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David Zion - The Official Web Site of the Financial ...


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David Zion - The Official Web Site of the Financial ...

  1. 1. Accounting Issues and Analyst Research David Zion, CFA, CPA Accounting Analyst [email_address] (212) 538-4837 Date: January 2009
  2. 2. Anything Remotely Related to Accounting <ul><li>Written research </li></ul><ul><ul><ul><ul><li>Pension Pressure . . . On Balance Sheets, Earnings and Cash Flows </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Goodwill Impairments, Goodwill Going Bad </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Focusing on Fair Value, Mark-to-Market Accounting </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Derivatives Emerging from the Shadows, FAS 161 Increases Transparency </li></ul></ul></ul></ul><ul><ul><ul><ul><li>In Search Of . . . Other-Than-Temporary Impairments, More Write-Downs to Come? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Impairments, Not All Write-Offs Are Created Equal </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Buyer Beware…Changing the Rules on M&A Accounting Again </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Changing the Rules on Converts, Again, Earnings Weaker, Balance Sheets Healthier </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The Magic of Pension Accounting, Part IV </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Peeking Behind the Tax Curtain, FIN 48 Reveals Tax Risk </li></ul></ul></ul></ul><ul><ul><ul><li>Accounting consultant </li></ul></ul></ul><ul><ul><ul><li>Customized product </li></ul></ul></ul>
  3. 3. In Theory Investor’s Focus is on Future… <ul><ul><ul><li>$$ Cash is king $$ $$ Show me the money $$ </li></ul></ul></ul><ul><ul><ul><li>Risks – Sustainability of cash flow </li></ul></ul></ul><ul><ul><ul><li>Claims on cash flow </li></ul></ul></ul><ul><ul><ul><li>Growth of cash flow </li></ul></ul></ul>CASH FLOW … Many Use Earnings as a Shortcut
  4. 4. What’s the Big Deal? Who Cares? It’s Just Accounting <ul><ul><li>A new accounting rule does not change the economics of a business, actual cash flows don’t change </li></ul></ul><ul><ul><ul><li>However </li></ul></ul></ul><ul><ul><ul><li>It does take a different picture of the economics </li></ul></ul></ul><ul><ul><ul><li>If that picture provides investors with new insights about the sustainability, growth, risk, and potential claims on future cash flows, valuations could change </li></ul></ul></ul><ul><ul><ul><li>Don’t forget that the economics of a business can change if a company changes its behavior in response to a new accounting rule </li></ul></ul></ul>Biggest Impact is Change in Behavior
  5. 5. Accounting Tells A Story <ul><li>Problem: The reported results may not always reflect the underlying economics of the business </li></ul><ul><li>Lots of questions to ask… </li></ul><ul><ul><li>What is quality of earnings and cash flows? In other words are they sustainable and generated by the core business? </li></ul></ul><ul><ul><li>Is the smooth consistent earnings stream, really smooth and consistent? </li></ul></ul><ul><ul><li>Why are the “nonrecurring” items, recurring? </li></ul></ul><ul><ul><li>Do acquisitions, transactions make business/economic sense? </li></ul></ul><ul><ul><li>How complex is capital structure? (If its complicated, why?) </li></ul></ul><ul><ul><li>How much of the capital structure is off-balance sheet? </li></ul></ul><ul><ul><li>Are there any significant commitments, contingencies, related party transactions? etc. etc. etc. etc. etc. </li></ul></ul>Challenge is Figuring Out Whether it’s Fiction
  6. 6. …More Questions <ul><ul><li>What are significant estimates, assumptions management makes in financial statements? How do they match up vs. peer group, historical, your own assumptions? </li></ul></ul><ul><ul><li>How did changes in assumptions impact financial statements and results? What is driving the results is it improved performance or changes in management assumptions? </li></ul></ul><ul><ul><li>How do important accounting policies match up vs. peer group? (Aggressive/Conservative) Are you comparing apples and oranges? </li></ul></ul><ul><ul><li>Has the company had to restate results, investigated by SEC or change auditors? </li></ul></ul><ul><ul><li>Does the company provide Plain English disclosure? Does it go above and beyond required disclosures? etc. etc. etc. etc. etc. </li></ul></ul>
  7. 7. Impairments
  8. 8. Write-Offs, Write-Downs, Impairments <ul><ul><ul><li>Do you know what a write-off is? </li></ul></ul></ul><ul><ul><ul><li>Economic impairment may not result in immediate accounting impairment </li></ul></ul></ul><ul><ul><ul><ul><li>Could take time </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Lots of management judgment </li></ul></ul></ul></ul><ul><ul><ul><li>Could change expectations </li></ul></ul></ul><ul><ul><ul><ul><li>Doesn’t affect current period cash flows…it does reflect management’s expectations of future cash flows…if that changes investor’s expectations it could change stock prices </li></ul></ul></ul></ul>Market Should Be Way Ahead of Accountants on Impairments, Right?
  9. 9. Goodwill Going Bad Don’t Ignore Goodwill Impairment Charges <ul><ul><ul><li>S&P 1500 – 500 companies market cap less than book </li></ul></ul></ul><ul><ul><ul><li>402 companies, estimated goodwill impairment, $469 billion </li></ul></ul></ul>
  10. 10. Deferred Tax Assets, Need a Valuation Allowance? Now 69 Companies Deferred Tax Assets > 50% of Market Cap Highest Ratio of Deferred Tax Assets to Market Cap in the S&P 1500 US$ in millions 1 From the most recent annual filings as of January 17, 2008. 2 Market cap as of December 31, 2007. Note: Amounts may not recalculate due to rounding. Source: Company data, Credit Suisse estimates. 36% 150 54 (28) 82 SMP Standard Motor Prods 37% 342 126 (266) 392 HOV Hovnanian Entrprs Inc -Cl A 38% 91 34 (17) 51 CSAR Caraustar Industries Inc. 38% 1,935 733 - 733 KBH KB Home 45% 279 125 (35) 160 FMT Fremont General Corp. 50% 228 113 (8) 121 GGC Georgia Gulf Corp. 50% 1,008 504 - 504 ALK Alaska Air Group Inc. 55% 282 155 (307) 463 SPC Spectrum Brands Inc. 59% 210 123 (2) 125 ROIAK Radio One Inc. 64% 1,179 759 (151) 910 CBB Cincinnati Bell Inc. 72% 193 139 (5) 143 FRNT Frontier Airlines Holdings 98% 89 87 (1) 88 MESA Mesa Air Group Inc. 99% 198 197 (7) 204 TRX.B Tronox Inc. 171% 13,725 23,521 (7,180) 30,701 F Ford Motor Co. 368% $ 14,088 $ 51,823 $ (6,523) $ 58,346 GM General Motors Corp. Net Deferred Tax Assets / Market Cap Market Cap 2 Net Deferred Tax Assets 1 Valuation Allowance 1 Gross Deferred Tax Assets 1 Ticker Company
  11. 11. Accounting for Investments in Debt & Equity Securities Economically Similar Investments Accounted for Differently (Based on Intent) = Earnings Management, Patchwork Balance Sheet, Lack of Comparability Source: Credit Suisse Accounting & Tax Research Realized gains and losses, investor’s share of investee’s earnings/losses and other-than-temporary impairments Cost, adjusted for investor’s share of investee's earnings/losses and dividends Ownership interests between 20% and 50% or investor can otherwise exercise &quot;significant influence&quot; Equity Realized gains and losses, dividend income and other-than-temporary impairments Historical Cost Ownership interests that are less than 20% where equity securities do not have a readily observable fair value Cost Realized gains and losses, interest income and other-than-temporary impairments Amortized cost Intent and ability to hold security until maturity Held-to-Maturity Realized gains and losses, interest/dividend income and other-than-temporary impairments Fair value with changes in fair value reported in other comprehensive income (equity) Any securities not classified in another category Available-for-Sale Changes in fair value along with interest/dividend income Fair value Securities held for a short period (active buying and selling), or any security where fair value option is applied Trading / Fair Value Option (FAS 159) Income Statement Balance Sheet Criteria Method
  12. 12. Unrealized Losses on Investments in Debt & Equity Securities (Financial Sector) at 12/31/07 What the heck is other-than-temporary? Note: Amounts may not recalculate due to rounding. Source: Company data, Credit Suisse. US$ in millions $ (79,713) $1,991,293 $ (29,972) $ 939,376 $ (49,741) $ 1,051,917 Total - - - - - - Real Estate Management & Development - - - - - - Real Estate Investment Trusts (233) 10,740 (108) 7,596 (124) 3,144 Consumer Finance (5,446) 185,510 (2,535) 104,677 (2,911) 80,834 Commercial Banks (5,930) 160,171 (2,703) 81,117 (3,227) 79,054 Capital Markets (6,605) 275,898 (4,881) 195,012 (1,724) 80,886 Diversified Financial Services (21,352) 567,008 (8,131) 331,157 (13,220) 235,851 Thrifts & Mortgage Finance $ (40,148) $ 791,965 $ (11,613) $ 219,818 $ (28,536) $ 572,148 Insurance Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Industry Total 12 months or more Less than 12 months
  13. 13. Impact of an Other than Temporary Impairment Charge Why does anyone care about Other-Than-Temporary Impairments? Source: Credit Suisse Accounting & Tax Research <ul><ul><ul><li>Freddie Mac: “…the fair value of these investments has declined and may be further adversely affected by additional ratings downgrades or market events. These factors could negatively affect our core capital and results of operations, if we were to conclude that other-than-temporary impairments occurred.” </li></ul></ul></ul>⇩ ⇩ No Change ⇩ ⇩ Cost ⇩ ⇩ No Change ⇩ ⇩ Equity ⇩ ⇩ No Change ⇩ ⇩ Held-to-Maturity No Change ⇩ ⇧ No Change ⇩ Available-for-Sale Total Equity (Book Value) Retained Earnings AOCI Assets Earnings Category Shareholders' Equity Balance Sheet Income Statement
  14. 14. Fair Value Accounting, aka Mark-to-Market
  15. 15. FAS 157, Fair Value Accounting <ul><ul><ul><li>What Did it Change? </li></ul></ul></ul><ul><ul><ul><ul><li>New disclosures (level 1, 2, 3) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Not very much, actually… </li></ul></ul></ul></ul><ul><ul><ul><li>Defines Fair Value as an Exit Price: </li></ul></ul></ul><ul><ul><ul><ul><li>Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. </li></ul></ul></ul></ul><ul><ul><ul><li>Subtle clarifications </li></ul></ul></ul><ul><ul><ul><ul><li>Fair value is an exit price (could have been exit or entry before) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Must use “market participant” assumptions (i.e. not the company’s) </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Even if you think market is undervaluing the asset </li></ul></ul></ul></ul></ul><ul><ul><ul><li>The accounting is not the problem, its reflecting an economic reality: Asset values are falling. </li></ul></ul></ul><ul><ul><ul><ul><li>Real problem = overexposure to certain assets, poor risk management, mispriced risks, lots of leverage and asset-liability mismatch </li></ul></ul></ul></ul>Has Been Blamed for Everything from Credit Crisis to Global Warming
  16. 16. Fair Value Hierarchy How Reliable Are the Fair Value Measurements Source: Financial Accounting Standards Board, Credit Suisse, Company Data. Distressed debt, private equity, real estate, “exotic” derivatives, illiquid mortgage-backed securities High grade and high-yield corporate bonds, mortgage backed securities, corporate bank and bridge loans, loan commitments, less liquid listed equities, municipal bonds, physical commodities, over-the-counter derivatives such as interest rate swaps U.S. government and agency securities, foreign government debt, listed equities, money market securities Examples Mark-to-Model Mark-to-Market / Mark-to-Model Mark-to-Market In other words Unobservable inputs for the asset or liability. Company’s assumptions about market participant assumptions (i.e., assumptions-squared). <ul><li>Inputs other than Level 1 quoted prices that are observable for the asset or liability either directly or indirectly, includes: </li></ul><ul><li>Quoted prices for similar assets or liabilities. </li></ul><ul><li>Quoted prices in markets that are not active. </li></ul><ul><li>Inputs other than quoted prices that are observable (e.g., yield curves, volatilities, prepayment speeds, credit risks, default rates, etc.) </li></ul><ul><li>Inputs that are derived from or corroborated by observable market data by correlation or other means (e.g., implied volatilities) </li></ul>Quoted prices in active markets for identical assets or liabilities FAS 157 Definition Least reliable Less reliable Most reliable Reliability Level 3 Level 2 Level 1
  17. 17. How Much of the Balance Sheet is at Fair Value?
  18. 18. What’s on the Balance Sheet at Fair Value?
  19. 19. Level 3 Assets > Book Value Level 3 Gets All the Attention
  20. 20. Questions to Ask <ul><ul><ul><li>What significant risks are companies exposed to in each level? </li></ul></ul></ul><ul><ul><ul><li>How are risks managed? </li></ul></ul></ul><ul><ul><ul><li>How much is hedged? How is it hedged? What is counterparty risk? </li></ul></ul></ul><ul><ul><ul><li>For Levels 2 and 3 what are key assumptions? </li></ul></ul></ul><ul><ul><ul><li>How have assumptions changed? What impact did changes have on financial statements? </li></ul></ul></ul><ul><ul><ul><li>Can company provide a sensitivity analysis? </li></ul></ul></ul>Still Looking for Answers, More Transparency Could Boost Confidence
  21. 21. Derivatives
  22. 22. Derivatives Notional 29% CAGR vs. Derivatives Accounting 24% CAGR 1,000 + Pages of Derivatives Accounting Guidance Note: The composition of the ISDA survey changed over time, it first started to include credit derivatives and equity derivatives in 2001-2002. Source: International Swaps & Derivatives Association, Financial Accounting Standards Board and Credit Suisse Accounting & Tax Research US$ in trillions
  23. 23. Large Derivative Exposures… <ul><ul><ul><li>Derivatives Emerging from the Shadows with FAS 161 </li></ul></ul></ul><ul><ul><ul><ul><li>Companies have to tell you three things each quarter: </li></ul></ul></ul></ul><ul><ul><ul><ul><li>How and why they use derivatives (speculation or risk management)? What risks are they hedging? What new risks have they exposed themselves to? What is volume of derivative activity? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>How derivatives and hedged items are accounted for. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>How derivatives and hedged items impact balance sheet, earnings and cash flows (future cash flows, not current period) </li></ul></ul></ul></ul>… Weak Derivative Disclosures
  24. 24. Exposure to Derivatives Use the Fair Value Disclosures to Find Exposure to Derivatives
  25. 25. Pensions
  26. 26. The Unknown Spooks Investors <ul><li>No Surprise That We Have Been Inundated with Questions </li></ul><ul><ul><li>Defined Benefit Pension Plans </li></ul></ul><ul><ul><ul><li>Confusing accounting – FAS No. 87 </li></ul></ul></ul><ul><ul><ul><li>Complicated funding requirements </li></ul></ul></ul><ul><ul><ul><ul><li>Separate set of assumptions and calculations </li></ul></ul></ul></ul><ul><ul><ul><li>Mysterious economics </li></ul></ul></ul><ul><ul><ul><ul><li>Obligation with unknown cash flows </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Unique obligation, where employees are the creditors, may not be most efficient way to raise capital </li></ul></ul></ul></ul>Recipe for Confusion
  27. 27. Pension Plans Losing Ground <ul><li>Aggregate Funded Status for S&P 500 Defined Benefit Pension Plans </li></ul>Estimated $420 Billion Deterioration in Health of Plans During 2008 Estimated $362 billion in underfunding
  28. 28. Pension Pain <ul><ul><li>Pension Pressure </li></ul></ul><ul><ul><ul><li>Underfunding more than 10% of market cap for 70 companies </li></ul></ul></ul><ul><ul><ul><li>Book value could drop by more than 10% for 108 companies </li></ul></ul></ul><ul><ul><ul><li>Earnings headwind for 274 companies from higher pension costs </li></ul></ul></ul><ul><ul><li>Too Much Focus on Earnings Impact of Plans, Waste of Time </li></ul></ul><ul><ul><ul><li>Depends upon fair value or calculated value </li></ul></ul></ul><ul><ul><ul><li>Focus on Three Things </li></ul></ul></ul><ul><ul><ul><li>Pension claim, underfunding </li></ul></ul></ul><ul><ul><ul><li>Future costs, new pension liabilities </li></ul></ul></ul><ul><ul><ul><li>Risk </li></ul></ul></ul><ul><ul><ul><ul><ul><li>Asset/Liability mismatch </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Liquidity, funding needs </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Mispricing, incorrect assumptions, etc. </li></ul></ul></ul></ul></ul>
  29. 29. The Magic of Pension Accounting <ul><ul><ul><li>Made plans appear healthier than they really were </li></ul></ul></ul><ul><ul><ul><li>Made plans appear less volatile (almost risk free) </li></ul></ul></ul><ul><ul><ul><li>Allowed companies to go on long pension funding holidays </li></ul></ul></ul><ul><ul><ul><li>Turned plans into profit centers </li></ul></ul></ul><ul><ul><ul><li>Made it very easy to make pension promises </li></ul></ul></ul>Accounting and Funding Rules Appeared to Protect Companies from their Pension Plans That’s No Help When Pension Promises Come Due
  30. 30. Is it a Pension Plan or an Operating Company? Assets would increase by > 10% for 158 companies
  31. 31. The Largest Liability Put the Pension Obligation on Balance Sheet and it Would be the Largest Liability for 103 Companies Debt Largest Liability for 222 Companies
  32. 32. Earnings More Volatile Than It Appears … It Only Highlights the Volatility that Already Exists Accounting Change Would Not Create the Volatility…
  33. 33. Adjusting Operating Income <ul><li>Largest % and $ Drop in Cumulative Operating Income (1999-2006) after Adjusting for the Pension Plan </li></ul><ul><li>Adjusted Operating Income = Reported Operating Income + Pension Cost – Service Cost </li></ul>Operating Income is Not All Operating US$ in millions <ul><ul><ul><li>On the other hand, we found 168 companies where operating income would increase . </li></ul></ul></ul>
  34. 34. Changing Behavior <ul><ul><ul><li>Changes in… </li></ul></ul></ul><ul><ul><ul><li>Pension Accounting </li></ul></ul></ul><ul><ul><ul><li>Funding Rules </li></ul></ul></ul><ul><ul><ul><li>Health of Plans </li></ul></ul></ul><ul><ul><ul><li>Spark Changes in Corporate Behavior… </li></ul></ul></ul><ul><ul><ul><li>The Deep Freeze </li></ul></ul></ul><ul><ul><ul><li>Getting out of the Pension Business </li></ul></ul></ul><ul><ul><ul><li>Changing Asset Allocations (Liability Driven Investing, LDI) </li></ul></ul></ul>
  35. 35. The End Result? <ul><ul><ul><li>Pension Risks Unlikely to Stay Where They Are, Shifted to: </li></ul></ul></ul><ul><ul><ul><li>Workers </li></ul></ul></ul><ul><ul><ul><li>Others </li></ul></ul></ul><ul><ul><ul><ul><li>Insurance Companies </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Investment Banks? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Asset Managers, etc. </li></ul></ul></ul></ul><ul><ul><ul><li>If companies continue taking risks in their pension plans, large asset-liability mismatch </li></ul></ul></ul><ul><ul><ul><li>Do the companies have any expertise managing those risks? </li></ul></ul></ul><ul><ul><ul><li>Are investors willing to pay for companies to take on those risks? </li></ul></ul></ul>
  36. 36. Passing the Buck Source: From The Wall Street Journal—Permission, Cartoon Features Syndicate
  37. 37. Options
  38. 38. Employee Stock Options = Deferred Compensation <ul><ul><ul><li>Employee stock options are a form of deferred compensation and represent a cost </li></ul></ul></ul><ul><ul><ul><li>Company is giving its employees something of value in return for their service </li></ul></ul></ul><ul><ul><ul><li>Factor into valuation analysis in two ways: </li></ul></ul></ul><ul><ul><ul><ul><li>Old Stuff. Outstanding employee stock options represent an economic liability. Need to measure how much of a claim the option holders have on your stake in the company </li></ul></ul></ul></ul><ul><ul><ul><ul><li>New Stuff. Future option grants are a cost of doing business. Need to measure how much of the shareholders’ stake management plans to give away to its employees with future option grants </li></ul></ul></ul></ul>Focus on the Economics of Employee Stock Option Plans
  39. 39. $391 Billion Off Balance Sheet Option Liability Source: Company data, Credit Suisse estimates. $391 billion fair value = $228 billion intrinsic value + $163 billion time value <ul><ul><ul><li>28 billion options </li></ul></ul></ul><ul><ul><ul><li>Give employees the right to buy $964 billion worth of stock or 8.1% of total market cap </li></ul></ul></ul>
  40. 40. Options Are Like Onions, They Have Layers Estimated Drop in FV of Options Due to Drop in Option Price > 10% of Operating Income
  41. 41. The Impact of Changing Volatility on Operating Income Decline in Fair Value of Options Granted due to a Drop in Volatility > 10% of Operating Income
  42. 42. Leases
  43. 43. Off Balance Sheet Lease Liability $396 Billion Operating Lease Liability for the S&P 500 <ul><ul><ul><li>FASB and IASB working on lease accounting </li></ul></ul></ul><ul><ul><ul><li>Could result in a major overhaul, including bringing off balance sheet operating leases on balance sheet </li></ul></ul></ul>
  44. 44. Bringing Operating Leases on Balance Sheet Liabilities More Than Double <ul><ul><ul><li>If it’s not a liability, what do you make of it? (A hat? A broach? A pterodactyl?) </li></ul></ul></ul><ul><ul><ul><li>Whether it shows up on balance sheet today depends on how lease is structured </li></ul></ul></ul><ul><ul><ul><li>Capital vs Operating, 4 Criteria (transfer ownership, bargain purchase option, lease term > 75% of economic life, PV of min lease > 90% of fair value of leased asset) </li></ul></ul></ul><ul><ul><ul><li>Analytically bring on balance sheet, investors should already be adjusting </li></ul></ul></ul>US$ in millions
  45. 45. Off-Balance-Sheet
  46. 46. Off-Balance-Sheet Activity <ul><ul><ul><li>Look for companies to try and explain </li></ul></ul></ul><ul><ul><ul><ul><li>What they are doing off balance sheet </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Why they are doing it </li></ul></ul></ul></ul><ul><ul><ul><ul><li>What risks are involved </li></ul></ul></ul></ul><ul><ul><ul><li>Ask yourself some questions: </li></ul></ul></ul><ul><ul><ul><ul><li>Do the transactions make sense? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Do they have a valid business purpose? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Should you bring them on balance sheet analytically? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Is it just another fancy form of financing? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Have you factored risks into your analysis? </li></ul></ul></ul></ul>Have you run scenarios in your model using different assumptions?
  47. 47. Off Balance Sheet Risks How have you factored this stuff into your model?
  48. 48. Off Balance Sheet Club $1.5 Trillion Off Balance Sheet Assets, $2.3 Trillion Off Balance Sheet Liabilities <ul><ul><ul><li>Four off balance sheet risks, pensions, OPEB, options, and operating leases…there are plenty more </li></ul></ul></ul>Maybe balance sheets aren’t as healthy as they initially appear US$ in millions
  49. 49. Taxes
  50. 50. Corporate Taxes – A Giant Black Box <ul><ul><li>The hardest thing in the world to understand is the income tax. </li></ul></ul><ul><ul><li>Albert Einstein </li></ul></ul><ul><ul><ul><li>Multiple corporate entities </li></ul></ul></ul><ul><ul><ul><li>Taxed in multiple jurisdictions (state, local, federal, international) </li></ul></ul></ul><ul><ul><ul><ul><li>Example: GE files over 6,500 tax returns in 250 global taxing jurisdictions </li></ul></ul></ul></ul><ul><ul><ul><li>Multiple sources of tax law (legislation, statutes, case law, etc.) </li></ul></ul></ul><ul><ul><ul><li>Taxes are one of the larger costs a company will incur </li></ul></ul></ul><ul><ul><ul><li>Accounting for income taxes: One of the most complicated and least understood areas in accounting </li></ul></ul></ul>Asking for Trouble
  51. 51. Taxes <ul><ul><li>Is the tax rate sustainable? </li></ul></ul><ul><ul><li>How much of the EPS growth was attributable to lower tax rate? </li></ul></ul><ul><ul><li>How much of the cash flow growth was attributable to paying less in taxes? </li></ul></ul><ul><ul><li>How do cash taxes compare to book taxes? </li></ul></ul><ul><ul><li>When will they become a cash tax payer? </li></ul></ul><ul><ul><li>How should I value their NOLs? When do they expire? </li></ul></ul><ul><ul><li>Will the deferred tax liabilities ever come due? </li></ul></ul><ul><ul><li>Is the company being audited? </li></ul></ul><ul><ul><li>What is the amount of undistributed foreign earnings? </li></ul></ul><ul><ul><li>Will the company need to set up a deferred tax valuation allowance? etc. etc. etc. </li></ul></ul>One of the most complicated and least understood areas of accounting.
  52. 52. Now There’s Only Death <ul><ul><li>FIN 48, Accounting for Uncertainty in Income Taxes </li></ul></ul><ul><ul><ul><ul><li>Uncertain tax position = Company takes a position on its tax return (typically to reduce the tax bill) uncertain whether the IRS or some other tax authority will accept </li></ul></ul></ul></ul><ul><ul><ul><ul><li>What’s really got the companies worried is the new disclosures </li></ul></ul></ul></ul><ul><ul><ul><ul><li>First time disclosing tax reserves. Is it a roadmap for the IRS? More like a compass. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Potential Impacts of FIN 48 </li></ul></ul></ul></ul><ul><ul><ul><ul><li>More volatile effective tax rates = More volatile earnings </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Reduced ability to manage earnings </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Companies paying more in taxes </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Increased risk of IRS audit and </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Less aggressive applications of the tax code </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>May uncover tax risks you were unaware of </li></ul></ul></ul></ul>
  53. 53. Peeking behind the Tax Curtain $141 Billion in Unrecognized Tax Benefits (i.e., Tax Reserve) Risk: Payment of back taxes, penalties & interest
  54. 54. <ul><ul><li>Investors uncovering tax risks could affect valuations: </li></ul></ul><ul><ul><ul><li>Estimates of future cash flows (how sustainable is tax rate?) </li></ul></ul></ul><ul><ul><ul><li>Higher required return (increased tax risk could increase cost of capital) </li></ul></ul></ul>FIN 48 Reveals Tax Risk Are you willing to pay for companies to take on this type of risk? Tax Risk Report Card
  55. 55. Other Stuff
  56. 56. Pro Forma EPS, Cash EPS, Non-GAAP or… Source: From The Wall Street Journal—Permission, Cartoon Features Syndicate
  57. 57. Why does Pro Forma EPS always seem to be higher than GAAP EPS? <ul><ul><li>Pro forma or cash earnings – spread vs. GAAP – What adjustments are being made? Do the adjustments make any sense? (don’t be afraid to challenge the convention, just because “everyone” does it doesn’t mean its right) </li></ul></ul>
  58. 58. Accounting Motivated Transactions <ul><ul><li>Accelerated vesting of options </li></ul></ul><ul><ul><li>Six month & 1 day option repricings </li></ul></ul><ul><ul><li>Structuring a lease in just the right way to get preferred accounting treatment </li></ul></ul><ul><ul><li>Restructuring off-balance-sheet transactions to keep them off-balance-sheet </li></ul></ul><ul><ul><li>Finding a replacement for co-co’s, etc. etc. etc. </li></ul></ul>Is management focused on the economics of the business or the accounting? <ul><ul><li>Is the company incurring an economic cost to reduce an accounting cost, or to paint a prettier accounting picture? </li></ul></ul><ul><ul><li>Is there an economic reason for the transaction? </li></ul></ul><ul><ul><li>Be on the look out for overly complex transactions </li></ul></ul>
  59. 60. Disclosure <ul><li>Disclosure Appendix </li></ul><ul><li>Important Global Disclosures </li></ul><ul><li>I, David Zion, CFA, CPA, certify that (1) the views expressed in this report accurately reflect my personal views about all of the subject companies and securities and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. </li></ul><ul><li>The analyst(s) responsible for preparing this research report received compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities. </li></ul><ul><li>Analysts’ stock ratings are defined as follows***: </li></ul><ul><li>Outperform (O): The stock’s total return is expected to exceed the industry average* by at least 10-15% (or more, depending on perceived risk) over the next 12 months. </li></ul><ul><li>Neutral (N): The stock’s total return is expected to be in line with the industry average* (range of 10%) over the next 12 months. </li></ul><ul><li>Underperform (U)**: The stock’s total return is expected to underperform the industry average* by 10-15% or more over the next 12 months. </li></ul><ul><li>*The industry average refers to the average total return of the relevant country or regional index (except with respect to Europe, where stock ratings are relative to the analyst’s industry coverage universe). </li></ul><ul><li>**In an effort to achieve a more balanced distribution of stock ratings, the Firm has requested that analysts maintain at least 15% of their rated coverage universe as Underperform. This guideline is subject to change depending on several factors, including general market conditions. </li></ul><ul><li>***For Australian and New Zealand stocks a 7.5% threshold replaces the 10% level in all three rating definitions, with a required equity return overlay applied. </li></ul><ul><li>Restricted (R): In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. </li></ul><ul><li>Volatility Indicator [V]: A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward. </li></ul>
  60. 61. Disclosure <ul><li>Analysts’ coverage universe weightings are distinct from analysts’ stock ratings and are based on the expected performance of an analyst’s coverage universe* versus the relevant broad market benchmark**: </li></ul><ul><li>Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. </li></ul><ul><li>Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. </li></ul><ul><li>Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. </li></ul><ul><li>*An analyst’s coverage universe consists of all companies covered by the analyst within the relevant sector. </li></ul><ul><li>**The broad market benchmark is based on the expected return of the local market index (e.g., the S&P 500 in the U.S.) over the next 12 months. </li></ul><ul><li>Credit Suisse’s distribution of stock ratings (and banking clients) is: </li></ul><ul><li>Global Ratings Distribution </li></ul><ul><li>Outperform/Buy* 45% (56% banking clients) </li></ul><ul><li>Neutral/Hold* 41% (56% banking clients) </li></ul><ul><li>Underperform/Sell* 12% (47% banking clients) </li></ul><ul><li>Restricted 2% </li></ul><ul><li>*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors. </li></ul><ul><li>Credit Suisse’s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein. </li></ul><ul><li>Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: and analytics/disclaimer/managing_conflicts_disclaimer.html </li></ul><ul><li>Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties. </li></ul><ul><li>Important Regional Disclosures </li></ul><ul><li>Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares. </li></ul><ul><li>Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. </li></ul><ul><li>For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit </li></ul><ul><li>As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report. </li></ul><ul><li>Principal is not guaranteed in the case of equities because equity prices are variable. </li></ul><ul><li>Commission is the commission rate or the amount agreed with a customer when setting up an account or at anytime after that. </li></ul><ul><li>CS may have issued a Trade Alert regarding this security. Trade Alerts are short term trading opportunities identified by an analyst on the basis of market events and catalysts, while stock ratings reflect an analyst's investment recommendations based on expected total return over a 12-month period relative to the relevant coverage universe. Because Trade Alerts and stock ratings reflect different assumptions and analytical methods, Trade Alerts may differ directionally from the analyst's stock rating. </li></ul><ul><li>The author(s) of this report maintains a CS Model Portfolio that he/she regularly adjusts. The security or securities discussed in this report may be a component of the CS Model Portfolio and subject to such adjustments (which, given the composition of the CS Model Portfolio as a whole, may differ from the recommendation in this report, as well as opportunities or strategies identified in Trading Alerts concerning the same security). The CS Model Portfolio and important disclosures about it are available at </li></ul><ul><li>For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at or call +1 (877) 291-2683. </li></ul>
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