TOPICS FOR THE SESSION

 Accounting analysis

 Key concepts

 Exercise 2 debrief

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Exercise 2

A: Depreciation and tangible assets

 In 2012 Lufthansa reported that it depreciated its aircraft over 12 years on a straight-line
basis, with an estimated residual value of 15% of initial cost.
 In contrast, industry peers such as Air France-KLM and British Airway were using straight
line depreciation rates between 4 and 5 percent (of initial cost).
For analysts these differences raised several questions.

Questions:
1. What are the potential explanations for the different policies?
2. Calculate the differences in the depreciation rates and explain the impact of the
differences on the FS;
3. Assume that you as analyst consider that there is no reasons for different policies and
that Lufthansa’s depreciation rate should match the one of its peers ones. Show the
adjustments to the balance sheets and to the 2012 income statement.
in millions €
Aircraft cost 1/1/2012 22,486
Accumulated depreciation 1/1/2012 12,238
10,248

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

IMPACT ON BALANCE SHEET (due to accumulated depreciation)
Aircraft cost, 1/1/2012 22,486
Depreciable cost = cost *(1-15%) 19,113
Accumulated depreciation, 1/1/2012 12,238
old net amount@1/1/2012 10,248 = cost - accumulated depreciation

Accum depreciation/depreciable cost 64.03% =12,238/19,113 =% already depreciated

useful life 12
average age of aircraft 7.68 = useful life* % already depreciated

new rate 4,5%

(a) average age of aircraft 7.68
(b) new depreciation rate 4.50%
(c) Aircraft cost, 1/1/2012 22,486
Accumulated depreciation, 1/1/2012 (d) = (a)*(b)*(c) 7,775
new net amount@1/1/2012 14,711 = (c) -(d)
change in asset base@1/1/2012 4,463

IMPACT ON NET INCOME

Old rate: depreciation expense per year: 7.083% 1,593 = 7.083%* depreciable cost (=19,113)
New rate: depreciation expense per year: 4,5% cost 1,012 = 7.083%* depreciable cost (= 22,486); no residual value
change in depreciation expense year 2012 -581

before after
BS IS BS IS DIF
01/01/2012 10,248 14,711 4,463
31/12/2012 8,655 1,593 13,699 1,012 -581

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Exercise 2

B: Impairments in assets and accumulated impairment

Assume that you are an analyst following the company XPTO. The company
construct a new 500m2 plant in the beginning of 20X1 for €1 Million. The selling
price per m2 indicated by a property specialist is €1.200 as of Dec 31 20X2. The
company disclosed in the notes to its financial statements as of Dec 31, 20X2 that:
 Depreciation method: straight line
 Useful life: 20 years
 Value in use: 800.000€

Questions:
• Analyze whether there is any impairment and provide the adjustments needed
as of Dec 31 20X2.
• What are the impacts of not recognizing the impairment?

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 1.20X1 12.20X1 12.20X2
purchase price 1,000,000 1,000,000 1,000,000
depreciation 50,000 50,000
accumulated depreciation 50,000 100,000
carrying amount 1,000,000 950,000 900,000

FV less costs to sell 600,000 =500*1200

Value in use 800,000

Impairment loss 100,000 net income

Revised carrying amount 800,000

Impacts of not recognizing impairment:

 Assets’ base overstated

 Delay in the recognition of a loss
(instead of recognizing loss now, firm recognizes greater expense over useful life; if
firm sells asset, recognizes a loss only when selling asset)

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Exercise 2

C: Off balance sheet assets

Bayer, one of the largest chemical and pharmaceutical companies in the world, does not
capitalize most of its R&D costs because regulatory uncertainties surrounding the
development and marketing of new products mean that the recognition criteria for research
expenditures are rarely met. The R&D outlays expensed every year over the period 2009-
2014 were:

R&D outlay
Year
(€ bn)
Assume that R&D occurs evenly throughout the
year, only half a year’s amortization is taken in the
2014 3.6
year of spending and that the average life of R&D
2013 3.2
2012 3.0
is five years.
2011 2.9
2010 3.1
2009 2.7

Required: Calculate the value of the R&D asset as of 31/12/2013, as if it the R&D
expenditures were capitalized. Show the impacts in the financial statements as of
31/12/2013 (ignore taxes).

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 accumulated depreciation
2009 2010 2011 2012 2013 Net amount
2009 50%*2.7/5 2.7/5 2.7/5 2.7/5 2.7/5 0.54 0.5*2.7/5 0.27
2010 - 50%*3.1/5 3.1/5 3.1/5 3.1/5 0.62 1.5*3.1/5 0.93
2011 - - 50%*2.9/5 2.9/5 2.9/5 0.58 2.5*2.9/5 1.45
2012 - - - 50%*3.0/5 3.0/5 0.6 3.5*3.0/5 2.1
2013 - - - - 50%*3.2/5 0.32 4.5*3.2/5 2.88
2.66 7.63

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 R&D outlay Proportion to be Asset Expense
Year
(€ bn) capitalized in 31/12/2013 31/12/2013 2013
2013 3.2 (1-1/5*50%) 2.9 0.32
2012 3.0 (1-1/5*50% - 1/5) 2.1 0.6
2011 2.9 (1-1/5*50% - 1/5*2) 1.5 0.58
2010 3.1 (1-1/5*50% - 1/5*3) 0.9 0.62
2009 2.7 (1-1/5*50% - 1/5*4) 0.3 0.54
7.63 2.66
Adjustments
Dec 31, 2013
Liabilities &
Assets equity
Balance sheet
Non-current intangible asset +7.6
Shareholder's equity +7.6

Income statement
Depreciation +2.66
Other operating expenses -3.2
Net profit 0.54

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Exercise 2

D: Unearned revenues
MicroStrategy, a SW company that bundles customer support and SW updates with its initial
licensing agreements. In March 20X1, MicroStrategy conceded that it had incorrectly
overstated revenues on contracts that involved significant future customization and consulting
by $54.5 million. As a result, it would have to restate its FS for 20X0 as well as for several
earlier years. To undo the distortion in 20X0, the following adjustments have to be made:
• Impact on revenues and deferred revenues $54.5 M
• Impact on cost of sales and inventory: cost = 3% licence revenue
Adjustments
• Marginal tax rate 35% Liabilities
Assets
& Equity
Balance sheet
Question: Current assets - inventories
• What is the full effect of the adjustment on Current liabiliy - unearned revenue
Deferred tax liability
the quarterly financial statements? Shareholders' equity

Use the table below

Income statement
Revenue
Cost of sales
Tax expense

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Adjustments
Liabilities
Assets
& Equity
Balance sheet
Current assets - inventories 1.6 (2) undo understatement of inventories (sale of product was recognized), increase asset
Current liabiliy - unearned revenue 54.5 (1) undo understatement of liability (revenue was recognized instead of a liability), increase libility
Deferred tax liability -18.5 (3) lower tax liability
Shareholders' equity -34.4

Income statement
Revenue -54.5 (1) undo overstatement, reduce equity
Cost of sales -1.6 (2) undo overstatement, increase equity (lower expense)
Tax expense -18.5 (3) undo overstatement, lower revenues, lower taxes
-34.4

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Exercise 2

E: Inventories
Company A (FIFO) Company B (LIFO)
20X1 20X0 20X1 20X0
Current assets (including inventory) 280,000 300,000 90,000 80,000
LIFO reserve 0 30,000 20,000
Current liabilities 140,000 150,000 55,000 45,000

current ratio = current assets/current liab 2.0 2.0 1.6 1.8

Questions:
• Assume that prices are rising, what is the impact on inventories and COGS of company B using
LIFO instead of FIFO?

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

• Assume that prices are rising, what is the impact on inventories and COGS of company B using
LIFO instead of FIFO?

LIFO: last in first out

 Inventory assets = No. Units in stock × older purchase costs
 Cost of good sold = No. Units sold × more recent purchase costs

FIFO: first in first out

 Inventory assets = No. Units in stock × more recent purchase costs
 Cost of good sold = No. Units sold × older purchase costs

 Rising prices: Inventories LIFO are at lowest price; COGS LIFO are at highest price

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

• Adjust the numbers to a comparable basis (FIFO) to infer conclusions from the liquidity ratio:
current ratio. Show also the adjustments in COGS.

Company A (FIFO) Company B (LIFO)

20X1 20X0 20X1 20X0
current assets (including inventory) 280,000 300,000 90,000 80,000
LIFO reserve 0 30,000 20,000
current liabilities 140,000 150,000 55,000 45,000

COGS 100,000 110,000 80,000 70,000

current ratio = current assets/current liab 2.0 2.0 1.6 1.8

current assets adjusted to FIFO 280,000 300,000 120,000 100,000

current liabilities 140,000 150,000 55,000 45,000
current ratio adjusted 2.0 2.0 2.2 2.2

COGS adjusted 100,000 110,000 70,000 NA

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Exercise 2

F: Off balance sheet assets and liabilities

2014 Company A Company B
Total debt 1,200 2,400
Total equity 2,000 4,000
Average interest rate on debt 10% 8%
lease payments on operating leases
2014 10 180
2015 18 210
2016 22 230
2017 25 256
2018 25 512
2019 25 1,024
2020 25 2,048
EBIT 850 1,350
Interest expense 120 192

Questions:
• Based on the information given above and assuming no adjustment to equity, do the necessary
adjustments to put operational leases on balance sheet and calculate companies’ solvency
measured by Debt/Debt+Equity
• Now, calculate companies’ solvency measured by interest coverage (EBIT/interest). Do all the
necessary assumptions.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

Based on the information given above and assuming no adjustment to equity, do the necessary
adjustments to put operational leases on balance sheet and calculate companies’ solvency
measured by Debt/Debt+Equity

Before adjustments Company A Company B

Debt/Debt+Equity 38% 38%
After adjustments
2014 9.1 166.7
2015 14.9 180.0
2016 16.5 182.6
2017 17.1 188.2
2018 15.5 348.5
2019 14.1 645.3
2020 12.8 1,195.0
Debt adjusted by leases 100.0 2,906.2
Debt 1,200.0 2,400.0
Total debt adjusted 1,300.0 5,306.2
Debt/Debt+Equity 39% 57%

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

Now, calculate companies’ solvency measured by interest coverage (EBIT/interest).
Do all the necessary assumptions.

Before adjustments Company A Company B

EBIT 850 1,350
Interest expense 120 192
Interest coverage 7.1 7.0
After adjustments
EBIT before adjustment 850 1,350
add back lease rent 2014 10 180
deduct depreciation (assumed straight line: PV lease
14 415
payments/nr years of lease
EBIT after adjustment 846 1,115
Int. expense before adjustment 120 192
add Int. expense = Debt adjusted * avg rate 10 232
Interest expense after adjustment 130 424
Interest coverage adjusted 6.5 2.6

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Next class

Preparation:

 Next class there will be “brainstorming time”

Groups will have time to share results/concerns/questions with me and other groups

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes