Financial Education

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.

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.

Unlike models that discount dividends or free cash flow, in which a significant portion of the estimated value is the terminal value, a residual income model tends to be front-end loaded by the reliance on book value. This can be an advantage since forecasting errors tend to magnify over time. Using only the residual income is likely to result in smaller errors and even if the error is not reduced, the future income is less significant to the overall value calculation.

On the statement of cash flows, all contributions to a pension fund are treated as operating cash flows. Such contributions are typically constrained by minimum requirements set by law and maximum levels above which the contributions are no longer tax deductible. Contributions will not typically match the changes in the actual obligation.

If the company pays more into the plan than the change in benefit obligation, it will reduce the net liability of the fund. Conversely, contributing less than the change in benefit obligation will increase the net liability. For analysis purposes, changes in liability may be better treated on an equal basis with changes in other liabilities – namely as financing cash flows.

To do so, the investor would need to examine the pension disclosures and determine the difference between the change in the funded status and the actual contributions made to the plan. This difference would then be treated as a cash inflow or outflow from financing activities. This can be useful to gauge the sustainable level of cash from operating activity as well.

In the course of business, firms can accrue two types of liabilities: operating liabilities and financial liabilities.

Operating liabilities are the consequence of normal operating practices. Operating and trade liabilities occur when the company owes money to suppliers (accounts payable) or employees (wages payable) for goods and services that have already been provided but not yet paid for. In addition, in some business customers are required to pay a deposit before receiving the goods and services they are buying. In such cases, the amount of the deposit creates a liability that the firm must satisfy by delivering the promised goods or service or by refunding the deposit.

Financial liabilities represent borrowings from banks or other lenders that must be repaid with interest.

Under IAS 16, as under US GAAP, property plant and equipment are initially recorded on the balance sheet at cost, and systematically charged to expense as depreciation. Unlike GAAP, IAS permits upward revaluation (to the fair value as of the revaluation date) of property, plant and equipment.

Typically, when assets are revalued downward the charge flows through the income statement. In the case of upward revaluation, however, the change typically bypasses the income statement and is made directly to equity. The exception to these general rules is when the revaluation reverses a previous revaluation. In such cases, the reporting mimics that of the original revaluation. So downward reversals go straight to equity, while upward reversals are reported in the P&L.

The single stage residual income model expresses the value of a stock as BV + BV{(ROE – r)/(r-g)} where

BV = the current book value of equity

ROE = return on equity or Net income divided by book value

r = the required return on an equity investment with risk characteristics similar to the firm in question

g = the growth rate

Algebraically, if an investor is confident that the book value and ROE are reliable, and that the estimate for required return is appropriate, the market price can be used to impute expected growth. Alternatively, for any given r, the amount of growth needed to justify the current market price can be calculated.

Consider Microsoft (MSFT). According to Yahoo! Finance it currently has a book value per share of $3.32 and an ROE of 39.52%. The share price is $29.00. How fast would Microsoft need to grow in order to justify the current share price given a required return of 10% per year?

$29.00 = $3.32 + $3.32((0.3952 – 0.10)/(0.10 – g))

Solving for g yields an implied growth rate of approximately 6.2% per year. This is below the growth rate of the last five years (8.1% per year) and below the consensus forecast growth rate for the next five years (11.5%). This could mean:

• the stock is undervalued
• growth will be lower than estimated
• the average investor requires more than a 10% annual return
• some combination of the above

As with implied growth rates based on the dividend discount model, using the market price to impute implicit assumptions can help investors narrow down possible discrepancies between market price and consensus forecasts.

Economic value added, or EVA(R) is a proprietary residual income model developed by Stern Stewart & Company. Like other residual income models, it charges a capital cost to accounting income measures. However, there are several adjustments made to the accounting figures to have them conform more closely to economic cash flows. Some of the major adjustments include:

• Capitalizing and amortizing research and development rather than expensing it immediately.
• Deferring capital charges on strategic investments not expected to have an immediate accounting payoff.
• Ignoring deferred taxes until paid.
• Adjusting capital and earnings for LIFO inventory accounting.
• Operating leases are treated as capital leases.
• Adjustments are made to non-recurring items.

Similar adjustments can be made to generic residual income models, but the outcome of the model will differ based on which adjustments the investor chooses to make.

Subsequent to passage of SFAS 158, companies adhering to U.S. GAAP are required to show the net funded status of their pension plans directly on the balance sheet. If fund assets exceed the projected benefit obligation the company will list a net asset. Otherwise, the net amount will be reflected as a liability. Under International Accounting Standards, the net asset or liability might not be reflected on the balance sheet due to permissible smoothing mechanisms.

Although SFAS 158 moves toward full accountability for pensions, the treatment still differs from that of other assets and liabilities. For example, a company borrowing $1 million to buy equipment would record both the asset and the liability, not merely the net amount. Investors can use the pension disclosures to adjust the balance sheet such that it reflects the underlying economic position of the pension plan.

To do so, any net liability or asset would be removed and the plan assets would be added as a separate asset, while the projected benefit obligation would be added to liabilities. A further adjustment would be to treat the actual return on plan assets as a component of income, and the interest on the obligation as an expense.