Financial Education

Companies occasionally engage in non-cash transactions. Examples include asset exchanges, acquisitions made in exchange for stock of the parent company, or the exchange of convertible bonds into shares.

Since such transactions do not involve cash, they are not reported on the face of the statement of cash flows. However, significant non-cash transactions must be disclosed in the financial statement notes or a supplement to the cash flow statement.

When a company has issued securities that can be exchanged for common shares, converting the securities into common shares would potentially dilute the ownership stake of existing shareholders. When calculating earnings per share, companies must consider the potential dilution.

For securities that pay a dividend or periodic interest payment, the after-tax payments would be added back to earnings (since those payments would no longer be necessary if the securities were converted.) Then, the number of shares into which the securities are converted is added to the shares outstanding.

Diluted EPS = (Earnings + After tax payments on convertible securities)/(Shares outstanding plus shares issued on conversion)

In some cases, securities would be antidilutive, or increase earnings per share if they were assumed to be converted. Such securities are not included in the diluted EPS calculation, as it is intended to represent the maximum possible dilution.

Cash Flow Return on Investment (CFROI) is an internal rate of return (IRR) type metric measuring the return expected to be generated by a firm’s existing assets throughout their useful lives. CFROI can be calculated in five steps:

• compute the average life of assets by dividing gross assets by depreciation expense
• compute gross cash flow by adjusting net income for non-cash charges, financing expenses, operating lease payments and equity reserve accounts
• compute the gross investment as gross plant and equipment adjusted for reserves, capitalized expenses, restructuring charges, amortization and the present value of operating leases
• compute the value of any assets that will not depreciate (which will represent the future value)
• solve for IRR (or CFROI)

When used to value stocks, the residual income model separates value as the sum of two components:

• The current book value of equity (BV)
• The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Like any model, residual income models are more appropriate at some times than others. They are most appropriate when:

• The subject company is non-dividend paying
• Free cash flow is unstable or negative over a reasonable forecast horizon
• Other approaches result in greater sensitivity to terminal value than the investor finds comfortable

The are less appropriate when:

• the company’s accounting practices result in significant dirty surplus
• the components of residual income (book value, ROE) are not predictable

Deferred tax assets represent taxes that have been paid (or often the carryforward of losses) but which have not yet flowed through the income statement. A deferred tax liability represents tax payments that have appeared on the income statement but not yet been paid. They usually arise when accounting standards and tax authorities recognize the timing of taxes due at different times. For example, when a company uses accelerated depreciation when reporting to the tax authority (to increase expense and lower tax payments in the early years) but uses the straight-line method on the financial statements. Since these differences will correct over the course of the asset’s depreciable life, they are called “temporary differences.”

Under IAS 12 and US GAAP (SFAS 109), deferred taxes are accounted for under the liability method. Under this method, deferred tax assets and liabilities are recognized when there is a temporary difference between the stated value of an asset or liability for tax purposes and the value for financial reporting purposes. The deferred tax is also contingent upon the expectation that future revenue and income will be sufficient to offset the deferred tax.

To determine the deferred tax treatment under various circumstances:

• An asset whose carrying value exceeds its tax basis will result in a deferred tax liability.
• An asset whose carrying value is less than its tax basis will result in a deferred tax asset.
• A liability whose carrying value exceeds its tax basis will result in a deferred tax asset.
• A liability whose carrying value is less than its tax basis will result in a deferred tax liability.

Market Value Added (MVA) is the difference between the market value of a firm and its invested capital. In theory, the MVA should equal the present value of all future economic value added (EVA).

When used to value stocks, the residual income model separates value as the sum of two components:

• The current book value of equity (BV)
• The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Strengths of the model include:

• Less sensitivity to estimated terminal value than other models
• Rely on readily available accounting data
• Can be used to value stocks that do not have stable dividends or cash flow
• Focus on economic, rather than accounting, profitability

Weaknesses include:

• Relies on accounting data (which can be manipulated)
• May require adjustments based on accounting methods, particularly in cases of a dirty surplus.

Pension accounting rules permit certain expense items to be smoothed into income. However, the required disclosures allow investors to adjust the income statement to reflect the true underlying economic cost related to pension plans. The economic cost should equal any change in the plan liability other than benefits paid or employer contributions.

Consider the following pension disclosures from KLA-Tencor’s 10K.

The pension obligation increases by 4,175, and benefits paid of $1,519 should be added back to that amount to determine the underlying economic change in obligation. 4,175 + 1,519 = 5,694.

The fair value of assets rose by $1,255. The contributions and benefit payments were a net $789 which should be deducted from this. Notice that in this case the benefits paid figure differs between the asset side and the liability side. It is possible some benefits were paid as a lump sum settlement. At any rate, the net change in assets was 1,255 - 789 = 466.

The net change in the economic liability, then, was 5,694 - 466 = 5,228. Contrast that with the reported pension expense.

The economic change in the value of the pension was $5,228, but the income statement showed an expense of just $2,280. An investor might want to adjust the income statement by adding $2,948 to pension expense, reducing operating income by the same amount. The effect on net income would be smaller due to the tax effects.

For KLA-Tencor, reported operating income was 589,868 in 2007. After this adjustment it would have been$586,920 - approximately half a percent lower. Earnings per share for the year would have been at least a penny lower.

IAS and US GAAP both require a statement of cash flows divided into operating, investing and financing sections. The two standards differ in the classification of certain items, particularly interest and dividend payments. The differences are summarized in the table below.

The “top line” revenue number is of particular significance in financial statement analysis. For one thing, overstating the revenue line will generally have a direct impact on profits. A relatively easy way to assess the earnings quality of revenue is to convert it into cash collections from customers, as would be done when creating a direct-method statement of cash flows.

Under normal circumstances, revenue and cash collections from customers should follow a similar pattern. By analyzing the ratio of revenue to cash collection over time, investors may be able to detect changes in the quality of sales. The conversion itself is fairly simple: Cash collections from customers = Revenue - the change in accounts receivable + any change in deferred revenue.

It is useful to check the footnotes to the financial statements, as deferred revenue and certain receivables are frequently lumped into “other” liabilities and assets, respectively. It would also be prudent to adjust receivables for any changes in the amount of securitized, or “factored” receivables.