Making Key Strategic Decisions
A common error in the income approach to valuation is improperly matching
the income stream and discount rate. The equity net cash flow represents
the return on investment to the equity holders. Thus, the appropriate discount
rate in the DCF model is the company's cost of equity. The invested capital net
cash f low is the rate of return to all holders of invested capital and, therefore,
the company's weighted average cost of capital should be used.
Projected Financial Statements
Management of ACME prepared a financial projection and discusses it and the
underlying assumptions with Victoria. Management's financial projections are
presented in Exhibits 18.5, 18.6, and 18.7. Key assumptions incorporated into
the projections include:
• Sales would grow 12% in 2001 and 2002, 11% in 2003 and 2004, and 10%
in 2005.
• Costs of goods sold are 69% of sales.
• Operating expenses (exclusive of officers' salaries) are 12% of sales.
• Officers' salaries (at market) are 3.1% of sales.
• The 2001 capital expenditures are $2.8 million and increase thereafter
5% per year.
• The company needs a minimum cash balance of $200,000.
Invested Capital Net Cash Flow
After-tax net income
+ Depreciation and amortication (noncash) expenses
− Capital expenditures
− Increases (or + decreases) in working capital requirements
+ Interest expense × (1 minus tax rate)
= Net cash f low to holders of total invested capital (debt and
equity)
Equity Net Cash Flow
After-tax net income
+ Depreciation and amortization (noncash) expenses
− Capital expenditures
− Increases (or + decreases) in working capital requirements
+ Increases (or − decreases) in long-term debt
= Net cash f low to equity holders
Application of DCF Model
Type of Type of
Income Stream Discount Rate
Equity net cash f low Cost of equity
Invested capital net cash f low Weighted average cost of capital
Business Valuation 611
• The dividend payout ratio (the amount of cash f lows actually distributed
to shareholders; the remainder is reinvested in the company) ranges from
55% to 65% per year.
Residual Value
The DCF valuation methodology assumes the company will be sold at some
point in the future and the business owner will receive the proceeds. Victoria
assumes ACME will be sold five years in the future, on December 31, 2005.
(Five years is common among analysts for established businesses. Start-up
businesses may require financial projections for a longer period such as 10
years until the company's earnings become stable.) The value of a company at
the end of the financial forecast is the residual value. The residual value of
EXHIBIT 18.5 ACME Manufacturing Inc.: Projected income statements
2001–2005.
($million)
Pro Forma 2001 2002 2003 2004 2005
Revenue $50.29 $56.32 $63.08 $70.02 $77.72 $85.50
Cost of goods sold 34.58 38.86 43.53 48.32 53.63 58.99
Gross profit 15.70 17.46 19.56 21.71 24.09 26.50
Operating expenses 5.95 6.76 7.57 8.40 9.33 10.26
Officers' salary 1.54 1.75 1.96 2.17 2.41 2.65
Depreciation & amortization 1.00 0.88 1.01 1.14 1.28 1.43
Interest expense 0.84 1.04 1.10 1.14 1.21 1.28
Operating profit 6.37 7.03 7.92 8.85 9.87 10.88
Other expenses/(income) (0.30) (0.21) (0.21) (0.21) (0.21) (0.21)
Income before taxes 6.66 7.24 8.13 9.06 10.08 11.09
Income taxes 2.67 2.90 3.25 3.63 4.03 4.44
Adjusted net income $4.00 $4.34 $4.88 $5.44 $6.05 $6.65
Common Size
Pro Forma 2001 2002 2003 2004 2005
Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 68.8 69.0 69.0 69.0 69.0 69.0
Gross profit 31.2 31.0 31.0 31.0 31.0 31.0
Operating expenses 11.8 12.0 12.0 12.0 12.0 12.0
Officers' salary 3.1 3.1 3.1 3.1 3.1 3.1
Depreciation & amortization 2.0 1.6 1.6 1.6 1.6 1.7
Interest expense 1.7 1.8 1.7 1.6 1.6 1.5
Operating profit 12.7 12.5 12.6 12.6 12.7 12.7
Other expenses/(income) −0.6 −0.4 −0.3 −0.3 −0.3 −0.2
Income before taxes 13.2 12.9 12.9 12.9 13.0 13.0
Income taxes 5.3 5.1 5.2 5.2 5.2 5.2
Adjusted net income 8.0% 7.7% 7.7% 7.8% 7.8% 7.8%
612 Making Key Strategic Decisions
ACME is estimated based on the net cash f lows in 2005 and then increasing
them by the estimated sustainable (long-term) earnings growth rate. For the
projection's final year, items such as interest expense and depreciation need to
be stated at their stabilized ongoing amounts since the hypothetical new buyer
at December 31, 2005, is expecting to receive a stabilized annual net cash flow
using this residual value methodology. The result of this portion of the DCF
analysis is the estimated net cash f lows someone would expect ACME to earn
in 2006. The presumption is that the company will be sold at the end of 2005,
its earnings have stabilized, and a new owner can expect to receive the 2006
cash f lows.
A multiple is applied to ACME's estimated 2006 net cash f low in order to
determine the residual value at the end of 2005. The multiple is based on the
inverse of the company's weighted average cost of capital less the estimated
sustainable long-term earnings growth rate. This is called a capitalization rate
(or capitalization factor) and is illustrated:
Capitalization rate Discount rate Sustainable long-term earnings
growth rate
Price-earnings (P/E) multiple
Capitalization rate
= −
= 1
EXHIBIT 18.6 ACME Manufacturing Inc.: Projected invested capital net
cash f lows 2001–2005.
($million)
2001 2002 2003 2004 2005
Projected after-tax income $4.35 $4.88 $5.44 $6.05 $6.65
Projected interest expense 1.04 1.10 1.14 1.21 1.28
Tax shield of interest expense (0.42) (0.44) (0.45) (0.48) (0.51)
Common stock dividend adjustment (0.30) (0.26) — — —
Projected depreciation/amortization 0.88 1.01 1.14 1.29 1.43
After-tax gross cash f low to invested capital 5.55 6.28 7.26 8.06 8.86
± Increase/decrease in working capital
(excluding interest-bearing ST debt) (0.54) (0.63) (0.65) (0.72) (0.73)
± Increase/decrease in investments (2.80) (2.94) (3.09) (3.24) (3.40)
± Increase/decrease in other assets (0.13) (0.15) (0.16) (0.18) (0.20)
± Increase/decreasein other liabilities — — — — —
Cash available for financing 2.08 2.57 3.37 3.92 4.53
− Preferred stock dividends — — — — —
Net cash f low 2.08 2.57 3.37 3.92 4.53
+ Beginning cash balance 0.04 0.20 0.20 0.20 0.20
Preliminary cash available 2.12 2.77 3.57 4.12 4.73
− Minimum required cash balance (0.20) (0.20) (0.20) (0.20) (0.20)
Available for dividend to invested capital,
net free cash f low $1.92 $2.57 $3.37 $3.92 $4.53
Business Valuation 613
Required Discount Rate (Rate of Return)
As previously discussed, since ACME is being analyzed on a debt-free basis,
Victoria uses the weighted average cost of capital (WACC) as the discount rate.
The WACC incorporates the cost of debt and the cost of equity using market
evidence and weights them based on capital structure. Each element of the
weighted average cost of capital as it applies to ACME is discussed in the following
sections.
Cost of Equity
As discussed earlier in this chapter, an investor has many places to invest his or
her funds. A rational investor expects a higher rate of return when an investment
carries more risks. In developing ACME's rate of return on equity capital,
Victoria uses the modified capital asset pricing model (CAPM) that is
defined as:
Equity rate of return Risk-free rate Equity risk premium Beta)
Size risk premium Specific company risk premium
= + ×
+ +
(
EXHIBIT 18.7 ACME Manufacturing Inc.: Projected balance sheets
2001–2005.
Adjusted ($million)
2000 2001 2002 2003 2004 2005
Cash $ 0.04 $ 0.20 $ 0.20 $ 0.23 $ 0.24 $ 0.40
Accounts receivable 6.87 7.69 8.61 9.55 10.61 11.67
Inventory 4.45 4.98 5.58 6.19 6.88 7.56
Other current assets 0.34 0.38 0.42 0.47 0.52 0.57
Total current assets 11.69 13.24 14.81 16.44 18.24 20.20
Fixed assets 14.34 17.14 20.08 23.16 26.40 29.80
Accumulated depreciation (2.94) (3.82) (4.83) (5.97) (7.26) (8.69)
Net fixed assets 11.40 13.32 15.25 17.19 19.15 21.12
Other assets 1.33 1.47 1.61 1.77 1.95 2.15
Total assets $24.42 $28.03 $31.67 $35.41 $39.34 $43.46
Accounts payable $ 4.55 $ 5.12 $ 5.74 $ 6.37 $ 7.07 $ 7.77
Notes payable — 0.30 0.26 — — —
Current portion LTD 4.58 3.28 3.45 3.63 3.85 4.07
Other current liabilities 2.37 2.66 2.97 3.30 3.66 4.03
Total current liabilities 11.50 11.35 12.42 13.29 14.58 15.87
Long-term debt 5.83 7.65 8.04 8.46 8.98 9.49
Total liabilities 17.33 19.00 20.46 21.75 23.57 25.36
Equity 7.09 9.03 11.21 13.66 15.77 18.10
Total liabilities & equity $24.42 $28.03 $31.67 $35.41 $39.34 $43.46
614 Making Key Strategic Decisions
Investments in closely held businesses are widely considered to be longterm
rather than short-term investments. Accordingly, the risk-free rate, the
first element in the modified CAPM, is based on the 20-year U.S. Treasury
bond yield as of the valuation date. U.S. Treasuries are considered risk-free investments
and the 20-year bond is considered a long-term investment benchmark
for purposes of valuing closely held businesses. At the valuation date, the
risk-free rate is 6.4%.
Victoria explains that the second element of the modified CAPM is the
equity risk premium. The equity risk premium is the additional rate of return
investors in stocks require above a risk-free rate of return because of the
higher risks of investing in equities. Ibbotson Associates of Chicago, Illinois,
has performed annual empirical studies of the equity risk premium that investors
have received dating back to 1926. As of ACME's valuation date, the
historic equity risk premium since 1926 has been 8.1% above the risk-free
rate. Again, since investments in closely held businesses are considered long
term, the equity risk premium is also measured on a long-term basis.
The CAPM uses the sensitivity of a company (investment) as compared to
swings in the overall investment market. The risk that is common to all investment
securities that cannot be eliminated through diversification is called systematic
risk. When using CAPM, the systematic risk of a particular investment
is measured by beta. Beta is a measure of the relationship between the returns
on an individual investment and the returns of the overall market as typically
measured by an index such as the Standard & Poor's 500. For example, the
market prices of some investments have a tendency to rise and fall faster than
the overall market. The base measure of beta is 1.0. When an investment's
beta is greater than 1.0, its returns have tended to be more than the market returns.
Also, the investment's losses have tended to be greater than the market's
losses. An investment with a beta of less than 1.0 has had returns that tend to
be less than the market returns. In summary, beta measures an investment's
return volatility as compared to the overall market. If an investment has a beta
greater than 1.0, its returns are more volatile and carry more risk than the
market. If beta is less than 1.0, its returns are less volatile and carry less risk
than the market.
One way to estimate the beta of a closely held company is to use the average
beta of guideline publicly traded companies. Beta is a coefficient used by
financial analysts that adjusts the general equity risk premium to a specific investment
in the CAPM. A complete discussion of beta is beyond the scope of
this chapter but it is widely available in finance literature. The beta of publicly
traded companies is generally available from investment publications and from
empirical studies such as the one conducted by Ibbotson Associates.
Victoria's research analysis indicates the average beta of publicly traded
companies in ACME's industry is 0.99 as of the valuation date. She concludes
that this average is a reasonable estimate of ACME's beta for use in the CAPM.
Therefore, the equity risk premium for ACME is 8.0% (the general equity
risk premium of 8.1% multiplied by the beta of 0.99).
Business Valuation 615
Victoria tells Bob that the capital asset pricing model is widely used by
analysts for investment management where a specific investment's risks can be
eliminated through portfolio diversification. Business valuation theory uses
CAPM but modifies it to consider a specific company's unsystematic risks in
addition to the systematic risks. Unsystematic risk represents those risks
uniquely associated with an investment that cannot be avoided through portfolio
diversification. ACME's unsystematic risks are discussed next.
Studies have shown that investments in small companies typically have
more risk than those in large companies. Generally, small company earnings
and stock prices are more volatile than those of larger companies. Over the
long term, investors in smaller companies have received higher rates of return
than investors in the larger Standard & Poor's (S&P) 500 companies. Empirical
data from Ibbotson Associates shows that the smallest 20% of public companies
have yielded an extra 2.2% rate of return above the returns of S&P 500
companies since 1926. Therefore, Victoria adds a premium of 2.2% to ACME's
required rate of return for the risks associated with its size as compared to
S&P 500 companies.
Finally, the differences between ACME and small publicly traded companies
are considered. Victoria previously identified the quantitative and qualitative
attributes of ACME that are considered negative and positive risk
factors for the company. These were presented earlier in the chapter. After reviewing
her quantitative and qualitative analyses, she determines that ACME
is somewhat more risky than small public companies. In Victoria's judgment,
she adds a 2% specific company risk premium as an additional required rate of
return for an investor in ACME.
In summary, Victoria determines ACME's cost of equity using the modified
CAPM as shown Exhibit 18.8.
Cost of Debt
Victoria analyzes ACME's audited financial statements, including the footnotes,
and interviews management to determine the company's interest rate on
long-term financing was 9%. This was comparable to market interest rates.
Since interest paid by the company is tax deductible, the after-tax effective
EXHIBIT 18.8 ACME Manufacturing Inc.:
Cost of equity.
Risk-free rate 6.4%
Overall equity risk premium 8.1%
Multiply by Beta 0.99
ACME's equity risk premium 8.0%
Small company risk premium 2.2%
Specific company risk premium 2.0%
ACME's cost of equity 18.6%
616 Making Key Strategic Decisions
interest rate is less than 9%. Victoria determines that ACME is in the 40% income
tax bracket. Therefore, ACME's after-tax cost of debt is 5.4% as presented
in Exhibit 18.9.
Weighted Average Cost of Capital
Victoria estimates the optimal capital structure for ACME as 40% debt and
60% equity based on her analysis of the average capital structures of publicly
traded companies and then considering that ACME does not have the same access
to capital sources as public companies.
Based on this weighting between debt and equity, ACME's weighted average
cost of capital is 13.3%. The calculation is presented in Exhibit 18.10.
Discounted Cash-Flow Calculation
As previously discussed, ACME's forecasted invested capital net cash f lows for
2001 to 2005 are discounted to present value as of the December 31, 2000, valuation
date. The discount rate is ACME's weighted average cost of capital—
13.3%. In addition, the residual value of ACME in 2005 is discounted to
present value using the same rate.
Victoria prepares Exhibit 18.11 that presents the resulting value from discounting
the cash f lows for the five-year period and also discounting the residual
value. It assumes that the annual cash f lows are earned equally throughout
each year. Therefore, the present value calculation for the annual cash flows
uses the middle of each year (June 30) to determine the length of time for the
present value calculation. This is called the mid-year convention. For example,
EXHIBIT 18.9 ACME Manufacturing Inc.:
Cost of debt.
ACME's borrowing rate 9.0%
Multiply by the tax effect (1 − Tax rate of 40%) 60%
ACME's cost of debt 5.4%
EXHIBIT 18.10 ACME Manufacturing Inc.:
Weighted average cost of capital.
Cost of equity (above) 18.6%
Equity weighting 60%
11.1%
Cost of debt (above) 5.4%
Debt weighting 40%
2.2%
ACME's weighted average cost of capital 13.3%
Business Valuation 617
the first forecasted year (2001) is discounted one-half year, rather than one
complete year, to the valuation date of December 31, 2000.
The residual value is based on the expected invested capital net cash flow
in the last year of the projection (2005) of $4.533 million. Victoria estimates
ACME's long-term sustainable earnings growth rate at 5% annually. Accordingly,
the cash f low for 2006 is estimated at $4.760 million ($4.533 million ×
1.05). The multiple Victoria applies for the residual year is 12. The calculation
for the multiple is presented in Exhibit 18.11. ACME's residual value at December
31, 2005, is estimated as $57.1 million.
The present values of the five years of cash f lows are added together
plus the present value of the residual value. These items represent the anticipated
future benefits to all capital holders at December 31, 2000. The sum of
the present values represents the market value of the total invested capital
(MVIC) of $42.1 million. ACME's interest bearing debt of $10.4 million is
subtracted resulting in $31.7 million for the value of ACME's common stock
EXHIBIT 18.11 ACME Manufacturing Inc.: DCF method of
valuation as of December 31, 2000.
(Exhibit 18.6)
Forecast Projected Present
Year Cash Flows WACC Value
2001 $1,921,000 13.3% $ 1,804,731
2002 2,565,000 13.3% 2,126,878
2003 3,367,000 13.3% 2,464,157
2004 3,917,000 13.3% 2,530,165
2005 4,533,000 13.3% 2,584,349
Residual value (see below) 13.3% 30,591,919
Value of invested capital 42,102,198
Less: debt capital (10,411,554)
Value of equity $31,690,644
Value of equity (rounded) $31,700,000
Residual Value at December 31, 2005
2005 Projected cash f low $4,533,000
Estimated sustainable growth rate 1.05
2006 Projected cash f low 4,759,650
Price multiple
WACC (discount rate) 13.3%
Less: Sustainable growth rate −5.0%
Capitalization rate 8.3%
Multiple (inverse of capitalization rate) 12
Residual value at December 31, 2005 $57,115,800
Present value of residual value $30,591,919
618 Making Key Strategic Decisions
as of December 31, 2000, on an as-if-freely-traded basis. Since this amount is
based on rates of return of freely traded marketable securities, Victoria will
take a valuation discount for lack of liquidity at the end of her analysis.
Because Victoria made adjustments to the 2000 pro forma income statement
(see the pro forma column in Exhibit 18.5) for discretionary items (officers'
compensation and rent expense) and income tax expense, the 2000 pro
forma earnings and resulting value of $31.7 million represents a value for a
control (rather than a minority) equity interest.
In summary, the discounted cash flow methodology determines ACME's
value today, which represents an owner's perceived future benefits discounted
to the present value. The DCF method forecasts ACME's cash f lows into the
future and discounts them to their present value. In addition, this method assumes
that the owner will sell the company at some point in the future and receive
the sale price. The estimated future sale price is also discounted back to
present value. The present values of future earnings and future sale price are
added together to determine the value of ACME.
MARKET APPROACH: PUBLICLY TRADED
GUIDELINE—COMPANIES METHOD
Bob asks Victoria to explain the market approach to determining value. She
says the market approach is a general way of determining a value by comparing
the asset to similar assets that have been sold. In business valuation, this can be
done by looking for any prior arm's-length sales of the company's stock, sales of
other companies, or prices of shares in publicly traded companies. In the latter
two instances, careful analysis of the other companies must be done to determine
if they would properly serve as guidelines under this approach. The
American Society of Appraisers describes guideline companies as those "companies
that provide a reasonable basis for comparison to the investment characteristics
of the company being valued. Ideal guideline companies are in the
same industry as the company being valued; but if there is insufficient transaction
evidence available in the same industry it may be necessary to select companies
with an underlying similarity of relevant investment characteristics
(risks) such as markets, products, growth, cyclical variability and other salient
factors." 2
In ACME's case, there have never been any prior sales of corporate stock.
In addition, Victoria is unable to find any sales of guideline companies in which
adequate information is available. However, she is able to identify five publicly
traded companies that could potentially serve as guidelines under the market
approach.
Having identified the list of potential public companies through database
searches, Victoria performs a qualitative and quantitative analyses on the companies
to determine whether they should serve as guideline companies. This
analysis results in the selection of five companies.
Business Valuation 619
Victoria's analysis looks at the public companies' balance sheets and income
statements over several years, growth rates, margins, returns on assets
and equity, and financial ratios. She also analyzes various share price multiples
of the public companies such as:
• Market value of invested capital to sales.
• Market value of invested capital to earnings before interest, taxes, depreciation,
and amortization (EBITDA).
• Market value of invested capital to earnings before interest and taxes
(EBIT).
• Market value of equity to pretax income.
• Market value of equity to net income.
• Market value of equity to cash flow.
• Market value of equity to book value.
Based on her detailed analyses of the guideline companies and comparing
them to ACME, Victoria determines that the following price multiples of the
public companies appear to be most correlated and relevant for application to
ACME: market value of invested capital to sales, market value of invested capital
to EBITDA, market value of invested capital to EBIT, and market value of
equity to pretax income.
The median price multiples for the five public companies are:
Then Victoria applies the median price multiples to ACME. See Exhibit
18.12 for her calculations. Her analysis indicates a value of ACME's equity
at December 31, 2000, of $35.2 million on an as-if-freely-traded basis.
Since Victoria made adjustments to the 2000 income statement (see the
resulting pro forma column in Exhibit 18.5) for discretionary items (officers'
compensation and rent expense), she explains that the 2000 earnings and resulting
value of $35.2 million represents a value to an owner of a control equity
interest. Thus, Victoria concludes that there is no need to add a control
premium. A control premium is an upward adjustment to the value that ref
lects the power of control as compared to the value of a noncontrol equity interest.
(However, many analysts believe that a control premium would be
necessary simply because of the use of public minority share multiples even
though the income was adjusted upward to ref lect the discretionary expenses
of a control owner. Many of these people, however, would not use the median
multiple of the public companies as Victoria did but adjust it [usually down]
Median
Price
Multiple
Market value of invested capital to sales 0.54
Market value of invested capital to EBITDA 5.80
Market value of invested capital to EBIT 7.26
Market value of equity to pre-tax income 6.72
620
EXHIBIT 18.12 ACME Manufacturing Inc.: Publicly Traded Guideline Co. method of valuation.
ACME ($million)
Median Market Value
Multiple of Pro Forma of Invested Market Value Weighted
Price Multiple Guidelines Amountsa Capital Less: Debt of Equity Weight Average
Market value of invested capital
to sales 0.54 Sales $50.29 $27.16 $10.41 $16.75 25% $ 4.19
Market value of invested capital
to EBITDA 5.80 EBITDA 8.21 47.62 10.41 37.21 25% 9.30
Market value of invested capital
to EBIT 7.26 EBIT 7.21 52.34 10.41 41.93 25% 10.48
Market value of equity to pretax
income 6.72 Pretax income 6.66 N/A N/A 44.76 25% 11.19
Value of Equity $35.16
a See Exhibit 18.5 for 2000 pro forma amounts after valuation adjustments were made.
Business Valuation 621
for fundamental differences between the selected public companies and the
private business. Thus, if these analysts first adjust the price multiple downward
as a fundamental adjustment and then apply an upward control premium,
the result may be similar to Victoria's valuation conclusion.)
However, since the $35.2 million value is based on freely traded marketable
securities, Victoria will take a valuation discount for lack of liquidity at
the end of her analysis.
RECONCILIATION OF VALUATION METHODS
The results of Victoria's valuation analysis are:
Method Value
Income approach $31.7 million
Market approach 35.2 million
Average 33.5 million
Victoria chooses to weigh each method equally resulting in an average
value of $33.5 million. This value represents 100% of the common stock of
ACME at December 31, 2000, on an as-if-freely-traded and control basis.
DISCOUNT FOR LACK OF LIQUIDITY
A freely traded basis means an investment can be sold and converted to cash
within several days. When shares of stock are sold on a public exchange, the
seller will usually receive cash within a few days making them freely traded investments.
Under the income approach, Victoria used rates of returns from
publicly traded securities. Under the market approach, she used price multiples
of publicly traded shares. Thus, the values under both of Victoria's approaches
result in as-if-freely-traded values. Because it would likely take Bob
(or any other owner of the business) several months or longer to sell ACME and
receive cash, the liquidity of an investment in ACME's shares is significantly
different than the liquidity of publicly traded shares of stock. Therefore, Victoria
takes a discount from the as-if-freely-traded value of $33.5 million for
ACME's equity.
The preceding provides the rationale for applying a discount for lack of
liquidity. However, the amount of the discount must be quantified. The closest
empirical evidence to quantify the discount comes from studies of restricted
public stock prices and studies of share prices just prior to companies' initial
public offerings. These studies indicate discounts for lack of marketability of
35% to 45% on average. Since these studies relate to minority equity positions
in the companies instead of control positions, Victoria uses a discount below
the averages of the studies. Based on her analysis and judgment, she applies a
10% lack of liquidity discount to the as-if-freely-traded $33.5 million equity
622 Making Key Strategic Decisions
value. This represents the discount an investor would require for buying shares
in ACME instead of an investment that is freely traded.
VALUATION CONCLUSION FOR ACME
Victoria concludes that the fair market value of the common stock of ACME as
of December 31, 2000, was $30,150,000 ($33.5 million less 10% discount for
lack of liquidity).
VALUING MINORITY INTERESTS
The preceding ACME case study valued 100% of the equity (stock) in the
business. Had Bob owned only, say, 25% of the common stock, Victoria would
have to apply some additional analysis to value his minority interest. With a
25% interest, Bob would no longer have the ability to control the company.
A minority interest is a business ownership of less than 50% of the voting
shares. The owner of a minority interest in most private businesses cannot control
the company. A control interest in a company has the power to direct management
and policies of a business usually through ownership of enough shares
to inf luence voting and other decisions. Intuitively, someone would rather own
a control interest in a private business (51%) instead of a minority interest
(49%) because of the power to control the company. Buyers would typically
pay a significantly different price when comparing a 51% interest to a 49%
interest. This phenomenon is called a discount for lack of control (or minority
discount).
The second area of additional analysis for Victoria would be for the typical
difficulty in selling a minority interest in a closely held business. Marketability
is the ability to quickly convert property (an investment) to cash at
minimal cost. Hypothetically, if Bob owns only 25% of ACME's stock and
someone else owns the other 75%, the number of buyers interested in buying
Bob's shares is significantly less than if he owns 100%. Since Bob actually
owns the entire company, he has several ways to sell it. For example, he can sell
the company through an investment banker or business broker. He can also
take the company public. If Bob hypothetically only owns 25% of ACME's
stock, these options are not realistically available to him. Therefore, his minority
interest is less marketable. Intuitively, investors prefer owning marketable
investments over nonmarketable ones. Therefore, buyers of minority interests
in private companies typically pay less since the shares are not marketable.
This is called a discount for lack of marketability.
In valuing a minority interest, a major consideration is the timing and
amount of the anticipated future economic benefits flowing directly to the minority
owner. This consists of the company's periodic distributions to the minority
owner and the estimated holding period for owning the equity interest
Business Valuation 623
until it is sold and the sales proceeds are received. We saw through the DCF
model that the value of the asset is the present value of the expected future
benefits. In valuing a minority interest, the emphasis shifts toward the future
benefits flowing to the minority shareholder as opposed to the business overall.
For example, if a minority owner expects not to receive any distributions from
the business for 10 years even though the business is profitable, this is significantly
different from a business that makes annual shareholder distributions of
the profits. The values in these two situations would be considerably different.
BUSINESS VALUATION STANDARDS
Professional business appraisers follow certain standards when doing business
valuations. Business valuation standards include the following:
Uniform Standards for Professional Appraisal Practice—The Appraisal
Foundation.
Standards issued by various membership organizations such as American
Society of Appraisers, Institute of Business Appraisers, and National Association
of Certified Valuation Analysts.
VALUE ENGINEERING
Just as the CEO of a public company tries to enhance the value of the shares,
management of a private company can work on increasing the value of the
business in anticipation of a future sale. Certain factors can have a significant
effect on the value of a typical closely held business. Management can focus on
these factors to potentially increase the future value of the business. Some of
the factors are obvious, while some are not. They include the following:
• Decrease expenses (increases cash f low/income).
• Increase revenues (increases cash f low/income).
• Significantly increase the earnings growth rate (may increase earnings
projections, lower capitalization rate due to growth factor).
• Eliminate the owners' personal expenses and perquisites (increases cash
f low/ income, lowers buyer risk of inaccurate financial statements).
• Report all income on the financial statements and tax return (increases
cash f low/income).
• Develop the management team for the possibility that the current
owner(s) may leave the business upon a sale (lowers buyer risk of earnings
volatility).
• Plan for the current owner-managers' continuing employment under the
new owner for a fixed period (lowers buyer risk of earnings volatility and
loss of customers, employees, and vendors).
624 Making Key Strategic Decisions
• Have annual financial statements audited or reviewed by a certified public
accountant and improve interim financial reporting (lowers buyer risk
of inaccurate financial statements).
• Develop a list of potential synergistic buyers and identify the ones with
the most to gain from an acquisition of the subject company (search for
the highest synergistic value to be paid).
• Decrease dependency on major customers and vendors (lowers buyer risk
of earnings volatility in the event of the loss of any of these customers or
vendors).
• Begin assembly of key business information for potential buyers (lowers
buyer risk of perceptions of potential earnings volatility without having
such knowledge).
• Improve any existing poor financial statistics or ratios (lowers buyer financial
risk).
Public companies report earnings and performance on a quarterly basis
and the share prices frequently react quickly. On the other hand, private company
values generally react more slowly to changes. Thus, management may
need to work on value improvement factors one to two years in advance of marketing
a business.
SUMMARY
The fair market value of a private business is essentially an estimate of the
price that a willing buyer would pay and a willing seller would accept. Buyers
have different motives for buying a business. Financial buyers are looking for a
return on their investment. Strategic buyers are usually looking to integrate
their company with the business for unique strategic reasons. Financial buyers
pay fair market value while strategic buyers usually pay a price ref lective of
the unique strategic advantages to the specific buyer. Often, strategic buyers
pay more than fair market value. Although it is possible to conduct a business
valuation that is not overly complex, the question remains whether the resulting
value is accurate. Many variables go into a valuation analysis. A business
valuation is both a quantitative and qualitative process that is focused on assessing
investment risk and investment return. It is largely an assessment of the
risks a buyer is taking in acquiring and owning the company. In addition, a valuation
attempts to project the earnings an owner of the business can expect in
the future as a return on investment.
Author's Note. This chapter is not intended to be a complete text on business
valuation. It is meant to illustrate through examples many of the fundamentals
of business valuation and their application. The proper application of valuation
theory depends on the actual facts and circumstances of the investment being
valued.
Business Valuation 625
FOR FURTHER READING
Desmond, G. and J. Marcell, Handbook of Small Business Valuation Formulas and
Rules of Thumb, 3rd ed. (Los Angeles: Valuation Press, 1993).
Pratt, S., R. Reilly, and R. Schweihs, Valuing a Business: The Analysis and Appraisal
of Closely Held Companies, 4th ed. (New York: McGraw-Hill, 2000).
Pratt, S., R. Reilly, and R. Schweihs, Valuing Small Businesses and Professional Practices,
3rd ed. (New York: McGraw-Hill, 1998).
Reilly, R. and R. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill,
1998).
Smith, G. and R. Parr, Valuation of Intellectual Property and Intangible Assets (New
York: John Wiley, 2000).
Trugman, G., Understanding Business Valuation: A Practical Guide to Valuing Smallto
Medium-Sized Businesses (New York: AICPA, 1998).
, Handbook of Business Valuation, 2nd ed. T. West and J. Jones, Eds. (New
York: John Wiley, 1999).
, Stocks, Bonds, Bills, and Inf lation Yearbook Valuation Edition (Chicago:
Ibbotson Associates, published annually).
INTERNET LINKS
www.aicpa.org American Institute of Certified Public
Accountants
www.appraisers.org American Society of Appraisers
www.appraisalfoundation.org Appraisal Foundation
www.gofcg.org Financial Consulting Group
www.ibbotson.com Ibbotson Associates
www.instbusapp.org Institute of Business Appraisers
www.nacva.com National Association of Certified
Valuation Analysts
NOTES
1. International Glossary of Business Valuation Terms, jointly published by the
American Institute of Certified Public Accountants, American Society of Appraisers,
Canadian Institute of Chartered Business Valuators, National Association of Certified
Valuation Analysts, and Institute of Business Appraisers. Further terminology
from this jointly published international glossary is included in glossary at the end of
this book.
2. American Society of Appraisers, Statement on Business Valuation Standards 1.
626
Glossary
Accounting exposure: Increases or decreases in assets and liabilities resulting from
exchange rate movements, which may not be associated with either current or
prospective cash inf lows or outf lows. Accounting exposure is distinguished from
economic exposure where cash inf lows and outf lows are expected to be associated
with exchange rate movements.
Accrual accounting: An accounting method that recognizes revenues as they are
earned and expenses as they are incurred. The timing of revenue and expense
recognition is not tied to the timing of the inf low and outf low of cash. Accrual accounting
is seen as essential in order to develop reliable measures of periodic financial
performance.
Acquisition: The purchase—not necessarily for cash—of a controlling interest in a
firm.
Activity-based costing: A process of identifying the different activities that generate
costs.
Adapter: Typically, a small circuit board inside a computer that lets the computer
work with hardware external to the computer. Examples: A network adapter allows a
computer to be hooked into a network; a display adapter allows a computer to drive
(display text, graphics) a computer monitor.
AICPA: The American Institute of Certified Public Accountants. This is the national
professional association of certified public accountants (CPAs).
All-current method: A method of translating foreign-currency financial statements
whereby all assets and liabilities are translated at the current (balance sheet
date) exchange rate, contributed capital accounts are translated at historical exchange
rates (rates in existence when the account balances first arose), and all revenues
and expenses are translated at the average exchange rate in existence during
the reporting period. Translation adjustments resulting from fluctuating exchange
rates are accumulated and reported with accumulated other comprehensive income
in shareholders' equity.
Amortization: the periodic, noncash charge used to reduce an intangible asset.
Application Service Providers (ASP): Companies that rent out applications and
process data for other companies, similar to service bureaus in the 1960s and 1970s.
Glossary 627
Asset (asset-based) approach: A general way of determining a value indication of
a business, business ownership interest, or security by using one or more methods
based on the value of the assets of that business net of liabilities.
Asset acquisition: an acquisition executed by purchasing the assets of the target
firm.
Asymmetric risk: An exposure that results in profits or losses only if the underlying
price or economic variable moves in one direction.
At-the-money: The condition of a call or put option when the strike price equals
the stock price. Some economists define at-the-money as being the case when the
stock price equals the present value of the strike price.
B2C e-commerce: The sale of goods and services between a company and a consumer
over the Internet.
Balanced scorecard: A comprehensive set of performance measures intended to
capture a more balanced picture of management's success in achieving goals than can
be captured by financial measures only.
Bearish: Pessimistic. Anticipating a decrease in an asset value.
Best efforts underwriting: An agency arrangement by which underwriters agree
to use best efforts to sell all, or a certain minimum number of, shares of a public
offering.
Beta: A measure of systematic risk of a security; the tendency of a security's returns
to correlate with swings in the broad market.
Bidder: The firm that initiates a merger or acquisition; the bidder usually retains
control of the surviving firm.
Bit: The smallest gradation of data stored in a computer. Technically, a bit is either
a 1 or a 0. Computers use groups of bits, called bytes, to represent character data.
Blue-sky laws: State laws regulating securities that provide for licensing
brokers/dealers and registering new securities issuances.
Budget: A comprehensive, quantitative plan for utilizing the resources of an entity
for some specified period of time—showing planned revenues, expenses, and resulting
earnings—together with a planned balance sheet and cash f low statement. If budgets
adjust for volume they are called f lexible; otherwise, they are static.
Budget entity: Any accounting entity, such as a firm, division, department, or
project, for which a budget is prepared.
Budget performance report: An internal accounting report that shows the difference
between actual results and expected performance planned in a budget.
Budget review process: The process of evaluating budget proposals and arriving
at the master budget.
Budget variance: The difference between the budgeted data and actual results.
Bullish: Optimistic. Anticipating an increase in an asset value.
Business valuation: The act or process of determining the value of a business enterprise
or ownership interest therein.
Byte: Typically, eight bits in a computer, which as a unit, represent one character of
data. A computer diskette can store 1,400,000 bytes of data, or 1,400,000 characters
of data. This represents about 500 pages of single-spaced text.
628 Glossary
C+, C++: Programming languages used in the 1990s to program many personal computer
and UNIX based applications.
Call option: An asset which gives the owner the right but not the obligation to purchase
some other asset for a set price on or up to a specified date.
Capital asset pricing model (CAPM): A model in which the cost of capital for any
security or portfolio of securities equals a risk-free rate plus a risk premium that is
proportionate to the systematic risk of the security or portfolio.
Capital loss carryover: The excess of capital losses over capital gains that may not
be deducted currently but may be carried forward and set off against future capital
gains.
Capital structure: The composition of the invested capital of a business enterprise;
the mix of debt and equity financing.
Capitalization: The conversion of a single period stream of benefits into value.
Capitalization factor: Any multiple or divisor used to convert anticipated benefits
into value.
Capitalization rate: Any divisor (usually expressed as a percentage) used to convert
anticipated benefits into value.
Cash flow: Cash that is generated over a period of time by an asset, group of assets,
or business enterprise. It may be used in a general sense to encompass various levels
of specifically defined cash flows. When the term is used, it should be supplemented
by a qualifier (e.g., "discretionary" or "operating") and a definition of exactly what it
means in the given valuation context.
Cash settled: A future contract that does not require delivery of the underlying
asset upon expiration. Instead of actual delivery, the contract is marked to market, so
that one party is compensated in cash by the other for the change in the underlying
asset price.
CD: A compact disk, which stores roughly 700,000,000 bytes (700 megabytes) of
data in digital format. CDs used in computers and in stereos are identical. A music
CD has the capacity to store roughly one hour of sound.
Changes in accounting estimates: Estimates are essential to the implementation
of accrual accounting. A typical example would the estimates of useful lives and salvage
values that are necessary in computing depreciation. Changes in either useful
lives or salvage values would represent changes in accounting estimates.
Changes in accounting principles: A change in the accounting treatment applied
to a particular area of accounting. The most common examples would be discretionary
changes in inventory and depreciation accounting. A firm might change
from the LIFO to the FIFO inventory method or from the accelerated to straightline
method of computing depreciation. Most accounting changes are not discretionary
but rather are the result of the mandatory adoption of new accounting
standards.
Charges: Commonly used in accounting in referring to expenses and losses.
COBOL: A programming language used prior to the early 1990s to program most
business applications.
Comfort letter: Communication from the independent auditor to the underwriter,
at the time of registration of securities, which includes information about the auditor
's role, auditor 's independence, compliance of the financial statements with the
Glossary 629
Securities Act of 1933, and any changes in the financial statements subsequent to information
included in the Registration Statement.
Comprehensive income: An expanded measure of income that includes items of
other comprehensive income in addition to traditional realized net income.
Conglomerate merger: a combination of firms in unrelated industries.
Consolidation: A merger in which an entirely new firm is created.
Constant-dollar method: A method of inf lation accounting whereby accounts,
which are measured according to historical cost accounting principles, are restated
into units of the same purchasing power using the same general price index.
Control: The power to direct the management and policies of a business enterprise.
Control premium: An amount (expressed in either dollar or percentage form) by
which the pro rata value of a controlling interest exceeds the pro-rata value of a noncontrolling
interest in a business enterprise, that ref lects the power of control.
Cooling-off period: That period from the filing of a Registration Statement in connection
with an IPO (or other public offering) until the effective date of the Registration
Statement, during which time the only written information that may be
provided to prospective investors is the Prospectus itself.
Core earnings: Earnings exclusive of the effects of nonrecurring items (see sustainable
earnings base). Also refers to earnings that only derive from the primary, or
core, activities of the firm.
Cost approach: A general way of estimating a value indication of an individual asset
by quantifying the amount of money that would be required to replace the future service
capability of that asset.
Cost driver: The cause of the cost of an activity.
Cost of capital: The expected rate of return (discount rate) that the market requires
in order to attract funds to a particular investment.
CPU: The Central Processing Unit of a computer. The CPU is the computer 's equivalent
to its brain: All logical operations occur in the CPU, and the CPU directs all
other hardware associated with the computer.
Credit risk: The loss potential that would result from the inability of a counterparty
to satisfy the terms of the foreign currency derivative.
CRT: A Cathode Ray Tube is very similar to the picture tube in a television set. Most
computer monitors use CRT technology, which is relatively cheap.
Currency swap: An exchange of currencies between two parties with an agreement
to re-exchange the currencies at a future date at the same rate.
Current-cost method: A method of inf lation accounting that replaces historical
cost accounting principles with current (replacement) cost as the basis for financial
statement measurement.
Data warehouse: A repository for data transactions, in a database format. This
technology is frequently used as a stop gap to replace older legacy systems in order
to allow greater access to data.
Decision support system: An application used by middle-level and senior management
to make management decisions.
Deferred tax valuation allowance: A portion of a deferred tax asset that is judged
unlikely to be realized.
630 Glossary
Derivative: An instrument whose value or contingent cash f lows are a function of
the value of some other asset or economic variable.
Derivative instrument: A financial instrument that derives its value from its relationship
to some other financial contract, currency, commodity, or index.
Discontinued operations: Operations that constitute an entire segment of the
firm's business and not, for example, simply one product line in a segment made up of
a number of related product lines. Other key characteristics include: Segments engage
in business and produce revenues and incur expenses; the operations of segments
are regularly reviewed by the chief operating officer of the enterprise; and
discrete financial information can be provided on the operations of segments.
Discount rate: A rate of return (cost of capital) used to convert a monetary sum,
payable or receivable in the future, into present value.
Duration gap: A situation in which assets are more sensitive to interest rates than
are liabilities. As interest rates rise, assets fall more than liabilities, wiping out equity.
DVD: Digital Video Disks are the direct descendents of CDs, but have the capacity
to store roughly 10 times the amount of data as does a CD. This capacity allows a
DVD to store all of the pictures and sounds that make up an entire, feature-length
movie.
Economic exposure: "Derived from the risk that currency f luctuations could affect
the dollar value of future cash f lows at the operating income level" (Dow 1995
annual report, p. 36).
Economies of scale: the decrease in the marginal cost of production as a firm's
output expands.
EDGAR: The electronic filing system by which IPOs and other filings required
under the Securities Act of 1933 and the Securities Exchange Act of 1934 are effected.
The public may access such filings through the World Wide Web.
EDI: Electronic Data Interchange. Used by businesses to transact commerce electronically.
These transactions include purchase orders, shipping notifications, invoices,
and so on.
Effective income tax rate: Total income tax provision (expense) deducted from
pretax income from continuing operations divided by pretax income from continuing
operations.
Effectiveness: The degree to which a goal is met.
Efficiency: A measure of the inputs needed to produce a given level of output in
pursuit of a goal, or the outputs produced in pursuit of a goal by a given level of
inputs.
Efficient search sequence: A pattern of searching for nonrecurring items that is
designed to maximize their discovery and minimize search time.
Electronic commerce: The transacting of business over the Internet, whether for
the purchase or sale of goods and services.
E-mail: Electronic mail is one of the most common and important computer applications,
allowing people to communicate cheaply and quickly with other computer
users almost anywhere on earth.
Encryption: Encryption is a process of encoding data to protect its confidentiality.
Typically, we encrypt data before it is transmitted from one computer to another so
that, should the data be intercepted by a third party during transmission, the data
Glossary 631
will be unintelligible to that third party. Secure Web sites use encryption to protect
confidential data that users might send them, such as credit card numbers.
Equity net cash flows: Those cash f lows available to pay out to equity holders (in
the form of dividends) after funding operations of the business enterprise, making
necessary capital investments, and ref lecting increases or decreases in debt financing.
Equity risk premium: A rate of return in addition to a risk-free rate to compensate
for investing in equity instruments because they have a higher degree of probable risk
than risk-free instruments (a component of the cost of equity capital or equity discount
rate).
ERP: An integrated software package that processes and controls all the functions of
a company, including order processing, inventory control, purchasing, invoicing, financial
systems, and customer management.
Exercise price: Same as Strike price.
Exotics: Engineered derivatives that contain unusual features, or nonstandard contingent
cash f low formulas.
Extraordinary gains and losses: Revenues or gains and expenses or losses that are
both unusual and nonrecurring.
Fair market value: The price, expressed in terms of cash equivalents, at which
property would change hands between a hypothetical willing and able buyer and a
hypothetical willing and able seller, acting at arm's length in an open and unrestricted
market, when neither is under compulsion to buy or sell and when both have
reasonable knowledge of the relevant facts.
Family limited partnership: An estate planning device which may entitle a donor
to a discount on the value of gifts while allowing the donor to maintain control over
the assets given away.
FAQ: Frequently asked questions. A file of questions that are frequently asked about
a specific product or topic that is available to users through the Internet or intranet.
FASB: See Financial Accounting Standards Board.
FIFO: A method of computing cost of sales that includes the oldest inventory costs
first in the computation of cost of sales. That is, the cost of goods purchased first
(first-in) are included first (first-out) in the computation of cost of sales.
Financial Accounting Standards Board (FASB): The principal private sector
organization with the responsibility of establishing U.S. generally accepted accounting
principles (see GAAP).
Fire wall: A hardware and software device that protects an organization's computer
systems and data from possible electronic intrusion from external sources. Computers
that are connected to the Internet would be under constant threat from hackers and
snoops without the protection of a fire wall.
Firm underwriting: An arrangement by which the underwriters agree themselves
to purchase all the shares of a public offering.
Fixed costs: Those costs that are not responsive to changes in volume over the relevant
range, but which respond to factors other than volume. Fixed costs are sometimes
known as "period costs" when they depend on time (e.g., rent, depreciation,
insurance).
Flexible budget: A budget prepared for more than one level of activity, covering
several levels within the relevant range of activity. Also called a dynamic budget.
632 Glossary
Foreign Corrupt Practices Act of 1997: The law that explicitly prohibits the
bribery of foreign governments or political officials and requires firms to keep accurate
and detailed records of company financial activities and maintain an adequate
system of internal controls.
Foreign currency transaction: Any transaction (e.g., the sale or purchase of inventory,
the lending or borrowing of money) that creates a balance-sheet account that
is denominated in foreign currency. Examples include foreign-currency denominated
receivables and loans, and foreign-currency denominated payables and long-term
debt.
Form S-1: The standard form which is to be completed by a registrant and filed
with the Securities and Exchange Commission in connection with an IPO (and with
many other public offerings).
Forms 10-K, 10-Q, 8-K: Principal periodic reports filed by most companies registered
under the Securities Acts.
Forms SB-1 and SB-2: Forms for filing an IPO or other public offering with the Securities
and Exchange Commission for certain small business issuers.
Forward: A contract in which two parties agree to a deferred transaction. One party
is obligated to deliver an underlying asset or commodity; the other party is obligated
to take delivery and pay for it. The terms of the deferred transaction are fully specified
in the forward contract.
Forward exchange contract: A privately negotiated agreement to purchase foreign
currency for future receipt or to sell foreign currency for future delivery. The
amount of foreign currency, the rate of exchange, and the future date of settlement
are established at the time the contract is made.
Forward exchange rate: Rate at which currencies are to be exchanged at future
dates.
Functional currency: The currency of the primary economic environment in
which the entity operates. Typically, this is the currency of the environment in which
it generates and expends cash. The functional currency may be the U.S. dollar and not
the local currency of the foreign country.
Futures contract: An exchange-traded instrument with a preestablished expiration
date, whose market value is linked to the relative exchange rates between two currencies.
A futures contract can be purchased (a long position), resulting in a gain if
the foreign currency appreciates and a loss if it depreciates. A contract can also be
sold (a short position), resulting in a gain if the foreign currency depreciates or a loss
if it appreciates.
GAAP: See generally accepted accounting principles.
Generally accepted accounting principles: The body of standards, rules, procedures,
and practices that guide the preparation of financial statements. For commercial
firms, the primary bodies involved with adding to or modifying existing GAAP
are the Financial Accounting Standards Board, the American Institute of Certified
Public Accountants, and the Securities and Exchange Commission.
Geographical information system: A computer application that uses a mapping
system display on a terminal or a printer. Data, such as sales data or census data, is
overlaid over the geographical information for decision-making purposes.
Glossary 633
Giga-: The prefix given to another number which means a billion. Thus, a 10 gigabyte
hard drive has the capacity to store 10 billion bytes of data.
Going private: The conversion of a public firm into a private company, usually by
either a leveraged buyout (LBO) or a management buyout (MBO).
Goodwill: As it relates to valuation, that intangible asset arising as a result of name,
reputation, customer loyalty, location, products, and similar factors not separately
identified. The excess of purchase price over fair market value of net assets acquired
under the purchase method of accounting; goodwill appears on the acquirer 's balance
sheet as an intangible asset and is amortized over a period of not more than 40
years.
Hedge: To reduce risk by taking a position that offsets some preexisting risk
exposure.
Hedging: Steps taken to protect the dollar value of a foreign-currency asset or to
hold constant the dollar burden of a foreign-currency liability, in the presence of
f luctuating exchange rates, by maintaining offsetting foreign-currency positions.
Horizontal merger: A merger of firms producing similar goods or services.
Hypertext: Hypertext is the data-connecting protocol of the Internet that allows a
document on the World Wide Web to connect with (or link to) other documents on
the Web.
Income (income-based) approach: A general way of determining a value indication
of a business, business ownership interest, security, or intangible asset using one
or more methods that convert anticipated benefits into a present single amount.
Income from continuing operations: A measure of financial performance for the
period that excludes the effects of discontinued operations, extraordinary items, and
the cumulative effect of accounting changes. All other revenues, gains, expenses, and
losses are included in the computation of income from continuing operations.
Intangible assets: Nonphysical assets (such as franchises, trademarks, patents,
copyrights, goodwill, equities, mineral rights, securities, and contracts as distinguished
from physical assets) that grant rights, privileges, and have economic benefits
for the owner.
International Accounting Standards Committee (IASC): An organization representing
accounting bodies from over 70 countries whose mission is to harmonize
accounting standards internationally.
In-the-money: An option is in-the-money when exercise would be profitable. For a
call option this is when the underlying stock price is above the strike price. For a put
option, this is when the stock price is below the strike price.
Intrinsic Value: The amount of money earned when an option is exercised, or zero,
whichever is greater. For a call option, intrinsic value is the maximum of zero or the
stock price minus the strike price. For a put option it is the maximum of zero or the
strike price minus the stock price.
Invested capital: The sum of equity and debt in a business enterprise. Debt is typically
(a) long-term liabilities or (b) the sum of short-term interest-bearing debt and
long-term liabilities.
Invested capital net cash flows: Those cash f lows available to pay out to equity
holders (in the form of dividends) and debt investors (in the form of principal and
634 Glossary
interest) after funding operations of the business enterprise and making necessary
capital investments.
Investment risk: The degree of uncertainty as to the realization of expected
returns.
Investment value: The value to a particular investor based on individual investment
requirements and expectations.
IPO: An initial public offering; such transaction is registered with the Securities and
Exchange Commission and permits a company, called a "registrant," first to offer to
the public its shares of common stock or other securities.
Irregular items of revenue, gain, expense, or loss: See nonrecurring items.
ISP: An Internet service provider is an organization that sells connectivity to the Internet.
An ISP has a permanent, high capacity connection to the Internet. Customers
of the ISP use a telephone or cable modem to connect themselves to the ISP, and,
thereby, the Internet. America OnLine is the largest ISP in the world.
Kilo-: The prefix given to another number which means a thousand. Thus, a 10 kilobyte
document contains 10,000 bytes or characters of data.
Labor variance: A measure of the change in the cost of labor, analyzed according
to wage changes and changes in labor productivity.
LAN: A local area network is a group of computers, usually within one or a few
nearby buildings, which are connected to each other to allow the sharing of data,
printers, e-mail, and other capabilities.
LCD: A liquid crystal display is a method of displaying data using a relatively f lat
panel. Many digital watches use LCDs to show time. LCD technology competes with
CRT technology in computer monitors. LCDs take up less space than CRTs, but cost
more.
Leading and lagging: A foreign-currency hedging technique that involves the
matching of cash f lows associated with foreign currency payables and receivables by
speeding up or slowing down their payment or receipt.
Legacy systems: Older systems that were developed prior to the 1990s using older
technologies. Usually mission critical systems, they are both costly and difficult to
replace.
LIBOR: The London interbank offered rate. The interest rate used in Euromoney
transactions between London banks. It is widely used as the benchmark f loating rate
in swaps.
LIFO inventory method: A method of computing cost of sales that charges the
most recent inventory costs to cost of sales. The most recent (last-in) inventory items
go into the cost of sales computation first (first-out).
LIFO liquidation: A reduction in the physical quantity of inventory by a firm using
the LIFO method. Typically, older and lower costs will be associated with the liquidated
quantities. This has the effect of reducing cost of sales and increasing earnings.
This earnings increase is treated as nonrecurring in the computation of sustainable
earnings.
LIFO reserve: The excess (typically) of the replacement cost of a LIFO inventory
over its LIFO carrying value.
Link: A connection from one World Wide Web document to another. Typically, one
navigates the Web by following a series of links.
Glossary 635
Liquidity: the ability to quickly convert property to cash or pay a liability.
Long: To enter a future or forward as the long party. Also known as "buying" the future
or forward.
Long party: The party in a forward or future contract that will take delivery of
the underlying asset and make payment, that is, the buying party. The party in a forward
or future contract that benefits from a rise in the price of the underlying
asset.
Management's Discussion and Analysis of Results of Operations and Financial
Condition (MD&A): A report required under Securities and Exchange Commission
regulations, constituting part of an S-1 for an IPO and an annual report on
Form 10-K. The discussion of operations is required to include material nonrecurring
items of revenue, gain, expense, and loss.
Mark to market: The process by which at the end of each trading day, a payment is
made from one party in a futures contract to the other, based on that day's movement
in the futures price. When the futures price rises, the short party pays the long party
the amount of the price rise. When the futures price falls, the long party pays the
short party the amount the price fell.
Market (market-based) approach: A general way of determining a value indication
of a business, business ownership interest, security, or intangible asset by using
one or more methods that compare the subject to similar businesses, business ownership
interests, securities, or intangible assets that have been sold.
Marketability: The ability to quickly convert property to cash at minimal cost.
Master budget: The total budget package of an organization, including both the
operating and financial budgets. Sometimes referred to as the profit plan.
Material items: Items of sufficient size to have the potential to inf luence decision
makers or other users of financial statements.
Material variance: A measure of the change in cost of materials used, analyzed
according to price changes and changes in material efficiency.
MD&A: See Management's Discussion and Analysis of Results of Operations
and Financial Condition.
Mega-: The prefix given to another number which means a million. Thus, a 10
megabyte file contains 10,000,00 bytes or characters of data.
Merger: The combination of two or more companies into a single entity
Minority discount: A discount for lack of control applicable to a minority interest.
Minority interest: An ownership interest less than 50% of the voting interest in a
business enterprise.
Modem: A device used to allow computers to communicate with each other over
wires not originally designed for computer communications. The most common
form of modem allows computers to communicate over regular voice telephone
wires. Cable modems allow computers to communicate using wires originally designed
for cable TVs.
Monetary assets and liabilities: Assets and liabilities that represent a fixed
number of monetary units. Monetary assets include cash and accounts receivable;
monetary liabilities include accounts and notes payable. During inf lationary
periods monetary assets (liabilities) result in purchasing power gains (losses),
respectively.
636 Glossary
Multimedia: The simultaneous use of multiple forms of media on a computer. If
you were to watch a football game on your computer that is coming to you over the
Internet, you would be simultaneously using both video and sound media.
Multistep income statement: An income statement format that includes one or
more profit subtotals such as gross profit and operating profit (also see single-step income
statement).
NASD: See National Association of Securities Dealers Inc.
NASDAQ: National Association of Securities Dealers Automated Quotation System.
An organized, electronically linked over-the-counter market for stocks. The
NASDAQ stock index comprises stocks that trade on NASDAQ. These stocks are generally
smaller, less capitalized stocks than those that compose the S&P 500.
National Association of Securities Dealers Inc: A self-regulatory organization
which regulates the business of broker/dealers, including underwriters who sell securities
to the public. In an IPO or any other public offering, the underwriters must obtain
approval of the NASD of their compensation as "fair and reasonable."
Net cash flow: A form of cash flow. When the term is used, it should be supplemented
by a qualifier (e.g., "Equity" or "Invested Capital") and a definition of exactly
what it means in the given valuation context.
Net operating loss carry-forward: Under U.S. tax law, operating losses can be
carried back and set off against profits in the previous three years. A refund of taxes
can be obtained. If the loss is greater that the profits in the three previous years, then
the loss can be carried forward for 20 years and set off against the profits of
future years. The carrying forward of a loss may produce a future tax savings. In contrast,
the carrying back of a loss produces a tax refund.
NetWare: The network operating system standard through the early and mid-1990s.
Developed by Novell.
Network: The connecting together of two or more computers, typically with the
purpose of sharing resources, such as printers, data, or an Internet connection.
Nonrecurring items: Items of revenue, gain, expense, and loss that appear in
earnings on only an infrequent or irregular basis, f luctuate significantly in terms of
amount and or sign, and are often not related to the core operational activities of
the firm.
Notional principal: The principal amount specified in a swap agreement, which
though not exchanged, serves as the benchmark to determine all cash f lows. The cash
f lows generally equal the difference between two interest rates, multiplied by the
notional principal.
Operating income: An intermediate, pretax measure of financial performance.
Only operations-related items of revenue, gain, expense, and loss are included in the
computation of operating income.
Operational control system: Systems that run the company's day-to-day
operations.
Opportunity cost: A benefit forgone as a result of pursuing an alternative action.
Option contract: The right, but not the obligation, to purchase foreign currency at
a fixed price (a call option), or the right, but not the obligation, to sell foreign currency
at a fixed price (a put option).
Glossary 637
Other comprehensive income: A set of unrealized income elements that are
added to conventional net income to arrive at comprehensive income. The key other
comprehensive income items are foreign currency translation adjustments, unrealized
gains and losses on certain securities, and adjustments related to underfunded
pension plans.
Out-of-the-money: An option is out of the money when exercise would generate a
loss. For a call option this is when the underlying stock price is below the strike price.
For a put option this is when the stock price is above the strike price.
Overhead variance: A measure of the change in the cost of overhead items, analyzed
according to price and salary changes and changes in labor productivity.
Over-the-counter: Description of contracts that are negotiated between two parties,
often with the help of an intermediary. Over-the-counter derivatives are custom-
tailored to meet the needs of the parties involved. Over-the-counter derivatives
are not traded on exchanges.
Participative budgeting: The process of preparing the budget using input from
managers who are held responsible for budget performance.
PDA: Personal Digital Assistants are small, pocket-sized computers, usually with
LCD screens, which allow users to keep their calendar, list of contacts, play games,
and, in some cases, send and receive e-mail.
Physical delivery: A future contract that stipulates actual delivery of the underlying
asset upon expiration of the contract.
"Plain English": The standards for clarity in drafting various portions of a
Prospectus, as set forth in SEC Rule 421.
Plain vanilla: The most common type of swap. It is a fixed for f loating interest rate
swap, where LIBOR is the f loating rate. The fixed rate is the current rate of the
Treasury bond with the same maturity as the swap.
Pooling method: After the acquisition, the bidder and target firm balance sheets
are combined simply by adding book values
Premise of value: An assumption regarding the most likely set of transactional
circumstances that may be applicable to the subject valuation (e.g., going concern,
liquidation).
Premium: The amount paid to the target over current market price to execute an
acquisition.
Premoney valuation: The valuation ascribed to a business enterprise prior to the
issuance of additional equity securities, for the purpose of pricing those securities to
their public or private purchasers.
Private placement: An offering of securities to a sufficiently small or to a sufficiently
sophisticated group of purchasers, such that registration of the transaction is
not required with the Securities and Exchange Commission.
Private Securities Litigation Reform Act of 1995: A U.S. statute that establishes
a safe harbor for forward-looking statements by public companies, insulating
the company and management from liability for statements that ultimately prove to
be inaccurate if they are believed to be true when made and if the contingencies on
which their accuracy depend are properly articulated.
Productivity: Output divided by input. Productivity rates measure the input required
for a unit of output. Compare the definition of efficiency.
638 Glossary
Profit plan: A company's total budget used in achieving a desired profit goal. Sometimes
the term refers only to the operating budget, and sometimes it is used synonymously
with the term master budget.
Prospectus: Part I of a Registration Statement filed by a company offering its securities
to the public, which Registration Statement is filed with and must be approved
by the Securities and Exchange Commission. The Prospectus describes the registering
company, its business and finances, and the risk factors the company faces.
Proxy: The grant by a shareholder to another party of the right to vote the stockholder
's shares of stock.
Proxy contest: An attempt to gain control of a corporation by soliciting shareholder
votes.
Purchase method: After the acquisition, the target firm's assets are put on the bidder
's balance sheet at their fair market value.
Put option: An asset that gives the owner the right but not the obligation to sell
some other asset for a set price on or up to a specified date.
RAM: Random access memory is the hardware which a computer uses for storing
programs and data that the computer is currently using. In human terms, you can
think of RAM as the memory storing part of your brain. When you are thinking about
a problem, you are using your own RAM to work through various calculations and
thoughts.
Rate of return: An amount of income (loss) and/or change in value realized or
anticipated on an investment, expressed as a percentage of that investment.
Red herring: A preliminary, nonfinal Prospectus distributed by underwriters for
the purpose of generating interest in shares of stock to be offered to the public.
Registration statement: A filing made with the SEC by a company issuing its securities
to the public, which describes the company and its financial condition. Part I
consists of the Prospectus.
Regulation FD: A Securities and Exchange Commission Regulation which among
other matters requires a company which purposely or inadvertently releases previously
unknown material information to promptly further distribute that information
to the public.
Regulation S-K: A Regulation of the Securities and Exchange Commission that sets
forth the standards for drafting the body of a Prospectus.
Regulation S-X: A Regulation of the Securities and Exchange Commission that sets
forth the standards for the preparation of financial statements to be included in documents
filed with the Securities and Exchange Commission.
Remeasurement: See temporal translation procedure.
Reporting currency: The currency in which a firm prepares its financial statements.
Residual value: The prospective value as of the end of the discrete projection
period in a discounted benefit streams model.
Restructuring charges: Expenses typically recognized in conjunction with downsizings,
reengineerings, reorganizations, and comparable activities. The expenses are
usually made up of cash costs, accruals of obligations for future expenditures, as well
as the write-down of assets.
Risk factors: That section of a Prospectus, or of a Form 10-K or other SEC filing,
which lists the operational and financial risks faced by a company.
Glossary 639
Risk-free rate: The rate of return available in the market on an investment free of
default risk.
Risk premium: A rate of return in addition to a risk-free rate to compensate the investor
for accepting risk.
Road show: A trip, generally of two or more weeks' duration, by underwriters and
company management to meet with underwriters, brokers, and investors in different
cities in order to explain a proposed public offering of securities.
Roll over: To enter a new future or forward contract to replace a contract that is
expiring.
ROM: Read-only memory are forms of data storage which cannot be written to (or
changed), but from which data can only be retrieved. A music CD (and, hence, CD
ROM) is a device from which you can play back music, but you cannot record your
own music to a CD ROM. (If you can record to a CD, the device is called a CD-R
(for recordable), not a CD ROM.)
Securities Act of 1933: The U.S. statute that permits the private placement or private
sale of securities without registration provided full and fair disclosure is made
and that requires the registration of public offerings of securities.
Securities and Exchange Commission (SEC): An agency of the U.S. government
which regulates the public issuance of securities under the Securities Act of 1933
and the conduct of trading markets and brokerage firms under the Securities Exchange
Act of 1934, so as to protect investors from fraud and misleading or inadequate
corporate and financial information.
Securities Exchange Act of 1934: The U.S. statute which established the Securities
and Exchange Commission and regulates the operation of broker/dealers. Under
this statute, companies with publicly held securities are required to make periodic
reports to the public on various forms, most typically Forms 10-K, 10-Q, and 8-K. Officers,
directors, and significant shareholders of publicly held companies are required
to report purchases and sales of securities and the formation of "groups" for the holding,
voting, purchase, or sale of publicly traded securities.
Short: To enter a future or forward as the short party. Also known as "selling" the
future or forward.
Short party: The party in a forward or future contract that will deliver the underlying
asset and receive payment (i.e., the selling party). The party in a forward or future
contract that benefits from a decline in the price of the underlying asset.
Single-step income statement: An income statement format that simply deducts
expenses and losses from revenues and gains in arriving at a single measure of income
from continuing operations.
Speculate: Attempt to profit by taking on a risk exposure.
Spot market: The market in which transactions are executed for immediate delivery
of an asset.
Spot price: The price to be paid for immediate delivery of an asset or commodity.
Spot rate: Rate at which currencies are exchanged for immediate delivery.
Standard and Poor's 500: A stock portfolio consisting of 500 large corporations.
The composition and value of the stock portfolio is tracked and reported by the Standard
and Poor 's publishing company. The S&P 500 value is widely used as a benchmark
index of overall stock market performance.
640 Glossary
Standard of value: The identification of the type of value being utilized in a specific
engagement (e.g., fair market value, fair value, investment value).
Standards: Predetermined, expected levels of efficiency or measures of desired
performance (e.g., a budget amount, a standard cost, or a nonquantitative statement
of desired performance). A standard cost is the predetermined cost of an input per
unit of output. Standards may be unchanging (basic), perfect (ideal), or currently
attainable.
Statements of Financial Accounting Standards (SFAS): Pronouncements of
the Financial Accounting Standards Board that are the central elements of generally
accepted accounting principles.
Stock acquisition: The purchase of a controlling interest in a firm by buying its
outstanding equity.
Strategic information system: An application used by senior management to create
a company's strategy.
Streaming media: Typically, refers to Internet sites that send out a continuous
flow of sound or video signal to user. An example might be www.radiotango.com,
which plays tangos 24 hours per day.
Strike price: The prespecified purchase or sale price for the underlying asset in an
option contract.
Sustainable earnings base: A revised historical earnings series from which the
effects of all nonrecurring items have been removed (see core earnings).
Sustainable earnings worksheet: A worksheet used to organize and summarize
nonrecurring items so that their effects can be removed from as-reported net income
in order to arrive at a sustainable earnings base.
Swap: An agreement between two parties to exchange cash f lows over a period of
time. Cash f lows are determined by an agreed upon formula specified in the swap
agreement—a formula that is contingent on the performance of other underlying
instruments.
Symmetric risk: An exposure that results in profits when an underlying price or
economic variable moves in one direction, and proportional losses if the variable
moves in the opposite direction.
Synergy: The incremental value generated by the combination of two or more firms.
Synthetic stock portfolio: A portfolio that consists of Treasury bills and a long
position in equity futures contracts. A properly constructed synthetic stock portfolio
behaves the same as a portfolio consisting of actual stocks.
Systematic risk: The risk that is common to all risky securities and cannot be eliminated
through diversification. When using the capital asset pricing model, systematic
risk is measured by beta.
Takeover: The transfer of corporate control from one group of shareholders to
another.
Target: A firm that is the subject of takeover or acquisition activities.
Tau: The amount of time remaining prior to an option's expiration.
Taxable transaction: An acquisition in which the target firm shareholders are immediately
subject to capital gains on their sale of shares.
Glossary 641
Tax-adjusted nonrecurring items: Pretax nonrecurring items of revenue, gain,
expense, and loss that are multiplied by one minus a representative income tax rate.
The result is the after-tax effect of each of these items on net income.
Tax-free transaction: An acquisition in which the primary consideration paid to
the target's shareholders is the acquirer 's common stock, thereby deferring capital
gains taxes until the new shares are sold.
TCP/IP: The communications standard that is used by the Internet. A protocol is
the understanding that computers have for how information will be delivered over
the communications network, which enables computers with different operating systems
to communicate with each other and to eliminate errors in data.
Temporal (remeasurement) translation procedure: A method for translating
foreign currency financial statements in which monetary assets (including assets
valued at market) and liabilities are translated at current exchange rates. Nonmonetary
assets, liabilities, and paid-in capital accounts are translated at historical exchange
rates; cost of sales and depreciation expense are translated at the rates in
existence when the related inventory or fixed assets were acquired; and revenues
and other expenses are translated at the average exchange rate in existence during
the reporting period. Translation gains and losses are reported as a component of
net income.
Transaction exposure: The potential for gains and losses as foreign-denominated
assets and liabilities (e.g., accounts receivable, accounts payable, notes payable), increase
or decrease in value with changes in exchange rates.
Transfer prices: Prices charged when goods or services are transferred either
within firms (e.g., from one division of a firm to another) or between related firms
(e.g., between a parent and its subsidiaries).
Translation exposure: Typically, the excess of foreign-currency assets over foreign
currency liabilities of foreign subsidiaries. Translation gains result from increases in
the value of the foreign currency and losses in the event of decreases.
Translation of foreign currency financial statements: The restatement of the
financial statements of a foreign entity from its local currency to the reporting currency
of its parent.
UNIX: An open operating system running on many manufacturers' computers. The
first successful nonproprietary operating system. It was developed by Bell Labs in
the 1970s.
Unsystematic risk: The portion of total risk specific to an individual security that
can be avoided through diversification.
Unwind: To close out a future or forward position.
URL: Universal Resource Locator is the Internet address for a given Web site. The
URL for the president of the United States is www.whitehouse.gov.
Valuation date: The specific point in time at which the valuator 's opinion of value
applies (also referred to as "Effective Date" or "Appraisal Date").
Variances: Measures of the difference between actual costs and standard costs.
They are favorable if costs are less than expected and unfavorable otherwise. Variances
may be analyzed by the effect of changing prices (price variances) or changing
usage (quantity or usage variances).
642 Glossary
Vertical merger: A merger in which the two firms are from different stages of the
same industry or production process (e.g., an automobile manufacturer purchases a
steelmaker).
WAN: A wide area network is a connection of two or more computers which are geographically
distant from each other. The typical purpose of a WAN is to send data or
communicate with distant facilities. Thus, an airline might have a WAN connecting
all of its airports world wide to allow for the quick communications of scheduling
changes between its various facilities.
Weighted average cost of capital (WACC): The cost of capital (discount rate) determined
by the weighted average, at market value, of the cost of all financing
sources in the business enterprise's capital structure.
Windows NT or 2000: Quickly becoming the network operating system standard
of the industry. Developed by Microsoft.
Write an option: Sell an option. The writer is paid the option premium up front.
The writer of a call must later sell the underlying asset if the call option owner
exercises. The writer of a put must later buy the underlying asset if the put option
owner exercises. The writer of the option is essentially liable for any future payoffs
received by the option owner. Also known as shorting the option.
643
About the Authors
Charles A. Anderson's career includes academic and business experience. He
has been a faculty member of both the Harvard Business School and the Stanford
Business School. He was the president, chief executive officer, and a
director of Walker Manufacturing Co., J.I. Case, and the Stanford Research
Institute. He has served on a number of corporate boards of directors, including
NCR Corp., Owens-Corning Fiberglas Corp., Boise-Cascade Corp., and
the Eaton Company.
Robert N. Anthony is Ross Graham Walker Professor of Management Control,
Emeritus, at Harvard Business School. He has been a director and chairman
of the audit committee of Carborundum Company and Warnaco, Inc. He
has been a director of several smaller organizations and a trustee (including
chairman of the board) of Colby College, and of Dartmouth-Hitchcock Medical
Center. He is the author or coauthor of some 20 books and 100 articles on
management subjects, especially management control; his books and articles
have been translated into 12 languages. He is a past president of the American
Accounting Association.
Richard T. Bliss has been involved in corporate financial analysis since 1987
and is currently on the finance faculty at Babson College. He teaches at the undergraduate,
MBA, and executive levels, specializing in the areas of Corporate
Financial Strategy and Entrepreneurial Finance. Prior to coming to Babson,
Dr. Bliss was on the faculty at Indiana University and he has also taught extensively
in Central and Eastern Europe, including at the Warsaw School of Economics,
Warsaw University, and the University of Ljubljana in Slovenia.
With publications in the areas of corporate finance, entrepreneurship,
and banking, Dr. Bliss has an active research agenda. His recent work on the
impact of bank mergers on CEO compensation has been cited in Fortune magazine
and numerous other business publications and will be published in the
Journal of Financial Economics.
644 About the Authors
Dr. Bliss holds a PhD in Finance from Indiana University. He also received
his MBA in Finance/Real Estate from Indiana University and graduated
with honors from Rutgers University, earning a BS degree in Engineering and a
BA degree in Economics
Edward G. Cale Jr. is a professor of information systems at Babson College in
Wellesley, Massachusetts. Dr. Cale holds a BS in electrical engineering from
Stanford University and an MBA and a DBA from the Harvard Business
School. After working for five years in the aerospace and integrated circuits industries,
Dr. Cale has spent the past 20 years in academia, teaching, conducted
research, and consulting in the management of information technology.
Eugene E. Comiskey received his PhD from Michigan State University and
his professional qualifications include both Certified Public Accountant (CPA)
and Certified Management Accountant (CMA). Professor Comiskey taught
from 1965 to 1980 at the Krannert Graduate School of Management at Purdue
University and also as a visiting faculty member during 1972 and 1973 at
the University of California, Berkeley. While at Purdue, he twice received the
Salgo Noren Foundation Award as the outstanding professor in the Graduate
Management Program. Since arriving at Georgia Tech he has six times been
recognized as Professor of the Year by the Graduate Students in Management
organization. In 1999, Professor Comisky was the recipient of the Educator of
the Year award from the Georgia Society of CPAs.
Professor Comiskey has published over 60 papers in a wide range of professional
and scholarly journals and edited books. A book, with Charles W.
Mulford, Financial Warnings (478 pages), was published in 1996 by John Wiley
& Sons and is now in its fifth printing. Another book, Guide to Financial Reporting
and Analysis (624 pages), also with Charles W. Mulford, was published
by John Wiley & Sons in 2000. A third book, The Financial Numbers Game, is
under contract with John Wiley and should be published in late 2001 or early
2002. Current research interests center on financial analysis and financial reporting
practices, financial early warnings, international financial reporting
practices, and the role of financial data in credit decisions. For over 25 years,
Professor Comiskey has worked with commercial banks, both in the United
States and in Europe and Asia, in the design and delivery of educational programs
to improve the financially oriented credit analysis skills of lenders. Since
1988, he has been a partner in Financial Training Associates, a financial training
and consulting firm that he founded with his colleague Charles W. Mulford.
Professor Comiskey served from 1978 to 1980 as Director of Research
for the American Accounting Association. He also served (1995–1996) as president
of the Financial Accounting and Reporting Section of the American
Accounting Association. The Section has a membership of over 1,500 and is
made up of scholars and practitioners who have a primary interest in matters
related to the measurement and disclosure of financial information. Professor
About the Authors 645
Comiskey served two terms on the editorial review board of the Accounting
Review—the second term was as an editorial consultant, or under current
nomenclature, an associate editor. He has also served a term on the editorial
review board of Issues in Accounting Education and is now serving a threeyear
term on the editorial board of Accounting Horizons.
Michael A. Crain, CPA/ABV, ASA, CFE, MBA, is a business appraiser and litigation
consultant practitioner in Ft. Lauderdale, Florida. He is an Accredited
Senior Appraiser in business valuation awarded by the American Society of
Appraisers and he is Accredited in Business Valuation from the American Institute
of Certified Public Accountants (AICPA). He has served on the examination
committee for the AICPA's business valuation accreditation and on other
AICPA national committees. He has been retained as an expert witness and
testified on numerous occasions. His articles have appeared in the Journal of
Accountancy, CPA-Expert, and other professional publications, and he has spoken
on numerous occasions to national audiences.
Steven P. Feinstein, PhD, CFA, is an associate professor of finance at Babson
College and a consultant with the Michel/Shaked Group in Boston. He holds a
PhD in economics from Yale University. Prior to entering academia, Dr. Feinstein
served as an economist at the Federal Reserve Bank of Atlanta. Dr. Feinstein's
primary areas of research are financial valuation and the use and pricing
of derivatives. He has presented his research at numerous academic conferences
including the annual meetings of the American Finance Association and
the Financial Management Association. His articles have appeared in Derivatives
Quarterly, the Journal of Risk, Risk Management, the Atlanta Federal Reserve
Bank Economic Review, the American Bankruptcy Institute Journal, and
the Journal of Financial Planning. Dr. Feinstein conducts professional seminars
for executives and has consulted for a wide variety of institutions. Clients
have included Bankers Trust, Cho Hung Bank of Korea, Chrysler, Honeywell,
ITT, Lehman Brothers, Nippon Life Insurance, Travelers Insurance, and numerous
law firms.
Theodore Grossman is a member of the faculty of Babson College, where he
teaches information technology and accounting. He lectures on various information
technology topics such as Web technologies, e-commerce, strategic information
systems, managing information technology, and systems analysis and
design. He also performs extensive consulting for food and nonfood retailers,
suppliers of technology products to the retail industry. He is called upon frequently
to act as an expert witness in complex litigation in matters relating to
technology and cyber law. Prior to joining Babson College, he was the founder
and CEO of a computer software company for the retail industry. He holds a
BS degree in engineering from the University of New Hampshire and an MS in
management from Northeastern University.
646 About the Authors
Robert Halsey has an MBA in finance and a PhD in accounting from the University
of Wisconsin—Madison. During his business career, he managed the
commercial lending division of a large Midwestern bank, and served as the
Chief Financial Officer of a privately held retailing and manufacturing company.
Prior to joining the faculty of Babson College, Dr. Halsey taught at the
University of Wisconsin—Madison where he received the Douglas Clarke
Memorial Teaching Award. His research interests are in the area of financial
reporting and include firm valuation, financial statement analysis, and disclosure
issues. He has published in Advances in Quantitative Analysis of Finance
and Accounting, the Journal of the American Taxation Association, and Issues
in Accounting Education.
Stephen M. Honig is senior partner with the Boston office of the national law
firm of Schnader, Harrison, Segal & Lewis, LLP. A holder of a BA from Columbia
College and an LLB from Harvard University, Mr. Honig has worked in
the private and public finance of emerging technology companies since 1966.
He was assisted in the preparation of his chapter by his partner Albert Dandridge,
formerly on the staff of the Securities and Exchange Commission, and
associate Craig Circosta, both of Schnader's Philadelphia office.
William C. Lawler is an Associate Professor of Accounting at Babson College,
Wellesley, Massachusetts, and Director of the Consortium for Executive Development
at Babson College's School of Executive Education. Dr. Lawler did
his undergraduate work at the University of Connecticut and his graduate
studies at the University of Massachusetts. His teaching and research focus on
two areas: financial footprints of business unit strategy and the impact of new
technologies on cost systems design.
Professor Lawler has authored several papers and given numerous professional
presentations. His primary focus is on aiding operational managers in understanding
the financial consequences of their decisions. He has run seminars
on this topic for such diverse groups as telecom managers in China, production
managers in the Czech Republic, and R&D managers in the United States. Dr.
Lawler consults with a number of companies, ranging from small biotechs to
Fortune 100 computer companies, concerning the design and use of cost information
systems for management decision support rather than external financial
reporting. His most recent publications in this area are chapters on Activity
Based Accounting and Profit Planning for the third edition of The Portable
MBA in Finance and Accounting.
John Leslie Livingstone earned MBA and PhD degrees from Stanford University.
He is a CPA, licensed in New York and Texas, and a CVA (certified in
business valuation). Les directs a nationwide business consulting practice,
headquartered in West Palm Beach, Florida. He has been a partner in Coopers
& Lybrand (now PricewaterhouseCoopers), an international accounting
firm, and in The MAC Group, an international management consulting firm
About the Authors 647
specializing in business strategy with offices in Boston, Chicago, Los Angeles,
New York, San Francisco, Washington, D.C., London, Paris, Munich, Rome,
Madrid, and Tokyo (since acquired by Cap Gemini/Ernst & Young). He has
consulted to major corporations and other organizations such as the U.S.
Postal Service and the SEC. He was the Arthur Young Distinguished Professor
of Accounting at Ohio State University, Fuller E. Callaway Professor of
Accounting at Georgia Institute of Technology, and Chairman of the Department
of Accounting and Law at Babson College. He has authored or coauthored
10 books, several chapters in authoritative accounting handbooks, and
many articles in professional journals.
Richard P. Mandel is an associate professor of law at Babson College, where
he teaches a variety of courses in business law and taxation on the undergraduate
and graduate school levels and has served as chairman of the Finance Division.
He is also a partner in the law firm of Bowditch and Dewey, of Worcester
and Framingham, Massachusetts, where he specializes in the representation of
growing businesses and their executives. Mr. Mandel has written a number of
articles regarding the legal issues encountered by small businesses. He holds an
AB in Government and Meteorology from Cornell University and a JD from
Harvard Law School.
Charles W. Mulford is Invesco Chair and professor of accounting in the
DuPree College of Management at Georgia Tech. Since joining the faculty in
1983, he has been recognized nine times as the Core Professor of the Year and
once as the Professor of the Year by the Graduate Students in Management. In
1999 the Graduate Students in Management voted to rename the Core Professor
of the Year Award the "Charles W. Mulford Core Professor of the Year
Award." An additional teaching award received in 2000 was the universitywide
W. Roane Beard Class of 1940 Outstanding Teacher Award.
Dr. Mulford's scholarly pursuits include the publication of numerous papers
in scholarly as well as professional accounting and finance journals. His
research interests center on the effects of accounting standards on investment
and credit decision making, earnings forecasts, the relationship between
accounting-based and market-based measures of risk and international accounting
and reporting practices. More recently, his research interests have
turned to the use of published financial reports in the prediction of financial
distress. He has coauthored a book on the subject, Financial Warnings, published
in 1996. A second book on financial analysis, Guide to Financial Reporting
and Analysis, was published in July 2000. A third book on how
accounting is used to mislead investors, The Financial Numbers Game: Identifying
Creative Accounting Practices, is scheduled for publication in 2001. All
three books were or will be published by John Wiley & Sons, New York.
In addition to his work at Georgia Tech, Professor Mulford regularly consults
with major domestic and international commercial banks on issues related
to credit decision making.
648 About the Authors
Charles Mulford has a doctorate in accounting from Florida State University
and is professionally qualified as a Certified Public Accountant (CPA) in
Florida and Georgia. Prior to joining the Georgia Tech faculty, he practiced
public accounting with the firm of Coopers & Lybrand. He was an audit senior
in the firm's Miami office.
Michael F. van Breda teaches at Southern Methodist University where he
was chair of the accounting department for a number of years. He is currently
Director of the Graduate Certificate Program in Finance and Accounting. His
courses have included cost and managerial accounting at the graduate level.
He obtained his PhD in Accounting from Stanford University and his MBA
from the University of Cape Town. He was previously on the faculty of
MIT and has held positions at the University of Cape Town, the University
of the Witwatersrand, and at University College, Oxford. He is the author of
numerous scholarly publications one of which won the Lybrand silver medal for
its contribution to managerial accounting. He is the coauthor (with Eldon S.
Hendriksen) of the fifth edition of Accounting Theory (Richard D. Irwin,
1991). In addition he has consulted to a number of major corporations.
Andrew "Zach" Zacharakis, PhD, is the Paul T. Babson Term Chair in Entrepreneurship
and an associate professor of entrepreneurship with the Arthur
M. Blank Center for Entrepreneurship at Babson College. Professor Zacharakis
received a BS (finance/marketing), University of Colorado; an MBA (finance/
international business), Indiana University; and a PhD (strategy and
entrepreneurship/cognitive psychology), University of Colorado. At Babson, he
teaches the business plan preparation course at both the MBA and undergraduate
levels. He also actively advises entrepreneurial start-ups and venture
capital firms. His primary research areas include the (1) venture capital
decision-making process and (2) entrepreneurial growth strategies. Professor
Zacharakis has articles appearing in Journal of Business Venturing, Entrepreneurship:
Theory and Practice, Journal of Small Business Management, Venture
Capital: An International Journal of Entrepreneurial Finance, Journal of
Private Equity Capital, International Trade Journal, Academy of Management
Executive, Journal of Business Strategies, Case Research Journal, as well as
Frontiers of Entrepreneurial Research. Professor Zacharakis has been interviewed
in newspapers nationwide including the Boston Globe and the Los
Angeles Times. He has also appeared on Bloomberg Small Business Report.
Professor Zacharakis's dissertation, The Venture Capital Investment Decision,
received a Certificate of Distinction from the Academy of Management and
Mr. Edgar F. Heizer recognizing outstanding research in the field of new
enterprise development. Professor Zacharakis's actively consults with entrepreneurs
and small business start-ups. His professional experience includes positions
with The Cambridge Companies (investment banking/venture capital),
IBM, and Leisure Technologies.
649
Index
Accounting:
changes in, 51–53
cross-border deals, 586
for goodwill, 399–400
government, 217–218
hedge, 389–393
information systems, 543, 544–545
international differences in, 356, 393–400
policies note, 82
standard cost accounting systems, 217–219
Accounts payable, 18, 20–21, 188
Accounts receivable, 18, 19, 187, 543
Accrued expenses (financial budget), 189
Acid test ratio, 18, 28
Acquisition, 83–84, 322–324, 561–592
antitrust concerns, 585–586
bidder, 562
cash vs. stock deals, 582–583
conglomerate merger, 563–564
consolidation, 562
cost reduction benefits, 576–577
cross-border deals, 586
definitions/background, 562–563
horizontal, 563
identifying/screening candidates, 581–582
Internet links, 591
postmerger implementation, 586–589
practical considerations, 581
proxy contests, 562
purchase vs. pooling accounting, 583–585
successful case study (Cisco Systems Inc.),
571–573
takeover, 562
taxes, 322–324, 583, 585
track record of, 564–571
value creation in, 573–581
vertical, 563
Activity-based costing (ABC), 126–148
Activity-based management (ABM), 136,
145
Activity indices, 206
Activity ratios (valuation), 601
Administrative expense budget, 186
Adobe Systems Inc., 359, 361
Advanced Micro Devices, 45
Advertising/promotion, 275–276
Advisory boards, 281–283
AGCO Corporation, 387, 388
Agent /principal, 237–238
Air Canada, 358
Air T Inc., 408
AK Steel Holding Corporation, 47, 54, 71
Alternatives, principle of, 596
Altman z score, 31–32
American Airlines, 576
American Institute of Certified Public
Accountants, 33, 35, 167
American Pacific Corporation, 408
Analog Devices Inc., 368, 369
Andrews, Kenneth R., 517
Antitrust concerns, 585–586
AOL/Time Warner, 561, 563, 586
Application service providers (ASPs), 556
Applications software, 156–164
Arch Chemicals Inc., 369, 405
Archer Daniels Midland Company (ADM),
59–61
Argosy Gaming, 43
Armco, 52–53
Armstrong World Industries Inc., 359, 361,
364
ARPANET, 541
Arvin Industries Inc., 364
Askin Capital Management, 428
650 Index
Asset(s):
current, 17–18
turnover, 30, 31
valuation approach, 594
AT&T/NCR merger attempt, 567–568, 588
Audit, 12–13
Audit committee, 523–529
Baker Hughes, 75–94
Balance sheet, 4, 6, 7, 8, 10, 15, 17, 25, 599–601,
613
Baldwin Technologies, 358, 361
Banking/finance, information technology in,
545–546
Bankruptcy predictor (ZETA), 32
Barad, Jill E., 519
Bard (C.R.) Inc., 64, 66, 67
Baxter International Inc., 373, 374
B.B. Lean Inc., 584, 585
Becton, Dickenson & Company, 388
Becton Coulter Inc., 363, 387, 388, 393
Beta, 613
Biogen, 61
Black & Decker, 404
Blyth Industries Inc., 373
Board of directors, 241–243, 281, 510–535
audit committee, 523–529
chief executive officer (CEO) and, 512–514,
518–519
compensation committee, 520–523
corporation business form and, 241–243
dealing with major crises, 518–520
finance committee, 529–532
meetings, 514–516, 517–518
member responsibilities, 512
reasons for having, 510–511
strategy, 516–518
Books "R" Us, 117, 118, 127
Break-even calculations, 107
Brooke Group Inc., 121–122
Brooktrout Technologies, 43
Brown & Williamson Tobacco Corporation,
121–122
Budget(s)/budgeting, 173–198
accounts receivable/payable, 187, 188
accrued expenses, 189
activity indices, 206
actual vs. static vs. f lexible, 193–195,
203–204, 205
administrative expense, 186
behavioral issues in, 181–182
capital expenditures, 188, 291–313
cash, 184–185, 189–190
comprehensive process (diagram), 179
control, 174, 178–181, 201–208, 219–220
cost of goods sold, 183–186
defining standards, 202
financial, 187–189
fixed cost, 215–217
forecasting and, 191–193
goal orientation, 176, 177
improper use of, 181
income statement, 186–187
labor indices, 211
legal /contractual requirements, 176
market effects, 207
master, 182–183
material indices, 210–211
overhead indices, 211–212
performance evaluation and, 176
periodic planning and, 175
price indices, 206
profit plan, 195
quantification, 175
realistic planning, 178
reasons for, 174–177
review process, 195–197
sales, 183
standards and, 202–203
statement of cash f lows, budgeted (indirect
method), 190–191
variable cost, 208–213
variance analysis/reports, 179, 180,
212–213
Buffett, Warren, 575
Buildup technique, 286, 287–288
Burn rate, 285
Business form/entity, 225–259. See also
Corporation; Limited liability company
(LLC); Limited partnership; Partnership;
Sole proprietorship
case illustrations, 225–226, 255–259
choice of, 255–259
comparison factors (five basic forms), 228,
231–244
Business plan, 260–290
getting started on, 262–263
length, 261–262
outline, 264
resources/Web sites, 289, 290
sections:
appendices, 288–289
company/product description, 271–273
competition analysis, 269–270, 271
cover, 265, 266
critical risks, 284–285
customer analysis, 269
development plan, 279–281
executive summary, 267–268
financial plan, 286–288
industry analysis, 268–269
marketing plan, 273–277
offering, 286
operations plan, 278–279
table of contents, 265–267
team, 281–283
Index 651
story model, 263–265
types of, 261–262
Buy-sell agreements, 345–347
Cabot, Louis B, 513
California First Bank, 360, 361
Capital asset pricing model (CAPM), 613–615
Capital budgeting, 188, 291–313
cost of debt financing, 303–304, 606,
615–616
decision rules, 292, 307–311
discount rate, 303–307, 613
divisional vs. firm cost of capital, 307
economic value added (EVA), 311, 312
forecasting cash f low, 297–299
leverage effects, 305–307
real options, 312
recent innovations in, 311–312
weighted average cost of capital (WACC),
304–305
Capitalization rate/factor, 612
Cash:
budget, 184–185, 189–190
deals, acquisitions (vs. stock deals), 582–583
equivalents, 18
synthetic, 439
Cash f lows:
forecasting, 292–299
nonrecurring items, 54–58, 90
statement of, 8–10, 11, 15, 54–58, 77,
190–191
Cerent Corporation, 572–573
Chambers, John, 572
Champion Enterprises, 46
Chase Manhattan, 576
Chief executive officers (CEO), 526–527
acquisitions and, 566
appraisal of, 512–513
board of directors and, 512–514
compensation, 520–522
terminating, 518–519
Cisco Systems, 530–531, 543, 566, 571–573, 582,
587, 588
Citicorp, 575
Client-server network, 164, 165
Collateralized mortgage obligations (CMOs), 428
Comfort letter, 472, 505–509
Commodities, 409
Company/product description (business plan
section), 271–273
Compaq, 373, 374
Compensation, 283, 315–317, 325–330, 520–523
Competitors. See also Industry(ies)
analysis, 269–270, 271, 274
financial ratio comparisons, 29
risks section of business plan (competitor
actions/retaliation), 284–285
Computer components, 152–155
Computing,"ubiquitous," 538
Conglomerate merger, 563–564
Conoco Inc., 405
Consolidation, 562
Control(s):
budgeting and, 174, 178–181, 201–208,
219–220
business entities/forms and, 228, 237–244
discount for lack of, 622
information technology, 551–552
interest, 622
premium, 619
Cookies, 169
Core earnings. See Sustainable earnings
Corporation:
continuity of life, 234–235
control, 238–243
directors, 241–243
formation, 229–231
liability, 245–247
officers, 243
out-of-state operation, 232
professional, 227, 233
sale of, 350–351
stockholders, 239–240
subchapter S, 227, 252–253, 318–322
taxation, 249, 250–253, 318–322
transferability of interest, 236
Cost(s):
awareness (budgeting function), 176
behavior estimation (methods of ), 116–120
benefits, mergers/acquisitions, 576
of capital, 304–305, 307, 606–608
of debt, 303–304, 606, 615–616
of equity, 606, 613–615
estimating headcount schedule, 287–288
fixed, 215–217, 218–219
of goods sold (budgets), 183–186
opportunity, 298
standard, 218–219
structure analysis, 104–106
sunk, 299
variable, 208–213, 218
Cost-volume-profit (CVP) analysis, 102–125
CVP analysis chart, 107, 108
for decision making, 109–111
high-low analysis, 118–119
in multiple product situation, 112–115
price discrimination, 111–112
regression analysis, 119–120
role of pricing, 121–123
sensitivity analysis, 113, 116
visual fit, 118–119
Coverage ratios (valuation), 601
Covey Systems, 588
Covisint, 555
CPA (certified public accountant), 12–13
Cross-border deals, 586
652 Index
Cross-hedge, 440
Crugnale, Joey, 273
Cryomedical Sciences, 45
Currency, 67– 69, 92–93, 356–375, 386–389, 438
financial reporting of foreign-currency
denominated transactions, 356–358
foreign exchange gains/losses, 92–93
futures, 368–369
hedging/risk management, 356, 358–375, 438
options, 365–368, 369
transaction/translation exposure, 67–69
Customer analysis (business plan section), 269
Customer value proposition (CVP), 129, 130
Daft, Douglas, 575
DaimlerChrysler, 388, 569, 570, 582–583, 588
Dana, 61
Database systems/software, 161, 543, 548–549,
550
Data warehousing, 549–551
Dead End Inc., 584
Death taxes, 344
Debt:
cost of, 303–304, 606, 615–616
long-term obligations, 22
ratio of, to equity, 26
Debt-free analysis (valuation), 605–606
Decision analysis, and CVP analysis, 109–111
Decision support systems/executive information
systems, 556–559
Dell Computer, 555
Delta Air Lines, 37–38, 414
Depreciation, 295
Derivatives, 361–370, 423–455
call options, 443, 444–445
case studies of debacles involving, 425, 432
Askin Capital Management, 428
Barings Bank, 425
lessons from, 432
Long-Term Capital Management (LTCM),
429–432
Metallgesellschaft, 426–427
Orange County, California, 428
Procter and Gamble, 425–426
Union Bank of Switzerland, 429
choosing appropriate hedge, 451–454
equity swaps, 448
exchange-traded vs. over-the-counter, 452
forwards, 434–436, 437–440
futures, 434, 436–440
instruments, 434–451
interest rate swaps/hedges, 438, 449–451
market timing, 439
options, 434, 440–442
put options, 445–447
risk transfer using, 423, 424, 432
size of market, 433–434
swaps, 434, 447–449
synthetic cash/stock, 439
written call option, 444–445
Desktop computers, 151
Detection Systems, 45
Development plan (business plan section),
279–281
Dibrell Brothers Inc., 68–69
Digerati Inc., 579
Directed share program, 467
Direct equity methodology, 605–606
Directors. See Board of directors
Discontinued operations, 47– 48, 49
Discounted cash f low (DCF), 300–301,
303–307, 609–618
Discounted payback period rule, 308–309
Discount for lack of control, 622
Discount rate, 303–307, 613
Distribution strategy, 275
Dividends, 26, 339–340, 530–531, 579
Doom loop, 121
Dow Chemical Company, 364, 405
Due diligence checklist /examination outline,
466, 478–498
"Dumping," 123
Dupont analysis/formula, 30, 31
Earnings, 35–101, 475, 525–526, 608–609
adjustment to, for valuation purposes,
608–609
analysis of, 35–101
annual reports referenced, 96–98
Internet links, 95–96
nonrecurring items, 35–71
"other comprehensive income," 71–72
smoothing, 525–526
sustainable (core/underlying), 72–96, 617
Eaton, Robert, 570
EBIT, 21, 26, 27
Eckel, Robert, 519
Economic value added (EVA), 311, 312
Electronic commerce, 168–169, 554–555
Electronic Data Interchange (EDI), 547, 548,
552
Electronic mail (e-mail), 165–166
Electronic Transaction Network (ETN/ W),
126–148
ABC example, 126–148
customer value proposition (CVP), 130
history, 127–130
transaction processing, 140–144
value system and strategy, 130–131
Employee stock ownership plans, 341–343
Engineered instruments, 434
Engineering studies, 213–214
Enterprise resource planning (ERP) systems, 544
Equity risk premium, 613
Escalon Medical Corporation, 54, 55, 57, 58
Estate planning, 343–347
Index 653
Estimates, changes in, 53–54
Executive compensation, and taxes, 325–335
Exotics, 434
Extraordinary items, 47–51
Fairchild Corporation, 43, 62, 69, 70
Family limited partnership, 344–345. See also
Limited partnership
Fashionhouse Furniture, 353–357, 361, 375, 401,
404, 407, 413, 415
Federal Express, 360, 361
File server, 164
Finance committee, 529–532
Financial budget, 187–189. See also Budget(s)/
budgeting
Financial Management Association, 168, 172
Financial plan (in business plan), 286–288
Financial ratios, 21–23, 28–29, 30–31, 601–603
activity ratios, 601
analysis, 601–603
combining, 30–31
coverage ratios, 601
industry composites comparison, 29
investment profitability, 25–28
leverage ratios, 601
liquidity ratios, 601
long-term solvency analysis, 21–23, 28
profitability ratios, 28, 603
sales profitability, 23–25, 28
short-term liquidity analysis, 28
Financial statements, 3–34, 286 –288, 409–410,
524, 610–611
analyzing, 16–28
assets/liabilities, current, 17–18
audit, 12–13, 524
balance sheet, 4, 6, 7, 8, 10, 15, 17, 25,
599–601, 613
in business plan, 286–288
case study, 4–13, 17
cash f low statement, 8–10, 11, 15, 54–58, 77,
190–191
compilation, 13
of foreign subsidiaries, 356, 375–386
format, 14–16
income statement, 5, 10, 11, 14, 23, 24, 25,
39–54, 56, 90, 186 –187, 410, 601, 602
inf lation effects and adjustment of, 409–410
Internet links, 33–34
points to remember about, 10–11
projected, 610–611
review, 12, 13
service levels (CPA) relating to, 12–13
uses of, 13–14
valuation and analysis of, 599–603
Financing:
sources, 460
timing/availability (critical risks section of
business plan), 285
Firewall, 553
First Aviation Services, 61–62
Forecasts/projections:
budgets and, 191–193
cash f low, 292–299
sales/marketing, 276–277
Foreign company, predatory pricing by
(dumping), 123
Foreign exchange. See Currency
Foreign subsidiaries:
evaluation of performance of, 356, 401–407
impact of exchange rate movements on
performance evaluation, 401–404
transfer pricing, 404–407
translation of financial statements of, 356,
375–386
U.S. government restrictions on business
practices, 356, 413–415
Forward contracts, 361, 434–436, 437–440
Franklin Planner, 588
Freeport-McMoRan, 46
Futures, 361, 434, 436–440
Galey & Lord, 384, 385
General Electric, 555
General partnership, 226 –227. See also
Partnership
General Utilities doctrine, 351
Gerber Scientific, 61
Gift tax, 317–318
Glaxo Wellcome PLC, 576
Global finance, 353–422
accounting policy differences, 356, 393–400
case illustration (Fashionhouse Furniture),
353–357, 361, 375, 401, 404, 407, 413,
415
companies referenced, 417–419
currency risk management, foreign
subsidiaries, 356, 386–389
financial reporting of foreign-currency
denominated transactions, 356–358
hedge accounting, 389–393
inf lation effects, 356, 407–413
performance evaluation, foreign
subsidiaries/management, 356, 401–407
risk management alternatives for foreigncurrency
denominated transactions, 356,
358–375
translation of financial statements of foreign
subsidiaries, 356, 375–386
U.S. government restrictions, 356, 413–415
Goal orientation (budgets), 176–177
Goodwill, 399–400, 583–584
Goodyear Tire and Rubber Company, 38, 63
Government accounting, 217–218
Government restrictions on business practices
associated with foreign subsidiaries and
governments, 356, 413–415
654 Index
Gross profit, 5
Guideline companies approach, 618
Handy and Harman Inc., 58–59
Hardware, 150–155, 537–539
Hartmarx Corporation, 408, 409
Headcount schedule, 287–288
Hedge(s)/hedging, 356, 358–375, 389–393. See
also Derivative(s)
accounting (current GAAP requirements),
389–393
cash f low, 391–392
choosing appropriate, 451–454
cross-hedge, 440
decision factors, 370–375
fair value, 390–391
foreign-currency, 359, 361–370, 438
interest rate, 438, 449–451
with internal offsetting balances or cash f lows,
358–361
natural, 359
of net investments in foreign operations, 392–393
risk management alternatives for foreigncurrency
denominated transactions, 356,
358–375
Heinz Company (H.J.), 43, 376, 377
Henry Schein Inc., 388
High-low analysis (method of cost behavior
estimation), 118–119
Holden, James, 570
Horizontal merger, 563
Hostile takeover attempts, 519–520
Human Genome Sciences, 576
Hybrid instruments, 434
Illinois Tool Works Inc., 384, 385
Imperial Holly, 46
Income approach (valuation), 594, 609–618
Income statement, 5, 10, 11, 14, 23, 24, 25,
39–54, 56, 90
adjusted for changing prices, 410
alternative formats, 40–42, 46
analysis, 601, 602
budgeted, 186–187
nonrecurring items, 39–54, 56, 90
spreadsheet pro forma, 158
Index arbitrage, 425
Industry(ies):
analysis, business plan section, 268–269
analysis, for valuation, 597
comparisons for valuation, 604
financial ratios, comparing composites for, 29
information technology budgets for specific,
546
Inf lation, 356, 407–413
Information technology:
accounting information systems, 544–545
accounting sites, 172
advanced technology, 559
application service providers (ASPs), 556
application software, 156 –164, 543–544
in banking and finance, 545–546
budgets for, by industry, 546
database, 161, 548–549, 550
data warehousing, 549–551
decision support systems/executive
information systems, 556–559
electronic commerce, 554–555
financial management sites, 172
firewall, 553
for the firm, 536–560
fourth generation programming languages, 541
future, 170–171
hardware, 150–155, 537–539
historical perspective, 536–537
for the individual, 149–172
information systems paradigm, 540
Internet /intranet /extranets, 541–543,
553–554
justifying cost of, 553
networks/communication, 164–170, 546–548
personal finance software, 161, 162
presentation graphics software, 160
project management software, 161–164
search engines, 171
software, 540–541
spreadsheet software, 157–160
strategy, 552–553
types of information systems, 540
useful Web sites, 171–172, 560
Web hosting, 556
word processing, 156–157
Initial public offerings (IPOs), 460–461,
473–477
Interest(s):
complete termination of, 341
control, 622
minority, 622–623
pooling of, 584
transferability of, 228, 235–237
Interest expense, 296
Interest-free loans, 328–330
Interest rate swaps/hedges, 438, 449–451
Interface Inc., 358, 359, 373
Internal audit organization, 528–529
Internal control, 528
Internal rate of return (IRR), 309–311
International Trade Commission (ITC), 123
Internet /intranet /extranets, 166 –167, 541–543,
553–554
accounting sites, 172
domain types, 167
financial management sites, 172
hypertext link, 167
vs. intranet /extranets, 553–554
privacy, 169
Index 655
search engines, 171
Web browsers, 169
vs. World Wide Web, 167–168
Internet service providers (ISPs), 166
Inventory:
adjustment, 92
disclosures, 58–59
ending (in financial budget), 187
LIFO method, 58–59, 318–319, 409–411
note, nonrecurring items, search process, 90
subchapter S, 318–319
turnover ratio, 18, 19–20
Investment(s), 25–28, 532, 596, 607, 621
Irregular items. See Nonrecurring items
(gains/losses)
Jackson Printing, 199–220
JLG Industries, 369
Johnson & Johnson Inc., 373, 403, 408
J.P. Morgan, 576
Kayman Savings and Loan, 450–451
Kaynar Technologies, 70
Keating Computer, 449–450
Kekorian, Kirk, 569
Kellogg's, 191–193
Kelly, Carol, 127–148
Labor indices, 211
Laptop computers, 151
Legacy systems, 541
Legal /contractual requirements (budgets), 176
Leverage, 27, 30, 31, 305–307, 601
Levitt, Arthur, 70
Liability, 228, 244–248
Liggett Group Inc., 121
Like-kind exchanges, 337–339
Limited liability company (LLC), 227–228
continuity of life, 235
control, 244
formation, 231
liability, 247–248
out-of-state operation, 232
pass-through entity, 318
recognition as legal entity, 233
taxation, 254–255
transferability of interest, 237
Limited partnership:
continuity of life, 235
control, 243–244
family, 344–345
formation, 231
liability, 247
out-of-state operation, 232
pass-through entity, 318
recognition as legal entity, 233
taxation, 253–254
transferability of interest, 236
Liquidity:
analyzing short-term, 16–21, 28
discount for lack of, 621–622
ratios, 601
Local area network (LAN), 164
Lockup agreements, 467
Long-Term Capital Management (LTCM),
429–432
Long-term solvency, analyzing, 21–23, 28
Loss:
passive, 320–322
risk management by prevention/control of, 423,
424
Lotus Corporation, 544
Lyle Shipping, 361
Lynch, Peter, 532
M.A. Hanna Company, 62
Management by exception, 202
Management's Discussion and Analysis (MD&A),
64–67, 80–82, 90, 469
Market approach:
publicly traded guideline-companies method,
618–621
valuation, 594
Market effects (budgetary control), 207
Marketing plan (business plan section), 273–277
advertising/promotion, 275–276
distribution strategy, 275
pricing strategy, 274–275
product /service strategy, 274
sales/marketing forecasts, 276–277
sales strategy, 276
target market strategy, 273–274
Market interest and growth potential (critical
risks section of business plan), 284
Market timing, 439
Market value, fair, 595, 604–606
Market value of invested capital (MVIC), 608
Mason Dixon Bancshares, 35–36, 65
Master budget, 182–183. See also Budget(s)/
budgeting
Material indices, 210–211
Mattel Inc., 519
MC Enterprises Inc., 579
Mergers. See Acquisition
Micron Technology, 61–62
Microsoft, 121, 582
Miller Brewing, 576
Moore's Law, 538–539
Multimedia, 154–155, 170
Nabisco Foods, 561
NASDAQ, 469, 470
Net present value (NPV), 292–312
cash f low projection/forecasting, 292–299
computing, 292–301
cost of debt financing, 303–304
656 Index
Net present value (NPV) (Continued)
decision rules other than, 307–311
discounting cash f lows, 300–301
discount rate, 303–307
divisional vs. firm cost of capital, 307
examples, 302–303
leverage effects, 305–307
taxable income and income tax, 296
time value of money, 299–301
weighted average cost of capital (WACC),
304–305
windfall profit and windfall tax, 295–296
Network(ing), 164–170, 546–548. See also
Internet /intranet /extranets
architecture, 164
browsers, 169
client-server, 164, 165
cookies, 169
electronic commerce, 168–169
electronic mail (e-mail), 165–166
file server, 164
firms and, 546–548
individuals and, 164–170
local area network (LAN), 164
operating system, 164
peer-to-peer, 164
streaming media, 170
wide area network (WAN), 165, 166
wireless modems, 164
World Wide Web, 167–168
Network adapter, 154
Nonrecurring items (gains/losses), 35–71, 90, 91
accounting changes, 51–53
changes in estimates, 53–54
in continuing operations income, 42–43
discontinued operations, 47– 48, 49
extraordinary items, 47–51
foreign exchange (transaction and translation
exposure), 67–69
identification process, 39
in income statement, 39–54, 56
in income tax note, 59–62
in notes to financial statements, 67–71
interpreting information in operating activities
section, 56–58
in inventory disclosures of LIFO firms, 58–59
located below income from continuing
operations, 46–47
in Management's Discussion and Analysis
(MD&A), 64–67
nature of, 37–39
operating income (inclusions/exclusions),
43–46
in "other income and expense" note, 62–64
quarterly and segmental financial data, 70–71
restructuring notes, 69
search process, 39, 40, 90, 91
in statement of cash f lows, 54–58
Offering, 286
Officers, 243
Olin Corporation, 369
Operating systems, 156
Operations/operating:
consolidated statements of (example), 76
expenses (critical risks section of business
plan), 285
income, 43–46
nonrecurring items, 43–46
plan, 278–279, 280
Opportunity costs, 298
Options, 361, 434, 440–442
Osmonics, 43
"Other comprehensive income," 71–72
"Other income and expense" note, 62–64, 90
Overhead, 299
Pall Corporation, 62, 359, 373, 405
Partner(s), strategic, 281
Partnership, 226–227
continuity of life, 234
control, 237–238
formation, 229
liability, 245
limited (see Limited partnership)
pass-through entity, 318
recognition as legal entity, 232–233
taxation, 250
transferability of interest, 236
Passive losses, 320–322
Pass-through entities, 319–320
Pave-Rite Inc., 583
Payback period rule, 308
Peer-to-peer network, 164
Pegasus Systems Inc., 408
Penn Central Corporation, 513
Pension funds, 531–532
Performance:
evaluation (budget function), 176
of foreign subsidiaries/management, 356,
401–413
Personal digital assistants (PDAs), 149, 151–152
Personal finance software, 161, 162
Philip Morris Companies Inc., 385, 403, 576
Phillips Petroleum, 65–66, 75
Pickens, T. Boone, 577
Pizzi, Denise, 127–148
Planning, 195
budgets and, 175, 178, 291–313 (see also
Budget(s)/budgeting; Capital budgeting)
business plan, 260–290
enterprise resource planning (ERP) systems,
544
estate, 343–347
Polaroid Corporation, 369, 373, 408
Pollo Tropical, 46
Pooling of interests method, 584
Index 657
Portuguese firm example (Electricidade de
Portugal SA), 396–399
Praxair Inc., 385–386, 403
Predatory pricing, 121–122
Presentation graphics software, 160
Price(ing):
capital asset pricing model (CAPM), 613–615
CVP (cost /volume/profit) analysis and,
121–123
discrimination, 111–112
financial statement adjustments, 410–413
indices, 206, 411–412
options, 443–444
predatory, 121–122, 123
strategy (business plan), 274–275
strike, 364
transfer (multinational firm), 404–407
variances, and budgetary control, 204
Principal /agent, 237–238
Private, going, 562
Product description, in business plan, 271–273
Productivity, measuring, 199–221
budgetary control, 201–208, 219–220
collecting standards, 213
fixed cost budgets, 215–217
government accounting, 217–218
standard cost accounting systems, 217–219
variable cost budgets, 208–213
Product /service strategy (marketing plan within
business plan), 274
Profitability:
ratios for analyzing, 23–28, 603
in relation to investment, 25–28
in relation to sales, 23–25, 28
valuation and, 603
Profit chart, 108
Profit margin, 30–31
Profit plan, 195
Project management software, 161–164
Proxy contests, 562
Proxy regulations, 473–474
Publicly traded companies, 459–509
comfort letter, 472, 505–509
directed share program, 467
due diligence checklist, 466, 478–498
guideline-companies method, 618–621
initial public offerings (IPOs), 460–461,
473–477
Internet links, 477
lockup agreements, 467
process of going public, 464–473
underwriters, 464–466
Publishing industry value system, 103
Purchase vs. pooling accounting, 583–585
Quaker Oats Company, 369, 372, 388, 568,
569–570, 575
Quarterly financial data, 70–71
Quarterly reports (Form 10-Q), 527
Quick ratio, 18, 28
Real options, 312
Registration statement, 469
Regression analysis, 119–120
Remuneration, board, 522–523
Residual value, 611–612
Restructuring notes, 69
Return on assets, 30
Return on equity, 30
Revenue acceleration, 525
Reverse triangle merger, 352
Risk, 33
avoidance, 423
choosing appropriate hedge, 451–454
competitor actions and retaliation, 284–285
critical risks section of business plan, 284–285
currency, 356, 386–389
financing timing/availability, 285
instruments, 434–451
loss prevention and control, 423, 424
management approaches (four), 423
market interest and growth potential, 284
operating expenses, 285
retention, 423–424
risk-free rate, 613
sharing, 582
systematic risk, 613
time/cost to development, 285
transfer, 423, 424 (see also Derivative(s))
unsystematic risk, 615
Risk Management Association (RMA), 33
RJR Tobacco, 561
Rock, Eric, 127–148
Roger, Dave, 126–148
Rollinick, William, 519
ROTA (return on total assets), 26
Russo, Carl, 572
Sales:
budget, 183
in business plan, 276–277
forecasts, 276–277
ratios for analyzing profitability in relation to,
23–25, 28
strategy, 276
Sarni Inc., 583
Schremp, Jergen, 570
Search engines, 168
Securities Exchange Commission (SEC), 33, 70,
468–469, 474, 475, 498–504
Segmental financial data, 70–71
Segment and related information note, 86–87
Sensitivity analysis, 113, 116
Server technology, 538
Shareholders, 189, 239–240, 511
Shaw Industries Inc., 40, 41–42
658 Index
Sherwin-Williams Company, 62–63, 64
Silgan Holdings Inc., 408
Sirena Apparel Group, 525
SmithKline Beecham PLC, 576
Snapple Beverage Corp., 568, 569–570
Social Security/FICA, 326
Software, 156 –164, 540–541
Sole proprietorship, 226
continuity of life, 234
control, 237
formation, 228–229
liability, 245
out-of-state operation, 231
recognition as legal entity, 232
taxation, 248–249
transferability of interest, 235–236
Southwest Airlines, 53–54
Spin-offs and split-ups, 347–350
Spreadsheet software, 157–160
Standard(s):
collecting, 213
cost accounting systems, 217–219
currently attainable, 203
engineering studies, 213–214
fixed costs, 218–219
government accounting, 217–218
motivation, 213–215
past data, 215
setting (by board of directors), 516
time/motion studies, 214
types of, 202–203
valuation, 623
variable costs, 218
Stead, Jerre, 568
Stock(s), 331–335
appreciation rights (SARs), 331–332
vs. cash deals (M&A), 582–583
employee plans (ESOP), 341–343
shareholders, 189, 239–240, 511
substantially disproportionate distributions,
340–341
synthetic, 439
tax issues, 331–335, 340–341
Storage Technology Corp., 376, 377
Story model, 263–265
Straddle, 425
Strategic partners, 281
Strategy, 516–518, 552–553
Streaming media, 170
Strike price, 364
Subchapter S, 227, 252–253, 318–322
Substitution, principle of, 596
Sunk costs, 299
Sustainable earnings, 72–96, 617. See also
Earnings
Swaps, 361, 433, 434, 447–449
equity, 448
interest rate, 449–451
SWOT, 178
Synthetic cash, 439
Synthetic stock, 439
Systematic risk, 613
Taglines, 263
Takeover, 562
Tax issues:
acquisition, 322–324, 578, 580, 583, 585
business decisions, 314–352
business expenses, 325–326
business forms/entities, 228, 248–255
buy-sell agreements, 345–347
case illustration, 315
complete termination of interest, 341
deferred compensation, 326–328
dividends, 26, 339–340
employee stock ownership plans, 341–343
equity sharing, 330–335
estate planning, 343–347
executive compensation, 325–330
family limited partnerships, 344–345
foreign subsidiaries, 405–406
gift tax, 317–318
income tax note (example), 78–79
individual federal income tax rates, 249
interest-free loans, 328–330
like-kind exchanges, 337–339
nonrecurring items, 59–62, 78–79, 90, 93
passive losses, 320–322
pass-through entities, 319–320
reverse triangle merger, 352
sale of corporation, 350–351
shelters, 321
spin-offs and split-ups, 347–350
stock appreciation rights (SARs), 331
stock options, 332–334
subchapter S corporation, 316–322
substantially disproportionate distributions,
340–341
taxable income and income tax, 296
three-corner exchange, 339
unreasonable compensation, 315–316
vacation home rental, 335–338
Team (business plan section), 281–283
advisory boards, 281–283
bios/roles, 281
board of directors, 281
compensation, 283
external members, 281–283
ownership, 283
strategic partners, 281
Technology. See Information technology
Telef lex Inc., 359
Telsik, Sarah, 519
Tenneco Inc., 364, 373, 405
Three-corner exchange, 339
Tiger International Inc., 410–413
Index 659
Timeline, 281, 282
Time/motion studies, 214
Time value of money (TVOM) analysis, 299–301
Time Warner/AOL, 561, 563, 586
Titan International Inc., 370–371, 388
Toys "R" Us Inc., 40, 42, 43
Transaction processing, 140–144
Transfer pricing, 404–407
Transfer of risk, 424, 432
Travelers Inc., 575
Trimark Holdings, 45
Turnover ratios, 18
UAL Inc., 364
"Ubiquitous" computing, 538
Underlying earnings. See Sustainable earnings
Underwriters, 464–466
United Airlines, 563, 576
United States government restrictions on
business practices associated with foreign
subsidiaries and governments, 356, 413–415
UNIX operating system, 538
Unsystematic risk, 615
Unusual charges, 85, 94
USAir, 563, 576
Vacation home, renting (tax impact), 335–338
Valuation of business, 593–625
adjustment to earnings for purposes of,
608–609
appraisal of fair market value, 604–606
approaches to value (asset /income/market),
594
band of investment, 607
buyers (different types of ), 594–595
comparison to industry averages, 604
control interest, 622
control premium, 619
cost of capital, 606–608
direct equity methodology, 605–606
discounted cash f low method, 609–618
discount for lack of control, 622
discount for lack of liquidity, 621–622
discount for lack of marketability, 622
fair market value, 595, 604–606
financial buyers, 594–596
financial statement analysis, 599–603
guideline companies approach, 618
industry analysis, 597
Internet links, 625
investment risk, 596
marketability, 622
market value of invested capital (MVIC), 608
minority interests, 622–623
"mom and pop" business, 595
principle of alternatives, 596
principle of substitution, 596
process overview, 595–597
publicly traded guideline-companies method,
618–621
ratio analysis, 601–603
reconciliation of methods, 621
standards, 623
strategic/investment buyers, 595
Value creation in M&A, 573–581
Value engineering, 623–624
Varco, 93–94
Variable overhead indices, 211–212
Variance analysis/reports (budgets), 179, 180,
212–213
Veeco Instruments, 43
Vertical integration, 576, 577
Vertical merger, 563
Vishay Intertechnology Inc., 364
Visual fit (method of cost behavior estimation),
118–119
Walker, James, 260
Wal-Mart, 552–553, 554, 559
Warrants, 445
Wealth, maximizing, 291–292
Weighted average cost of capital (WACC),
304–305, 616
Western Digital Corporation, 354
Wide area network (WAN), 165, 166, 537, 547
Windfall profit and windfall tax, 295–296
Wireless modems, 164
Word processing software, 156–157
World Market Watch, 34
World Wide Web, 167–168. See also
Internet /intranet /extranets
W.W. Grainger, 555
Xerox Palo Alto Research Center, 538
Y2K, 541
York International Corporation, 369
ZETA, 32
Z score, 31–32
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