Selected Accounting Issues for Analysis
Submit an accounting analysis of what you believe are three of the most significant accounting issues for UPS. In other words, if you were to do a complete accounting analysis you would examine all the major issues that might have a bearing on your financial analysis and forecast. You do not have to do an in-depth analysis of all issues but based upon a quick look examine three accounting issues in depth that you believe may turn out to be highly significant.
Read the file in canvas on selected accounting principles and use it as your guide for some of the more important accounting issues to consider. The significance of each one depends on the company and whether it even has these items. There may be no one issue such as a defined benefit plan, operating leases, restructurings, etc. Use the example for leases I have posted for Starbucks to get a feel for capitalizing operating leases as opposed to the text example for that topic. Keep in mind that the impact on the income statement for operating leases will depend on where in the life of each lease you are so it is difficult to make an income statement adjustment for operating leases. There will be an increased expense in the early stages of the lease and a lower impact in later years than the rental payment. Our focus in operating leases would be the balance sheet. For most issues you will be most concerned with the income statement impact and how it might be reflected in ratio analysis and a five year forecast. Look over the other files, videos, etc. in the canvas module that involve accounting issues before beginning your review of accounting and your mini accounting analysis of three accounting topics (issues) for this assignment. I would like you to analyze either leases or pensions for one of the 3 accounting principles in your accounting analysis. The student example for accounting analysis from a previous exam posted in canvas is much longer than expected for this assignment. It is intended to provide some guidance for you. I have been limiting the number of pages in more recent exams and you will not be expected to do as much for this area or other areas of the exam when that is posted in a few weeks.
Guidelines -
Operating Leases
One of the most common adjustments that analysts make for their financial analysis is the adjustment to reflect the additional debt and related assets for operating leases. The need for this arises because US GAAP treatment allows companies that don't meet any one of four criteria to treat the lease as an operating lease. Thus, if the lease is non-cancelable and has no bargain purchase option, no transfer of ownership, the lease term and present value of lease payments do not meet the 75% and 90% tests, the lease can be considered operating. For our purposes, capital leases are fine. We are concerned that in substance operating leases represent future obligations that are equivalent to debt. Although the criteria for recognizing leases is likely to change (please see the document about lease proposals) we will still need to potentially make an adjustment for now.
Our goal is to take footnote information and calculate the present value for all future lease obligations. We can do that by assuming a discount rate (based upon the average borrowing rate of the firm) and discounting each of the next five years. We will need at least another calculation to account for the total of payments beyond the five years. This can be accomplished by dividing the total by the most recent year for an estimate for each of the years beyond five years and discounting them individually. Alternatively, we could take the total and divide by the most recent year, and based upon the resulting number, take an average of that number and the five years for an average of the remaining life of the lease. We can use that number for the year to select for the discount rate. Thus, if we estimated four remaining years till the leases are extinguished, we could add five and 9, divide by 2 and use a seven year factor for our discount rate time period. Keep in mind there are other estimation techniques and they should all produce similar estimates.
The Excel file in Weeks6-7 has a possible solution for converting operating leases into capital leases.For our purposes we will focus on the debt impact and a debt ratio such as liabilities to assets. You can ignore the income statement impact since for most leases the conversion would produce higher expenses in earlier years and lower expenses in later years of the lease term. For our five year forecast this is not likely to be a significant difference. In addition, under current GAAP the tax deduction is only based upon the actual payments made and not a hypothetical conversion and it is difficult to determine the exact time period for individual leases.
S&P, Moody's, Value Line and others account for the additional risk associated for operating leases. It should be noted that if the amount of operating leases is relatively small no calculation and adjustment may be needed. Thus, an analyst should examine the relative size of leases before going to all of the trouble of completing the above mentioned process. In this class you should examine the lease footnote and even if an adjustment is not warranted explain the reason why.
Research and Development Expenses
Under US GAAP R&D is expensed immediately. However, many would consider this investment if it is likely to produce future revenues. Thus, an analyst may wish to capitalize R&D. In the Week 6 module is a brief spreadsheet analysis of both immediate expensing and capitalization for R&D. You will note that initially R&D expense will be higher if immediately expensed. Here no asset would be recognized. If R&D is capitalized then the expensed amount is the total of amortized amounts and an asset is recognized for the unamortized balance. Thus, for any given time period the difference in yearly expenses will be impacted by the trend in previous R&D incurred but under capitalization there is likely to be a significant balance sheet difference. This conclusion regarding R&D holds for companies continuing to spend more each year on R&D. My example is based upon a five year amortization period. In many cases this would be longer and the differences greater.
Also keep in mind that getting a feel for company success in R&D is critical. Firms that produce positive results from R&D should be looked at more carefully than those will a weaker track record. The decision to make adjustments for one company may not be warranted in a different situation.
Pension Expense/Liability
Pensions may be the most important adjustment needed since the dollars amounts may be large. However, first you need to determine the type of plan if there is one. For companies with defined contribution plans no adjustment will be necessary since the only obligation is usually a designated % that is funded each year. Here no further obligation is incurred beyond the current year. Most newly formed companies have defined contribution plans. However, older established companies have defined benefit plans that require more analysis. (It should be noted that many companies have discontinued these plans in the last ten years and switched to defined contribution plans).
If the company has a defined benefit plan please note whether it is underfunded. This refers to the pension plan liability exceeding the pension plan assets. This difference should be reflected on the balance sheet with the exact amounts disclosed in the pension footnote. The significance of the liability is that additional amounts may need to be expended in future years to make up for the shortfall.
For our purposes you should look carefully at the pension assumptions used in the calculation for the pension expense and liabilities. Here the details matter. A higher discount rate would lower the pension liability but increase the interest expense. The parameters here are limiting and most companies have lowered their discount rate in recent years to reflect the historical low rates currently in effect. These have risen slightly in the last year or so in response to fed policy and increasing rates. Future increases in salaries are another required assumption. This is a very company specific number but the variation here is limited and most companies are reasonable with this factor of the benefit formula. The expected return on plan assets is the big issue for our purposes. This assumption reduces pension expense and can have a meaningful impact on the income statement. Thus, you will need to review the assumption for expected return on plan assets and decide if an adjustment is necessary. For this conclusion you need to know a little about the plan asset composition and the financial markets. Since a company is required to show an asset breakdown you will need to know the percentage of equities, fixed instruments, etc. and assign an expected return. Thus, if a firm had 50% equities and 50% bonds, and you believed stocks over the long term would return 6% and bonds 4% respectively, then the expected return would be 5%. You would compare this number with the company's expected return. In addition you can look for survey results such as the PWC document in the Week 6 module. Here you will get an idea of what other companies are selecting for the assumed rate of return on plan assets. While this document indicates an average rate of 7.75% given the current economic environment there should be some concern whether companies can earn this over the long term. Here the analyst needs to use judgment and recognize that companies can lower their pension expense by selecting a higher return here and that perhaps 6%-7% would be more reasonable.
A way to check on whether companies have achieved expectations is to look at OCI. If the plan returns have not met expectationsthen the difference is reflected in OCI. In other words, the difference between actual and expected returns is captured in OCI and a large number here may indicate that the company has been too optimistic in the past. A way to adjust for this is to adjust either your S,G, and A expenses upward going forward to account for the greater expense(funding needed) for the future. This will be clearer when you see our spreadsheet format next week. For now, you can look at this area by taking the beginning plan assets by your assumed rate of return and comparing it the amount included in the company's note. If your amount is lower perhaps an adjustment going forward is warranted for this or a similar amount. Keep in mind pensions are a long term expense and individual year extremes should be considered for their likelihood to continue in the future. The FASB only requires that companies make an accounting adjustment if the difference between expected and actual returns exceeds a corridor of the greater of 10% of plans assets or the PBO. This is then amortized by the average service lives of employees. Thus, it takes a large number to be included in net income for overestimates in the expected return.
Restructurings
Restructuring charges are common today as companies seek to cut costs. Store closings, layoffs and the like are often used to make a firm more competitive. Keep in mind that some analysts on Wall Street prefer to ignore these expenses and thereby add them back to reduce their impact on the bottom line. The video suggests this approach. This may or may not be warranted. We are doing our financial analysis as part of our effort to prepare a forecast. If the restructuring charges are considered a one-time event and not likely to occur again then adding them back (eliminating their impact) may be justified. However, if the firm has restructurings often such as every few years, then including them in operations may be warranted. This is a judgment call.
Income Tax Expense
The analyst should examine the tax footnote and observe the effective rate paid. Most companies pay well below the statutory rate and this info can be used for your forecast. Is the rate consistent and what accounts for the differences between book and tax paid? Are these differences likely to continue in the future? Are changes in the law expected? In Congressional testimony the CEO of Apple noted that Apple paid around 10% in tax. This is significantly lower than footnote disclosure suggests. Apple like many companies is deferring taxes on overseas income and the question is whether it will ever be paid. If not, Apple shareholders are benefiting more than the reported numbers indicate. Here an examination of cash flows via the Statement of Cash Flows would also help.
Inventory
While not the issue it once was during periods of high inflation, the specific inventory method should be reviewed for reasonableness. In addition, for companies using LIFO check to see if there is a LIFO reserve (the ending inventory is undervalued) and whether there is a LIFO liquidation which creates a one-time boost to net income that will not occur again and should be deducted for purposes of trend analysis.
Contingent Liabilities, etc.
Read the footnote for contingencies, lawsuits and other potential obligations. While litigation is common in some industries, the size and scope of it may require some further analysis and even an adjustment if you believe the company has an unrecorded obligation. I would also include warranties here as well or in your analysis of estimates.
Impairments
Companies have to test for impairments but over the years some firms have applied things a bit loosely and waited before recognizing them fully. Thus, earnings management may run though this area of GAAP and this would impact your analysis of trends since some write-downs may have been warranted in earlier years.
Comprehensive Income
Always look at comprehensive income and compare it to reported income. While the issues addressed here relate to foreign currency, gains or losses on available for sale securities, derivative gains or losses, and changes in the additional pension liability their significance is that they bypass the income statement. Thus, they can have an impact on economic income but don't get the attention they deserve on the income statement. You should evaluate the significance of any of these items on their potential to impact future cash flows. Your eventual forecast for a company will be converted into free cash flow. These will in turn be discounted to arrive at the firm's stock price. Anything that impacts future cash flows is relevant to your analysis. Be concerned with the shortcomings of GAAP and use your advanced knowledge of accounting to aid you in assessing real profitability and its impact on cash flows.
Cash Flow from Operating Activities (CFFO)
Always compare CFFO to Net Income over the three year period in a 10K. You would expect it to be higher.
Revenue Recognition, Goodwill, Bad Debt Expense and More
The FASB and IASB have recently issued their new statement on revenue recognition. It will not be implemented for several years. You should always satisfy yourself that revenue recognition criteria for your company is in compliance with GAAP (it likely is) but reasonable as well. Read the article in the Week 3 module about HP. They acquired another company and are slugging it out in court about overstated revenues for that acquisition and related receivables. This is likely to be a classic case discussed for years. The HP write-offs for the related goodwill were front page stories for much of last fall. Examine goodwill carefully since it may indicate a company paid too much in an acquisition.
Bad debt expense or the estimate for bad debts is also a potential issue especially in weak economic times. It was not that long ago that Target had to write-off significant receivables as we entered the 2008 recession. Aggressive use of credit cost the hundreds of millions of dollars. Always check receivables and their relationship to sales over a period of time.
Assignment-
https://www.dropbox.com/s/z8c6dbxcbrtq4gw/Accounting%20Assignment.rar?dl=0