Prior to beginning work in this discussion thread, read

Prior to beginning work in this discussion thread, read pages 51 through 80 of Understanding Corporate Annual Reports, Voluntary disclosures in corporate annual reports – More than meets the eye, and Integrated Performance Report.

This is the time to share in discussion format your critical learnings and any details from your AOR. These thoughts should be qualitative, quantitative, generic, and specific. The learnings should be related to your AOR and what you can put to work in the short- and long-term in the real world. Please use 150 words or more.

two general categories: operating leases and capital leases. On the one hand, operating leases are often viewed as temporary rentals, with rent expense being reported in the income statement of the company needing the asset. This company renting is referred to as the lessee. Operating leases can be short-term relative to the total life of the asset being rented. In addition, the rentals over the lease period do not provide a significant recovery of the asset’s value over the term of the lease for the company providing the asset. Regardless of this fact, minimum lease payments under operating lease agreements often represent a substantial fixed charge awaiting the lessee.

A capital lease, on the other hand, is generally long-term. It requires rentals that are significant and approximate the value (excluding future interest) of the asset being rented. When this type of agreement is executed, the lessee must view the leased asset as if it had been purchased using a long-term financing arrangement. The company that owns the asset is willing to receive installment payments over the lease term, and in this case provides the financing. Keep in mind that there is no transfer of title to the lessee. The transaction is simply accounted for as if it were a capital asset acquisition.

The rationale for this accounting treatment is to prevent companies from not reporting the liability that parallels a lease agreement of this nature. Since the lease agreement emulates a purchase with long-term financing, companies are required to account for them in a manner similar to a pur- chase. Therefore, leases of this nature require balance sheet recognition of a capitalized leased asset and the associated long-term liability.

According to its balance sheet, The Home Depot has capitalized leases that total $261 million. Since the leases are reported as assets, they will be associated with a related liability as well. Capital lease obligations are reported in both the current and long-term liability sections of the balance sheet.

As the leased assets are used in The Home Depot Company’s operations, they will decline in usefulness similar to a purchased asset. Therefore, cap- italized leased assets are depreciated as well. In most instances, assets of this nature are written off over the lease term. Upon the termination of the lease agreement, the leased asset should be fully depreciated and the lease obli- gation fulfilled by the lessee. At this point, the asset simply transfers back to the lessor, or is sold to the lessee at a bargain purchase price.

Long-Term Investments

Long-term investments, discussed along with their short-term counterpart, are recorded when a company invests in another company’s debt or equity.

ELEMENTS OF THE BALANCE SHEET 51

Co py ri gh t © 2 00 3. J oh n Wi le y &a mp ; So ns , In c. [ US ]. A ll r ig ht s re se rv ed . Ma y no t be r ep ro du ce d in a ny f or m wi th ou t pe rm is si on f ro m th e pu bl is he r, e xc ep t fa ir u se s

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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 1/4/2018 5:25 PM via ASHFORD UNIVERSITY AN: 81992 ; Stanko, Brian, Zeller, Thomas L..; Understanding Corporate Annual Reports : A User's Guide Account: s8856897

If management intends to hold these investments beyond one year, these investments must be categorized under the heading long-term investments. Occasionally management reclassifies long-term investments as market con- ditions change from one period to the next.

Long-term stock investments can be accounted for under the (1) cost, (2) fair value, (3) equity, or (4) consolidation approach. A careful review of the investments footnote (following the financial statements) may identify the types of investments and their related valuation. On occasion, if the reported investment is minimal, the note will provide little assistance.

According to the footnote, The Home Depot classifies its debt invest- ments as AFS and accounts for them at their current market price. AFS investments are classified as short- or long-term investments, depending on management’s intent. In either case, changes in market value are recognized in stockholders’ equity as unrealized gain or loss on AFS securities. Upon careful review we find no mention of gain or loss under other comprehen- sive income. This suggests that no material change in the market value of the AFS securities has taken place.

NOTES RECEIVABLE A note receivable is a written promise to pay a specific amount or amounts at some point forward. Most notes receivable are loans but can result from a conventional sales arrangement that allows for extended terms. Occasionally, accounts receivable can be converted to a note receivable to extend the original terms of the agreement, generate a rate of return for the holder of the note, and strengthen legally the agreement between the parties. The Home Depot reports $77 million in notes receiv- able at the close of fiscal year 2000.

Intangible Assets, Including Costs in Excess of Fair Value of Net Assets Acquired

Previous classifications included assets that were generally tangible in nature. Intangible assets, however, generally lack physical substance and possess a greater degree of uncertainty in regard to future benefits than do tangible assets. They represent rights, privileges, and competitive advan- tages, backed by a legal agreement. Nonetheless, intangible assets, when properly created or acquired, can enhance the profitability of the enterprise for years to come. Once recorded, these assets operate no differently than tangible assets such as property, buildings, equipment, or fixtures. Their costs are capitalized and generally allocated to future periods through a

52 BALANCE SHEET

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method known as amortization. Amortization of intangible assets and depre- ciation of fixed assets both represent cost allocation processes that satisfy the matching principle. Examples of intangible assets include patents, copy- rights, trademarks, organizational costs, and goodwill:

■ Patents grant to the organization the exclusive right to manufacture, sell, or control a product or process for a specific period of time.

■ Copyrights give the owner the right to reproduce and sell a published work or artistic creation.

■ Trademarks are rights that relate to brand or trade names. ■ Organizational costs include all costs incurred in the formation

of the enterprise and would include attorney and accounting fees, federal and state filing costs, underwriting costs, and so on. They are regarded as expenditures that will benefit the organization over its life. These costs are capitalized and generally written off over a period of 5 to 10 years (5-year write-off period for taxable enti- ties).

■ Goodwill is recognized when one company acquires another com- pany and pays more than the value of its net identifiable assets (assets less liabilities). It is often said that goodwill is the most intangible of the intangible assets group.

The Home Depot reports goodwill (cost in excess of the fair value of net assets acquired) at $314 million at the close of fiscal year 2000. Goodwill can only result from the purchase of another company and represents the expected value of better-than-normal future operating performance. It is measured as the difference between the purchase price of an acquired firm and the fair value of its identifiable net assets.

Goodwill has traditionally been written off over a period not to exceed 40 years. This write-off can place a significant drag on earnings for an extended period of time.2 A recent change in accounting for good- will by the Financial Accounting Standards Board (FASB) requires com- panies to no longer write off newly acquired goodwill. The FASB believes that companies should write down goodwill only when its value appears to be permanently impaired. The Board’s rationale is that the synergistic benefits derived through business combinations often have indefinite lives. To arbitrarily write down goodwill does not follow the matching principle. In a sense, the FASB is suggesting that goodwill is similar to land in that it need not be written off unless its value becomes impaired.

ELEMENTS OF THE BALANCE SHEET 53

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Current Liabilities

Liabilities and stockholders’ equity support a company’s investment in assets. Liabilities must be recognized on the date they were incurred. Liabilities, much like assets, can be classified according to when they will be satisfied. Current or short-term liabilities are obligations that will be sat- isfied in the upcoming year; noncurrent liabilities will be settled at some point beyond the current period. The Home Depot balance sheet reports a number of current liabilities:

■ Accounts payable ■ Accrued salaries payable and related expenses ■ Sales taxes payable ■ Other accrued expenses ■ Income taxes payable ■ Current installments of long-term debt

A pie chart can be used to quickly identify large liabilities. Figure 3.6 clearly shows that accounts payable is 45 percent and other accrued expenses are 32 percent of total current liabilities. Graphing this information over time, as demonstrated with inventory, will point to respective growth, stability, or decline in these areas.

ACCOUNTS PAYABLE Accounts payable, also known as trade accounts payable, represent amounts owed to other companies as a result of goods, services, materials, supplies, and so on acquired throughout the year. Almost 50 percent of The Home Depot’s current liabilities, or $1.976 bil-

54 BALANCE SHEET

Current Liabilities

Accounts Payable

Accrued Salaries

Sales taxes payable

Other accrued expenses

Income taxes payable

Current installments of long-term debt

20%

45%

14%

32%

45%

(Percentage amount is less than 1% and not shown in pie chart.)

Figure 3.6 Analysis of current liabilities.

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lion, is tied to accounts payable. Obviously, to support the operation of more than 1,100 stores, The Home Depot must continually purchase sig- nificant quantities of goods from product supply houses. Conventional payment terms might require satisfaction of these obligations within 30 to 60 days of the invoice date, depending on The Home Depot’s relationship with the vendor.

ACCRUED SALARIES PAYABLE AND RELATED EXPENSES The recognition of accrued salaries and related expenses results from the application of accrual basis accounting. Accrual accounting requires revenues to be recognized when earned and expenses when incurred. The actual receipt of or payment with cash is not essential to the recognition of revenues and expenses in the accounting records. The key issue is whether product sales have occurred and what costs or expenses relate to the sale. Salaries are accrued because they are an expense that relates to the generation of revenue in the current period.

When an accrual takes place, it is often related to a transaction that does not coincide with the close of the fiscal year or the exact amount is not yet known (in the case of a contingent liability). For example, The Home Depot may distribute compensation to a certain group of employ- ees on a weekly basis and others twice a month, on the 10th and 25th. Because the distribution of wage does not cover services provided by employees through the close of the fiscal year, an accrued liability for wages earned between the last payment date and the end of the year must be reported in the balance sheet. The accrued liability for salaries and other related expenses reported by The Home Depot amounts to $627 mil- lion. This amount would also include payroll taxes that the company is responsible for and would include FICA, FUTA, and SUTA payroll taxes. This amount was computed at the close of the business year and recorded via a year-end adjusting entry.

SALES TAXES PAYABLE State and federal mandates require corporations to collect sales tax when sales of tangible personal property are executed. Upon receipt from its customers, corporations have a legal obligation to remit these taxes to an appropriate government agency. Sales taxes are remitted periodically; therefore, any amounts collected represent a liability for the company collecting them.

The Home Depot reports $298 million of sales taxes payable at the close of the fiscal year. This is classified as a current liability because satisfaction of this obligation will take place in the following quarter.

ELEMENTS OF THE BALANCE SHEET 55

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OTHER ACCRUED EXPENSES Other accrued expenses can include a variety of obligations. For example, this may include interest accrued on The Home Depot notes payable. The company presently has 6 percent senior notes out- standing that require interest payments each March 15 and September 15. Because the interest payment date does not fall at the end of The Home Depot’s fiscal year, there must be an accrual of interest from the last interest payment date through the end of the fiscal year. The company has additional obligations in the form of leases and installment notes that would require similar accounting accruals.

Accrued expenses can also include estimated liabilities that will be settled in the upcoming year. This could include property tax expense that has been assessed for the current year but will be paid in the upcoming year, a litigation loss that has been accrued for but not yet settled, or bonuses that have been earned by key executives but will be paid in the upcoming quarter. Revenues received in advance (unearned revenue), such as deposits for goods ordered by The Home Depot customers, would also be recognized as a current liability.

INCOME TAXES PAYABLE Income taxes payable represents an estimated lia- bility that is generally satisfied with periodic payments by the corporation to several taxing authorities. Income tax payments are based on an estimate of corporate pretax income. As estimates change with the passage of time, so will the periodic installments paid by the firm. Any estimated liability should be reported at the close of the fiscal year.

To understand what constitutes pretax income, one must first under- stand the difference between before tax financial reported income (income statement) and pretax income (tax return). Revenues and expenses for tax purposes are determined in accordance with the rules set forth by the Internal Revenue Code and other IRS regulations. Revenues and expenses for financial reporting purposes are based on generally accepted accounting principles (GAAP). The result can be a significantly different income measure depending on which set of rules is applied. Because of this, companies generally report future tax liabilities and/or assets. Any income tax obligation (benefit) due in the following year is reported as a current liability (asset).

The Home Depot reports a current liability of $78 million to various tax authorities at the close of the 2001 fiscal year. However, as will be seen later, The Home Depot has a noncurrent or deferred obligation to the income tax authorities of $195 million as a result of operations. The issue of deferred income taxes will be more thoroughly discussed in the “Long-Term Debt (Excluding Current Installments)” section in this chapter.

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CURRENT INSTALLMENTS OF LONG-TERM DEBT The final item shown under current liabilities involves components of long-term debt that are due in the upcoming period. This is typically referred to as the current maturities of long-term debt and may include obligations such as installment notes, mort- gages, leases, and bond issues.

Upon review of The Home Depot notes to the financial statements, we notice it has issued high-grade, commercial paper that bears an average interest cost of 6.1 percent. Commercial paper generally represents short- term debt. The Home Depot is also a party to a number of capital leases that require period payments of principal and interest. The portion of principal that will be settled in the coming year is reported as a current portion of that long-term debt. Mortgage notes or other installment notes operate in much the same way. The Home Depot has $4 million of long-term obligations that will be settled in the coming year.

Long-Term Debt (Excluding Current Installments)

Long-term liabilities generally represent the most significant obligation for the corporation. Although this obligation does not impact a firm’s cur- rent liquidity, ultimately it becomes payable. Thus, there is significant concern with regard to the payment of ongoing interest and the ability to retire the obligation, either over time or when it becomes due as a single amount.

Long-term liabilities are obligations arising from past events that are not payable in the coming year. Generally, there is a much greater degree of formality when an organization incurs long-term debt. Long-term capi- tal leases, mortgage obligations, pensions, and other retirement benefit obligations are examples of long-term liabilities. Most of these examples, as was illustrated, require the recognition of both a short- and a long-term obligation.

According to note 2, The Home Depot’s long-term debt comprises $754 million of commercial paper (usually short-term notes with original maturities of 30 to 270 days issued by highly rated corporations but clas- sified by The Home Depot as long-term because of their rollover status), $500 million of senior notes due in 2004, $230 million of capital lease obligations payable in varying installments through 2027, and another $75 million in notes payable in varying installments through 2018. All of these obligations must be managed properly to prevent a decline in the company’s credit rating.

ELEMENTS OF THE BALANCE SHEET 57

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Other Long-Term Liabilities

Other long-term liabilities outside of those discussed in note 2 are not clearly identifiable from the notes to the financial statements. Companies that raise capital through the issuance of bonds would recognize a long-term obligation: bonds payable. Additionally, many companies pro- vide to employees pension and health-care benefits upon retirement. Generally, these employee benefits are not earned until the employee has been with the company for a number of years, known as a vesting period.

From an accounting perspective, companies that provide employee retirement benefits must accrue for them with the passage of time. If com- panies fund less than 100 percent of the accrued pension or other post- employment expense, a liability for the future obligation must be recognized. Obligations relating to pension plans and other post-employment benefit (OPEB) programs are reported under long-term liabilities as accrued pension cost obligation or accrued other post-employment benefit obligation. Table 3.2 illustrates the magnitude of pension and other post-employment benefit obligations for Abbott Laboratories at the close of its 1998 fiscal year. Four components are of special interest:

1. Projected benefit obligation is the actuarial present value of employee benefits earned using projected salary levels and present years of service.

2. Pension or OPEB plan assets are placed in trust by the company, invested, and then distributed to employees upon retirement. Their value fluctuates with the stock market and the economy.

3. Prepaid (accrued) benefit cost is the pension or OPEB asset or lia- bility being reported in the balance sheet.

4. Net cost is the pension or OPEB expense for the current reporting year.

Although it is beyond the scope of this book to discuss the calculations that led to the following numbers, it is necessary to highlight two important points. First, Abbott Laboratories reported 1998 pension and OPEB expense (or cost) in the amount of $62.1 million and $69.5 million. The expense comprises four items:

1. Service cost increases pension expense because of an additional year of service benefits (pension and OPEB) earned by Abbott Laboratories employees.

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ELEMENTS OF THE BALANCE SHEET 59

Table 3.2 Note 5: Post-Employment Benefits, Abbott Laboratories

Defined Benefit Medical and (in thousands) Plans Dental Plans

1998 1998

Projected benefit obligations, January 1 $2,000,329 $646,448

Service cost — benefits earned during the year 108,754 30,664

Interest cost on projected benefit obligations 140,287 43,770

Actuarial loss (gain), primarily changes in discount rate and lower than estimated health care costs 182,829 18,057

Benefits paid (85,722) (23,993)

Other, primarily translation 2,143 —

Projected benefit obligations, December 31 $2,348,620 $714,946

Plans’ assets at fair value, January 1, principally listed securities $2,192,486 $86,600

Actual return on plans’ assets 426,023 18,656

Company contributions 18,945 1,265

Benefits paid (85,722) (23,993)

Other, primarily translation (761) —

Plans’ assets at fair value, December 31, principally listed securities $2,550,971 $82,528

Projected benefit obligations less than (greater than) plans’ assets, December 31 $202,351 ($632,418)

Unrecognized actuarial (gains) losses, net (143,876) 137,701

Unrecognized prior service cost 6,134 —

Unrecognized transition obligation (21,015) —

Prepaid (accrued) benefit cost $43,594 ($494,717)

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60 BALANCE SHEET

Table 3.2 Note 5: Post-Employment Benefits, Abbott Laboratories (Continued)

Service cost—benefits earned during the year $108,754 $30,664

Interest cost on projected benefit obligations 140,287 43,770

Expected return on plans’ assets (179,194) (7,211)

Net amortization (7,728) 2,290

Net pension or OPEB cost $62,119 $69,513

2. Interest cost is the cost of the projected benefit obligation, measured on a present value basis. The mere passage of time increases the pro- jected benefit obligation and pension expense.

3. Expected return on plan assets is used in the calculation of pension and OPEB expense to reduce its potential volatility. The reduction of pension and OPEB expense by an expected return on plan assets yields net pension or OPEB expense (or cost).

4. Net amortization relates to the actuarial adjustments (changes in discount rates, mortality rates, etc.) that are made periodically, thereby increasing or decreasing the projected benefit obligation. Rather than adjust pension or OPEB expense dollar for dollar, the resulting gains and losses (known as liability gains/losses) are often amortized over time.

A second adjustment often involves asset gains/losses. Asset gains/losses result from the difference between the expected return on pension or OPEB plan assets and the actual return on plan assets. Because of the potential for large swings in the stock market, the use of an average expected return over time reduces volatile reporting.

Next, Abbott Laboratories reports an asset prepaid benefit cost of $43.5 mil- lion for its defined benefit pension plan and an accrued liability of $494.7 million for OPEB. This means that there are sufficient (actually an excess of ) pension plan assets to cover Abbott Laboratories’ projected benefit obligation. However, the OPEB obligation is currently under-funded, thus the recognition of the $494.7 million obligation. Accrued pension and OPEB obligations emerge when the company’s pension or OPEB expense is not covered by an equal cash contribu- tion to the respective plans. This recognition simply follows the accrual basis of accounting.

Deferred Income Taxes

Deferred income tax liabilities and assets represent future income tax obli- gations or future income tax benefits as a result of past events. They ariseCo py ri gh t © 2 00 3. J oh n Wi le y &a mp ; So ns , In c. [ US ]. A ll r ig ht s re se rv ed . Ma y no t be r ep ro du ce d in a ny f or m wi th ou t pe rm is si on f ro m th e pu bl is he r, e xc ep t fa ir u se s

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when GAAP and the Code conflict with regard to the timing of revenues, expenses, gains, and losses. The resulting timing differences are temporary (in most cases), but nonetheless

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