THE ANALYST'S
ACCOUNTING OBSERVER
Jack T. Ciesielski, CPA, CFA
______________________________________________________________________________________________________
Volume 8, No. 4
March 29, 1999
A User’s Guide To 1998 Annual Reports - Part II
As the 1998 annual reports reach investors and analysts, it’s time to start thinking about what to get
out of them. The disclosures to be expected in the Management’s Discussion & Analysis have already been
dissected in Part 1 - time now to look at the main course served up in the annual reports.
And the main course is - the financial statement package plus the footnotes. It’s not reasonable to say
that the financials alone are the main course and the footnotes are merely dessert. The two are as inseparable
as salt on a steak or butter on a lobster.
What follows here are some suggestions to help you enjoy the main course. Similes aside, the financial
statements plus the footnote disclosures present the most vivid picture of how an enterprise earns its place
in the world. Analysts and investors still have to do some heavy thinking, but the annual reports provide the
raw materials to get the job done - that job being the critical evaluation of an enterprise and its management.
I. Isolating The Soft Spots
The past year has seen a string of restatements of financials, the most obvious ones occurring at
Sunbeam and Cendant. Two bad apples don’t spoil the whole bushel - but the bad apples have had plenty
of help. In 1998, a string of companies like Fine Host, National Auto Credit, Philip Services, Baan, Vesta
Insurance, Livent, Gunther International kept auditors fully employed with re-audits and reissued financial
statements.
Events like these provoked the SEC to take action in 1998, starting with Chairman Levitt’s landmark
Executive Summary - Next Page
Table Of Contents
I. Isolating The Soft Spots
- Financial Statement Quicksand .............................................................
1
II. Hitting The Soft Spots
- Recognizing The Traps .........................................................................
5
III. Other Considerations
- Not Soft Spots, But Worth Paying Attention. .......................................... 16
Appendix
- Two SEC Letters, One Footnote ........................................................... 20
Companies in this report:
3Com
Alcoa
AlliedSignal
America Online
Baan
BankAmerica
Coca-Cola Company
(Continued on back page)
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Copyright 1999, R.G. Associates, Inc. Reproduction prohibited. See last page.
The Analyst’s Accounting Observer
Volume 8, No. 4 March 29, 1999
Executive Summary: A User’s Guide to 1998 Annual Reports - Part II
Annual reports now reaching the desks of analysts and investors contain disclosures that are never
quite so detailed as during the rest of the year. These disclosures help analysts determine the extent to which
the “soft spots” of accrual accounting can be manipulated to certain ends. How to analyze these disclosures
is the focus of this report.
Hitting The Soft Spots. Financial statement users are advised to check the accounting policy footnotes to
understand:
• Revenue recognition policies. Checking this note can give readers an understanding of issues related
to sales that might not be real sales - transactions involving significant obligations to complete work, liberal
return policies, conditional payment for goods, related party sales, and “bill and hold” sales.
• Depreciation policies. Test the depreciable lives of assets by comparing to other firms in the industry,
and see if the firm has had trouble estimating the economic life of assets in the past by looking for SFAS No.
121 writedowns.
• Derivative instruments. At face value, see if firms are using derivatives only for hedging purposes.
• Consolidation principles. Check to see if there are foreign subsidiaries whose results might be
reported on a lagged basis - with possible confounding results on subsequent expectations.
Other footnotes contain more specialized information. Worth studying:
• Restructuring/Merger-related reserves. Use the activity shown in reserve schedules to understand the
cash and non-cash effects of reserve activity.
• Pension disclosures. Look for “jimmied” earnings rate assumptions to boost net income. Look also
for the amount of earnings improvement due to the improvement in pension asset performance; strong market
performance driving pension asset returns may mask mediocre operating performance.
• Valuation accounts. Study valuation accounts and any disclosed activity to determine if such
accounts have been treated as “rainy day funds.”
• Related party transactions. Check for a related party footnote to see if there have been transactions
with management that might indicate unfavorable terms to shareholders.
Other Considerations. Aside from disclosures that aid in evaluating “soft spots,” there’s other worthwhile
information contained in the annual reports.
• Segment disclosures. The new requirements for segment disclosures kick in this year. Expect a net
improvement in the quantity of segments shown and disclosures about them.
• Stock compensation disclosures. Check the footnotes to see how stock compensation is affecting the
bottom line - even if it isn’t presented in the income statement. Check also to see if stock compensation is
expanding - the disclosures to examine this are abundant.
• Year 2000 issues. Aside from disclosures in the MD&A, the Y2K issue can have a significant impact
on revenue recognition, loan loss allowances, asset writedowns, and the accrual of loss liabilities.
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Phone: (410)783-0672
R.G. Associates, Inc.
Fax: (410)783-0687
The Fidelity Building
Internet: jciesielski@accountingobserver.com
210 N. Charles Street, Suite 1325
Website: www.accountingobserver.com
Baltimore, MD 21201-4020
-3-
speech in September entitled “The Numbers Game” (which you can read in its entirety at
http://www.sec.gov/news/speeches/spch220.txt). The public’s consciousness has been raised by the
plethora of magazine articles and news stories addressing the SEC’s attack.
One focus of the press stories has been the SEC’s issuance of 150 letters to the CFOs of firms
that have announced writedowns, restructuring actions or in-process R&D charges, as well as the
issuance of a similarly-themed letter to bank CFOs relating to their development and disclosures
regarding their loan loss provision and allowance. Both letters are included in the appendices to this
report; both are recommended reading. Since the issuance of these letters, a favorite Wall Street
guessing game has been, “Who received the letters?” - prompted by the supposition that these
companies are targets for SEC investigations and forced restatements of earnings1. And everyone
knows what that means for the stock prices of such firms.
The very same players who are so willing to dump stock of perhaps perfectly good companies
are also unlikely to have read the letters at all. Spend a few minutes with those letters - you’ll see
that they are not so much warnings of impending intrusions by jack-booted regulators as they are
reminders that generally accepted accounting principles require transparent disclosures when
certain events have occurred. It’s likely that those firms are running a risk of SEC intervention only
if those disclosures are not present in the published year-end financials.
That said, notice the purpose of the letters is to remind companies of their responsibility to
report clearly the accounting for some events where management estimates or judgments can have
a significant impact on earnings - leaving the door open to earnings manipulation to suit a
management’s purposes. Simply due to the nature of accrual accounting, earnings are full of
estimates and judgments. These “soft spots” can have magnificent impacts on earnings, merely
through the adjustment of non-cash estimates and assumptions. If there is adequate disclosure of
changes in such non-cash estimates and assumptions, there’s a chance that investors and analysts can
spot gamed earnings - and assess whether or not they want to pay up for shares of firms that practice
accounting legerdemain. The SEC’s letter effort is aimed at making sure that there are adequate
disclosures surrounding some frequent transactions involving plenty of accounting judgment.
It’s all the more important for analysts and investors to pay attention to the “soft spots” in
the annual report disclosures, because any gaming of accounts through estimates or assumptions
is generally undetectable in the paltry disclosures companies make in their 10-Qs during the first
nine months of the reporting year. Learn what you can when you can; that time is now upon us.
In the ensuing sections of this report, we’ll look at the disclosures present in the annual
reports that should help analysts assess soft spots as well as annual performance.
1
If you are one of the players who insists on guessing who were the 150 firms on the receiving end of the letters, why
not check the Charge Clock at The Analyst’s Accounting Observer website? (www.aaopub.com/CLOCK/index.htm)
Listed there are the 200 largest charges taken in 1998, categorized by kind of charge - restructuring, writedown, inprocess R&D, and merger-related charges. It’s not inconceivable that the SEC maintains a similar list or checks resources
such as this one.
-4-
Table 1. A Summary Of Chief Financial Statement “Soft Spots.”
“Soft Spot”
What the analyst wants to figure out:
Revenue recognition
- Is revenue recognized at shipment? Most firms do, but there’s always opportunity for shipping before
customers want goods - known popularly as “channel stuffing”. Look at allowance for sales returns to see
if it’s been unusually active, at least compared to past years (if the company has included it in the 10-K).
- Is revenue recognized on percentage of completion? How has the company done in past on its estimates
of completion? Early recognition, with later overruns? Do they finish contracts fairly quickly?
- Are there unfinished obligations or deliverables related to revenue already recognized? A critical issue with
software companies.
Long-lived assets:
Depreciation policies
- Do the life spans of the associated assets make sense? Are they unusually low compared to others in the
same industry? Have the lives been stretched in order to boost near-term earnings? (To make Wall Street
estimates?) Do SFAS No. 121 writedowns contradict policy on asset lives?
Capitalization policies
for intangibles
- Companies must expense preopening costs, starting in 1999. What other expenditures do they capitalize?
How do they justify the amortization associated with them? How do they compare to their competition? Are
amortization policies reasonable? (Check the Accounting Policies footnote.)
Allowance for doubtful accounts/ loan
loss reserves
- Are additions to such allowances lower or higher than in the past? Does the collection experience justify
such discretion? Is a lowering of the allowance due to hard times in industry and difficulty in making earnings
estimates? (Look at allowance for doubtful accounts activity in 10-K).
Warranty reserves
- Have additions to the reserves been reduced in order to make earnings targets? Why? Have charges gone
down as well? Is there better quality in products - what do charges to reserve tell the analyst? (A company
may have disclosed a schedule of warranty reserves in its 10-K. If not, and warranties are significant to the
firm’s business, ask management about activity.)
Tax asset valuation
accounts
- Tax assets must be stated at the value at which management expects to realize them - just like accounts
receivable. An allowance must be set up to lower the tax assets to the level expected to eventually be
converted into cash. Determining the allowance involves an estimate of future operations: will the firm
generate enough income to use up the asset?
- Check for contradictions between MD&A and the allowance level, or the tax footnote and the allowance
level. You can’t have an optimistic MD&A and a fully reserved tax asset, or vice-versa. One of them has to
be wrong.
- Look for changes in the tax asset valuation account. May be 100% reserved at first, then “optimism”
increases whenever an earnings boost is needed. Lowering the reserve decreases tax expense and
increases net income.
Pension plan
assumptions
- How does the “expected return on plan assets” compare to the return actually earned by plan assets? Look
at history - is the expected return too optimistic?
- Has the expected return been increased in the current year? This has the effect of increasing earnings
immediately - without increasing cash flow. (Look at pension footnote disclosures).
Non-cash income:
LIFO layer reductions
- “Biting down” into lower-costed layers of inventory (can happen in inventory reduction programs) will
generate earnings without cash flow. Management can intend to reduce the layers that produce the desired
benefit. (Check inventory footnote: such effects must be disclosed).
Non-cash income:
pension income
- Does an overfunded pension plan produce pension income rather than expense? If so, its earnings return
assumptions are even more critical to earnings. Have they been increased? Again, this can produce income
without corresponding cash flow. (Check pension plan disclosures).
Related party transactions
- Is the management of the company using it as a piggy bank? Does one firm have control over the other’s
destiny through supply contracts or other dealings?
- Do extensive dealings take place with non-public companies that are under management control? If so,
non-public companies could take significant lumps to make the public company look good - providing
opportunity for owner to cash out.
In-process R&D
writeoffs
- What percentage of the company acquired is classified as “acquired R&D?” No single percentage is “right”,
but a continued history of large writeoffs may indicate more smoke than fire in a company.
- A “soft spot” because an unfair allocation of purchase price to IPR&D can favorably skew earnings
comparisons for years to come. Unfortunately, there’s little that analysts and users can do to verify.
- New FASB treatment (forthcoming - perhaps by year end) will call for capitalization, gradual writedown.
Restructuring
charges
- There’s no theoretical need for these, but they can stoke earnings for years to come. See text for more
discussion.
Merger-related
charges
- Same as restructuring charges.
II. Hitting The Soft Spots
Often overlooked, the footnotes are chock full of information to help you set your premises
-5-
in evaluating a firm’s performance. That’s where analysts can pick up the most knowledge about the
soft spots; spend time with them and you can learn a lot about how a company justifies its existence.
A. Significant Accounting Policies
The “Significant Accounting Policies” footnote is usually the first footnote in the annual
report, and it’s probably the one that’s most unjustifiably ignored by readers. There are basic
concerns that analysts and investors usually harbor about revenue recognition, depreciable lives, and
general derivative policies - and this is the one place that such concerns are usually addressed. Here’s
what you should seek from the accounting policies footnote.
-Revenue Recognition Policies:
Most firms recognize revenue when goods are shipped or when services have been provided and most firms say as much when they report their revenue recognition policy. Nevertheless, the
financial statement reader ought to be alert for other revenue recognition issues in studying
disclosures or in querying management.
• What kind of return rights do customers possess? Are there 10-K schedules showing
activity in the sales returns & allowances accounts? If so, does the activity in them reflect overall
industry conditions - or does it contradict them? How does it compare to past activity?
• Is revenue recognized on partial shipments? If so, are the unshipped portions critical for the
use of the entire product? Such a condition might indicate that revenue recognition is inappropriate.
• Are there revenue transactions with related parties? The implications are obvious: sales can
be made to companies owned or controlled by management for the express purpose of raising
revenues and earnings when they are needed to maintain a trend. This kind of chicanery occurred in
a real-life case last year involving Baan Co. of the Netherlands.
•Do legitimate sales exist if the customer’s obligation to pay depends on: Success in raising
financing? The sale of the goods to someone else? Customer acceptance after an evaluation period?
• Is there continuing involvement by the seller after the sale? Best example: the software
industry.2 A software license agreement may call for upgrade rights, training, debugging or what
have you - all elements that might preclude immediate recognition of the entire license fee as
revenue, even though the cash price was received up front.
• Does the enterprise bill for shipments over which it retains physical control? Sunbeam lent
notoriety to the practice of “bill and hold” sales, in which customers were billed for goods that
remained on premises maintained by Sunbeam. No delivery of goods, but title passed and the
revenue was recognized. One should question the mettle of revenues recognized in this fashion.
Investors need not have been surprised when press stories detailed abuses in this area in
early 1998: the revenue recognition policy was described in the Sunbeam accounting policies
footnote in the 1997 annual report.
Even if the above revenue recognition issues aren’t addressed in the accounting policy
footnote, they are worth considering - and pressing management for answers when analyst doubts
2
See Volume 7, No. 8, “Accounting For Software Revenues: The Changes Take Effect” for more discussion.
-6-
exist about the veracity of recorded revenues.
- Depreciation & amortization policies:
An old analytical chestnut: check to see if companies are improving their earnings -without
improving the company - by lengthening the life of depreciation schedules. Here’s where the analyst
can find out: by reading the accounting policy footnote for property, plant and equipment and
checking to see if the lives have been lengthened when compared to last year’s footnote. The same
kind of analysis can be applied to goodwill and other intangible asset balances. If lengthened in a
material way, the firm should be mentioning it - if not in this note, in the Management’s Discussion
& Analysis.
That’s the chestnut. There are a couple of other nuggets to be mined from these disclosures:
• How different is the firm’s depreciation and amortization policy from others in the same
industry? The easy way to check is to pull out the annual reports of other firms in the same industry
and compile a list of asset lives by category. Yes, it’s entirely possible that the industry as a whole
can have an overly cheerful assessment of asset lives - but at least you can find out if the firm in
which you’re interested is an outlier among fools.
• Even if the depreciable lives have not been “stretched” or if they are not out of line with the
industry, are they still too long? That’s not an over-cautious question. The issuance of SFAS No.
121, “Accounting for Impairments of Long-lived Assets and Long-lived Assets to be Disposed Of”
has caused many asset writedowns to occur in its wake.3 That standard called for the recorded
balance of long-lived assets to be reduced to fair value when it becomes apparent that the assets will
not generate enough cash to recover their cost.
When companies take a writedown under the premises embodied in SFAS No. 121, they are
basically admitting that they hadn’t been depreciating such assets rapidly enough in the past - or
they had embarked on poorly budgeted capital expenditures. So if a firm has taken such charges in
the past, it wouldn’t be unfair for an analyst or investor to question whether or not the firm’s
estimating skills are any sharper in estimating the lives of the other remaining long-term assets on
its books. The presence of SFAS No. 121 charges should be a signal to analysts to be skeptical.
Ironically, SFAS No. 121 may be an earnings management tool in itself. Reducing the
long-term asset base decreases the future charges for depreciation and amortization - raising
earnings estimates and thus providing managements an incentive to be as “conservative” as
possible in calculating the charges for asset writedowns. The fix for this would be disclosures of
the assumptions used in calculating the SFAS No. 121 writedowns: market participants could see
for themselves if the conservatism was justifiable or just a tool for achieving a desired result.
Unfortunately, the FASB did not require any stringent disclosures about the nature of these
charges.
- Derivative Financial Instruments
While SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” is
not effective until next year for most companies, it’s especially important to get a handle on how
3
See Volume 5, No. 1, “Industry Focus On SFAS No. 121: Why Charges Occur” and Volume 4, No. 11, “SFAS No. 121:
Corporate “Ultra Slim-Fast” for more on the mechanics of this standard.
-7-
firms use derivatives in the meantime - while the accounting treatments for them may still be fairly
inconsistent from company to company.
In the accounting policy footnote, most companies swear they do not use derivative
instruments to speculate nor do they use them to increase reported earnings. More conclusive
evidence may appear when SFAS No. 133 is implemented.
- Consolidation Principles
While not exactly one of the “soft spots,” it’s a worthwhile step to check the accounting
policy footnote to see if the firm has any overseas subsidiaries possessing a different year end than
the parent. Conceivably, the reporting for a foreign subsidiary could be as much as three months
behind the parent’s - and in that three month window, a devaluation or some other economic
catastrophe could wreak havoc on that sub’s operations. The effects wouldn’t be contained in the
parent’s current reporting, but would show up in the following quarter’s results.
If this were to be the case, the effects are to be disclosed - providing the financial statement
user with a “heads up” on the next quarter’s reporting.
Those are the chief soft spots to hit while studying the accounting policy footnote. Move on
to the other footnotes - starting with footnote disclosures about restructuring and merger-related
charges.
B. Restructuring & Merger-related Charges
Readers of these reports are no strangers to the analytical roadblocks posed by restructuring
and merger-related charges.4 The accounting in this area is conceptually weak: it permits the firm
to take big up-front hits to earnings in connection with a corporate blood-letting or corporate
marriage. The actual associated cash expenditures will be secreted over perhaps several years, as the
workers accrue their benefits - and the expenditures will never show up in earnings. Instead, they
will reduce a corresponding liability set up the same day as the charge taken.
That’s an awful lot like paying someone their entire salary on the first day of the year in
advance of performing the work they have to do to earn it - just because it’s probable that they’ll
earn it for the year. No analyst or investor would tolerate such accounting behavior if that was the
way a firm handled its payroll costs - but make it a “one-time event” and it’s a truly beautiful thing,
even if it doesn’t make sense.
Worse yet: the estimates for the amounts to accrue can be far from reality. There’s every
incentive for a management to “estimate high” in setting up charges for restructuring and mergerrelated activities, and their linked reserves. Those overstuffed reserves can be reversed and “leaked”
into earnings over time. In his “Numbers Game” speech, Chairman Levitt likened such accounts to
a cookie jar into which companies can dip when they need an earnings boost.
4
See Volume 4, No. 4, “Restructurings: New Rules For The Game”, Volume 4, No. 8, “The 20% ROE Club: Admission
Courtesy Of GAAP,” and Volume 5, No. 9, “Reviewing Restructurings: What The Disclosures Show.”
-8-
Even if it’s theoretically deficient, GAAP5 still requires that firms disclose activity in the
liabilities associated with restructurings and mergers - and in those disclosures, any adjustments of
the reserves should be apparent. The problem, however, is that companies have not been very
fastidious about presenting good disclosures in the quarterly reports and 10-Qs. Given the SEC
letters mentioned earlier, and the attention they’ve drawn, expect to see fair disclosures of such
activity in the 1998 annual reports. Whether such disclosures continue to show in the forthcoming
quarterly reports remains to be seen.
BankAmerica provides a good example of the currently-required disclosures in its annual
report - and it neatly illustrates the shortcomings of the current accounting and disclosures. It also
shows the kind of analytical work that it’s possible to do when the disclosures are present.
BankAmerica is actually NationsBank, which combined with the BankAmerica “classic” and
assumed the old BankAmerica’s identity. They joined forces on September 30, 1998 in a pooling
transaction,6 in which a $725 million pre-tax charge ($519 million after-tax) was recorded; in the
fourth quarter, another $600 million pre-tax charge ($441 million after-tax) was recorded. This was
on top of the pooling combination between the NationsBank and Barnett Banks in the first quarter
of 1998. At the time of that merger, NationsBank recorded a $900 million pre-tax charge ($642
million after-tax). The table nearby summarizes the 1998 activity for these merger-related charges;
the actual footnote is reproduced in the Appendix.
Observe that there were substantial cash payments against both of these reserves during 1998.
After all, these reserves were established to pay severance and other employee-related costs; to pay
for conversion costs;7 and other costs of exiting activities and merging others. Though there isn’t
much description of the nature of the costs beyond severance, it’s not likely that any of them would
be settled satisfactorily by the exchange of wampum. One has to wonder then, about the curious
nomenclature in the fourth column: “non-cash reductions applied to reserve.”
5
Help may be on the way. The FASB is considering a formal definition of “constructive liabilities” - liabilities that must
be recognized even if there is no specific contract or obligation requiring their recognition. The FASB has concluded
(so far) that employee severance costs and costs to exit an activity - typical restructuring and merger-related actions do not constitute constructive liabilities. Therefore, they could no longer be accrued in large up-front charges.
6
Merger-related charges are handled quite differently in purchases and poolings. In a purchase, any merger-related
charges are considered part of the purchase price and will increase goodwill rather than being recognized in earnings at
deal’s close. They’ll hamper future earnings through amortization. In a pooling, the charges are recorded immediately
in earnings at the time of the merger, and ignored in future earnings. The associated reserves live on, however.
7
Though not described in the footnote, conversion costs are presumed to be the costs of changing an old NationsBank
branch with a new BankAmerica identity. If that’s what is meant, that kind of cost sounds more like an item that should
be capitalized because it will provide future benefits - as opposed to a cost related to exiting an activity.
-9-
Whatever you want, according to current GAAP.
The reported diluted EPS figure of $2.90 includes all of the
up-front charges associated with two 1998 mergers. Analysts and
investors are always asked to overlook such charges for
comparison purposes; that’s where the $3.64 figure comes from.
What if restructuring/merger charges were recognized as
they were incurred - just as they are for the thousands of other
expenses generated throughout the year? Novel idea. GAAP
disclosures let us estimate it, and in BankAmerica’s case, it’s $3.13.
It’s conceivable that employees
could be paid severance benefits with
newly issued stock options or with property of BankAmerica - but not likely. It’s
even conceivable that, for conversion or
exit costs, some excess properties might
be sublet by the new BankAmerica at
rates less than the amount the firm pays and the difference might be charged as
“non-cash reductions applied to reserve.”
No explanation is given for the “non-cash
reductions” - the reader is left to his own
devices. “Non-cash reductions applied to
reserve” thus becomes a “non-description
description.” One could interpret those
reductions as the transfer of property or
lease payment differentials - but one
could just as easily assume that they
represent reversals of the reserves set up
earlier in the year. They also could represent transfers from one liability account
to another, or maybe even adjustments to
the basis of assets. It simply can’t be
determined. Nevertheless, $393 million is
too much economic activity to merely gloss over.
Suppose they are reversals of earlier-established reserves. In that case, there are some
interesting analyses that one can make from this supposition. First of all, note that in the case of the
Barnett reserves, some $247 million had been “non-cash reduced” in slightly less than a year. If those
reductions represent reversals of original estimates of what it would cost for merging Barnett with
NationsBank, one would have to be amazed at how poorly the estimates were drawn. A $247 million
reversal on a $900 million reserve represents an initial estimate that was 27% wide of the mark - an
estimate proven wrong in less than a year.
Apply the same logic to the BankAmerica reserve. It was initially established on the closing
date, September 30, and restocked by the year end - only three months. In three months, $146 million
of the $1.325 billion would have been reversed - indicating an estimation error of 11%. Note that
it’s possible that all of any assumed reversals could have related to the original $725 million reserve
established on September 30 - putting the estimation error at 20%.
If these “non-cash reductions applied to reserves” really are reversals, such wide margins
in estimating “liabilities” for merger-related charges show how unreliable such accounting can be.
It would appear to be very difficult to get a reliable grasp on the costs of an integration early on in
a merger. Better accounting would be to recognize the charge for the expense after services have
actually been performed and an exchange transaction has occurred - just like the accounting for
other liabilities such as payroll and rent, where an amount paid to settle is reliably determined.
-10-
BankAmerica Merger-Related Reserves: 1998 History.
(Dollars in Millions)
Barnett Merger
Severance, change in control
and other employee-related costs
Conversion and related costs
Exit and related costs
Other merger costs
BankAmerica Merger
Severance, change in control
and other employee-related costs
Conversion and related costs
Exit and related costs
Other merger costs
Total reserve activities
Balance,
1/1/98
Amount
Included
in Expense
Cash
Payments
Applied to
Reserve
Non-Cash
Reductions
Applied
to Reserve
Balance,
12/31/98
$----$--
$375
300
125
100
$900
($318)
(8)
(101)
(99)
($526)
($55)
(192)
--($247)
$2
100
24
1
$127
$----$--
$740
150
300
135
$1,325
($155)
(3)
(62)
(117)
($337)
($98)
(4)
(44)
-($146)
$487
143
194
18
$842
$--
$2,225
($863)
($393)
$969
There’s more. If these “non-cash reductions applied to reserves” were reversals, an astute
investor would want to estimate the degree to which they affected net income. After all, non-cash
income is not highly prized by investors - that’s why the accounting mechanisms that generate it are
analytical “soft spots.” The BankAmerica disclosures are helpful in this ferreting out this information
- but not quite helpful enough, as will be seen.
Estimated After-tax Diluted EPS Benefits Of “Non-cash Reductions Applied To Reserves.”
Barnett Merger
Pre-tax cost
After-tax cost
After-tax rate
1Q98 Charge
$900
$642
71.3% x
Combined
BankAmerica Merger
Charges
Pre-tax cost
$1,325
After-tax cost
$960
After-tax rate
72.5% x
Total DEPS Benefit
DEPS excluding charges
Adjusted for removal of non-cash charges
Difference
(Gross)
Reserve
Reductions
After-tax
Earnings
Benefit
Average
Diluted
Shares
Benefit
In
DEPS
($247) 4
($176) ÷
1,775.760
4
($0.10)
($146) 4
($106) ÷
1,775.760
4
($0.06)
($0.16)
$3.64
$3.48
-4.4%
“Combined charges” refers to the $725 million ($519 million after-tax) charge taken in 3Q98 plus the
$600 million ($441 million after-tax) charge taken in 4Q98. Since it’s not disclosed which non-cash reductions
relate to which charge, the blended after-tax rate was applied to the reductions as a whole. The difference
between the two after-tax rates was very slim, regardless.
The above table shows the calculation of the after-tax benefit obtained from the non-cash
-11-
reductions of the reserves. Simply determine the after-tax cost rate of the entire charge, and apply
that it to the “non-cash reductions applied to reserves” to determine the after-tax benefit of these
adjustments. Then figure the benefits on a per-share basis.
Typically, market participants exclude the after-tax effect of charges from the earnings.
That’s the $3.64 figure shown in the table - recorded diluted EPS plus the after-tax effect of the
$2.225 billion of merger-related charges. That kind of adjustment doesn’t take into account any
reductions in the charges that occurred later - and if those adjustments were taken into account, the
diluted EPS that the world fixates upon would read $3.48 instead of $3.64.
That may sound like an insignificant amount for the year - but the schedule in the annual tells
nothing about the timing of the reversals. One cannot tell what quarters were affected by them, and
there are no similar schedules in the quarterly reports. Suppose all of the reductions occurred in one
quarter. Would $.16 of reversal credits be material in any one quarter? Probably. “New”
BankAmerica earned $.50 in the third quarter and $.91 in the fourth quarter.
Take the information provided one step further - look at the cash paid against the reserves
as well as the “non-cash reduction applied to reserves.” There’s nothing in GAAP that prohibits
firms from recognizing such expenditures as expenses - they could simply elect to recognize the
costs as they were incurred instead of taking huge “up-front” charges.8 What would the earnings look
like? To calculate the additional costs to subtract from reported earnings, one must apply the same
kind of mechanics as shown in the reductions example. The table below summarizes the calculations.
Estimated After-tax Diluted EPS Costs Of Cash Payments Applied To Reserves.
Barnett Merger
Cash
Payments
$526 x
After-tax
Rate
71.3% 4
Estimated
After-tax
Cost
$375 ÷
A-T Per Share
Expense
Diluted
To Deduct
Shares
From DEPS
1,775.760 4
$0.21
÷
BankAmerica Merger
337
$863
x
72.5% 4
244
$619
1,775.760
4
0.14
$0.35
Tally it up: BankAmerica’s operating earnings were $3.64, which excludes only the initial
effects of the charges. Back out any theoretical reductions of the reserves, and the figure drops to
$3.48; subtract the after-tax expenses that would have been incurred without a reserve, and the
figure drops further to $3.13. That’s a 14% decrease from what the world normally scrutinizes - and
a figure that’s more reflective of the underlying economics of the firm. Yet again, there’s no way to
determine which quarters were most affected by the cash paid.
8
It’s true. EITF Consensus No. 94-3 prescribes the accounting for establishing liabilities in connection with costs to exit
an activity - but if a firm cannot meet the criteria for establishing the liabilities, it must record expenditures in earnings
as they are incurred. The burden of compliance with the standard falls on the firm that chooses to establish an up-front
liability. A firm might simply pay - and recognize - costs as incurred without establishing a reserve.
-12Net income
$500
Add:
Total after-tax charges (restructuring or merger-related)
1,000
Subtotal: where most analysis stops
$1,500
Deduct:
Estimated after-tax reserve reversals
Estimated after-tax cash payments in reserves (not in expense before)
Net income adjusted for activity in reserves and charges taken
At left, a simplified
model for translating
net income into earnings adjusted for reserve activity - which
reflects the cash earnings more accurately.
(100)
(400)
$1,000
Bear in mind that the letters sent by the SEC emphasized that companies need to make clear
disclosures in these kinds of accounts in their annual reports. Analysts and investors will be able
to best perform this kind of analysis now, at least on an annual basis - but unless the SEC keeps
hounding companies into the new year, it’s unlikely we’ll see detailed schedules of reserve activity
in the quarterly reporting.
No quarrel with BankAmerica - it is complying with generally accepted accounting
principles in its treatment of the merger-related reserves. GAAP could certainly be polished in this
area, however.
C. Pension Disclosures
This is the first year in which firms must comply with SFAS No. 132, “Employers’
Disclosures about Pensions and Other Postretirement Benefits.” This standard9 significantly cleaned
up the clutter in pension disclosures.
Analysts and investors need to consider
that pension assumptions are prime levers to
push or pull in achieving a desired earnings
level. The easiest, quickest way to boost earnings via pension assumptions is to boost the
expected rate of return on assets.
Service cost
Interest cost
Expected return on plan assets
Amortization of unrecognized:
- Prior service cost
- Net losses
- Transition amount
Pension cost
$104.4
280.4
(334.2)
66.9
6.9
1.2
$125.6
Why? Because net pension cost is an
Goodyear Tire’s 1998 pension cost. Note that if
amalgam of different components related to the Goodyear were to raise its assumptions on the earnings
passage of time (interest cost), benefits earned of the pension assets, the credit would increase by employees (service costs) and other adjust- thereby lowering the net pension cost.
ments - all reduced by the earnings expected on
the pension assets. If one simply raises the earnings assumptions on the pension assets, the net
9
See Volume 6, No. 12, “Improving Disclosures: The FASB Wants To Revise Pension Notes.”
-13-
pension cost is lowered - and net income is increased.
The only time of year analysts get to see the pension disclosures in full daylight is in the
annual report - so pull it out and check to see if the earnings rate assumptions have been increased.
It’s an exercise that requires some judgment and follow-up; increased earnings rate assumptions
may be perfectly justifiable given a firm’s pension asset mix.
Earnings Rate Assumption
1998
1997 Change
Allied Signal
Alcoa
Boeing
Coca Cola
Du Pont
Eastman Kodak
General Electric
General Motors
Goodyear
Minnesota Mining & Mfg.
Morgan, J.P.
Philip Morris
Sears Roebuck
United Technologies
10.00%
9.00%
8.75%
8.75%
9.00%
9.50%
9.50%
10.00%
9.50%
9.00%
8.70%
9.00%
9.50%
9.60%
10.00%
9.00%
8.33%
9.00%
9.00%
9.50%
9.50%
10.00%
9.50%
9.00%
8.70%
9.00%
9.50%
9.70%
–
–
0.42%
-0.25%
–
–
–
–
–
–
–
–
–
-0.10%
A small sample, but interesting nevertheless: of these Dow Jones 30 firms with December
year ends, only one of them - Boeing - increased
its pension assets earnings rate assumption.
In light of general strong market returns,
it’s interesting to note that there were two firms that
decreased their earnings rate assumption - perhaps indicating that there was an expected change
in asset mix or returns.
Aside from looking for “jimmied” earnings rate assumptions, analysts and investors ought
to take a critical look at the overall amount of earnings improvement due to pension plan
performance - even if earnings assumptions are held steady. The accompanying table shows why.
Bull Market Benefits: Lower Pension Costs.
Allied Signal
Alcoa
Boeing
Coca Cola
Du Pont
Eastman Kodak
General Electric
General Motors
Goodyear
Minnesota Mining & Mfg.
Morgan, J.P.
Philip Morris
Sears Roebuck
United Technologies
Pension Cost
1998
1997
($10)
$22
89
93
(121)
65
68
68
(140)
(27)
88
115
(1,016)
(331)
1,642
1,850
126
135
150
151
5
27
297
39
88
106
145
125
Change
($32)
(4)
(186)
–
(113)
(27)
(685)
(208)
(9)
(1)
(22)
258
(18)
(20)
For the same 14 companies shown
previously, there are two new incidents of
“pension income” being reported where there
had been pension cost in 1997. Twelve of
the companies showed net decreases in
pension cost.
Note that Boeing swung into a pension income situation in 1998 - and also
increased its pension asset earnings assumption by .42%. On average plan assets
of $32.9 billion, that assumption change
generated “pension income” of $138 million enough to throw the pension fund into “profit
center” status.
These improvements drive the
change in net income - they may give the impression to an analyst or investor that income
improvement was generated by operations when in fact it may be due to nothing more than a
combination of plentiful pension assets, a bull market and inertia in other pension costs due to a
declining workforce. The real problem is that for investors, any improvement may be largely
-14-
cosmetic - even if a firm is producing pension income, it does not generate cash flow that can be
used for share buybacks, dividends or capital expenditures.10
A Comparison: Earnings Improvement Driven By Pension Improvement.
Boeing
Du Pont
General Electric
General Motors
Pretax Income
1998
1997
Change
$1,397
($341)
$1,738
1,648
1,432
216
13,477
11,179
2,298
4,612
7,792
(3,180)
Pension Cost
Improvement
$186
113
685
208
% of
Income Swing
11%
52%
30%
NM
An interesting perspective on performance: the four firms above had the biggest absolute
improvement in pension cost of the fourteen examined. Compare the change in pretax income to the
improvement in pension cost, and you’ll see that pension cost improvement is quite a significant contributor
to earnings improvement. (Except in the case of General Motors: the decrease in operating income was
stanched somewhat by the pension cost improvement.)
The question for investors: if bull markets make earnings improvement automatic through fatter
pension funds, at what point do investors stop paying up for this kind of earnings improvement? If full credit
is given for this kind of earnings performance, then rising markets due to rising earnings become a circular
device.
D. Valuation Accounts
Valuation accounts are those that state another account fairly. One example would be the
allowance for doubtful accounts: while accounts receivable may reflect the total amount billed for
sales, it’s not always likely that they’ll be collected in full. An allowance to offset the accounts
receivable not expected to be collected will state receivables at their realizable value - the amount
that should be collected.
Another example is the valuation allowance for tax assets. Deferred tax assets represent the
amount of tax benefit expected to be eventually realized - and when the full realization is
questionable, an offset to the deferred tax assets should be recorded.
Note that such valuation allowances can be “stuffed” - overconservative assumptions may
be employed to build up a reserve, which can be reduced later when a firm needs to meet Wall Street
earnings expectations. Reducing a reserve, as shown in the restructuring discussion, will increase
net income.
Analysts and investors ought to examine valuation allowances skeptically. If there are
increases to the allowances, the reasons for them should be questioned. For instance:
• Is a sizeable increase in an allowance for doubtful accounts really proper if economic
conditions are favorable?
• Are tax asset valuation accounts related to net operating loss carryforwards justifiable if
there are ten years or more until the carryforwards expire? Suppose the NOLs relate to
foreign subsidiaries operating where the tax laws do not limit the life span of NOLs?
10
For more on the mechanics of pension plans, see Volume 2, No. 8, “Pot Of Gold Or Can Of Worms? Distortions
Caused By Overfunded Pensions” and Volume 3, No. 1, “The Secret Lives Of Pensions - Understanding Underfunding.”
-15-
Assessing valuation accounts is not simple, because one must understand the environment
to which it relates. You’ve got to figure out if the assertion made by the presence of (or changes in)
the valuation account make sense in terms the overall setting.
E. Related Party Transactions
One footnote that gets its best display of the year in the annual report: the related party
transactions footnote.
How a management conducts business with a firm that it is serving should be an issue of
interest to all investors. A management that wears two hats - serving the interests of shareholders
while dealing with the firm - is ripe for a conflict of interests. Sometimes these managements can
also be significant shareholders as well - and can also control other private businesses that do
business with the public enterprise run by management. Non-management shareholders should be
concerned that managements may enjoy enrichment at their own expense. To air potential conflicts,
GAAP disclosures require the reporting of management dealings with the firms that employ them.
In reviewing the footnotes, the overriding question is whether or not the transactions
conducted with management are done fairly from the shareholder point of view. It should also be
considered whether or not there are ways that business done with private firms controlled by
management could affect the profitability of the public firms served by management. For instance,
suppose a public firm has administrative support services provided by a private firm controlled by
management. Alternatively, perhaps the public firm buys raw materials for production from a
management-controlled private firm. Suppose further that the management owns significant stakes
in the public firm as well. That management would have an incentive to provide services or goods
to the public firm at significant discounts to market value, if it could enhance the profitability of the
public firm - and make the stock price increase. Analysts and investors need to be alert that
situations like this create an environment where earnings manipulation may well emerge.
Rite Aid Corp. management is currently in hot water for its dealings with the firm;
apparently, certain members owned stakes in firms that did business with Rite Aid, as well as
owning real estate that was rented to the firm . Curiously, there was no disclosure of these items in
last year’s annual report footnotes. That shouldn’t stop an analyst or investor from looking for them
in the annual reports of other firms, however.
-16-
III. Other Considerations
The prime purpose of reading financial statements is not to find misleading performance
presentations via “soft spots” - it’s to learn about the enterprise and how it’s being managed for
shareholders. There are other disclosures that either appear once a year in the annual report, or are
significantly richer in the annual report than any other time of year. They’re worth noting in your
review.
Segment disclosures. One disclosure that is better in the annual report than any other time
of year is the new set of required segment reporting disclosures.11 The new segment disclosures are
to be based on the way that management parses the company internally; investors and analysts will
be looking at the same segment information as management - which should make for clearer
MD&As.
Though they will be required on a comparative, quarterly basis in 1999 for calendar year
companies, the disclosures found in the annual report should be much more detailed than what will
appear in the interim financial statements.
The new disclosures are creating a stir already - IBM disclosed its losses in the PC business
under this reporting system, which was information that was previously undisclosed.
Stock compensation disclosures. Under the heading of “information you’ll see only in annual
reports”, there are the disclosures about stock compensation and its pro forma effects on earnings.12
Investors will frequently study the proxy statements and carp about the option packages awarded to
certain management members - but they miss the bigger picture presented in the footnotes. That’s
because the proxy information relates only to the best-awarded individuals in top management,
whereas the footnote information describes the effects on a firm’s profitability of option awards to
all members of the enterprise.
Investors who are curious about the “buried” cost of stock options in corporate earnings
ought to devote some time to the analysis of per share earnings. Look at:
• The gap between the basic earnings per share and the diluted earnings per share reported
in the income statement. The difference reflects the quantity EPS effect of dilutive securities like
stock options - simply by virtue of the fact that these securities exist.
• The gap between the pro forma basic and diluted EPS figures reported in the stock
compensation footnote. The difference between the two reflects the worth of the stock compensation
that’s been earned by employees in the current year.
• The gap between reported basic EPS and the pro forma diluted EPS. The difference
between the two figures represents all the dilution, all of the time - the amount attributable to the
11
For more details about the mechanics of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related
Information,” see Volume 6, No. 11, “ On The Way In 1998, Part Two: New & Improved Segment Reporting.”
12
See Volume 7, No. 11, Option Compensation: Lessons From The S&P 500”. These disclosures are discussed at length
in this report.
-17-
number of dilutive securities issued plus the value (ascribed to the current period) of the securities.
That third gap has been growing due to the phase-in implementation mechanics of SFAS No.
123, which prescribed the accounting for stock-based compensation. Check the table below.
The Option “Phase-In” Issue.
1995
1996
1997
1998
1999
Annual stock compensation expense
Award
$15,000
15,000
15,000
15,000
15,000
1995
$5,000
–
–
–
–
$5,000
1996
$5,000
5,000
–
–
–
$10,000
1997
$5,000
5,000
5,000
–
–
$15,000
1998
–
5,000
5,000
5,000
–
$15,000
1999
–
–
5,000
5,000
5,000
$15,000
The transition issue surrounding stock compensation expense in the pro forma EPS figures. It takes
three years for the full effect of stock compensation programs since 1995 to hit earnings. Because the
expense provisions are grandfathered into the figures, and because each of the awards affect more than one
year, it takes years for the full effect of stock compensation programs to be visible in earnings. And it ignores
the value of options outstanding before 1995 which may still exist.
The following table shows the third gap for a few companies. Note that in some cases, the
gap is bigger than the basic earnings per share - and notice that the gap is growing at a substantial
clip for all of the firms.
“Third Gap” Growth - Difference Between Basic & Pro Forma Diluted EPS.
3COM CORP
Basic EPS
P/F Diluted EPS
Gap
1998
$ 0.09
(0.18)
$ 0.27
1997
$ 1.51
1.26
$ 0.25
1996
$ 1.10
0.96
$ 0.14
% of Basic EPS
300%
17%
13%
8%
79%
Basic EPS
P/F Diluted EPS
Gap
$ 0.44
(0.05)
$ 0.49
$ (2.61)
(2.83)
$ 0.22
$ 0.18
0.07
$ 0.11
% of Basic EPS
111%
NM
61%
Gap Growth
123%
100%
$ 1.16
0.51
$ 0.65
$ 2.74
2.43
$ 0.31
$ (0.80)
(0.85)
$ 0.05
NM
Annual Gap Growth
AMERICA ONLINE
PERKIN ELMER CORP
Basic EPS
P/F Diluted EPS
Gap
% of Basic EPS
56%
11%
110%
520%
Basic EPS
P/F Diluted EPS
Gap
$ 0.74
0.58
$ 0.16
$ 0.42
0.34
$ 0.08
$ 0.19
0.17
$ 0.02
% of Basic EPS
22%
19%
11%
100%
300%
Gap Growth
LUCENT TECHNOLOGIES INC
Gap Growth
-18-
No judgment is made here about the worth of stock option programs in these or any
other companies - but bear in mind that while such programs can provide incentive to
managements to increase stock price, they can subvert shareholder interests as well. When
managements become obsessive-compulsive about the price of the firm’s stock, simply because
they are concerned about their own options being in the money, or because they need a bigger
empire via stock-financed acquisitions, you’ve got a climate in which earnings manipulation
will thrive. Objective financial reporting to shareholders then becomes endangered. So pay
attention to the stock-compensation disclosures, if only for a potential “climate-check” within
the firm.
Year 2000 accounting issues. Sure, you’re familiar with the Year 2000 MD&A disclosures
you’ve been seeing in the last couple years. You’re probably less familiar with the impacts that the
great millennium monster might have in the financial statements, aside from shutting down entire
firms. Nearby, a table summarizing some of its potential effects on areas of concern like revenue
recognition, loan loss allowances and other areas of major consequence to analysts and investors.
Year 2000 Bug Summary: More Than Just Costs To Adapt.
Costs of modifying software
Well established by now: needs or plans to rewrite code are not permitted to be
estimated in up-front mammoth liabilities, but should be expensed as incurred.
May cause pressure on SG&A budgets.
Costs of failure to be Y2K
compliant
“What, me worry?” If a firm takes no action to get in gear for Y2K, and is then
looking at losses due to its failure, it can’t accrue them up-front; it can only
recognize them as incurred. Otherwise, the potential would exist for creating
huge, vaguely defined reserves - which would need to be reversed later.
Disclosure of Y2K-related
commitments
- Best place to look: MD&A. A firm should be disclosing its obligations to pay on
contracts or commitments to vendors for the remediation of Y2K problems.
- Also to be considered for disclosure: any acceleration of debt payments due to
covenant defaults tied to Y2K readiness.
Revenue & loss recognition
An issue with software vendors. Suppose a vendor licenses a product that is not
Y2K compliant and commits to deliver a satisfactory version in the future. There
would need to be an allocation of the fee to the two components of the license
contract; 100% of the revenue could not be properly recognized at the time of the
license.
An issue with hardware and software vendors. If customers have the right to
return goods, and such goods (hardware or software) might be defective due to
Y2K non-readiness, are allowances for sales returns adequate? Is it proper to
even recognize sales immediately - or should revenues be deferred?
Allowance for loan losses
Loan quality may be affected by a borrower’s Y2K non-readiness. Potential loan
losses based on future events should not be provided; only provisions for losses
incurred at balance sheet date.
Losses from breach of contract
If Y2K non-compliance results in breach of contract - say, due to an implied or
expressed warranty of Y2K-readiness in a product sold - then possible losses due
to that breach must be disclosed in the notes. If an amount can be determined
that will probably be paid, then it must be recorded as a liability.
Impairment of assets
If not Y2K-compliant, there could be capitalized software costs related to internal
projects or products sold that might not be recoverable - and therefore, would
require a writedown. The same could be said for long-lived assets - most likely,
machinery - that contain devices that need to be Y2K compliant. Such assets
might not be possible to repair economically, and might need to be scrapped and
replaced. A writedown would be in order.
Source: “Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and
Municipal Securities Issuers,” Securities & Exchange Commission.
-19******************************
As you roam through the financial statements, you won’t uncover one number or one
sentence that says “the truth is here.” Any truth you find is likely to be determined in your own view.
Bear in mind that there are relationships that exist in the reported financial statements, and while
we’ve covered many of them, don’t forget other relationships:
• Cash flow from operations to earnings. Be sure to follow earnings into the cash flow from
operating activities in the cash flow statement. Look for the conversion of short-term assets like
receivables and inventory into cash. Are problems developing? Is the firm becoming more efficient
in converting them to cash?
• Cash flow to capital spending. Compare cash flow from operations to capital spending
plans delineated in the MD&A. Does cash flow cover it? Will debt or equity financing be needed?
Can the balance sheet support more debt? Is dilutive equity financing a possibility? Will dividends
be in jeopardy?
• Share buybacks. Look at the share buyback authorizations discussed in the MD&A and
consider them to be a potential resource requirement like capital spending. Go through the same
questions above.
You get the idea. Financial statements can get you on the path to understanding a firm’s
justification for existence, if said existence is to provide a return to shareholders. Set your premises,
read the annual reports, and then check your premises. Don’t be afraid to apply analytical elbow
grease to things like restructuring reserves and pension disclosures - that’s where the biggest
surprises are likely to be found. You’ll be surprised how much you didn’t know about a firm, once
you know your way around the financials.
-20-
Appendix: Sample SEC Letters/BankAmerica Footnote.
The letter sent to 150 companies that announced charges (p. 20) and the letter sent to bank
holding companies (p. 23) merit reading by analysts - if only to assess for oneself the message
contained in those letters. Read them and I think you’ll agree - these letters are much less a notice
of regulatory intervention than they are a “friendly reminder” that generally accepted accounting
principles require certain disclosures in those areas. Choosing not to comply with the same standards
that have existed for years may - and should - invite SEC intervention.
The relevant disclosures and standards in these letters are vital to analysts in their assessment
of “soft spots.” The intent of analysts is not to audit financial statements - but to make informed
judgments. Vigorous disclosures help market participants to color their judgments about the worth
of companies and their earnings.
The BankAmerica “Merger-related Activity” footnote was heavily relied upon for analysis
in this report, and follows on page 24 should you care to refer to it.
-21SAMPLE LETTER SENT TO COMPANIES REPORTING CHARGES
January x, 1999
Name
Chief Financial Officer
XYZ Corporation
Address
Dear Chief Financial Officer:
We understand that you will report significant charges in 1998 for asset write-downs,
restructuring activities, or acquired in-process research and development. In connection
with our focus on transparent financial reporting and potential earnings management issues,
we may select your 1998 annual report for review. For your consideration as you prepare that
filing, this letter identifies commonly requested MD&A and financial statements disclosures
that may be applicable in whole or part to the kinds of charges you incurred.
Asset Impairments
Disclose:
*
Description of the assets and the segments affected
*
Reasons write-downs became necessary
*
Amount of loss for each material asset category
- Property, plant & equipment
- Intangible assets
*
Method of determining fair value
*
Classification of loss in the statements of operations
If the assets are held for disposal, disclose:
*
Carrying amount of assets held for disposal and subsequent changes in carrying
amount
*
Expected disposal dates
*
Results of operations for the assets to the extent that
in the period and can be identified
*
those results are included
Effect of suspending depreciation
Costs to Exit Activities
Disclose:
*
Activities to be discontinued and the major actions to be taken, including
disposition methods and anticipated completion dates
*
Types and amounts of exit costs recognized as liabilities
statement classification.
and their income
*
Types and amounts of exit costs paid and charged against the liability
*
Adjustments to the liability, including changes in estimates
*
Revenues and net operating income for those exited activities that have separately
identifiable operations.
-22Employee Terminations
Disclose:
*
Amount and classification of the costs
*
Number of people and employee groups to be terminated
*
Actual amounts paid and actual employees terminated
*
Any adjustments of the liability
Exit or Employee Termination Costs of an Acquired Business
Disclose:
*
Whether you began to formulate an exit plan as of the
acquisition date
*
Types and amounts of exit liabilities assumed and included in the acquisition cost
allocation
*
Unresolved issues and the types of additional liabilities
adjustment of the purchase cost allocation.
that may result in an
Common types of restructuring costs that should be separately disclosed
Identify major types and amounts of costs included in restructuring charges and liabilities
in the financial statements. More complete break-out of the costs in MD&A often is necessary
for an understanding of the plan's cash requirements and how future periods are relieved of
costs expected to be incurred.
*
*
*
*
*
*
*
*
*
Termination payments to employees
Other employee related costs
Inventory write-downs
Purchase commitment losses
Other contract losses
Warranties and product returns
Leasehold termination payments
Other facility exit costs
Litigation and environmental clean-up costs
Acquired In-Process Research & Development
Disclose:
*
Specific nature and fair value of each significant in-process research and
development project acquired
*
Completeness, complexity and uniqueness of the projects at the acquisition date
*
Nature, timing and estimated costs of the efforts necessary to complete the
projects, and the anticipated completion dates
*
Risks and uncertainties associated with completing
consequences if it is not completed timely
*
Appraisal method used to value projects
*
Significant appraisal assumptions, such as -- period in which material net cash inflows from
significant projects are expected to commence;
-- material anticipated changes from historical
pricing, margins and expense levels; and
-- the risk adjusted discount rate applied to the
development on schedule, and
-23project's cash flows.
*
In periods after a significant write-off, discuss the status of efforts to complete
the projects, and the impact of any delays on your expected investment return, results of
operations and financial condition
Please use these lists only as general guidance. Refer to EITF 94-3, EITF 95-3, SFAS
121, APB 16, FIN 4 and Item 303 of Regulation S-K for additional information. Also, remember
to include a schedule of valuation and qualifying accounts meeting the requirements of Rule
12-09 of Regulation S-X. Additional matters that may be relevant are cited by Lynn Turner,
Chief Accountant of the SEC, in his letter to the American Institute of Certified Public
Accountants dated October 9, 1998, which is available at www.sec.gov/rules/othrindx.htm.
Sincerely,
Robert A. Bayless
Chief Accountant
-24SAMPLE LETTER SENT TO SOME BANK HOLDING COMPANIES
January x, 1999
Chief Financial Officer
Bank Name
Address
Dear Chief Financial Officer:
In connection with our focus on transparent financial reporting and potential earnings
management issues, we may select your 1998 annual report for review. For your consideration
as you prepare that filing, this letter identifies commonly requested disclosures that may
be applicable in whole or part to your explanation of the provision for loan losses and the
loan loss allowance.
Description of Business
Describe your systematic analysis and procedural discipline, required by FRR-28, for
determining the amount of your loan loss allowance. Explain:
*
how you determine each element of the allowance,
*
which loans are evaluated individually and which loans are evaluated as a group,
* how you determine both the allocated and unallocated portions of the allowance for loan
losses,
* how you determine the loss factors you apply to your graded loans to develop a general
allowance, and
* what self-correcting mechanism you use to reduce differences between estimated and actual
observed losses.
Management's Discussion and Analysis:
Explain fully the reasons for changes in each of the elements and components of the loan loss
allowance, even if the total provision for loan losses did not change materially from period
to period, so that a reader can understand how changes in risks in the portfolio during each
period relate to the loan loss allowance established at
period-end. Quantify and explain:
* how changes in loan concentrations, quality, and terms that occurred during the period are
reflected in the allowance,
*
how changes in estimation methods and assumptions affected the allowance,
* why reallocations of the allowance among different parts of the portfolio or different
elements of the allowance occurred,
*
how actual changes and expected trends in nonperforming loans affected the allowance,
* how actual changes and expected trends in risks associated with cross border outstandings
affected the allowance, and
*
how the level of your allowance compares with historical net loss experience.
Financial Statements
Include a complete description of your accounting policy for the allowance for credit
losses which specifically describes how you determine the amount of each element of the
allowance.
Sincerely,
Robert A. Bayless
Chief Accountant
-25-
Footnote Excerpt From BankAmerica 1998 10-K
Note Two - Merger-Related Activity
On September 30, 1998, the Corporation completed the Merger with BankAmerica, a multi-bank holding
company headquartered in San Francisco, California. BankAmerica provided banking and various other financial
services throughout the U.S. and in selected international markets to consumers and business customers,
including corporations, governments and other institutions. As a result of the Merger, each outstanding share
of BankAmerica common stock was converted into 1.1316 shares of the Corporation's common stock, resulting
in the net issuance of approximately 779 million shares of the Corporation's common stock to the former
BankAmerica shareholders. Each share of NationsBank common stock continued as one share in the Corporation's
common stock. In addition, approximately 88 million options to purchase the Corporation's common stock were
issued to convert stock options granted to certain BankAmerica employees. This transaction was accounted for
as a pooling of interests. Under this method of accounting, the recorded assets, liabilities, shareholders'
equity, income and expenses of NationsBank and BankAmerica have been combined and reflected at their
historical amounts. NationsBank's total assets, total deposits and total shareholders' equity on the date
of the Merger were approximately $331.9 billion, $166.8 billion and $27.7 billion, respectively.
BankAmerica's total assets, total deposits and total shareholders' equity on the date of the Merger amounted
to approximately $263.4 billion, $179.0 billion and $19.6 billion, respectively.
In compliance with certain requirements of the Federal Reserve Board(FRB), the Department of Justice
and certain New Mexico authorities in connection with the Merger, the Corporation entered into an agreement
to divest certain branches of Bank of America National Trust and Savings Association(Bank of America NT&SA)
with loans and deposits aggregating approximately $167million and $500 million, respectively, in various
markets in New Mexico. These transactions were completed in the fourth quarter of 1998.
In connection with the Merger, the Corporation recorded $1,325 million of pre-tax, merger-related
charges in 1998. Approximately $600 million ($441million after-tax) and $725 million ($519 million after-tax)
were recorded in the fourth and third quarters of 1998, respectively. The total pre-tax charge for 1998
consisted of approximately $740 million primarily in severance and change in control and other
employee-related items, $150 million in conversion and related costs including occupancy and equipment
expenses and customer communication, $300 million in exit and related costs and $135 million in other merger
costs (including legal, investment banking and filing fees). The Corporation anticipates recording an
additional pre-tax merger-related charge of approximately $400 million ($252 million after-tax) in 1999.
On January 9, 1998, the Corporation completed its merger with Barnett, a multi-bank holding company
headquartered in Jacksonville, Florida (the Barnett merger). Barnett's total assets, total deposits and total
shareholders' equity on the date of the merger were approximately $46.0 billion, $35.4 billion and $3.4
billion, respectively. As a result of the Barnett merger, each outstanding share of Barnett common stock was
converted into 1.1875 shares of the Corporation's common stock, resulting in the net issuance of
approximately 233million common shares to the former Barnett shareholders. In addition, approximately 11
million options to purchase the Corporation's common stock were issued to convert stock options granted to
certain Barnett employees. This transaction was also accounted for as a pooling of interests.
In connection with the Barnett merger, the Corporation incurred a pre-tax merger-related
charge during the first quarter of 1998 of approximately $900 million ($642 million after-tax), which
consisted of approximately $375 million primarily in severance and change in control payments, $300 million
of conversion and related costs and occupancy and equipment expenses (primarily lease exit costs and the
elimination of duplicate facilities and other capitalized assets), $125 million in exit costs related to
contract terminations and $100 million in other merger costs (including legal, investment banking and filing
fees). In the second quarter of 1998, the Corporation recognized a $430 million gain resulting from the
regulatory required divestitures of certain Barnett branches.
The Corporation recorded a pre-tax charge of $280 million in 1996 as a result of decisions to close
and/or sell certain of its business activities. The charge covered approximately $196 million for severance
payments, $72 million for occupancy expense, primarily reflecting the planned closure of 120 branches, and
$12 million for other costs.
On October 1, 1997, the Corporation completed the acquisition of Montgomery Securities, Inc., an
investment banking and institutional brokerage firm. The purchase price consisted of $840 million in cash
and approximately 5.3 million unregistered shares of the Corporation's common stock for an aggregate amount
of approximately $1.1 billion. The Corporation accounted for this acquisition as a purchase.
On October 1, 1997, the Corporation also acquired Robertson, Stephens & Company Group, L.L.C. (Robertson
Stephens), an investment banking and investment management firm. The acquisition was accounted for by the
purchase method of accounting. The Corporation sold the investment banking operations of Robertson Stephens
on August 31, 1998 and sold the investment management operations in 1999.
As previously disclosed, NationsBank, BankAmerica and Barnett merged in separate transactions accounted
for as pooling of interests. The following table summarizes the impact of the BankAmerica and Barnett mergers
on the Corporation's net interest income, non-interest income and net income for periods prior to the
respective mergers.
Net Interest
Non-interest
Net
(Dollars in Millions)
Income
Income
Income
----------------------- -------------- ------------- --------1997
NationsBank ...........
$ 7,898
$ 5,002
$3,077
BankAmerica ...........
8,669
6,012
3,210
Barnett ...............
1,840
971
255
-----------------Total ................
$18,407
$11,985
$6,542
=======
=======
======
-261996
NationsBank ...........
BankAmerica ...........
Barnett ...............
Total ................
$ 6,329
8,587
1,869
------$16,785
=======
$ 3,646
5,351
791
------$ 9,788
=======
$2,375
2,874
564
-----$5,813
======
The amounts presented above represent results of operations of the previously separate companies and
do not reflect reclassifications of certain revenue and expense items which were made to conform to the
reporting policies of the Corporation.
On January 7, 1997, the Corporation completed the acquisition of Boatmen's Bancshares, Inc. (Boatmen's),
headquartered in St. Louis, Missouri, resulting in the issuance of approximately 195 million shares of the
Corporation's common stock valued at $9.4 billion on the date of the acquisition and aggregate cash payments
of $371 million to Boatmen's shareholders. On the date of the acquisition, Boatmen's total assets and total
deposits were approximately $41.2 billion and $32.0 billion, respectively. The Corporation accounted for this
acquisition as a purchase.
In 1996, the Corporation completed the initial public offering (IPO) of 16.1 million shares of Class
A Common Stock of BA Merchant Services, Inc.(BAMS) (ticker symbol "BPI" on the New York Stock Exchange), a
subsidiary of the Corporation. On December 22, 1998, the Corporation and BAMS announced the signing of a
definitive merger agreement on which the Corporation agreed to buy BAMS outstanding shares of Class A common
stock. At closing, each outstanding share of BAMS common stock other than the shares owned by the Corporation
will be converted into the right to receive a cash payment equal to $20.50 per share without interest, or
approximately $330 million. BAMS will then become a wholly owned subsidiary of Bank of America NT&SA. The
transaction is expected to be completed during the second quarter of 1999.
The following tables summarize the activity in the merger-related reserves recorded in connection with
the BankAmerica and Barnett mergers during 1998:
BankAmerica Merger
Merger-Related Reserves
Non-Cash
Balance on
Amount
Cash Payments
Reductions
Balance on
January 1,
Included in
Applied to
Applied to
December 31,
(Dollars in Millions)
1998
Expense
Reserve
Reserve
1998
---------------------------------------- ------------ ------------- --------------- ------------ ------------Severance, change in control
and other employee-related costs .....
$-$ 740
$(155)
$ (98)
$487
Conversion and related costs ...........
-150
(3)
(4)
143
Exit and related costs .................
-300
(62)
(44)
194
Other merger costs .....................
-135
(117)
-18
----------------------$-$1,325
$(337)
$(146)
$842
===
======
=======
=======
====
Barnett Merger
Merger-Related Reserves
Non-Cash
Balance on
Amount
Cash Payments
Reductions
Balance on
January 1,
Included in
Applied to
Applied to
December 31,
(Dollars in Millions)
1998
Expense
Reserve
Reserve
1998
---------------------------------------- ------------ ------------- --------------- ------------ ------------Severance, change in control
and other employee-related costs .....
$-$375
$ (318)
$ (55)
$ 2
Conversion and related costs ...........
-300
(8)
(192)
100
Exit and related costs .................
-125
(101)
-24
Other merger costs .....................
-100
(99)
-1
------------------$-$900
$ (526)
$ (247)
$127
===
====
======
======
====
Total severance, change in control and other employee-related costs for both mergers included amounts
related to job eliminations, primarily in areas of overlapping operations and duplicate functions. Through
December 31, 1998,approximately 1,700 employees have entered the severance process as result of the Barnett
merger. For the BankAmerica merger, 5,000 to 8,000 positions after attrition, are estimated to be eliminated
and through December 31, 1998,approximately 1,800 associates have entered the severance process.
The only significant portion of the Barnett merger-related charge remaining at December 31, 1998 relates
to conversion and related costs, primarily abandoned owned and leased facilities and branch closure costs.
Exit costs primarily relate to contract termination payments, business realignment and other related
costs. Remaining exit and related costs balances included in the Barnett merger reserve on December 31, 1998
are expected to be used during the first half of 1999.
Primarily all reserves established in 1996 associated with the Bank South acquisition and restructuring
activities were fully utilized as of December 31, 1998. There were no additional provisions during 1998.
Companies in this report (continued):
DuPont
Eastman Kodak
General Electric
General Motors
Goodyear
International Business Machines
Lucent
Minnesota Mining & Mfg.
Morgan, J.P.
Perkin Elmer
Philip Morris
Rite Aid
Sears Roebuck
United Technologies
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