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Financial Analysis Chapter 2 Page 1 of 21
Financial Analysis: A User Approach
Chapter 8
Accounting Analysis: Specific Issues 1
Last chapter we introduced the idea that analysis should not
blindly use reported accounting information, but should instead
consider the potential for earnings management via aggressive
revenue recognition and cookie-jar reserves. In this chapter we
will begin to consider several specific accounting issues that
should be considered as you review financial statements and
perform analysis.
Marketable Securities
Companies have a variety of motives that lead them to invest in
marketable securities. Generally the motives are either return
or influence/control. When a company reaches a level of
investment that results in influence/control (generally greater
that 20% of the outstanding equity) the equity method is used.
When the investment is in debt securities and when the
influence is nominal (<20% ownership) the accounting
treatment is based on the type of security and the intent of
management.
Financial Analysis Chapter 2 Page 2 of 21
Classification
Type of
Security Cost of FV?
FV Changes
Reported in?
Held-to-
maturity
Debt
securities
purchased
with both the
intent and
ability to hold
until maturity
Cost N/A
Trading Debt and
Equity
securities that
management
purchases for
short term
gains
Fair Value Unrealized
holding gains
and losses
reported in net
income
Available Debt and
Equity
Securities not
classified as
HTM or
Trading
Fair Value Unrealized
holding gains
and losses
reported as
Other
Comprehensive
Income
Financial Analysis Chapter 2 Page 4 of 21
Financial Instruments
The following is a summary of the fair value of available-for-sale securities at June 27, 2008 (in millions):
Amortized Cost Unrealized Gain/ (Loss) Fair Value US Government & Agency $ 120 $ (1) $ 119 Asset Backed Securities 16 — 16 Corporate Bonds 18 — 18 Municipal Bonds 2 — 2 Auction Rate Securities 31 (3) 28 Commercial Paper 333 — 333 Bank Time Deposits 28 — 28 Money Market 546 — 546 Total $ 1,094 $ (4) $ 1, Included in cash and cash equivalents $ 911 Included in short term investments 151 Included in long term investments 28 $ 1,
At June 27, 2008, the Company had no marketable securities that had been in a continuous unrealized loss position for a period
greater than 12 months and determined no investments were other-than-temporarily impaired.
The fair value of the Company’s investment in debt securities, by remaining contractual maturity, is as follows (in millions):
June 27, 2008 June 29, Due in less than 1 year $ 432 $^2007 916 Due in 1 to 3 years 85 27 $ 517 $ 943
Fair Value Disclosures —The carrying value of cash equivalents approximates fair value. The fair values of short-term
investments, debentures, notes and loans are estimated based on quoted market prices as of June 27, 2008.
The carrying values and fair values of the Company’s financial instruments are as follows:
June 27, 2008 June 29, 2007 Carrying Amount Estimated Fair Value Carrying Amount Estimated (In millions)^ Fair^ Value Cash equivalents $ 911 $ 911 $ 862 $ 862 Short-term investments 151 151 157 156 Long-term investments 28 28 — — Floating Rate Senior Notes due October 2009 (300) (293) (300) (300) 6.375% Senior Notes due October 2011 (599) (584) (599) (588) 6.8% Senior Notes due October 2016 (599) (555) (598) (577) 6.8% Convertible Senior Notes due April 2010 (135) (142) (135) (145) 5.75% Subordinated Debentures due March 2012 (41) (40) (45) (45) 2.375% Convertible Senior Notes due August 2012 (326) (422) (326) (455) LIBOR Based China Manufacturing Facility Loan (30) ( 30 ) (60) (60)
The fair value of the Company’s 2.375% and 6.8% convertible securities is a function, in part, of the Company’s stock price.
Because the Company’s stock price has decreased since June 27, 2008, the fair value of these securities has also decreased.
Investment Securities —As of June 27, 2008, the Company held auction rate securities in the amount of $31 million, all of which
are collateralized by pools of student loans guaranteed by the Federal Family Education Loan Program. During the fiscal 2008
year, these securities failed to settle at auction and as a result the Company recorded an unrealized loss of $3 million and
reclassified the securities to long-term investments.
Financial Analysis Chapter 2 Page 5 of 21
Inventory
Several different accounting methods are available to compute
the value of Ending Inventories and the Cost of Goods Sold. The
most common methods chosen are:
LIFO – must be used when LIFO is used on your tax return
(LIFO conformity rule) – appropriate for companies that
face inflationary input prices (inputs contain energy and
labor costs that are increasing across time)
FIFO – typically used by companies that face deflationary
price streams (e.g. technology companies)
Average Cost – typically used by companies that do not
have a consistent pattern of input price movements
Additional Details:
Inventory accounting methods are largely based on tax
considerations
Companies can use different methods for different
categories of inventory
If a company uses LIFO the must disclose in their footnotes
the current replacement cost (which approximates FIFO).
As a result if you are performing a comparison of
companies that use different methods (LIFO/FIFO)
adjustments can be made
Regardless of method used to determine cost, all
companies must apply the lower-of-cost-or-market rule to
assess potential obsolescence
Financial Analysis Chapter 2 Page 7 of 21
Fixed Assets (Property, Plant, and Equipment)
PP&E accounting involves accounting method choice (Straight-
Line, Double Declining Balance, etc.) and management
estimates (estimated useful life, salvage value, impairment
assessment)
You are not required to use the same method for your financial
statements that you use on your tax return, in fact, MACRS
(modified accelerated cost recovery system) is used on tax
returns.
Often tax methods permit deductions on the tax return earlier
in the asset’s life when compared to the method used for
financial reporting. This is offset later in the asset’s life with
smaller amounts on the tax return when compared the
financial statement amounts. (Think straight line method on
the books and accelerated depreciation on the tax return.) This
difference will create deferred taxes on the financial
statements.
Financial Analysis Chapter 2 Page 8 of 21
While typically only Net PP&E is reported in the financial
statements, companies are required to report gross PP&E
(original cost) and accumulated depreciation in their footnotes.
These disclosures support the following computations:
Ratio Calculation
Average
Asset Age
= Accumulated Depreciation/Depreciation
Expense
Average Age
= Accumulated Depreciation/Ending Gross
PP&E
Average
Depreciable
Life
= Ending Gross PP&E/Depreciation Expense
From the STX 10-K
Property, equipment and leasehold improvements, net
Property, equipment and leasehold improvements consisted of the following:
Useful Life in Years June 27, 2008 June 29, 2007 (In millions) Land $ 21 $ 21 Equipment 3 - 5 4,404 4, Building and leasehold improvements Life of lease - 48 992 731 Construction in progress 428 348 5,845 5, Less accumulated depreciation and amortization (3,381) (2,826) $ 2,464 $ 2,
Amortization of leasehold improvements is included in depreciation and amortization expense.
Depreciation and amortization expense was $844 million, $851 million and $612 million for fiscal years
2008, 2007 and 2006, respectively.
Financial Analysis Chapter 2 Page 10 of 21
Income Tax
Financial reporting and tax reporting are based on different
agendas. Financial reporting methods are designed to report
performance and assets/claims to assets. Tax reporting
methods are designed to raise revenue for the government and
incent/disincent certain behaviors. As a result, book income
(pretax income based on the financial accounting method) and
taxable income (the amount used to determine your tax
liability) will almost always be different. As a consequence of
these differences, deferred taxes are used to reconcile the
difference between tax expense (roughly based on book
income) and taxes payable (based on taxable income).
Specifically deferred taxes are used to accounting for timing
differences between book and tax methods (revenue/expense
reported in different periods). Alternatively, deferred taxes are
not required for permanent differences (differences that do not
reverse).
Financial Analysis Chapter 2 Page 11 of 21
Example - Deferred Tax Liability
A company purchases a machine for $400 and depreciates it
using the following schedule:
Books Tax
Year 1 200 300
Year 2 200 100
Total 400 400
Assuming a 40% tax rate and $1,000 of book income before tax
for both years the following entries would be recorded.
Year Accounts Debit Credit
1 Income Tax Expense 400
Deferred Tax Liability 40
Income Tax Payable 360
2 Income Tax Expense 400
Deferred Tax Liability 40
Income Tax Payable 440
Financial Analysis Chapter 2 Page 13 of 21
Deferred tax assets can also arise from net operating loss
carryforwards.
Substantial disclosures are required related to income taxes.
These include:
Calculation of the effective tax rate and an explanation of
the sources of differences between the enacted rate and
the effective rate
Sources and amounts of deferred tax assets and deferred
tax liabilities
FIN 48R has been a controversial change in the reporting of
income taxes. Under this guidance companies must accrue
deferred taxes if in their option, under a more-likely-than-not
standard, they would be subject to additional tax if an
aggressive tax position were to be challenged by the relevant
taxing authority.
Ratio Calculation
Taxes Payable Rate = Current Income Tax
Expense/Pretax Income
Taxes Paid Rate = Cash Paid for Income
Taxes/Pretax Income
Financial Analysis Chapter 2 Page 14 of 21
From the STX 10-K
Income Taxes
The provision for (benefit from) income taxes consisted of the following:
Fiscal Years Ended June 27, 2008 June 29, 2007 June 30, (In millions)^2006 Current Tax Expense (Benefit): U.S. Federal $ 8 $ 6 $ 35 U.S. State 10 (1) 7 Foreign 26 8 19 Total Current $ 44 $ 13 $ 61 Deferred Tax Expense (Benefit): U.S. Federal $ 34 $ (319) $ 29 U.S. State 3 (40) 4 Foreign (14) (6) (10) Total Deferred $ 23 $ (365) $ 23 Provision for (Benefit from) income taxes $ 67 $ (352) $ 84 Income before income taxes consisted of the following: Fiscal Years Ended June 27, 2008 June 29, 2007 June 30, (In millions)^2006 U.S $ 90 $ (125) $ (18) Foreign 1,239 686 942 $ 1,329 $ 561 $ 924 For fiscal year 2008 there were $6 million tax benefits recorded to Additional Paid-In Capital associated with stock option deductions. The Company did not record a tax expense associated with stock option deductions in fiscal year 2007 compared to $44 million recorded in fiscal year 2006; the related tax benefit was recorded directly to Additional Paid-In Capital. U.S. federal and state deferred tax expense in fiscal year 2008 was $37 million. In fiscal year 2007, the deferred tax benefit of $359 million includes $319 million of deferred tax benefits resulting from the release of valuation allowance recorded in prior years. The fiscal year 2007 valuation allowance release was largely due to the completion during 2007 of the restructuring of the Company’s intercompany arrangements, which enables the Company to forecast future U.S. taxable income with greater certainty and U.S. taxable income from the intercompany sale of certain Maxtor assets. This 2007 valuation allowance release also included a reduction of $322 million in Maxtor goodwill required as a result of the reversal of valuation allowance previously recorded as of the acquisition date against Maxtor related deferred tax assets primarily for tax net operating loss carryovers.
Financial Analysis Chapter 2 Page 16 of 21
At June 27, 2008, the Company had U.S. federal, state and foreign tax net operating loss carryforwards of approximately $2 billion, $896 million and $690 million, respectively, which will expire at various dates beginning in 2009 if not utilized. At June 27, 2008, the Company had U.S. federal and state tax credit carryforwards of $ million and $87 million, respectively, which will expire at various dates beginning in 2009, if not utilized. These net operating losses and tax credit carryforwards have not been audited by the relevant tax authorities and could be subject to adjustment on examination. Of the $2 billion of loss carryovers noted above, approximately $859 million will be credited to Additional Paid-in Capital upon recognition. As a result of the Maxtor acquisition, Maxtor underwent a change in ownership within the meaning of Section 382 of the Internal Revenue Code (IRC Sec. 382) on May 19, 2006. In general, IRC Section 382 places annual limitations on the use of certain tax attributes such as net operating losses and tax credit carryovers in existence at the ownership change date. As of June 27, 2008, approximately $1.3 billion and $337 million of U.S. federal and state net operating losses, respectively, and $36 million of tax credit carryovers acquired from Maxtor are generally subject to an annual limitation of approximately $110 million. Certain amounts may be accelerated into the first five years following the acquisition pursuant to IRC Section 382 and published notices. On January 3, 2005, the Company underwent a change in ownership under IRC Section 382 due to the sale of common shares to the public by its then largest shareholder, New SAC. Based on an independent valuation as of January 3, 2005, the annual limitation for this change is $44.8 million. As of June 27, 2008, there is $453 million of U.S. net operating loss carryforwards and $110 million of U.S. tax credit carryforwards subject to IRC Section 382 limitation associated with the January 3, 2005 change. To the extent management believes it is more likely than not that the deferred tax assets associated with tax attributes subject to IRC Section 382 limitations will not be realized, a valuation allowance has been provided. The applicable statutory rate in the Cayman Islands was zero for the Company for fiscal years ended June 27, 2008, June 29, 2007 and June 30, 2006. For purposes of the reconciliation between the provision for (benefit from) income taxes at the statutory rate and the effective tax rate, a notional U.S. 35% rate is applied as follows. Fiscal Years Ended June 27, 2008 June 29, 2007 June 30, (In millions)^2006 Provision at U.S. notional statutory rate $ 465 $ 196 $ 323 State income tax provision (benefit), net of U.S. notional income tax benefit 12 (41) 7 Permanent differences 10 14 13 Valuation allowance (41) (279) 65 Use of current year U.S. tax credit (1) (27) (11) Foreign earnings not subject to U.S. notional income tax (406) (227) (309) Tax expense related to intercompany transactions 24 19 — Other individually immaterial items 4 (7) (4) Provision for (benefit from) income taxes $ 67 $ (352) $ 84 A substantial portion of the Company’s manufacturing operations in China, Malaysia, Singapore, Switzerland and Thailand operate under various tax holidays and tax incentive programs, which expire in whole or in part at various dates through 2020. Certain of the tax holidays may be extended if specific conditions are met. The net impact of these tax holidays and tax incentive programs was to increase the Company’s net income by approximately $ million in fiscal year 2008 ($0.40 per share, diluted), $194 million in fiscal year 2007 ($0.33 per share, diluted), and $197 million in fiscal year 2006 ($0.38 per share, diluted).
Financial Analysis Chapter 2 Page 17 of 21
The Company consists of a foreign parent holding company with various foreign and U.S. subsidiaries. Dividend distributions received from the Company’s U.S. subsidiaries may be subject to U.S. withholding taxes when, and if, distributed. Deferred tax liabilities have not been recorded on unremitted earnings of certain other foreign subsidiaries, as these earnings will not be subject to tax in the Cayman Islands or U.S. federal income tax if remitted to the foreign parent holding company. Effective at the beginning of the first quarter of fiscal year 2008, the Company adopted the provisions of FIN 48. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with FASB Statement No. 109, Accounting for Income Taxes. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. As a result of the implementation of FIN 48, the Company increased its liability for net unrecognized tax benefits at the date of adoption. The Company accounted for the increase primarily as a cumulative effect of a change in accounting principle that resulted in a decrease to retained earnings of $3 million and an increase to goodwill of $25 million. The total amount of gross unrecognized tax benefits as of the date of adoption was $385 million excluding interest and penalties. At June 27, 2008, the Company had approximately $374 million in total unrecognized tax benefits excluding interest and penalties. The total unrecognized tax benefits that, if recognized, would impact the effective tax rate were $63 million and $75 million as of June 29, 2007 and June 27, 2008, respectively.
Current Income Tax Expense 44 13
Cash Paid for Income Tax* 34 38
Pretax Income 1 , 329 561
Taxes Payable Rate 3. 31 % 2. 31 %
Taxes Paid Rate 2. 56 % 6. 77 %
* From SCFs
Financial Analysis Chapter 2 Page 19 of 21
Event Operating Lease Capital Lease
At lease inception No entry required Leased Asset
Lease Obligation
Each period during
the life of the lease
Rent Expense
Cash
Interest Expense
Lease Obligation
Cash
Depreciation Expense
Accumulated Deprec.
Because no asset or liability is reported for operation leases this
is referred to off-balance sheet financing.
Note – difference in the manner that companies have acquired
their PP&E (purchase, capital lease, operating lease) can make
comparisons difficult. There are methods to capitalize
operating leases which offer a potential solution.
Lease accounting is considered the poster child for the
problems of a rules-based approach. The IASB answer was to
develop a principles-based approach (if the substantial benefits
and risks of ownership are transferred via the lease then
capitalize, otherwise treat as operating) which exposes the
limitations of that type of solution. Both the FASB and IASB
seem to be ready to tackle the issue again. A new approach will
probably capitalize everything but that will have to wait until
the economy recovers as it will move trillions of liabilities onto
balance sheets.
Financial Analysis Chapter 2 Page 20 of 21
From the STX 10-K
8. Commitments
Leases —The Company leases certain property, facilities and equipment under non-cancelable lease agreements. Land and facility leases expire at various dates through 2082 and contain various provisions for rental adjustments including, in certain cases, a provision based on increases in the Consumer Price Index. Also, certain leases provide for renewal of the lease at the Company’s option at expiration of the lease. All of the leases require the Company to pay property taxes, insurance and normal maintenance costs. Future minimum lease payments for operating leases with initial or remaining terms of one year or more were as follows at June 27, 2008 (lease payments are shown net of sublease income): Fiscal Years Ending Operating (In Leasesmillions) 2009 $ 42 2010 38 2011 39 2012 34 2013 20 Thereafter 108 $ 281 Total rent expense for all land, facility and equipment operating leases was approximately $32 million, $36 million and $24 million for fiscal years 2008, 2007 and 2006, respectively. Total sublease rental income for fiscal years 2008, 2007 and 2006 was $6 million, $11 million and $6 million, respectively. The Company subleases a portion of its facilities that it considers to be in excess of current requirements. As of June 27, 2008, total future lease income to be recognized for the Company’s existing subleases is approximately $26 million.
