Xlri Accounting SEMINAR 2011: PBS Paribas

XLRI ACCOUNTING
SEMINAR 2011
PBS Paribas
Copyright © 2010 Deen Kemsley
Course Title
Financial Accounting Seminar:

Practical Equity and
Credit Analysis

Syllabus: Page 1
Accounting Seminar
February, 2011
Course Description and Syllabus
Professor: Deen Kemsley
E-mail: dkemsley@tulane.edu

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Syllabus: Page 2
Seminar Description
This seminar covers the role of accounting in the context of capital markets and the value of
the firm. Financial Accounting Standards Board (FASB) and the Securities and Exchange
Commission (SEC) pronouncements are applied to analyze firms, and current issues in the
accounting and financial analyst profession are evaluated. This is a practical, hands-on
course for future accountants and financial analysts.
Seminar Approach and Goals

This is a hands-on seminar taught as if you were a working analyst on Wall Street. We will
conduct several cases in class, so class participation is central to the course. See the
course schedule for specific topics we will cover. After taking this course, students will
have the tools to analyze firms in depth, leading to better global management and
investment decisions.
Student Learning Objectives

Key objectives are (1) to learn how to more thoroughly read and understand financial
statements, (2) to identify potential manipulation of the financial statements through the
five accounting ploys, (3) to understand the capital structure decisions of firms, (4) to
practice valuing firms using the financial statements and other available information, and
(5) to create accounting models that you can use throughout your career to analyze firms.

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Course Outline
Lecture 1 (2/25): New Wave Ice Tea: Accounting
Lecture 2 (2/25): Primary Financial Ratios
Lecture 3 (2/25): New Wave Ice Tea Case: Ratios
Lecture 4 (2/26): Valuation Methods and Analysis
Lecture 5 (2/26): New Wave Ice Tea Case: Valuation
Lecture 6 (2/26): Credit Analysis
Lecture 7 (2/27): Earnings Quality
Lecture 8 (2/27): U.S. Budget Accounting
Lecture 9 (2/27): Group Project

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Lecture 1
New Wave Ice Tea:

Accounting

The Accounting Equation
A = L + OE

Sample Accounting Box
A = L + OE
Capital Retained
Cash A/R A/P LTD Stock Earnings

Accounting Box: Requirements
To record transactions, note:
• Each row represents one transaction

• Positive numbers represent additions
• Negative numbers represent subtractions
• Each row must balance out

Accounting Box: Features
Key features of the

accounting box include: Cash A/R A/P LTD CS RE
• The top row represents

the beginning balance
sheet
• The bottom row
represents the ending
balance sheet
• The left-hand column
provides all input for the
cash flow statement
• The right-hand column
provides all input for the
income statement

Accounting Box: Tips
When using the accounting box note:
• Each and every entry in the cash column must enter the
cash flow statement. No other information should enter
the statement.
• Each and every entry in the retained earnings column
must enter the income statement. No other information
should enter the statement.
– Exception: Dividends affect retained earnings but not earnings
• Apply the tax rate to pretax earnings (not to total
revenue)

Case
New Wave Ice Tea

Case Purpose and Overview
The purpose of this case is to refresh you regarding
the fundamental principles of accounting. The
case describes the first three years of a start-up
company. Using the templates I provide, you get
hands-on practice of accounting principles as
follows:
• In Class: Record transactions for the years 2011 - 2013

(include all necessary year-end adjusting entries and the
year-end closing entry). Prepare the Income Statement,
Balance Sheet, and direct Cash Flow Statement.

Case Setting
After your first day of training, you and four of your colleagues go out for
cold refreshments at a cafe. A friend at the table describes this great
ice-tea, Napa, which is produced in her hometown. You and your
friends believe there is a bright future in selling this excellent ice-tea in
area. Napa is not distributed here presently.
To take advantage of this business opportunity, you start a company

named New Wave Ice-Tea that will distribute Napa’s ice-tea. Napa
agrees to produce ice-tea for your company and sell it to you for $0.75
per can. Napa signs an agreement giving New Wave Ice-Tea the
exclusive right to sell their ice-tea in this area. You are first going to
sell the cans to colleagues with the hope of later selling it to a broader
market. You and your partners get the firm to agree to let you have
an ice-tea stand in front of the building. You have been appointed the
CFO and therefore are responsible to keep the books of this new
enterprise.

Income Taxes
The appropriate tax rate for New Wave Ice Tea is
40%.
New Wave Ice-Tea must accrue taxes for any profits earned
each year. Assume the taxes are paid in the following
year.

Initial Start-up: 2011
• Dec 31, 2011: Issued 25,000 shares for $25,000 ($5,000 from each of you).
• Dec 31, 2011: Leased the space in front of business school for $3000 per year.
Paid three years of rent in advance ($9,000).
• Dec 31, 2011: Purchased a juice stand for $10,000 in cash. The stand has a 10-
year life with $0 salvage value. Depreciation will be $1,000 each year.
• Dec 31, 2011: The 5 owners of New Wave Ice-Tea agree to earn a small salary of
$1000 each for the entire year. You do not need other employees at this point in
time.
• Dec 31, 2011: Purchased 6,000 ice-tea cans from Napa at a price of $0.75 each,
for a total amount of $4,500 that was paid for in cash. Napa was able to deliver
them the same day.

2012 Events
• Jan 1, 2012: Spent $1,000 cash for advertising.
• Mar 15, 2012: Purchased 14,000 more ice-tea cans for $10,500 on
account. The cans were received on this date, but have not yet been
paid for.
• April 30, 2012: Paid $8,000 to Napa for the purchase. You still owe
them $2,500.
• Summary Sales revenue for the year was $36,000. Most of it was
received as cash, but for some of your best customers you have set up
accounts receivable. During the year, $7,000 of the $36,000 was
accounts receivable.
• Summary: During the year, customers paid $5,000 of the accounts
receivable, so they still owed $2,000 at the end of the year.
• Summary: Total salaries earned during the year were $5,000. Cash
expended on salaries was $4,000.
• Dec 31, 2012: Count of ice-tea cans inventory at the end of the year
showed that 2000 cans remained that were valued at $0.75 each for a
total ending inventory value of $1,500.
• Dec 31, 2012: Ordered 60,000 more cans from Napa to be delivered
next year. New Wave Ice-Tea does not advance any money to Napa for
this order at this time.
2012 Adjusting Entries
Be sure to record year-end adjusting entries for the following
items:
• Inventory used
• Depreciation expense on the stand ($10,000 / 10 year =
$1,000)
• Rental expense for leasing the space in front of school
• Taxes accrued for pretax income earned this year (at
40%). These taxes will not be paid until next year.

2013
Sales have dramatically increased. You and your partners
have decided to expand and sell the ice-tea on the
Internet. The cans will be delivered to your client’s home
or office in less than five minutes from they time they
place the order.

2013 Events: Page 1
• Jan 1, 2013: Paid tax liability for the prior year.
• Jan 1, 2013: Paid $5,000 cash to have a web site developed. Assume
this cost is expensed immediately.
• Jan 1, 2013: Purchased a computer for $1,800 that will be used as
the server for the web site. The computer has a 3-year useful life.
Depreciation will be $600 each year.
• Jan 1, 2013: Hired a high-school student to deliver the ice-tea cans
on his bicycle and agreed to pay him $15,000 for the year. You will
pay him at the end of the year along with the other employees.
• Jan 1, 2013: Issued $50,000 of 8% 10-year bonds. The bonds pay
8% interest annually on January 1st of the following year.
• Jan 15, 2013: Received the 60,000 cans (cost =$0.75 per bottle).
New Wave Ice-Tea does not make a payment at this time.
• Jan 30, 2013: Paid Napa $40,000 as a partial payment for the 60,000
cans ordered at the end of 2009.
2013 Events: Page 2
• Sales revenue was $112,000, $78,000 of which was in cash and the
remainder was on account.
• Summary: Total accounts receivable collected during the year
amounted to $18,000.
• Summary: Salaries earned for the year were $20,000 (includes high-
school student’s salary of $15,000 and the owner’s salary of
$5,000). By the end of the year, all salaries earned during this year,
as well as salaries owed at the end of the last year, had all been
paid (e.g., salaries payable at the end of the year is zero).
• Dec 31, 2013: Inventory count at the end of the year indicated there
was 6000 cans on hand valued at $0.75 each for a total ending
inventory value of $4,500.
• Dec 31, 2013: Paid interest on the $50,000 loan.

2013 Adjusting Entries
Be sure to record year-end adjusting entries for the following
items:
• Inventory used
• Depreciation expense for the stand
• Depreciation expense for the computer
• Rental expense for leasing the space in front of the firm
• Taxes accrued for income earned this year (at 40%).
These taxes will not be paid until next year

2014 (Bonus Year)
Work backwards to solve the 2014 box.
• Use your 2013 ending balances to complete the top row

of the 2014 box.
• Use the 2014 ending balance sheet from the spreadsheet
to complete the bottom row of the 2014 box.
• Use the 2014 income statement and cash flow statement
from the spreadsheet to complete the box.
Enjoy the Challenge 

New Wave Ice Tea
2011 Template: Box
Inven- Prepaid Taxes Salary Capital
Date Description Cash A/R tory Expense PPE A/P Payable Payable LTD Stock RE
Beg
Bal
End
Bal

New Wave Ice Tea
2011 Template: Balance Sheet
Assets
Current Assets:
Cash
Receivables
Inventories
Prepaid Expenses
Total Current Assets
Long-Term Assets
Land, Building and Equipment
Less: Accumulated Depreciation
Other Assets
Total LT Assets
Total Assets
Liabilities and Equity

Current Liabilities:
Accounts Payable
Accrued Taxes
Total Current Liabilities
Long-term Debt
Total Liabilities
Stockholders' Equity:
Capital Stock
Retained Earnings
Total Stockholders' Equity
Total Liabilities and Equity

New Wave Ice Tea
2011 Template: Cash Flow
Cash Flow from Operating Activities
Cash Payments to Suppliers

Leased Space
Cash Flow from Investing Activities
Purchased Stand
Cash Flow from Financing Activities
Issue Stock
Total Cash Flow
Cash at the beginning of the year

Cash at the end of the year
Increase/ (Decrease) in cash

New Wave Ice Tea
2012 Template: Box
Beg
Bal
End
Bal

New Wave Ice Tea
Assets
Current Assets:
Cash
Receivables
Inventories
Prepaid Expenses
Land, Building and Equipment (PPE)

Less: Accumulated Depreciation
Total Assets

Accounts Payable
Accrued Taxes
Salaries Payable
Long-term Debt
Total Liabilities
Capital Stock
Retained Earnings

New Wave Ice Tea
2012 Template: Income Stmt
Sales
Costs and Expenses:
Cost of Sales
Selling, general and administrative
Depreciation
Interest
Total Costs and Expenses
Earnings before Taxes
Income Taxes
Net Earnings

New Wave Ice Tea
Payments received from customers

Cash Payments of Salaries
Total Cash Flow


New Wave Ice Tea
2013 Template: Box
Beg
Bal
End
Bal
New Wave Ice Tea
Assets
Current Assets:
Cash
Receivables
Inventories
Prepaid Expenses
Land, Building and Equipment
Less Accumulated Depreciation
Total Assets

Accounts Payable
Accrued Taxes
Interest Payable
Long-term Debt
Total Liabilities
Capital Stock
Retained Earnings

New Wave Ice Tea
2013 Template: Income Stmt
Sales
Costs and Expenses:
Cost of Sales
Selling, general and administrative
Depreciation
Interest
Total Costs and Expenses
Earnings before Taxes
Income Taxes (@40%)
Net Earnings

New Wave Ice Tea
Payments received from customers

Cash Payments of Salaries
Payment of Taxes
Purchased Computer
Issue Bonds
Total Cash Flow


Case Wrap Up
What are your key takeaways from this

case?

Lecture 2
Primary Financial Ratios

Lecture Outline
• Primary Financial Ratios
• Exercises

ROE: Primary Performance
Metric
Net Income
Shareholder’s Equity
The Return on Equity represents the return the company

earns on the shareholders’ investment in the firm. This
metric accounts for both operating and financing
performance.

Operating vs. Financing
Activities
One of the first steps in sound equity or credit research
analysis is to separate a company’s activities into two
separate categories: Operating and Financing.
Why Separate the Two Sets of Activities?

– The projected growth for operating activities is different
from the projected growth for financing activities.
– Hence, the valuation multiples for operating activities are
different from the multiples for financing activities.

Primary ROE Components
ROE
ROE
Return on
RNOA
RNOA + Debt on
Return
Debt
= Operating Profit after Tax = Debt/Equity Ratio x Financing Spread
Net Operating Assets
• Focuses on operating aspects • Focuses on the financing

of the company – measures aspects of the company
performance regardless of
financing method
• Viewpoint of the business
management

Primary RNOA Components
RNOA
RNOA
Operating
Operating Operating
OperatingAsset
Asset
X
Profit
ProfitMargin
Margin Turnover
Turnover
= Operating Profit after Tax = Operating Revenue
Operating Revenue Net Operating Assets
• Focuses on the profit the • Focuses on the efficiency

company generates per dollar with which the company
of sales. generates revenue from its
operating assets
“DuPont Analysis”

Operating Profit after Tax
+ Operating Revenue
- Operating Expenses
• COGS
• Selling, General, and Administrative
• Depreciation
• Etc.
- Taxes
• Taxes as Reported
• Tax Benefit from Debt*
Tax Rate x Interest Expense
*Note: Required adjustment because in the absence of debt, tax expense would
be greater than reported.
Note: If you know the tax rate (t), it’s sometimes simpler to account for
taxes using: Operating Profit After Tax = Operating Income x (1 – t).

NOA
+ Operating Assets
• All assets except financial assets.
– Financial assets include short-term investments, long-term investments in debt,

etc. Excess cash (i.e., cash not required to run operations) also represents a
financial asset. Note: For the sake of simplicity, we will begin by assuming
that all cash is operating capital – we will change that assumption later.
- Operating Liabilities (Don’t forget to subtract these!)

• Accounts Payable
• Salaries Payable
• Taxes Payable
• All other liabilities except financial liabilities (such as long-term
debt, etc.).

Cool Ice Tea
Balance Sheet
Income Statement
Current Assets:
Sales 523,000
Cash 245,000*
Costs and Expenses:
Receivables 150,000
Cost of Goods Sold (201,000)
Inventories 22,000
SG&A (198,000)
Total 417,000
Depreciation (18,000)
PPE 353,600
Interest (21,000)
Other Oper. Assets 47,000
Total Expenses (438,000)
Total Assets 817,600
Earnings Before Taxes 85,000
Income Taxes (34,000)
Accounts Payable 23,900
Net Income 51,000
Accrued Taxes 60,000
Total 83,900
Long-Term Debt 337,100 *For this part of the course, assume all cash is
operating in nature
Total Liabilities 421,000
Stockholder’s Equity:
Capital Stock 198,600
Retained Earnings 198,000
Total Stockholder’s Equity 396,600
Total Liabilities and SE 817,600
Exercise 1
(1) Calculate the following for Cool Ice Tea:
• RNOA
• Operating Profit Margin
• Operating Asset Turnover
(2) Express RNOA in terms of Operating Profit Margin and

Operating Asset Turnover.

Expense Ratios
Operating
Operating
Profit
ProfitMargin
Margin
Gross
GrossProfit
Profit - Operating
Operating
Margin
Margin Expense
ExpenseMargin
Margin
SG&A
SG&A Depreciation
Depreciation Taxes
Taxes Other
Other
Exp. + + +
Exp.Margin
Margin Exp.
Exp.Margin
Margin Exp.
Exp.Margin
Margin Exp.
Exp.Margin
Margin
Gross Profit Margin = (Operating Revenue – COGS)/Operating Revenue

Operating Expense Margin = (Operating Expenses* + Taxes**)/Operating
Revenue
* Excluding COGS ** Taxes as reported plus the tax benefit from debt
Exercise 2
(1) Decompose Cool Ice Tea’s Operating Profit Margin into its
subcomponents of Gross Profit Margin and Operating
Expense Margin.
(2) Decompose Cool Ice Tea’s Operating Expense Margin into

it various subcomponents.

Turnover
Operating
Operating
Asset
AssetTurnover
Turnover
Operating
Operating ÷ NOA
NOA
Revenue
Revenue
Inventory + Accounts
Accounts + Fixed
Fixed - Accounts
Accounts +/- Other
Inventory Receivable Assets Payable Other
Receivable Assets Payable

Inventory Turnover
Inventory Turnover = COGS/Inventory
Days of Inventory on Hand = Inventory/(COGS/365)

Inventory Turnover ↑
Operating Asset Turnover ↑
RNOA ↑
ROE ↑

Accounts Receivable Turnover
Accounts Receivable Turnover = Operating Revenue / Accounts

Receivable
Days of Accounts Receivable = Accounts Receivable/(Sales/365)
Accounts Receivable Turnover ↑

RNOA ↑
ROE ↑

Fixed Asset Turnover
Fixed Asset Turnover = Operating Revenue / Fixed

Assets
Fixed Asset Turnover ↑

RNOA↑
ROE ↑

Days of Accounts Payable
Days of Accounts Payable = Accounts Payable /

(COGS/365)
Days of Accounts Payable ↑

RNOA ↑
ROE ↑

Exercise 3
(1) Calculate the following metrics for Cool Ice Tea:
• Inventory Turnover
• Days of Inventory
• Accounts Receivable Turnover
• Days of Accounts Receivable
• Fixed Asset Turnover
• Days of Accounts Payable
(2) Holding all else constant, calculate the Accounts
Receivable Turnover if Cool Ice Tea reduced its
receivables from 150,000 to 75,000.
(3) Given the new Accounts Receivable Turnover you
calculated, what is the new RNOA?
Primary ROE Components
ROE
ROE
+Return on
RNOA Return on
RNOA Debt
Debt
= Operating Profit after Tax = Debt/Equity Ratio x Financing Spread
Net Operating Assets
• Focuses on operating aspects • Focuses on the financing

of the company – measures aspects of the company
performance regardless of
financing method
• Viewpoint of the business
management

Return on Debt
Return
Returnon
on
Debt
Debt
Debt/Equity
Debt
Debt/Equity
Debt Financing
Financing
Ratio X Spread
Ratio Spread
Cost
Costof
of
Debt
Debt ÷ Equity
Equity RNOA
RNOA - Debt
Debt
Interest
Interest
Expense
Expense ÷ Debt
Debt
(1-t)
(1-t)

Exercise 4
(1) Calculate the following metrics for Cool Ice Tea:
• Debt/Equity Ratio
• Cost of Debt
• Financing Spread
• Return on Debt
• ROE (Net Income/Shareholders’ Equity)
Note: Recall that RNOA = 8.7%
(2) Express Cool Ice Tea’s ROE in terms of RNOA and the
Return on Debt

Lecture 3
New Wave Ice Tea Case:

Ratios

New Wave Ice Tea Case
Requirements
To conduct this case:
• Open the New Wave Ice Tea ROE Template in Excel
• Using what you have learned in the course, create
appropriate formulas for each box. Note that you may
reference the cells to New Wave’s 2013 income statement
and balance sheet, which are on the spreadsheet
• Calculate ROE directly (net income/shareholders’ equity)
and compare it to the value you obtain from the ROE
template. If there are any discrepancies, correct the
template
• On the Excel sheet, write a short summary interpreting
your findings using concise bullet points

Hints
• Start on the RNOA (left-hand) side of the matrix
because you will need the RNOA calculation to
complete the right side of the matrix
• Start toward the bottom
• Note that you will have to carefully determine which
lines on the income statement and balance sheet
represent operating items
• As you interpret your calculations, consider what the
matrix teaches you that is not as apparent on the
financials themselves
• Check your ultimate answer for ROE to make sure it
equals Net Income/Stockholders’ Equity

New Wave ROE Template
New Wave Ice Tea Template

2010
ROE
RNOA Ret Debt
OPM OpAT D/E F Spread
GPM OpExp% OpRev NOA Tot. Debt Equity RNOA Cst Debt
SG&A % Depr% Tax% Cash A/R Inventory Accr. Tax Prepaids PPE A/P
Int Exp LT Debt
(1-t)

Lecture 4
Valuation Methods
And Analysis

Fundamental Analysis
Investors employ a wide variety of strategies:
• Short-term intraday trading on reactions to news, etc.
• Programmed trading
• Momentum trading
• Long-term investment
Fundamental research analysis primarily relates to long-term

investment

Fundamental Value
The fundamental value of the firm is its true “intrinsic” value
to investors.
If Fundamental Value > Current Price → Buy
If Fundamental Value < Current Price → Sell

Intrinsic Value at its Roots
At its roots, intrinsic value must represent the value of all
future distributions to shareholders.
• Dividends
• Share repurchases
• Liquidating distributions

Valuation Models
There are three primary valuation models:
• Dividend Discount Model (DDM)

• Discounted Cash Flow Model (DCF)
• Residual Income Model (RIM)

Relations among Models
DDM
DDM
DCF
DCF RIM
RIM
All three models are simply different mathematical

representations of the same model!

Implementation of Models
Each model focuses on a unique metric, so implementation of
the models varies:
Earnings → Cash Flows → Dividends

(RIM) (DCF) (DDM)
Nevertheless, if we could implement all three models

perfectly, they would all lead to the same intrinsic value!

Dividend Discount Model
Value = DIV1/(1+r) + DIV2 /(1+r)2 + … + DIVn/(1+r)n
• Fundamental Value equals the present value of all future

dividends
• Dividends include liquidating distributions, share
repurchases, etc.
Pro: The DDM focuses on cash that reaches investors’

pockets
Con: It is difficult to project future dividends because

current dividends often have little to do with future
dividends.
Discounted Cash Flow Model
Value = FCF1/(1+r) + FCF2 /(1+r)2 + … + FCFn/(1+r)n
• Fundamental Value equals the present value of all future free cash
flows
• Often, analysts measure FCFs for operations as a whole, although it
is easy to adjust this value to focus on equity investors alone. When
focusing on operations, r equals the weighted-average cost of capital
(WACC)
Pro: The DCF Model focuses on the source of dividends → cash

generated by the firm
Cons: In many cases, current cash flow is not highly correlated with
future cash flow, and the correct use of WACC is tricky
DCF Equity – Method One
There are two related ways to adjust DCF Operations to DCF
Equity. The first way is simply to subtract the value of
debt from the value of operations:
DCF Operations Value

- Value of Debt
DCF Equity Value
Note: Treat financial cash as negative debt.

DCF Equity – Method Two
The second way to convert a DCF Operations value into a
DCF Equity value is to discount free cash flows for equity
instead of discounting free cash flows for operations:
FCF Operations
+ Net Financial Income
- Net Debt Reductions
FCF Equity
Note: Treat financial cash as negative debt. Therefore,

increases in cash balances reduce net debt and must be
subtracted from FCF Operations to obtain FCF Equity.
Making this adjustment ensures the result represents FCF
for equity investors only.
Residual Income (Economic
Profit) Model
Value = BV + Premium
Value = BV0 + RI1/(1+r) + RI2/(1+r)2 + … + RIn /(1+r)n
RI1 = NI1 – rBV0
Pros: Focuses on earnings, which are generally correlated with long-run

future cash flows. Focuses on the residual income a firm generates,
which is fundamental to valuation (using any model). Clarifies
market-to-book ratios. Earnings are the ultimate source of cash
flows.
Cons: Earnings can be manipulated, so use of the model requires

thorough understanding of accounting. Error in r reduces the
benefits of the RIM.
Forecast and Terminal Periods
Forecast Period: The years for which an analyst specifically

forecasts dividends, free cash flow, or residual income.
Terminal Period: The period beyond the forecast period.
Estimated Value = Forecast Period Value + Terminal

Value

Terminal Value Estimation
Estimate terminal value by:
• Assuming a final liquidating distribution, or

• Assuming the cash flow in the final forecast period remains
constant in perpetuity, or
• Assuming the cash flow in the final forecast period grows
at a constant rate in perpetuity, or
• Assuming residual income grows (unlikely), remains
constant, or fades to zero (standard assumption) over
time.

DDM with Terminal Value
Forecast Period: 2 Years
Constant Terminal Dividend:
Value = DIV1/(1+r) + DIV2 /(1+r)2 + [DIV3/r](1+r)-2
Growing Terminal Dividend:
Value = DIV1/(1+r) + DIV2 /(1+r)2 + [DIV3/(r-g)] (1+r)-2

DCF with Terminal Value
Constant Terminal Cash Flow:
Value = FCF1/(1+r) + FCF2 /(1+r)2 + [FCF3/r](1+r)-2
Growing Terminal Cash Flow:
Value = FCF1/(1+r) + FCF2 /(1+r)2 + [FCF3/(r-g)] (1+r)-2

Residual Income with Terminal
Value
Constant Terminal Residual Income:
Value = BV0 + RI1/(1+r) + RI2 /(1+r)2 + [RI3/r](1+r)-2
Fading Terminal Residual Income over 5 Years:
Value = BV0+ RI1/(1+r) + RI2 /(1+r)2 + RI2(4/5)/(1+r)3

+RI2(3/5)/(1+r)4 +RI2(2/5)/(1+r)5 +RI2(1/5)/(1+r)6

Cool Ice Tea
Exercises

Cool Ice Tea
Balance Sheet
Income Statement
Current Assets:
Sales 523,000
Cash 245,000*
Costs and Expenses:
Receivables 150,000
Cost of Goods Sold (201,000)
Inventories 22,000
SG&A (198,000)
Total 417,000
Depreciation (18,000)
PPE 353,600
Interest (21,000)
Other Oper. Assets 47,000
Total Expenses (438,000)
Total Assets 817,600
Earnings Before Taxes 85,000
Income Taxes (34,000)
Accounts Payable 23,900
Net Income 51,000
Accrued Taxes 60,000
Total 83,900
Long-Term Debt 337,100 *For this part of the course, assume all cash is
financial in nature.
Exercise 1: DDM
Use the DDM to estimate the fundamental value of equity for Cool Ice Tea
assuming:
• The company pays out 80 percent of net income as dividends each year.
• For the first two periods, you forecast that earnings will grow by 5
percent per year.
• Beginning in the third period, you forecast earnings will grow by 3
percent per year in perpetuity.
• The first dividend will be paid one year from now (out of next year’s
earnings)
• The discount rate is 9 percent
Hint: Calculate the forecasted Period 1, Period 2, and Period 3 dividends

and then implement the relevant formula precisely. Note that Period 3
earnings are only 3 percent higher than Period 2 earnings.

Exercise 2: DCF
Use the DCF to estimate the fundamental value of equity for
Cool Ice Tea assuming:
• For the first two periods, you forecast free cash flows for
total operations of 60,000 and 65,000 respectively.
• Beyond the first two periods, you forecast free cash flows
will grow by 5 percent per year in perpetuity. Hence, free
cash flow for Period 3 is 68,250 (1.05 x 65,000).
• You forecast that debt will remain unchanged and that the
market value of debt equals the book value reported on
the balance sheets.
• The discount rate is 12 percent.

Exercise 3: RIM
Use the RIM to estimate the fundamental value of equity for
Cool Ice Tea assuming:
• For the first two periods, you forecast that earnings will
grow by 5 percent per year
• You forecast that the shareholders’ equity will grow by 5
percent for the first year
• Beyond the first two periods, you forecast that residual
income will fade to zero (linearly) over 3 years
• The discount rate is 10 percent

Lecture 5
New Wave Ice Tea Case:

Valuation

Case Overview
In this case, you are to do the following:
• Open the New Wave Ice Tea Valuation Template and

complete the income statement, balance sheet, and
cash flow forecasts.
• Complete the RIM, DDM, and FCF Equity Valuations
for New Wave Ice Tea as of the end of 2013.
• Address the case questions.
Note: The company will wrap up operations at the end

of 2018 and liquidate all net assets to shareholders in
a final dividend.
New Wave Ice Tea 2013
Balance Sheet
Current Assets:
Income Statement
Cash 95,700 Sales 112,000
Receivables 18,000 Costs and Expenses:
Inventories 4,500 Cost of Goods Sold ( 42,000)
Prepaid Expenses 3,000 SG&A ( 28,000)
Total Current Assets 121,200 Depreciation ( 1,600)
PPE 9,200 Interest ( 4,000)
Total Assets 130,400 Total Expenses ( 75,600)
Current Liabilities: Earnings Before Taxes 36,400
Accounts Payable 7,500 Income Taxes (14,560)
Accrued Taxes 14,560 Net Income 21,840
Interest Payable 4,000
Total 26,060
Long-Term Debt 50,000
Case: Phase 1
Using the financial statements provided, enter 2013 income
statement and balance sheet information. Doing so will
begin to populate some of the other cells on the
spreadsheet.
How does the format of the income statement on the

spreadsheet vary from the format of the reported income
statement? Comment on the rationale for the difference.

Phase 1 Solution: Income
Statements
New Wave Ice Tea
Income Statement 2013A 2014E 2015E 2016E 2017E 2018E
Revenue 112000 112000 112000 112000 112000 112000

Growth Rate % 0% 0% 0% 0% 0%
Cost of Sales -42000 -42000 -42000 -42000 -42000 -42000
Gross Profit 70000 70000 70000 70000 70000 70000
SG&A -28000 -28000 -28000 -28000 -28000 -28000

Depreciation -1600 -1380 -1173 -997 -847 -720
------- ------- ------- ------- ------- -------
Operating Income Before Tax 40400 40620 40827 41003 41153 41280
Tax on Operations at 40% -16160 -16248 -16331 -16401 -16461 -16512
------- ------- ------- ------- ------- -------
Operating Income After Tax 24240 24372 24496 24602 24692 24768
Interest Income on Cash 0 0 0 0 0 0

Interest Expense -4000 -4000 -4000 -4000 -4000 -4000
------- ------- ------- ------- ------- -------
Financial Income Before Tax -4000 -4000 -4000 -4000 -4000 -4000
Tax on Financial Income at 40% 1600 1600 1600 1600 1600 1600
------- ------- ------- ------- ------- -------
Net Financial Income -2400 -2400 -2400 -2400 -2400 -2400
------- ------- ------- ------- ------- -------
Net Income 21840 21972 22096 22202 22292 22368
Interest Rate 0%

Phase 1 Solution: Balance
Sheets
Balance Sheet 2013A 2014E 2015E 2016E 2017E 2018E
Cash 95700 137,140 160,492 183,761 206,960 -

Receivables 18000 - - - - -
Days of Receivables 59 0 0 0 0 0
Inventories 4500 - - - - -
Days of Inventory 39 0 0 0 0 0
Prepaid Expenses 3000 - - - - -
Depreciable Assets 9200 7820 6647 5650 4802 0
Total Assets 130400 144960 167139 189411 211762 0
Accounts Payable 7500 0 0 0 0 0

Days of Accounts Payable 65 0 0 0 0 0
Accrued Taxes 14560 14648 14731 14801 14861 0
Interest Payable 4000 4000 4000 4000 4000 0
Long-term Debt 50000 50000 50000 50000 50000 0
Shareholders' Equity 54340 76312 98408 120610 142901 0
Total Liabilities and Equity 130400 144960 167139 189411 211762 0

Phase 1 Solution: SE and
Depreciable Assets
Shareholders' Equity Detail 2013 2014 2015 2016 2017 2018
Beginning Balance 32500 54340 76312 98408 120610 142901

Contributions 0 0 0 0 0 0
Net Income 21840 21972 22096 22202 22292 22368
Dividends 0 0 0 0 0 0
Final Dividend 165269
Ending Balance 54340 76312 98408 120610 142901 0
Dividend Payout Ratio 0%
Depreciable Assets Detail
Beginning Balance 0 9,200 7,820 6,647 5,650 4,802

CAPEX 0 - - - - (4,082)
Depreciation 0 (1,380) (1,173) (997) (847) (720)
Ending Balance 9200 7820 6647 5650 4802 0

Case: Phase 2
Choose your interest rate for cash balances and enter it into
the appropriate cell (one cell only). In addition, choose
your dividend payout ratio and enter it into the appropriate
cell (one cell only). You can try a few values just to see
how different values affect the forecast.
How does a positive (or higher) interest rate affect projected

future net income?

Case: Phase 3
Choose values for Days of Receivables, Days of Inventories,
and Days of Accounts Payable (do not change the value
for the first year, because that value is based on actual
data). If desired, you may choose different values for
each year. For 2018, set all three values to zero.
When you increase the values for each of these parameters,

how does it affect the forecasted balance sheets (such as
cash and other balances)? Intuitively, why does the
balance sheet change the way it does?

Case: Phase 4
In the Depreciable Assets Schedule, choose values for CAPEX
each year. For 2018, let the model calculate the value.
How do positive values for CAPEX affect forecasted cash

balances? Why?

Case: Phase 5
Choose a revenue growth rate for each year. As you do,
recognize that, theoretically, the revenue growth rate
should be related to the dividend payout ratio and CAPEX.
All else equal, the more earnings a company retains and
invests in CAPEX, the higher the forecasted revenue
growth rate. So don’t a high revenue growth rate unless
you also choose a lot of CAPEX. Feel free to try a variety
of growth rates before settling on your final choice.
How sensitive is forecasted net income to your choice of

revenue growth rates?

Case: Phase 6
Compare your forecasted values for FCF Operations versus
FCF Equity. What are the primary reconciling items
between these two numbers? NOTE: There are rows in
the model that specify the reconciling items line by line.
Intuitively, why do these reconciling items make sense?
Compare your forecasted values for FCF Equity versus

forecasted dividends? What does this comparison teach us
about the relation between the DDM and DCF methods?

Case: Phase 7
Complete the Residual Income valuation schedule. To

do so:
• Link the net income line in the schedule to your

forecasted income statement
• Recall that residual income = net income – required
return
• To estimate the required return, use the 2013 Book
Value of equity for your beginning book value
How does changing the cost of equity affect your

estimate value?
Case: Phase 8
Complete the Dividend and DCF valuation schedules.
Now compare the estimates you obtain for all three

methods. What is the key point? What are your
most important takeaways from this case?

Case: Phase 9
Now that your model is up and running, go back and

change all of your assumptions, one at a time. As
you do, determine how sensitive your estimated
intrinsic value depends on each assumption.
Summarize your conclusions from this sensitivity
analysis.

97
Lecture 6
Credit Analysis

Role for Rating Agencies
Standard
Standard
Moody’s
Moody’s &&Poor’s
Poor’s
Credit
Credit
Analysis
Analysis
Credit
Credit
Ratings
Ratings
Note: Other U.S. rating

Perceived
Perceived
agencies include Fitch, AM Risk
Riskand
and
Best, CreditPointe, & Interest
Egan-Jones InterestRates
Rates
The Ratings
Moody’s S&P
Investment Grade Maximum
Aaa AAA Safety
Aa AA
A A
Baa BBB
Speculative (Junk) Grade
Ba BB
B B
Caa CCC
Risky

Rating Objectives
Standard
Standard
Moody’s
Moody’s &&Poor’s
Poor’s
Estimated
Estimated Default
Default
Recovery
Recovery Risk
Risk

S&P Ratings Performance:
1981 - 2001
Listed below are the average 1-year default rates for
selected industries for the period from 1981-2001:
S&P Rating Utilities High Tech Chemical

AAA 0.00 0.00 0.00
AA 0.00 0.00 0.00
A 0.11 0.00 0.00
BBB 0.14 0.73 0.19
BB 0.25 0.75 1.12
B 6.31 4.35 5.29
CCC 71.4 9.52 21.6

Moody’s Ratings
Performance: 1982 - 2006

Moody’s Recent Rating
Performance
Note: Per S&P, there were 124 total defaults

In 2008, with credit losses of $429.4 billion
Rating Process
Overall Credit
Analysis
Business Risk Financial Risk

Analysis Analysis

Business Risk Analysis
Management
Management
Character
Character
Country
Country
Collateral
Collateral Risks
Risks
Business
Business Risk
Business Industry
Industry
Stability
Stability Risks
Risks
Operational
Operational Competitive
Competitive
Diversity
Diversity Position
Position

Management Character
Evaluate management’s track record by asking:
• What level of risk does management pursue?

• What return on investment (ROA and ROE) has
management obtained?
• Is the return commensurate with the risk?
• How effective are corporate governance controls?
• What is management’s history of integrity?

Country Risks
Evaluate Country Risks by asking:
• How effective is the regulatory and legal environment?

• How good is the labor force?
• How strong is the infrastructure?
• How favorable is monetary policy?
• What are the political risks?
• What is the foreign exchange risk?
• What is expected GDP growth?
• Etc.

Industry Risks
Evaluate Industry Risks by asking:
• What are future prospects for the size of the industry’s

overall market?
• Will product obsolescence threaten the industry?
• Will changing consumer preferences threaten the industry?
• Will changes in technology enhance or threaten the
industry?
• Will the industry be able to maintain barriers to entry?
• How might business cycles affect the industry?

Competitive Position
Evaluate the company’s competitive position by asking:
• How unique is the company’s main product?

• How innovative is the company?
• How much threat is posed by existing competitors?
• What is the threat of new entrants in the firm’s market?
• What is the threat of substitute products?
• How much bargaining power do the firm’s suppliers have?

Operational Diversity
Evaluate the company’s operational diversity by asking:
• How many businesses does the company conduct?

• How many types of products does it provide?
• How many plants does it use?
• How many distribution outlets does the company use?
• How many types of customers does the company serve?

Business Stability
Evaluate the company’s business stability by asking:
• How sensitive is the firm to economic downturns?

• How stable are historical sales?
• How has the company weathered prior disruptions?

Collateral
Evaluate a company’s collateral by asking:
• Does the company own valuable tangible assets?

• What is the estimated life of the assets?
• Do the assets already have other claims on them?
• How easily could the assets be converted to cash?
• Does the company own valuable financial assets to act as
collateral, such as marketable securities or receivables?
• Does the company own any intangible assets for
collateral, such as rights, patents, contracts, etc.?

Business Risk Exercise
For each of the seven business risk factors, work with your
partner to identify a sub-factor that you believe is
especially important and explain why you believe it is
important.

Financial Risk Analysis
Cash
Cash
Profitability
Profitability Flow
Flow
Financial
Risk
Capital
Capital Liquidity
Liquidity
Structure
Structure

Profitability Metrics
Future profitability is central to a firm’s ability to pay its debt
obligations, therefore all measures of profitability are
important, including the following:
EBIT/Total Assets
Operating Income/Sales
EBIT/Interest Expense
EBITDA/Interest Expense
ROE: Net Income/Equity
ROA: Net Income/Total Assets
Earnings Growth %

Profitability Metrics: Details
EBIT = Net Income + Net Interest Expense + Income Taxes
• Net Interest Expense = Interest Expense – Interest
Income (Note: Capitalized interest should be included in
this calculation).
EBITDA = EBIT + Depreciation and Amortization Expense

• For Jet Blue use the depreciation and amortization
numbers from the cash flow statement
Equity = Total Stockholders’ Equity
Sales = Total Operating Revenue

Cash Flow Metrics
Relevant Cash Flow Metrics include:
FFO/Total Liabilities
Operating Cash Flow/Total Liabilities
(Free Operating Cash Flow + Interest Expense)/Interest
Expense
FFO/CAPEX
Operating Cash Flow/CAPEX

Cash Flow Metrics: Details
FFO = Operating Cash Flow after backing out the effects of
changes in working capital assets and liabilities, such as
changes in receivables, payables, and inventories.
Total Liabilities = Total Assets – Shareholders’ Equity = All

Current and Long-Term Liabilities
CAPEX = Capital Expenditures from the Cash Flow Statement
Free Operating Cash Flow = Operating Cash Flow + Net

Interest Expense - CAPEX

Liquidity Metrics
Liquidity ratios include:
Current Assets/Current Liabilities
(Cash + Short-term Investments)/Current Liabilities

Capital Structure Metrics
Capital structure metrics help creditors assess a firm’s ability

to take on new debt. Key metrics include:
Debt Ratio: Total Liab/Total Assets

Market Debt Ratio: Total Liab/Total Assets
LT Debt Ratio: Long-Term Debt/(Long-Term Debt + Equity)
Note: The rating agencies often treat cash as negative debt.

This is called the “net debt” approach.
Note: There are several common variations of these ratios.

Primary Financial Ratios per
Rating: 1998-2000
AAA AA A BBB BB B CCC
EBIT/Interest Expense* 21.4 10.1 6.1 3.7 2.1 0.8 0.1
EBITDA/Interest Expense* 26.5 12.9 9.1 5.3 3.4 1.8 1.3
Free Op CF/Total Liab(%) 84.2 25.2 15.0 8.5 2.6 (3.2) (12.9)
FFO/Total Liab (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6
ROA (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0
Oper. Income/Sales (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9
Long-term Debt Ratio (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8
Total Liab/Assets (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7
*This is gross interest expense. Do not adjust for interest income or

capitalized interest.
Note: These are overall averages. Companies in capital-intensive industries
generally can get away with poorer ratios than other companies.

Case
Jet Blue Airways

Case Assignment
Using the information that follows, as well as information

from the web, to address the following points:
(1) Conduct a simple business risk analysis in which you
identify at least one point for each of the seven business
risk factors.
(2) In terms of bond ratings, assess overall business risk.
(3) For 2008 and 2009, calculate the eight primary financial
ratios for Jet Blue.
(4) In terms of bond ratings, assess overall financial risk.
(5) Guess S&P’s overall issuer (organization) bond rating for
Jet Blue.

Jet Blue Worksheet:
Business Risk Analysis
Management Character:
Country Risks:
Industry Risks:
Competitive Position:
Operational Diversity:
Business Stability:
Collateral:

Jet Blue Worksheet:
Primary Financial Ratios
Financial Ratio 2009 2008

Jet Blue Check Figures
EBIT 2008= 109

Interest Expense 2008 = 242
EBITDA 2008 = 319
Free Op CF 2008 = (472)
Total Liab 2008 = 4754
FFO 2008 = (26)
Long-Term Debt 2008 = 2872
Equity 2008 = 1266

Jet Blue Assets

December 31,

2009 2008
CURRENT ASSETS
Cash and cash equivalents $ 896 $ 561
Investment securities 240 —
Receivables, less allowance (2009-$6; 2008-$5) 81 86
Inventories, less allowance (2009-$3; 2008-$4) 40 30
Restricted cash 13 78
Prepaid expenses 147 91
Other 43 10
Deferred income taxes 78 106
Total current assets 1,538 962
PROPERTY AND EQUIPMENT
Flight equipment 4,170 3,832
Predelivery deposits for flight equipment 139 163
4,309 3,995
Less accumulated depreciation 540 406
3,769 3,589
Other property and equipment 515 487
346 353
Assets constructed for others 549 533
523 528
Total property and equipment 4,638 4,470
OTHER ASSETS
Investment securities 6 244
Restricted cash 64 69
Other 308 275
Total other assets 378 588
TOTAL ASSETS Copyright © 2010 Deen Kemsley $ 6,554 $ 6,020
Jet Blue Liabilities and Equity

December 31,
2009 2008
LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES
Accounts payable $ 93 $ 144
Air traffic liability 455 445
Accrued salaries, wages and benefits 121 107
Other accrued liabilities 116 113
Short-term borrowings — 120
Current maturities of long-term debt and capital leases 384 152
Total current liabilities 1,169 1,081
LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS 2,920 2,872
CONSTRUCTION OBLIGATION 529 512
DEFERRED TAXES AND OTHER LIABILITIES
Deferred income taxes 259 197
Other 138 92
397 289
STOCKHOLDERS’ EQUITY
Common Stock 3 3
Treasury stock, at cost; 27,102,136 and 16,878,876 shares in 2009 and
2008, respectively (2) —
Additional paid-in capital 1,419 1,287
Retained earnings 118 60
Accumulated other comprehensive income (loss), net of taxes 1 (84)
Total stockholders’ equity Copyright © 2010 Deen Kemsley 1,539 1,266
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $ 6,554 $ 6,020
Jet Blue Income Statements

Year Ended December 31,

2009 2008 2007
OPERATING REVENUES
Passenger $ 2,928 $ 3,056 $ 2,636
Other 358 332 206
Total operating revenues 3,286 3,388 2,842
OPERATING EXPENSES
Aircraft fuel and related taxes 945 1,397 968
Salaries, wages and benefits 776 694 648
Landing fees and other rents 213 199 180
Depreciation and amortization 228 205 176
Aircraft rent 126 129 124
Sales and marketing 151 151 121
Maintenance materials and repairs 149 127 106
Other operating expenses 419 377 350
Total operating expenses 3,007 3,279 2,673
OPERATING INCOME 279 109 169
OTHER INCOME (EXPENSE)
Interest expense (197) (242) (235)
Capitalized interest 7 48 43
Interest income and other 10 (5) 54
Total other income (expense) (180) (199) (138)
INCOME (LOSS) BEFORE INCOME TAXES 99 (90) 31
Income tax expense (benefit) 41 (5) 19
NET INCOME (LOSS) $ 58 $ (85) $ 12

Jet Blue Cash Flow Page 1


2009 2008 2007
CASH FLOWS FROM OPERATING
ACTIVITIES
Net income (loss) $ 58 $ (85) $ 12
Deferred income taxes 40 (6) 19
Depreciation 190 189 161
Amortization 44 21 19
Stock-based compensation 16 16 15
Gains on sale of flight equipment (3) (45) (9)
Collateral returned (deposits) for derivative
instruments 132 (149) —
Restricted cash returned by (paid for) business
partners 65 (70) —
Decrease (Increase) in receivables 3 4 (14)
Decrease (Increase) in inventories, prepaid and
other (43) (10) 3
Increase (Decrease) in accounts payable (66) 15 36
Other, net 50 103 116
Net cash provided by (used in) operating
activities 486 (17) 358

Jet Blue Cash Flow Page 2


2009 2008 2007
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (434) (654) (617)
Predelivery deposits for flight equipment (32) (49) (128)
Assets constructed for others (47) (142) (242)
Proceeds from sale of flight equipment 58 299 100
Refund of predelivery deposits for flight equipment 5 — 12
Purchase of held-to-maturity investments (22) — (11)
Proceeds from maturities of held-to-maturity investments — — 24
Purchase of available-for-sale securities (636) (69) (654)
Sale of available-for-sale securities 486 — 719
Sale of auction rate securities 175 397 —
Return of (deposits for) security deposits (10) 1 72
Other — (30) (9)
Net cash used in investing activities (457) (247) (734)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from:
Issuance of common stock 120 320 26
Issuance of long-term debt 446 716 376
Aircraft sale and leaseback transactions — 26 183
Short-term borrowings 10 17 48
Borrowings collateralized by ARS 3 163 —
Construction obligation 49 138 242
Repayment of:
Long-term debt and capital lease obligations (180) (673) (265)
Short-term borrowings (20) (52) (44)
Borrowings collateralized by ARS (110) — —
Other, net (12) (20) (10)
Net cash provided by financing activities 306 635 556
INCREASE IN CASH AND CASH EQUIVALENTS 335 371 180
Cash and cash equivalents at beginning of period 561 190 10
Cash and cash equivalents at end of period $ 896 $ 561 $ 190

Wrap Up
What are you primary

takeaways from this case?

Lecture 7
Earnings Quality

Lecture Outline
• Part 1: The Five Ploys
• Part 2: Detecting the Ploys
• Part 3: Earnings Quality Cases

Part 1
The Five Ploys

Earnings Quality
Companies sometimes manage their financial results to meet earnings
expectations or to otherwise reflect strength. As they do, their
actions reduce the “quality” of reported earnings.
Quality
Quality
Earnings
Earnings
Reliable
Reliable Relevant
Relevant Conservative
Conservative Sustainable
Sustainable

Why Earnings Management is
Possible
Possibility
Possibilityfor
for
Earnings
Earnings
Management
Management
Audits
Auditsare
arenot
not Flexibility
Flexibilityin
in
Perfect
Perfect GAAP
GAAP
Detectors
Detectors Requires
Requires
of
ofFraud
Fraud Judgment
Judgment

Degree of Earnings Management
Continuum of earnings management
Employment
Employment Behavior
of Fraudulent
of flexibility beyond the
conventional financial
that strains boundaries
GAAP reporting
GAAP of GAAP
flexibility

The Five Ploys
(1) Recognizing revenue early
(2) Recording fictitious revenue
(3) Overstating assets to defer expenses
(4) Understating liabilities
(5) Taking big baths

Ploy 1: Recognize Revenue Early
Firms often recognize revenue before they qualify to do so
Revenue
Revenue
Recognition
Recognition
Criteria
Criteria
Substantial Confidence
Confidence Good
GoodHandle
Handle
Substantial In On
Performance
Performance In On
Collections
Collections Costs
Costs

Ploy 1: Discussion
Bristol-Myers Squibb
• Put pressure on distributors to purchase extraordinary
amounts of Bristol-Myers goods at year end.
• SEC stepped in to require the company to restate earnings.
FASB Discussion Memorandum emphasizes substantial

performance, as defined by the contract between buyers
and sellers.

Ploy 2: Record Fictitious
Revenue
Firms record fictitious revenue by employing aggressive accounting
procedures or by conducting outright fraud. Examples include:
• Recording revenue when the firm ships goods to its own off-site
warehouse even though the goods have not yet been purchased by
customers.
– MiniScribe
• Grossing up revenue, e.g., recording large amounts of revenue along
with offsetting cost of sales for swap transactions, etc.
– Qwest and Enron
• Selling goods to affiliated parties, which may technically qualify as
sales under GAAP (if the affiliates are not consolidated) but which
are primarily conducted to increase reported revenue.
• Recording investment income as operating revenue.
• Otherwise recording revenue that lacks economic substance.
– Thousand Trails
Ploy 3: Overstating Assets to
Understate Expenses
Examples:
• Capitalizing expenditures as assets rather than recording
them as an expense.
– WorldCom
• Failing to write down assets which have permanently
declined in value (i.e., the PV of expected cash flows is
less than book value).
• Failing to properly amortize intangible assets when
impairment occurs.
• Otherwise overstating assets, e.g., ending inventory.
– Crazy Eddie
• Understate reserves for bad debts, inventory, etc.
– SunTrust Reserve/Non-Performing Loans has declined from 130%
(9/2007) to 62% (9/2008) and then to 60% (12/2008)
Ploy 4: Understate Liabilities
to Understate Expenses
Examples:
• Simply ignoring invoices when received.

– Crazy Eddie: In 1987, hid $3 million of A/P from auditors
• Recording revenue when cash is received even though
services have not yet been performed (this cash should be
recorded as an unearned revenue liability).
• Ignoring lawsuits and other contingent liabilities that are
likely to be realized.

Ploy 5: Take Big Baths
Firms sometimes record large special charges in the current period.
These charges set up reserve accounts that reduce recorded expenses
in later periods.
• Theory: Investors will largely ignore the one-time charge, and by

taking the charge today the income statement will look stronger in the
future.
Special Charges: Primarily asset write-offs of goodwill, inventory, or

PP&E (asset impairments).
Restructuring Charges: Restructuring charges are associated with

major changes in an entity’s business and/or strategy, such as
divestment of business units, termination of employees with
severance packages, etc.
Trend in Special Items: Sales
Special Items as a Percent of Sales
3.5
2.5
Percentage
1.5
0.5
0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year

Trend in Special Items: Firms
Percentage of Firms Recognizing Special Items
60
50
40
Percentage
30
20
10
0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year
Mini Cases
Duane Read Pharmacies in New York (October, 2008)
• Asked suppliers to give DR a credit for purchases
• Promised to pay back the credit after year end
• Asked suppliers to send a “construction project” invoice
for the credit.
• Total Ploy = $17.5 million
Q:What ploy(s) was Duane Read using?
Xerox (1998)
• Treated equipment rentals to customers as capital leases
so they could record “sales” ($592 million).
Q: What ploy(s) was Xerox using?
Part 2
Detecting the
Ploys

Audit Report
Look For:
• A qualified opinion
• Any reservations the auditors may express regarding the
financials
• Any changes in accounting methods the auditors
highlight

Proxy Statements
Look for:
• Executive stock options, which often provide the incentive

for earnings management
• Related-party transactions, which can be used to inflate
reported revenue or hide liabilities (e.g., Enron)
• Litigation that is not accrued on the financials
• Changes in auditors which may relate to disputes.
– OCA switched auditors right before it got caught cheating on its
financials

Financial Statement
Investigation
Analyze financial statement metrics:
• Across firms in the same industry (e.g., cross-sectional

analysis), and
• Over time for the same firm (e.g. cross-time analysis).
Key Point: Note that the indicators listed in this table often
can be interpreted two ways. On the one hand, they
could reflect earnings management. On the other hand,
they could reflect actual strength or improvement for the
firm. Therefore, when an indicator is detected, it simply
means that further analysis must be conducted to
distinguish between actual strength and feigned strength.

Detection Ratios
Metric Indicator Ploy Possibly Suggested
1 Accounts Receivable/Sales High or increasing

2 CFFO/Operating Income Low (below one) or decreasing
3 Accounts Receivable Cash Flow Effect Material and Negative
4 Ending Inventory/Sales High or increasing

5 Prepaid Expense/Sales High or increasing
6 Other Assets/Sales High or increasing
7 PPE/Sales High or increasing
8 Operating Expense/Sales Low or decreasing
9 Allowance for Doubtful Accounts/AR Low or decreasing

10 Inventory Reserve/Inventory Low or decreasing
11 Valuation Reserve/Deferred Tax Assets Low or decreasing
12 Deferred Revenue/Sales Low or decreasing

13 Accounts Payable/Sales Low or decreasing
14 Other Liabilities/Sales Low or decreasing
15 Special Charges High
Part 3
Earnings Quality
Cases

155
Earnings Quality Cases I
When
Company Scandal Allegations Ploy Involved
Went Public
Overstated results by inflating capital assets and
Adelphia Communications April 2002
underreporting expenses.
Inflated its 2001 revenue by $1.5 billion by
"channel stuffing," or forcing wholesalers to
Bristol-Myers Squibb July 2002 accept more inventory than they can sell now to
get it off the manufacturer's books, thus
accelerating sales
Engaged in 23 "round-trip" trades to boost
Duke Energy July 2002
trading volumes and revenue.
Boosted profits and hid debts totaling over $1
October
Enron billion by improperly using off-the-books
2001
partnerships.
Improperly booked $100 million of revenue for
Halliburton May 2002 annual construction cost overruns even though
customers had not agreed to pay for them.
Overstated $100 million in sales by improperly

Peregrine Systems May 2002
recognizing revenue from third-party resellers
Overstated income by booking $3.8 billion in

WorldCom March 2002
operating expenses as capital expenditures.
Falsifying financial results for five years, boosting

Xerox June 2000 income by $1.5 billion by treating term rentals of
equipment as current sales of capital assets.
January
Satyam Computer Services Inflated figures for cash and related sales
2009
156
Earnings Quality Cases II
Company Allegations Ploy
AOL booked ads it sold on behalf of others as revenue instead of just
AOL Time Warner
booking the commission AOL earned.
Using steep discounts, McAfee sold millions of dollars of product to its
McAfee Anti-Virus distributors that the distributors did not yet need, and then secretly paid the
distributors to keep the extra product rather than return it to McAfee.
Understated the legal settlement owed to ComEd

Nicor Energy
GE Recorded $370 million for the sale of trains that hadn’t yet occurred
Wrote off $2 billion of inventory even though much of this inventory retained
Cisco
a great deal of value
Microstrategy Backdated sales contracts
Reported greater ending inventory than really existed
Phar-Mor
Stayam Computer
Did not report a $250 million debt owed to others.
Services
Reported non-existent sales of milk to Cuban residents and reported
Parmalat
corresponding non-existent cash on its balance sheet
Anglo Irish Bank Hid loans (87 million Euros) the bank owed to shareholders
Mirant Overstated gas inventory by $85 million, increasing gross profits
Accounted for customers copayments for the purchase of Merck drugs even
Merck
though Merck never collected the copayments
Prematurely recognized $3.3 billion of revenue from at least 363 software
Computer Associates
contracts that the company had not yet executed.
Waste Management Understated depreciation by ©$1.7
Copyright billion
2010 Deen by using long useful lives
Kemsley
157
Satyam Computer Services
Case Format
• Read the statement by Satyam’s former CEO
• Identify the relevant items on Satyam’s quarterly balance
sheet and income statement.
• Address the following questions:
– What ploys did Satyam use?
– Overall, how much were net assets (i.e., assets – liabilities)
overstated?
• In crores rupees (which is the denomination used; one crore rupees
equals 10 million rupees). Note: Round each item to the nearest
crore.
• As a percentage of total reported net assets (i.e., shareholder’s equity)
– What stands out to you in this case?

January, 2009 Page 1

January, 2009 Page 2

Standalone Balance Sheet

Lecture 8
U.S. Budget Accounting

162
The View from the Year 2000
• U.S. Budget Surpluses for three years straight
• Budget Surplus for the year 2000 sets a new record: $236
billion (2.4% of GDP)
• The CBO projects large, rising surpluses for the next ten
years

163
CBO Budget Projections (2001)
vs. Actual (Billions)
2001 2002 2003 2004 2005 2006 2007 2008 2009

Projected
Surplus
(Deficit) 281 313 359 397 433 505 573 635 710
Percent of
GDP
2.8 3.0 3.3 3.5 3.5 3.9 4.1 4.5 5.0
Actual
Surplus
(Deficit) 128 (158) (378) (413) (318) (248) (162) (455) (1413)
Percent of
GDP
1.3 (1.5) (3.5) (3.6) (2.6) (1.9) (1.2) (3.2) (10)

164
Budget Deficit for 2010
Revenue $2.162 trillion

Expenditures 3.456 trillion
Deficit $1.294 trillion
October 2010 Deficit $140 billion

November 2010 Deficit $150 billion

165
Discussion Question
What factors do you think contributed to the budget

deficits after 2001?

166
Projected Budget Deficits
(Billions)
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
CBO
Proj. :
-1349 -980 -650 -539 -475 -480 -521 -525 -542 -649 -687
Percent
of GDP
-9.2 -6.5 -4.1 -3.2 -2.7 -2.6 -2.7 -2.6 -2.6 -3.0 -3.0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
WH
Proj. -1471 -1416 -911 -736 -698 -762 -758 -721 -749 -822 -900
7/2010
Percent
of GDP
-10.0 -9.2 -5.6 -4.3 -3.8 -4.0 -3.8 -3.4 -3.4 -3.6 -3.8
167
White House Projection: Selected
Assumptions
• A strong, sustained economic recovery will occur, with GDP growth of
3.9% in 2010, 4.7% in 2011, 5.8% in 2012, 5.9% in 2013, etc.
• Projections for 2016-2020 all assume full employment (5.2%)
• These projections do not include the December, 2010 extension of
unemployment benefits and Bush tax cuts.
• Any new health care plan will reduce the sum of deficits by $122B
(Gross cost of $590B offset by $712B of new taxes and savings)
• Total disaster costs over the 10-year period will be $44B
• As a percentage of GDP, defense and security spending will fall
dramatically (from 5.8% in 2010 to 4.1% in 2020)
• As a percentage of GDP, discretionary spending will drop to lower levels
than it has been for 50 years (from 3.8% in 2010 to 2.2% in 2019)
• State budget deficits are excluded.
Discussion: What are your views on these assumptions?
168
Paying for the Deficits
There are three fundamental ways to pay for the deficits. All
three ways represent tough choices.
• Reduce spending
• Raise tax revenue
• Monetize the debt

169
Reduce Spending
Obstacles
• The bulk of spending occurs in programs that are hard to
cut, including social security, Medicare, Medicaid, defense,
interest, etc.
• Cutting spending requires conscious political decisions to
induce pain now
– Lower GDP
– More Unemployment
– Lower Growth

170
Reduce Spending: The Setting

171
Raise Tax Revenue
Obstacles:
• Both political parties have announced opposition to broad-

based tax increases
• Large state and local government deficits are leading to an
increase in local tax rates
• Raising taxes depresses economic growth
• Raising tax rates reduces economic activity, thus reducing
taxable income
• Raising corporate tax rates does not increase overall tax
revenue very much; individuals would have to be taxed
more
172
Raise Tax Revenue: The Setting

173
Monetize the Debt (Quantitative
Easing)
One way to pay off debt is simply to print enough money to
pay it off (such as to continue buying mortgage backed
securities). This naturally leads to inflation and higher
interest rates. Inflation increases nominal GDP, so
inflation itself decreases the ratio of Public Debt/GDP.
The most common way the Fed monetizes the debt is to print
more money and use that money to buy treasuries (i.e.,
print money to pay off its debt).

174
Part 2
The National Debt

175
U.S. Debt Totals (Billions): White
House Projections
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Public
Debt 7545 9298 10498 11472 12326 13139 13988 14833 15686 16535 17502 18573
% of
GDP 53.0 63.6 68.6 70.8 71.7 72.2 72.9 73.6 74.2 74.9 75.9 77.2
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Gross
with 11876 13787 15144 16336 17453 18532 19683 20837 22011 23197 24450 25777
intra-
govt
% of
GDP 83.4 94.3 99.0 100.8 101.5 101.8 102.6 103.4 104.1 105.1 106.0 107.1
176
Federal Public Debt:
CBO’s 10-Year Projection

177
Total Federal Debt:
CBO’s Long-Term Projection
The source is the spreadsheet for CBO's alternative fiscal

scenario in its June Long-Term Budget Outlook .
178
CBO Long-Term Spending and
Revenue Projection

179
CBO: Long-Term Interest Expense
Projection

180
Part 3
Potential Outcomes

181
Some Possibilities
• Grow our way out of the woods through

innovation
• Consciously Reset the Economy to a
Sustainable Level through Austerity
• Argentine Disease (Hyperinflation)
• Japanese Disease (Long-term Economic
Malaise Followed by ?)

182
Reset the Economy through
Austerity
Strategy:
• Cut Spending Dramatically
• Raise Taxes Substantially
Consequences:
• Lower spending reduces GDP
• Higher taxes reduce GDP
• Unemployment swells
• Prices of goods and services (including homes) reset
to fundamental values (no bubbles)
• Permanently lower government benefits
• From this foundation, slowly rebuild the economy
183
Deficit Reduction Panel
Objective: To reduce deficit to sustainable level
• Reduce defense spending by $100 billion
• Reduce discretionary non-defense spending by $100 billion
• Cut federal workforce by 10%
• Eliminate mortgage interest deduction and earned income credit
• Raise gas tax by 15%
• Reduce tax rates to 23%
• Cap medical lawsuit damages
• Reduce Medicaid and Medicare payments to doctors
• Increase copayments for Medicaid and Medicare patients
• Reduce social security inflation adjustments
• Increase social security retirement age from 67 to 69
• Increase payroll taxes
184
Argentine Disease
Strategy:
• Monetize the debt by printing money
Consequences:
• The dollar crashes
• The price of imported goods skyrockets
• Interest rates skyrocket
• Investment plummets
• Wealth is destroyed
What are the odds?

185
Japanese Disease
Strategy:
• Keep spending
• Raise taxes
• Borrow to finance remaining deficits
• Intervene to maintain low interest rates
Consequences:
• National debt continues to rise
• Taxes drag on the economy
• Government spending crowds out private investment
• Asset prices do not fully reset to fundamental values
• Through government intervention, inflation and interest rates remain under
control for a season
• Eventually, the bond market reacts to enormous debt. When? And then
what?
What are the odds?
186
Discussion Wrap Up
What can we do as individuals to

address these issues on a personal
and family basis?

187
Lecture 9
Final Project:
Groups: Maximum of 3 individuals
Submission Guidelines: Email electronic copy to me
Maximum Length: 8 pages plus tables
The Project:
• Choose a (possibly U.S.-based) company to analyze (in some cases, you also may choose a
competitor)
• Use any combination of the techniques from the course to analyze the primary company.
Only use relevant techniques from the course. Ignore techniques that do not relate well to
your company.
• Write a report on the relevant aspect(s) of the company you have chosen to emphasize. The
report is not intended to be a comprehensive investment report. Instead, you should report
on a key item for investors to consider.
• Example Topics (this list is far from complete): Indicators of potential earnings management;
unique capital structure decisions; insights obtained from a DuPont analysis; the impact of fair
value accounting; a specific bond rating upgrade or downgrade, or the potential for a change
in rating; a critical analysis of analysts’ buy/hold/sell recommendations; a residual-income-
based valuation; the viability of a particular bank, etc.

188

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XLRI ACCOUNTING

Financial Accounting Seminar:

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Seminar Approach and Goals

Student Learning Objectives

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

New Wave Ice Tea:

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

To record transactions, note:

• Each row represents one transaction

Copyright © 2010 Deen Kemsley

Key features of the

• The top row represents

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

New Wave Ice Tea

Copyright © 2010 Deen Kemsley

• In Class: Record transactions for the years 2011 - 2013

Copyright © 2010 Deen Kemsley

To take advantage of this business opportunity, you start a company

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

• Use your 2013 ending balances to complete the top row

Enjoy the Challenge 

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Liabilities and Equity

Total Liabilities and Equity

Cash Payments to Suppliers

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow

Cash at the beginning of the year

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Land, Building and Equipment (PPE)

Liabilities and Equity

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Payments received from customers

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow

Cash at the beginning of the year

Copyright © 2010 Deen Kemsley

Liabilities and Equity

Copyright © 2010 Deen Kemsley

Copyright © 2010 Deen Kemsley

Cash Flow from Operating Activities

Payments received from customers

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Total Cash Flow

Cash at the beginning of the year