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Appendix 4-A
ESTIMATING OPERATING LEVERAGE




W1
W2 APPENDIX 4-A ESTIMATING OPERATING LEVERAGE
Appendix 4-B
EARNINGS PER SHARE”
ADDITIONAL ISSUES


Earnings per share is probably the most widely used indicator of corporate performance. Yet
most of those who use it do not understand how it is computed. Fewer still understand how it
is affected by the issuance of convertibles, options, or other potentially dilutive securities. In
the text we have outlined the procedures used in its calculation. In this appendix, we discuss
computational issues, disclosure requirements, and the few differences between US and
IASB standards.


COMPUTATIONAL ISSUES

Weighted Average Number of Common Shares Outstanding
The denominator must re¬‚ect all stock dividends and stock splits effective during the period
and those announced after the end of the reporting period (but before the ¬nancial statements
are issued) as if they had been effective at the beginning of the reporting period. All prior pe-
riods presented are restated for comparability.

Acquisitions
Shares issued in purchase method acquisitions (see Chapter 14) are included in the denomi-
nator only for the period following the acquisition date. Similarly, only the postacquisition
results of operations of the acquired ¬rms are included in the numerator of the EPS computa-
tion. Note that no restatement of prior periods is permitted for purchase method acquisitions.
The impact of the pooling method is quite different. Merged ¬rms are considered com-
bined entities for all years presented. The shares issued in the combination are assumed to
have been outstanding for all periods presented, and the results of operations for the two
¬rms are also combined for those periods in the EPS calculation.

Contingent Shares
Acquisitions and incentive compensation plans may require the issuance of common
shares if specific conditions, such as the passage of time, achievement of income levels, or
specified market prices of the common stock, are met. Securities whose issuance depends
solely on the passage of time are always included in the weighted average shares outstand-
ing. Other contingent shares are included in the computation of basic and diluted EPS if
the required income levels or market prices have been reached at the end of the reporting
period.
When the issuance of contingent shares depends on the achievement of earnings targets,
and when it is likely that those targets will be achieved, the computation of diluted earnings
per share includes both the incremental shares and the level of income assumed to have been
achieved. These adjustments to the EPS measures are required even if the incremental shares
are to be issued at a later date.

W3
W4 APPENDIX 4-B EARNINGS PER SHARE”ADDITIONAL SHARES


EPS Computations for Two-Class Securities
Some ¬rms issue more than one class of common stock or have “participating” securities
that are entitled to share in the dividends paid on common stock. EPS computations for each
class of nonconvertible1 two-class securities are based on an allocation of earnings according
to dividends paid and participation rights in undistributed earnings.

Adjustments for Rights Issues
Both SFAS 128 and IAS 33 mandate the use of the ex-rights method in the computation of
basic and diluted EPS for the bonus element (discount to market price prior to the offering)
in a rights issue. Under prior US GAAP, the bonus element was ignored. The ex-rights
method recognizes dilution when rights are issued to buy shares below the current market
price.

Impact of New and Proposed Accounting Standards
SFAS 144 (2001) broadened the de¬nition of discontinued operations as discussed on pages
54 and 275 of the text. This change means that, for ¬rms disposing of unpro¬table opera-
tions, income from continuing operations will be higher than it would have been under prior
accounting standards. Because income from continuing operations is the “control number”
used to determine whether options and convertible securities are dilutive, higher income
from continuing operations will result in more of these potential common shares entering
into the computation of dilutive EPS.
In its proposed reporting for securities with characteristics of liabilities or equity or both
(see Box 10-2 on page 338 of the text), the FASB intends to rede¬ne the control number as
income from continuing operations attributable to controlling shareholders. Under current
GAAP, income allocated to minority or noncontrolling shareholders is deducted in comput-
ing the income from continuing operations. Thus, companies with pro¬table majority-owned
subsidiaries will report higher control numbers under this proposed standard. Again, more
potential common stock will be classi¬ed as dilutive securities.


INTERNATIONAL DIFFERENCES

As stated in the text, the FASB and IASB developed their new standards together. As a re-
sult, there are few differences between the two. The most important difference is that US
GAAP requires that EPS be reported for all components of net income. IASB GAAP re-
quires disclosure of EPS only for net income; any other components of EPS reported, how-
ever, must accord with the new standard.
Under SFAS 128, earnings from continuing operations is the “control number” used to
determine whether potential common shares are dilutive (see previous section). Thus, ac-
counting changes, discontinued operations, and extraordinary items do not affect determina-
tion of the dilutive effect. Under IAS 33, net income is the control number. Given the high
frequency of extraordinary items and other differences between earnings from continuing
operations and net income, it is likely that, for some ¬rms, the dilutive effect will be different
depending on whether they use US GAAP or IASB GAAP.




1
If shares of one class are convertible into shares of another class, as is normally the case, the if-converted method
must be used for the convertible securities if the effect is dilutive.
Appendix 6-A
LIFO MEASUREMENT ISSUES


This appendix is concerned with two measurement issues that arise when the LIFO method
is used:
• Different varieties of LIFO
• Dif¬culties when LIFO is applied to interim earnings

Although these issues arise frequently, they are segregated within this appendix to simplify
the presentation in the chapter itself.

LIFO INVENTORY METHODS

The discussions in the chapter implicitly assume that:
• Firms account for each inventory item
• There is only one manner of applying the LIFO method of accounting

Neither assumption is correct. In practice, all but the smallest ¬rms have far too many inven-
tory items to use speci¬c item-based costing methods ef¬ciently. The potential for LIFO liq-
uidations and the resulting loss of tax bene¬ts are additional deterrents to the use of speci¬c
item methods. More ef¬cient methods of applying LIFO to inventories involve the pooling
of “substantially identical” inventory units to compute unit costs and physical quantities.
Reeve and Stanga (1987) found that a majority of LIFO method companies use a single
pool, generally de¬ned by the natural business unit, and they use the same pooling method
for ¬nancial reporting and taxes although conformity is not required. The number of pools
used was inversely related to the magnitude of tax bene¬ts (companies with large tax savings
from LIFO tended to use fewer pools).
They also reported substantial variation in the number of pools used within an industry
and across all the ¬rms in their sample. The impact on cash ¬‚ows and ¬nancial statements
suggests that analysts should carefully evaluate announcements of changes in LIFO pools to
understand the impact of the change on reported earnings.

Example: Oxford
Oxford [OXM], a clothing manufacturer, uses the LIFO method for most inventories. In ¬s-
cal 2002, Oxford reduced the number of inventory pools used to compute LIFO from ¬ve to
three. As a result, the company avoided a LIFO liquidation that would have increased net in-
come by 30% (and would have resulted in signi¬cant tax payments).1 The company stated
that one reason for the change was to “reduce the likelihood of LIFO layer liquidations.” The
change was reported as a change in accounting principle.
Inventories may also be pooled on the basis of similarity of use, production method, or
raw materials used. Liquidations are reduced because these “dollar value” LIFO methods
compute inventories using dollars, facilitating substitutions of items in the pools. Inventory

1
Despite the change in number of pools, Oxford reported a small LIFO liquidation for the year.


W5
W6 APPENDIX 6-A LIFO MEASUREMENT ISSUES


layers may be priced using indices published by the Bureau of Labor Statistics or internally
developed indices. The differences can be substantial.
For example, during 1990 Kmart switched to internally generated indices (from the U.S.
Department of Labor™s Department Store Price Index) for its U.S. merchandise inventories.
The ¬nancial statement footnote stated the ¬rm™s belief that the internal index “results in a
more accurate measurement of the impact of in¬‚ation on the prices of merchandise sold in its
stores.” The change reduced its COGS by $105 million (net of tax), increasing income by
$0.52 per share (32.3% of reported income for the year).
Retailers use more complex LIFO methods. Interested readers are referred to intermedi-
ate and advanced accounting texts for explanations of the LIFO Retail and Dollar Value
LIFO Retail methods.


INTERIM REPORTING UNDER LIFO
As discussed in Chapter 1, interim reporting creates special problems for both ¬nancial re-
porting and ¬nancial analysis. Because LIFO is a tax-based inventory method, its use creates
additional problems. The actual LIFO effect for the year cannot be known until the year is
complete. Thus, LIFO charges for interim periods require management assumptions regard-
ing both inventory quantities and prices at the end of the year.
Technological changes, ¬‚uctuations in demand, and strikes may also result in a reduc-
tion in LIFO layers during the year. The application of LIFO during interim periods may re-
sult in substantial distortions (income statement and balance sheet) if the factors causing the
LIFO liquidations are temporary and the layers will be replenished prior to year-end.
Financial reporting for interim periods is governed by APB Opinion 28, which provides
special inventory valuation procedures during interim periods when the ¬rm experiences a
LIFO liquidation during one or more of the ¬rst three quarters.
Permanent liquidations must be reported in the quarter of occurrence. However, when
management believes that the liquidated layer(s) will be replenished before year-end, the
cost of goods sold for the quarter must include the estimated cost of replacing the temporary
liquidation rather than the LIFO cost of the goods sold. The application of this method is il-
lustrated using the following example:

Assumptions: All transactions occur during the second quarter
Beginning inventory (FIFO): 10 units @ $30 $300
LIFO reserve (@ $20) ($200)
LIFO inventory 10 units @ $10 $100
Purchases: 20 units @ $30 $600
Goods available for sale $700
Sales: 21 units @ $40 $840

Management determines that the liquidation is temporary and expects the next purchase
price (cost to replace) to be $35. GAAP requires the use of $35 rather than the unit cost of
the liquidated layer. COGS is reported at
$635 (20 units @ $30 plus 1 unit @ $35)

Inventory is reduced by
$610 (20 units @ $30 and 1 unit @ $10)

The ¬rm recognizes a current liability (called the LIFO base liquidation) for the differ-
ence of $25, indicating that the ¬rm has temporarily “borrowed” a unit from the base layer.2
The next purchase of inventory is used to eliminate the current liability and replenish the

2
An AICPA issues paper, “Identi¬cation and Discussion of Certain Financial Accounting and Reporting Issues Con-
cerning LIFO Inventories” (AICPA, 1984), suggests that the interim liquidation may also be credited directly to
inventories.
W7
INTERIM REPORTING UNDER LIFO

LIFO base layer. This method eliminates any distortion in reported gross pro¬t and income
numbers due to temporary interim period liquidations.
Year-end LIFO liquidations are permanent reductions in LIFO layers, and the reported
gross pro¬t must include the impact of the reduction in LIFO reserves. If the foregoing sce-
nario occurs during the fourth quarter, the ¬rm would report COGS of $610 [(20 $30)
(1 $10)] and separately disclose the impact of the LIFO liquidation on COGS and net in-
come in the footnotes.

Example: Nucor
The following example illustrates the impact of volatile prices and the procedures required
for interim reporting. It is based on Nucor Corp., a steel and steel products manufacturer that
uses the LIFO method of inventory accounting. Steel scrap is a major component of inventory
cost, and since scrap prices can be volatile, Nucor must estimate its year-end position at the
end of each interim period. That is, it must estimate both physical inventory and the price of
scrap at year-end to establish the appropriate LIFO reserve at the end of each interim period.
In 1981, scrap prices rose during the ¬rst part of the year, but declined in the second
half. The LIFO reserve declined for 1981 as a whole, re¬‚ecting a decline in the price of steel
scrap. (At the end of 1981, the difference between the LIFO and FIFO cost of its inventory
was lower than it had been one year earlier.)
During the ¬rst two quarters, Nucor assumed that scrap prices would be higher at the end
of 1981 than one year earlier and accrued additional LIFO reserves. Because of the decline in
steel scrap prices late in the year, these earlier accruals were reversed in the fourth quarter.
The impact of the interim changes in the LIFO reserve can be seen in the following table:

Reported Nucor Quarterly Results 1981 ($ in thousands)

Quarter I II III IV Year
Pretax income $13,087 $11,204 $4,637 $15,901 $44,829
LIFO effect 1,873 1,900 0 (5,134) (1,361)
LIFO reserve (end of period) $25,600 $27,500 $27,500 $22,366 $22,366
(12/31/80 $23,727)
Source: Nucor, 1981 annual and interim reports.

Although the interim LIFO accruals (LIFO effect change in reserve) were made in
good faith, in retrospect we can see that they were incorrect and distorted operating results.
To correct that distortion, we can (with perfect hindsight) reallocate the decrease in the LIFO
reserve for the year so that an equal amount is credited to each interim period. We can obtain
the “true” interim results by restating the LIFO impact as follows:

Adjusted Nucor Quarterly Results 1981 ($ in thousands)
Quarter I II III IV Year

Pretax income $13,087 $11,204 $4,637 $15,901 $44,829
LIFO adjustment* $12,213 $12,240 $4,340 $ (4,793) $44,820
Adjusted pretax $15,300 $13,444 $4,977 $11,108 $44,829
% Change from reported 16.9% 20.0% 7.3% (30.1)% 0
*Difference between original LIFO effect and true LIFO effect (one-fourth of annual). For example, the ¬rst quarter
adjustment is $1,873 ( $1,361/4).

The Nucor case indicates that management assumptions can play a major role in re-
ported interim earnings and the application of LIFO accounting to interim periods can result
in large distortions in interim comparisons. It should also be noted that there are many ways
of making interim LIFO calculations. This illustration also serves as an example of fourth-
quarter adjustments that have a signi¬cant impact on reported earnings and trends re¬‚ected
during the previous three quarters.
Appendix 6-B
THE FIFO/LIFO CHOICE:
EMPIRICAL STUDIES


As noted in the chapter, the LIFO to FIFO choice provides an ideal research topic as the
choice has

1. con¬‚icting income and cash ¬‚ow (tax effect) implications, and
2. data availability allowing for adjustment from one method to the other permitting
“as-if” comparisons in research design.

Earlier research focused on market reaction to FIFO-to-LIFO switches and the motivation
for using one method as compared to the other. This line of research was consistent with
the market-based and positive accounting approaches1 to research prevalent at that time.
More recently, in line with the renewed interest in security valuation issues, researchers
have examined the relationship between equity valuation and alternative methods of in-
ventory reporting.

Equity Valuation Issues
Jennings, Simko, and Thompson (1996) examined the contention that

1. LIFO income statements were more useful than non-LIFO statements, and
2. Non-LIFO balance sheets were more useful than LIFO balance sheets
by comparing which set of statements better explained the distribution of equity values for a
set of LIFO ¬rms. The “as if” non-LIFO statements were created by using the LIFO reserve
disclosures and the methodology described in the chapter.
Their results were mixed. Consistent with their expectation, they found that LIFO-based
income statements explained more of the variation in equity valuations than non-LIFO in-
come statements. However, they found that LIFO balance sheets were more useful than their
non-LIFO counterparts”a surprising result given that non-LIFO balance sheets are closer to
current (rather than outdated LIFO) costs.
Jennings et al. explained these results by noting the negative empirical relationship (re-
ported earlier by Guenther and Trombley (1994))”between a ¬rm™s value and the magni-
tude of the LIFO reserve.2 They argue (and demonstrate using a theoretical model) that if
¬rms cannot (fully) pass on input price increases to their customers, a larger LIFO reserve in-
dicates lower future pro¬tability. In such cases, a negative relationship is expected between
¬rm value and the LIFO reserve.
Thus, the poor performance of the non-LIFO balance sheet may be explained as follows.
When the LIFO reserve is added to LIFO inventory to create the non-LIFO balance sheet in-
ventory, the positive relationship between value and assets may be offset by the loss of infor-

1
See Chapter 5 for further discussion.
2
This result seems anomalous because a higher LIFO reserve is indicative of higher asset values.


W8
W9
THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES


mation (with respect to the effects of in¬‚ation) that is provided by the LIFO inventory and
LIFO reserve individually.

As the elasticity of output prices with respect to input price changes fall, the LIFO and LIFO
reserve components of non-LIFO inventory have increasingly different implications for future
net resource in¬‚ows, and loss of information through aggregation increases.3

An alternative “deferred tax” explanation for the negative relationship between ¬rm
value and the LIFO reserve is offered by Dhaliwal, Trezevant and Wilkins (2000). They
argue that the LIFO reserve indicates a potential future tax liability if the inventory (or ¬rm)
is liquidated or sold.
Whichever argument is correct in explaining the negative relationship between ¬rm
value and the LIFO reserve, these results and those with respect to the comparison of LIFO
and non-LIFO balance sheets point out the need for well-grounded economic analysis when
preparing a research design for empirical testing.

The LIFO/FIFO Choice
As the chapter discussion indicates, there may be sound reasons for ¬rms to stay on FIFO. In
addition to those related to LIFO liquidations and declining prices, these reasons include bur-
densome record keeping requirements, the inability to write down obsolete inventory, and
the desire to maximize taxable income when using up a tax loss carryforward.
Another reason is the desire to avoid the negative effect of LIFO on a ¬rm™s reported
earnings. This motivation depends on whether (as discussed in Chapter 5) a market-based or
¬nancial contracting argument is used.
The market-based argument says that, whether or not the market is ef¬cient and can see
through the FIFO/LIFO choice to the real economics of the ¬rm, managers who believe that
the market can be fooled by lower reported earnings are reluctant to use LIFO.
Alternatively, the ¬nancial contracting approach considers the impact of the FIFO/
LIFO choice on management compensation and debt covenant restrictions. The bonus plan
hypothesis argues that when top management compensation is based on income, the ¬rm is
less likely to use the LIFO method if the resultant lower earnings reduce their compensation.
The debt covenant hypothesis argues that the negative effect of LIFO on a ¬rm™s re-
ported income and ratios increases the probability that a ¬rm will violate debt covenants re-
garding such ¬nancial measures as working capital, net worth, income, and the dividend
payout ratio. Highly leveraged ¬rms may be especially reluctant to use LIFO for that reason,
notwithstanding the tax bene¬ts.
Studies of the FIFO/LIFO choice generally examine the impact of the choice on ¬rms™
¬nancial performance in terms of both market reaction and management behavior, as well as
the effect on ¬rms™ ¬nancial statements. These studies and the hypotheses tested are affected
by both the progression in academic accounting theory and economic factors (such as higher
in¬‚ation) that caused a resurgence in the adoption of LIFO in the mid-1970s.

Market-Based Research
LIFO has been permitted in the United States since before World War II, and its rate of
adoption understandably follows the rate of in¬‚ation. In the 1970s, when the rate of in¬‚ation
reached double-digits, LIFO adoptions soared. Approximately 400 companies switched from
FIFO to LIFO in 1974 alone. This period coincided with heavy academic emphasis on mar-
ket-based empirical research and the ef¬cient market hypothesis, and the effect of the
FIFO/LIFO switch was viewed as an ideal area for research.
Given these conditions, the functional ¬xation hypothesis was tested to see whether:
• The market accepts ¬nancial statements as presented and thus views the switch to
LIFO unfavorably since income is depressed.

3
Ross Jennings, Paul J. Simko, and Robert B. Thompson III, “Does LIFO Inventory Accounting Improve the In-
come Statement at the Expense of the Balance Sheet?,” Journal of Accounting Research, (Spring 1996), p. 105.
W10 APPENDIX 6-B THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES


• The market is ef¬cient in the sense that it sees through reported data and views the
switch to LIFO positively since cash ¬‚ow increases.
Proponents of the ef¬cient market hypothesis predicted that the market would see through
the switch and react favorably to the cash ¬‚ow effects.
Surprisingly, the results were equivocal. Sunder (1973) examined a sample of ¬rms that
changed to LIFO in the period 1946 to 1966 and found that prior to the switch these ¬rms ex-
perienced positive abnormal returns (Figure 6B-1a). At the time of the change itself, the re-
action was slightly negative or nonexistent, as investors seemed to ignore the positive cash
¬‚ow effect. Moreover, the risk (beta) of ¬rms that switched to LIFO increased in the months
surrounding the switch.
This result was similar to that of Ball (1972), who examined the market reaction to sev-
eral accounting changes, FIFO/LIFO included. The positive reaction in the year of the switch
was interpreted by some as a sign that the market anticipated the switch and had reacted prior
to the actual announcement. Others felt that ¬rms that switched had been having good years
and could thus “afford” the negative impact of the switch, and that these studies suffered
from a self-selection bias.
Subsequent studies such as Eggleton et al. (1976), Abdel-khalik and McKeown (1978),
Brown (1980), and Ricks (1982) extended this research by controlling for earnings-related
variables and focusing on the large number of ¬rms that switched in the 1974 to 1975 period.
Generally, their results con¬rmed a negative market reaction in the year of the switch.
Ricks, for example, used a control sample of non-LIFO adopters (matched on the basis
of industry and earnings calculated “as if” the control company was also on LIFO) and com-
puted the cumulative average return differences between the two groups. His results, pre-
sented in Figure 6B-1b, clearly indicate better market performance for ¬rms that did not
adopt LIFO. Although these lower market returns were reversed within a year, the initial pro-
longed negative reaction is dif¬cult to understand.
One explanation for this anomalous behavior is that firms that switched to LIFO were
those most affected by inflation. Thus, the market may have reacted negatively to the
added risk (higher inflation) of these firms, explaining the lower returns and higher risk
measures.4
The dif¬culty with this explanation is that the sample ¬rms were matched by industry.
Thus, we must assume that the sample ¬rms were somehow more adversely affected by in-
¬‚ation than other ¬rms in the same industry. Biddle and Ricks (1988), discussed shortly, also
found evidence consistent with this explanation. Implicitly, these studies help explain why
¬rms stayed on FIFO; they wanted to avoid the unfavorable market reaction resulting from
the adoption of LIFO.
Biddle and Lindhal (1982) attempted to resolve some of these issues by arguing that pre-
vious studies did not consider the amount of tax savings from the LIFO adoption. They
found a positive association (see Figure 6B-1c) between the market reaction and the esti-
mated tax savings:

The results in this study are consistent with a cash-¬‚ow hypothesis, which suggests that in-
vestor reactions to LIFO adoptions depend on the present value of tax-related cash-¬‚ow sav-
ings. After controlling for abnormal earnings performance, larger LIFO tax savings were found
to be (cross-sectionally) associated with larger cumulative excess returns over the year in
which a LIFO adoption (extension) ¬rst applied.5

Biddle and Lindhal studied 311 LIFO adopters from the period 1973 to 1980. The pat-
tern of abnormal returns reported is similar to Sunder™s ¬ndings (Figure 6B-1a). Neither
study used a control group,6 making these results not directly comparable to those of Ricks.


4
This argument is consistent with the Jennings et al. (1996) explanation (discussed earlier) that the negative associa-
tion between equity values and the LIFO reserve was related to the inability of ¬rms to pass on higher input prices.
5
Gary C. Biddle and Frederick W. Lindahl, “Stock Price Reactions to LIFO Adoptions: The Association Between
Excess Returns and LIFO Tax Savings,” Journal of Accounting Research, Autumn 1982, Part II, pp. 551“588.
6
Biddle and Lindahl instead used the size of the tax saving as a “within-group” control.
W11
THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES




FIGURE 6B-1 Abnormal returns: Inventory method studies. Sources:
(a) 1946“1966 Adopters: Shyam Sunder, “Relationship Between Ac-
counting Changes and Stock Prices: Problems of Measurement and
Some Empirical Evidence,” Journal of Accounting Research, Supple-
ment 1973, pp. 1“45, Fig. 2, p. 18. (b) 1974“1975 Adopters: William E.
Ricks, The Market™s Response to the 1974 LIFO Adoption,” Journal
of Accounting Research, Autumn 1982, pp. 367“387, Fig. 2, p. 378.
(c) 1973“1982 Adopters: Gary C. Biddle and Fredrick W. Lindahl,
“Stock Price Reactions to LIFO Adoptions: The Association Between
Excess Returns and LIFO Tax Savings,” Journal of Accounting Re-
search, Autumn 1982, pp. 551“588, Fig. 1, p. 569.



Thus, it is possible that there was some systematic but unexplained factor affecting the 1974
to 1975 adoptions, and that the research results were sensitive to the research design and the
time horizon examined.

Biddle and Ricks (1988), using daily data, con¬rmed that there were negative excess market
returns around the preliminary dates of ¬rms adopting LIFO in 1974. There is little evidence of
W12 APPENDIX 6-B THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES

signi¬cant excess returns (negative or positive) near the preliminary dates of ¬rms adopting
LIFO in other years.7

To explain the negative returns, they examined analyst forecast errors for the 1974
LIFO adopters. They found that analysts significantly overestimated the earnings and did
not fully appreciate the magnitude of the impact of inflation.8 In other years, however, the
error in analyst forecasts for LIFO adopters was not significant. Further, they found that
the negative returns were positively correlated with the forecast error, indicating that the
market (as well as analysts) was surprised by the actual reported earnings. Thus, the nega-
tive returns were due to the “surprise” when the market realized that it had underestimated
the impact of inflation. As the firms that adopted LIFO were presumably those most af-
fected by inflation, the negative surprise reaction hit them hardest. In later years, however,
the market learned from experience and the impact of inflation was more readily factored
into earnings estimates.
Although these studies shed some light on the market reaction to LIFO adoption, they
still do not explain why some ¬rms remain on FIFO. On the contrary, Biddle (1980) found

surprising the ¬nding that many ¬rms voluntarily paid tens of millions of dollars in additional
income taxes by continuing to use FIFO rather than switching to LIFO.9

Contracting Theory Approach
The contracting theories of accounting choice focus on this issue. Abdel-khalik (1985) exam-
ined the bonus plan hypothesis and its implicit corollary that management-controlled ¬rms,
in which ownership is widely held, are more likely to use FIFO than owner-controlled ¬rms.
The rationale for this argument was that when management is more removed from ownership
of the ¬rm, then management compensation rather than the wealth of the ¬rm becomes the
primary motivator for manager actions. Thus, the LIFO-induced tax savings are less impor-
tant to the management-controlled ¬rm.
Abdel-khalik found that manager-controlled FIFO ¬rms had relatively higher income-
based bonuses. On the other hand, there was no evidence that differences in compensation
plans were related to the FIFO/LIFO choice. In explaining this (non)¬nding, Abdel-khalik
hypothesized that either
1. ¬rms switching to LIFO modify their compensation arrangements, or
2. as some executives have indicated to me, the FIFO-based income continues to be
used in determining annual bonus.10
Hunt (1985) examined the bonus plan and debt convenant hypotheses. His results did
not support the bonus plan hypothesis. Contrary to expectations, he found that LIFO ¬rms
tended to be less owner-controlled. Hunt, however, did ¬nd support for the debt covenant hy-
pothesis, especially with respect to the leverage and interest coverage ratios. His evidence
also indicates a threshold level of dividend payout ratios above which ¬rms are reluctant to
use LIFO.
Dopuch and Pincus (1988) examined the bonus plan, debt covenant, and taxation hy-
potheses in one study and found that the taxation effect provided the best explanation for the
LIFO/FIFO decision. They compared the holding gain that would have accrued to LIFO
¬rms had they stayed on FIFO with the holding gain for ¬rms that remained on FIFO.


7
Gary C. Biddle and William E. Ricks, “Analyst Forecast Errors and Stock Price Behavior Near the Earnings An-
nouncement Dates of LIFO Adopters,” Journal of Accounting Research, Autumn 1988, pp. 169“194.
8
At that time, LIFO adoptions were unusual, and it took time for analysts to learn to estimate the impact. That they
did learn is evidenced by the reduced earnings forecast errors for LIFO adopters in later years.
9
Gary C. Biddle, “Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory
Policy,” Journal of Accounting Research, Supplement 1980, pp. 235“280.
10
A Rashad Abdel-khalik, “The Effect of LIFO-Switching and Firm Ownership on Executive™s Pay,” Journal of Ac-
counting Research, Autumn 1985, pp. 427“447.
W13
THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES


They found larger holding gains for LIFO ¬rms, resulting in higher tax savings. In addi-
tion, the holding gain grew as they approached the switch date. Dopuch and Pincus argued
that this indicated

the long-term FIFO ¬rms in our sample have not been forgoing signi¬cant tax savings, in
which case remaining on that method is certainly consistent with FIFO being an optimal tax
choice, given other considerations. In contrast, long-term LIFO ¬rms would have forgone sig-
ni¬cant tax savings. . . . Finally, using the long-term FIFO sample™s average holding gains as a
base, our change-¬rms™ average holding gains became signi¬cantly larger than the FIFO aver-
age as they approached the year in which they switched, and this difference continued to grow
subsequently.11

Further, Dopuch and Pincus argued that ¬nancial analysts could have calculated the in-
creased holding gains for the switch ¬rms and thus anticipated the switch. Therefore, the in-
conclusive ¬ndings of the market reaction studies could be a result of ignoring the “advance
warning” market agents had regarding the switch.
More recently, Jennings et al. (1992) supported this advance warning contention. They
constructed a model that predicted which ¬rms in the 1974 to 1975 period were more likely
to adopt LIFO. The model accurately forecast adopting/nonadopting ¬rms approximately
two-thirds of the time. Furthermore, the prior probability of adoption affected the market re-
action. The less likely candidates for adoption (according to the model) had more positive
market reactions when they adopted LIFO. Similarly, ¬rms that were originally viewed as
likely candidates for adoption, but did not adopt, suffered negative market reaction when
they failed to adopt LIFO.
However, in summing up the research in this area, the editor of The Accounting Review
stated

We continue to be relatively uninformed about these issues and know little about the real rea-
sons that many ¬rms do not switch to LIFO when it appears that they would bene¬t by positive
tax savings.12




11
Nicholas Dopuch and Morton Pincus, “Evidence of the Choice of Inventory Accounting Methods: LIFO Versus
FIFO,” Journal of Accounting Research, Spring 1988, pp. 28“59.
12
Editor™s Comments, The Accounting Review, Vol. 67, No. 2, April 1992, p. 319.
Appendix 7-A
RESEARCH AND DEVELOPMENT AFFILIATES


INTRODUCTION

Because GAAP in the United States requires that all expenditures for research and develop-
ment (R&D) be expensed, ¬rms have looked for alternative methods of ¬nancing R&D that
postpone the associated earnings charge. Alternate ¬nancing methods may also have the fol-
lowing advantages:
• Targeting investors who are attracted by the risk/reward characteristics of speci¬c projects
• Focusing management attention on speci¬c projects by placing their development in a
separate entity.
We discuss the two most common forms of these arrangements, R&D partnerships and de-
velopment companies. The drug and biotechnology industries have been the most common
users of these techniques, perhaps because R&D is focused on the development of discrete
patentable products.

Appendix Objectives
1. Examine the motivation for the establishment of R&D arrangements.
2. Show the effect of R&D arrangements on the amounts and timing of research and de-
velopment expense.
3. Show the effects of R&D arrangements on reported net income, stockholders™ equity,
and ¬nancial ratios.
4. Compare the effects of R&D arrangements on companies using accounting methods
that expense all R&D with those permitting capitalization.

RESEARCH AND DEVELOPMENT PARTNERSHIPS
An R&D partnership raises funds from investors. Those funds are then used to pay the com-
pany for research. Any patents or products resulting from that research belong to the partner-
ship, but the company can either purchase the partnership or license the product. Thus, the
company controls the technology without reporting the expenses resulting from research
costs, as the “revenue” from the partnership offsets the research expense.
This arrangement has many of the attributes of an option; the ¬rm has a call option on
the patents or products developed for the partnership, with the purchase price being the exer-
cise or strike price. Shevlin (1991) treats such limited partnerships (LPs) as an option and
uses option pricing theory to value the LP:

The value of the LP call option to the R&D ¬rm may be decomposed into the present value of
the underlying project ¬nanced by the LP (an asset) less the present value of the payments to
the limited partners if the ¬rm exercises its option (liability).1


1
Terry Shevlin, “The Valuation of R&D Firms with R&D Limited Partnerships,” The Accounting Review, Jan. 1991,
pp. 1“21.


W14
W15
RESEARCH AND DEVELOPMENT PARTNERSHIPS


SFAS 68 (1982), Research and Development Arrangements, sets criteria to distinguish
true transfers of risk from disguised borrowings. The following are indicators that there has
not been a true transfer of risk:

1. The company has an obligation to the partnership (or investors) regardless of the out-
come of the research. Such obligation may take the form of a guarantee of partner-
ship debt or granting of a “put” option to the investors.
2. Conditions make it probable that the company will repay the funds raised by the part-
nership. Such conditions include the company™s need to control the technology
owned by the partnership or relationships between the company and the investors
(e.g., top management invests in the partnership).

If there has not been a true transfer of risk, then the company is required to expense the ac-
tual research costs and treat funds received from the partnership as borrowings.
When the requirements of SFAS 68 are met, however, the company can recognize rev-
enue from the partnership to offset R&D costs. The result is, in effect, a deferral of research
cost until products are sold (and license fees paid) or the partnership is purchased. Such
arrangements are disclosed in ¬nancial statement footnotes and analysts should be alert to
their effects on reported income.
In recent years, a new vehicle has largely superseded the R&D partnership: a separate
development company that sells “callable common” shares to the public. The shares are often
packaged with warrants of the (parent) company to make the resulting “units” more attrac-
tive to investors. The new common shares are callable at prices that promise a high rate of
return to investors if the venture is successful. These vehicles are similar to R&D partner-
ships in their effects on the ¬rm.

Analysis of Firms with R&D Af¬liates
The impact of R&D af¬liates on reported ¬nancial results is favorable as research costs are
offset by “revenue” from the af¬liate. Reported income would be lower if these costs were
funded by borrowing (or from the ¬rm™s own assets). Further, obtaining those funds would
require additional debt or equity capital. R&D ¬nancing arrangements permit the company to
conduct research without incurring debt or equity dilution, in addition to avoiding the effects
of reporting the research costs as an expense.
There is a cost to this capital, however. When the partnership is purchased or the
callable common is called, a substantial cash payment or share issuance is required. Given
the risk, investors in R&D af¬liates require a high rate of return.
The second cost factor is the impact when the af¬liate is purchased. At that time, the
purchase price must be written off as research costs.2 The resulting write-off usually exceeds
the amount of funds originally raised. But that write-off is delayed until the partnership is
purchased. In effect, these arrangements permit the deferral of research costs, but with the
penalty of a high interest factor (cost of capital).

R&D Af¬liates Outside of the United States
In jurisdictions that do not require all R&D to be expensed, the incentives for alternative
arrangements are weaker. Under IAS GAAP, as discussed in the chapter, research costs must
be expensed but development costs are capitalized and amortized. Canada has similar re-
quirements, as seen in the analysis of Biovail that follows. However, given the preeminence
of the United States capital market, even non-U.S. ¬rms may use these techniques to enhance
their earnings reported under U.S. GAAP.


2
FASB Interpretation 4 (1975) provides that when an acquisition is accounted for under the purchase method of ac-
counting, any portion of the purchase price allocated to R&D must be immediately expensed at the time of the ac-
quisition. Chapter 14 contains more discussion of this issue.
W16 APPENDIX 7-A RESEARCH AND DEVELOPMENT AFFILIATES


Example: Biovail
Biovail [BVF] is a Canadian pharmaceutical company. It used several R&D af¬liates to ¬-
nance drug development in the 1990™s. We will focus on one such arrangement, Intelligent
Polymers [INP], incorporated in Bermuda.
In October 1997, there was an initial public offering of 3.7 million units at $20 per unit,
resulting in net proceeds after expenses of approximately, $69.5 million.3 Each unit con-
sisted of:
• One Intelligent Polymer common share
• One warrant to purchase one Biovail share at $10 per share (adjusted for subsequent
stock splits) from October 1, 1999 through September 30, 2002
Biovail recorded a credit to equity of $8.244 million to re¬‚ect the value of the warrants is-
sued and an equal reduction of retained earnings to record the contribution to INP. The net
result of the offering was that INP received $69.5 million of capital with no net effect on
Biovail™s ¬nancial statements.
At the time of the offering, the two companies entered into a series of agreements, in-
cluding the following provisions:
1. INP agreed to spend the proceeds to develop seven possible products, paying BVF to
conduct the required research.
2. INP would hold the rights to products developed but Biovail would have options to
purchase those rights at predetermined terms.
3. Biovail had the option to purchase all shares of INP at the following prices:
• $39.06 per share before October 1, 2000
• $48.83 per share from October 1, 2000 through September 30, 2001
• $61.04 per share from October 1, 2001 through September 30, 2002

The development agreement resulted in payments from INP to Biovail shown in the follow-
ing table:

Years ended December 31 1998 1999 2000 Totals

Payments to Biovail $9.7 $33.0 $55.2 $97.9
Biovail™s related costs (6.7) (19.8) (35.2) (61.7)
Biovail gross pro¬t $3.0 $13.2 $20.0 $36.2

Over the three-year period, INP paid Biovail approximately $98 million for research. If
Biovail had conducted the research itself, the total cost would have been nearly $62 million.
The effect of forming INP was to increase Biovail™s reported pretax earnings by the amount
of the payments received. The signi¬cance of these amounts can be seen from Biovail™s rev-
enues (Exhibit 7A-1), which rose from $111.6 million in 1998 to $309.2 million in 2000.
In 1999, Biovail paid INP $25 million for the rights to one developed drug. On Septem-
ber 29, 2000, Biovail exercised its option to purchase all INP shares, for a total price (includ-
ing bank debt) of $204.9 million. The purchase resulted in a write-off of in-process research
and development (IPRD) of $208.4 million. The write-off resulted in an operating loss for
the year of $78 million. The IPRD was far above the actual research expenditures. However
the creation of INP had the effect of delaying the recognition of these costs in Biovail™s ¬-
nancial statement. It also reduced Biovail™s risk; if the INP research had not been successful,
Biovail would not have exercised its option.4
We can see the cost of capital implicit in the creation of INP by examining the invest-
ment from the investor point of view. Ignoring (for the moment) the Biovail warrants in-



3
All dollar amounts in this section are United States dollars even though Biovail is Canadian.
4
It is also possible that Biovail would have exercised its option even in the event of failure in order to maintain full
control of its proprietary technology.
W17
RESEARCH AND DEVELOPMENT PARTNERSHIPS


cluded in the offering, investors bought INP shares for $20 each. The call prices shown
above provide rates of return of 25% per annum. As Biovail shares rose substantially, trading
above $45 per share in November 2000, the actual return (including the gain in the Biovail
warrants) was even higher. Of course, investors took the risk that the INP research would not
have produced marketable drugs.5
In economic terms, the Intelligent Polymers capital came at a high price to Biovail.
However, the risk reduction may have made the cost of capital acceptable relative to other
sources of capital available at that time. The INP arrangement also resulted in postponed
recognition of the research costs associated with the development of these drugs. As IPRD
write-offs are often seen as “non-recurring” costs, it is uncertain how the ¬nancial markets
value ¬rms with such charges.

Comparison of Biovail Financial Statements: U.S. vs. Canadian GAAP
Under Canadian GAAP, IPRD and the acquisition cost of drug rights are capitalized and
amortized over the useful life of the products. Both the $25 million paid to INP in 1999 and
the cost of acquiring INP in 2000 resulted in asset recognition (rather than being expensed
under U.S. GAAP). Biovail had written off more than $105 million of IPRD in 1999 from
another R&D arrangement. The difference between the treatment of these transactions be-
tween U.S. and Canadian GAAP can be seen in Exhibit 7A-1.


EXHIBIT 7A-1. BIOVAIL
Financial Data under United States and Canadian GAAP
All data in $US thousands, except per share

Years Ended December 31 1998 1999 2000

United States GAAP
Revenue $111,657 $172,464 $ 309,170
Operating income (loss)* 45,303 (40,160) (78,032)
Net income (loss) 41,577 (109,978) (147,796)
Earnings per share (diluted) 0.38 (1.07) (1.16)

Total assets $198,616 $467,179 $1,107,267
Long-term obligations 126,835 137,504 438,744
Convertible securities 299,985
Common equity 49,888 267,336 237,458

Common shares outstanding 99,444 124,392 131,461

*Includes IPRD charges $105,700 $ 208,400

Canadian GAAP
Revenue $ 98,836 $165,092 $ 311,457
Operating income 35,145 64,117 116,223
Net income 31,419 52,080 81,163
Earnings per share (diluted) 0.29 0.47 0.57

Total assets $199,919 $635,137 $1,460,967
Long-term obligations 126,835 137,594 438,744
Shareholders™ equity 19,091 391,794 839,110

Common shares outstanding 99,444 124,392 131,461

Note: While the treatment of IPRD and the cost of acquired drugs are the principal differences between U.S. and
Canadian GAAP, the data also re¬‚ect other differences.
Source: Biovail 10-K, December 31, 2000



5
See footnote 4; for this reason, the risk may not have been excessive.
W18 APPENDIX 7-A RESEARCH AND DEVELOPMENT AFFILIATES


The principal differences are:
1. Under Canadian GAAP, there is a progressive improvement in both operating and
net income, as well as earnings per share. Under U.S. GAAP, the IPRD write-offs re-
sult in operating and net losses for both 1999 and 2000.
2. Canadian GAAP assets exceed those under U.S. GAAP, re¬‚ecting the capitalization
of drug acquisition costs.
3. Canadian GAAP equity exceeds that under U.S. GAAP, mainly due to the difference
in net income.
The ratio effects of these differences are the subject of Problem 7A-1.

Conclusion
The Biovail”Intelligent Polymers example illustrates the effects of research and develop-
ment arrangements on the ¬nancial statements of the sponsoring company. Such arrange-
ment can have major impacts on the amount and timing of reported net income, as well as
the balance sheet and cash ¬‚ow statements. While ultimately, company valuation depends on
research (and subsequent marketing) outcomes, the analyst should carefully consider the ef-
fect of such arrangements on the ¬nancial statements of affected companies.


PROBLEMS

7A-1. [Ratio effects of differences in accounting for R&D arrangements].
A. Using the data in Exhibit 7A-1, calculate the following ratios for Biovail for 1998
through 2000 under both United States and Canadian GAAP:
(i) Return on sales (net income margin)
(ii) Return on equity
(iii) Asset turnover
(iv) Equity per common share
Note: use year-end amounts for balance sheet data.
B. Discuss the differences between both the level and trend of the ratios computed in
part A.
C. The price of Biovail shares rose from less than $9 per share at the end of 1997 to
nearly $39 per share at the end of December 2000. Discuss which set of ratios ap-
pears to be re¬‚ected in the market performance of Biovail shares. Discuss any
other factors that may have affected the price of Biovail shares during this time
period.
D. State which of the two methods of accounting for IPRD (immediate write-off ver-
sus capitalization and amortization) comes closest to recognition of the economic
impact of the acquisition of drug rights. Justify your choice.
E. Discuss the limitations of the method chosen in part D.
F. Discuss whether the accounting for internal drug research expenditures should
differ from that for acquired drug rights.
7A-2. [Analysis of R&D Arrangements] In September 1997 ALZA (acquired by Johnson
and Johnson in June, 2001) contributed $300 million to Crescendo Pharmaceuticals, a
newly created company. ALZA formed Crescendo to help fund the development of
new pharmaceutical products. Crescendo and ALZA entered into the following agree-
ments:
1. Crescendo was required to spend virtually all of its available funds to fund the de-
velopment (by ALZA) of seven possible new products.
2. ALZA granted Crescendo a worldwide license to use ALZA technology in con-
nection with product development activities. Crescendo paid ALZA a speci¬ed li-
cense fee.
W19
PROBLEMS


3. Crescendo granted ALZA options to license products developed, exercisable on a
country-by-country basis after clearance from the Federal Drug Administration
(FDA) or appropriate foreign regulatory body. ALZA also had the right to pur-
chase Crescendo™s right to receive license fees. Both the license fee and the pur-
chase price were based on predetermined formulas.
4. ALZA had the right to purchase all Crescendo shares until January 31, 2002 at a
price equal to the greater of:
(i) $100 million
(ii) The market value of 1 million ALZA shares
(iii) $325 million less all amounts paid to ALZA by Crescendo under the agree-
ment, and
(iv) A formula based on license fees paid to Crescendo by ALZA over the previ-
ous four calendar quarters.
ALZA could purchase Crescendo shares for cash, ALZA shares, or a combination of
the two. The option deadline would be extended if Crescendo had not yet expended
all of its funds.
On September 29, 1997, ALZA contributed $300 million to Crescendo, of which
$247 was recorded as a “non-recurring” expense. Crescendo shares were distributed
to ALZA™s shareholders and debenture holders as a dividend.
Over the next three years, Crescendo made the following payments to ALZA:

Years Ended December 31 1998 1999 2000
Payments for research $95.0 $90.5 $68.3
Technology fees 10.7 6.7 2.7
Administrative service fees 0.2 0.2 0.2

ALZA paid the following to Crescendo for three drugs that had been successfully
developed:

Drug license fees $2.4 $4.5

On November 13, 2000 ALZA paid $100 million to acquire all outstanding
shares of Crescendo. $45.7 million of the purchase price was allocated to developed
products as deferred product acquisition costs and $9.4 million was expensed as
IPRD.
Exhibit 7AP-1 contains ¬nancial data on ALZA for the three years ended Decem-
ber 31, 2000.
Use the data provided to answer the following questions.
A. Prepare income statements for ALZA for the years 1998 through 2000 assuming
that the Crescendo transactions had not taken place.
B. Calculate the percentage change in each of the following from 1998 to 1999 and
from 1999 to 2000, using reported data:
(i) Revenues
(ii) Expenses
(iii) Operating income
(iv) Pretax income
C. Calculate the percentage change in each of the following from 1998 to 1999 and
from 1999 to 2000, using adjusted data from part A:
(i) Revenues
(ii) Expenses
(iii) Operating income
(iv) Pretax income
W20 APPENDIX 7-A RESEARCH AND DEVELOPMENT AFFILIATES

EXHIBIT 7AP-1. ALZA CORP.
Financial Data
All data in $millions, except per share

Years Ended December 31 1998 1999 2000

Net sales $ 289.4 $ 448.0 $607.2
Royalties, fees, and other 233.1 227.1 281.2
Research and development 124.4 120.8 100.1
Total revenues $ 646.9 $ 795.9 $ 988.5

Costs of products shipped (125.7) (158.4) (180.2)
Research and development (182.8) (183.6) (190.8)
Selling and administrative (141.9) (259.0) (349.4)
Merger-related charges ” (45.7) ”
In-process R & D 00000” 00000” 00.(12.4)
Total expenses $ (450.4) $ (646.7) $ (732.8)

Operating income 196.5 149.2 255.7
Interest and other income 26.4 41.6 59.0
Interest expense 00.(56.7) 00.(58.1) 00.(58.0)
Pretax income $ 166.2 $ 132.7 $ 256.7
Income tax expense 00.(57.9) 00.(41.7) 00.(26.0)
Net income* $ 108.3 $ 91.0 $ 230.7

*before cumulative effect of accounting change


D. Calculate the effect of the adjustments in part A on each of the following for the
three years ended December 31, 2000:
(i) Revenues
(ii) Expenses
(iii) Operating income
(iv) Operating margin
(v) Pretax income
(vi) Pretax margin
(vii) Times interest earned
E. Describe the effect of the Crescendo transactions on each of the following, using
the results of parts A through D:
(i) ALZA™s reported growth rate for 1999 and 2000
(ii) ALZA™s reported pro¬tability for 1998“2000
(iii) The volatility of ALZA™s pro¬tability for 1998“2000
(iv) ALZA™s reported return on equity for 1998“2000.
Hint: Consider the effect of the Crescendo transactions on ALZA™s equity.
F. Discuss the bene¬ts and drawbacks to ALZA of the Crescendo transactions, using
the results of parts A through E.
G. Considering the Crescendo transactions as a whole, justify the analytical adjust-
ments in this problem.
Appendix 7-B
ANALYSIS OF OIL AND GAS DISCLOSURES


INTRODUCTION

The two acceptable accounting methods used for oil and gas exploration: the successful ef-
forts method (SE) and full cost method (FC)1 are illustrated in Exhibit 7-1. The choice be-
tween these methods has signi¬cant effects on reported ¬nancial statements. These
differences can be summarized as follows:
• SE ¬rms, by expensing dry hole costs, have lower carrying costs of oil and gas re-
serves than FC ¬rms.
• SE ¬rms have lower earnings than FC ¬rms when exploration efforts are rising.
• SE ¬rms have lower cash from operations than FC ¬rms (unless explicitly adjusted
for, as in the case of Texaco).

APPENDIX OBJECTIVES

1. Examine the motivation for use of the successful efforts and full cost methods.
2. Describe the motivation and effects of changes between the two accounting methods.
3. Analyze the supplementary disclosures regarding oil and gas reserves, showing how
they can be used to gain insight into the:
• changes in reserve quantities over time.
• cost of ¬nding new reserves.
• level and trend of present value of reserves, a proxy for the fair value of oil and gas
reserves.
4. Show how to adjust present values for subsequent price changes.
5. Adjust stockholders™ equity and the debt-to-equity ratio for the difference between
the carrying cost and present value of oil and gas reserves.

Motivations for Accounting Choice
The differential effects on ¬nancial statements demonstrated in Exhibit 7-1 as well as the il-
lustration in Box 7-1 help explain why some ¬rms prefer the SE method and others the FC
method. Empirical evidence as to these preferences is provided in Box 7B-1.
Small ¬rms generally prefer the FC method; large ¬rms tend to be indifferent. For larger
¬rms, with relatively stable exploration budgets and relatively constant success ratios (pro-
ductive to total expenditures) across a “portfolio” of exploration projects, the year-to-year
variability of dry hole expense is low. Amortization of past expenditures is large, re¬‚ecting a
large reserve base. As a result, the difference between the two methods is small.
Additionally, larger oil companies are often diversi¬ed into the re¬ning and distribution
segments of the oil business. Income from these sources dampens the variability of exploration


1
Both methods are described on pages 244“246.


W21
W22 APPENDIX 7-B ANALYSIS OF OIL AND GAS DISCLOSURES


BOX 7B-1
SE Versus FC Choice of Methods: Empirical Evidence
of technical violation of debt/equity-related debt covenants.
A number of research studies* have examined characteristics of
Malmquist™s study confirmed that firms with higher debt/eq-
¬rms using SE versus FC accounting. Malmquist (1990) tested the
uity ratios are less likely to choose SE.
relationship between the following characteristics and ¬rm choice.

3. Management Compensation Contracts
1. Size
Earnings-based management compensation contracts are af-
The larger the ¬rm, the less likely it will choose FC for several
fected by the choice of accounting method. Opportunistic man-
reasons. First, large ¬rms prefer income-reducing alternatives
agers may choose full costing to increase the level of their
such as SE to avoid earning “windfall pro¬ts,” especially when
compensation and decrease its variability. Malmquist notes
prices are rising, given the political sensitivity of energy prices.
“there are strong disincentives and limits placed on such behav-
Second, large ¬rms have more drilling activities occurring si-
ior by the managerial labor market.” No apparent relationship
multaneously, creating a portfolio effect and thereby decreasing
between the choice of accounting method and the presence of an
income variability. Third, in addition to the risks associated with
earnings-based compensation contract was observed.
exploration, oil companies are subject to the risks associated
These results are consistent with some (but not all) of
with marketing and re¬ning. The larger the proportion of the
Deakin™s (1989) ¬ndings. Analyzing ¬rms that lobbied for FC
¬rm™s activities in marketing and re¬ning, the lower the impact
and the reasons given by those ¬rms for lobbying, Deakin found
of SE because its effect is limited to the income associated with
that, on average, they had characteristics consistent with the
exploration. As large ¬rms tend to be more diversi¬ed, they have
stated reasons. The reasons given by the ¬rms were:†
less incentive to opt for FC.
Using sales as a proxy for size (political costs) and the ratio
1. The expected impact on cost of capital and access to capital
of exploration costs to market value as well as the ratio of pro-
markets
duction costs to market value to measure the various aspects re-
2. The potential of the proposed elimination of the FC method to
lated to size, Malmquist found them all to be signi¬cant in
affect accounting income-based management incentive con-
explaining the accounting choice. Higher sales and a larger pro-
tracts
portion of production costs made the ¬rm more likely to choose
3. The perceived effect on future drilling activity
SE. Conversely, the larger the exploration cost proportion, the
4. The effect of rate regulation‡
more likely the ¬rm was to choose FC.
To some extent, generalizing from Deakin™s sample of com-
2. Dif¬culty of Raising Capital in the Equity
panies, which lobbied for a particular accounting method, to the
and Debt Markets
general population of ¬rms, is fraught with danger as the sample
may be biased. Taking the time and effort to lobby can be an in-
SE companies report lower assets than FC companies. There-
dication that these ¬rms are the ones most likely to be affected
fore, securities underwriters may be hesitant (or find it diffi-
by the choice. Thus, Deakin™s ¬nding that the presence of man-
cult) to sell the securities of firms having low or negative net
agement incentive contracts was associated with ¬rms that lob-
book value (equity) levels. Borrowing may also be more diffi-
bied for FC in contrast to Malmquist, who did not ¬nd such a
cult for firms with high and variable debt/equity ratios. More-
relationship, may re¬‚ect their different samples.
over, for debt already in existence, there is a higher probability

*See, for example, Steven Lilien and Victor Pastena, “Determinants of Intra-Method Choice in the Oil and Gas Industry,” Journal of Accounting and
Economics, 1982, pp. 145“170 and Edward B. Deakin III, “An Analysis of Differences Between Non-Major Oil Firms Using Successful Efforts and
Full Cost Methods,” The Accounting Review, Oct. 1979, pp. 722“734.

Edward B. Deakin III, “Rational Economic Behavior and Lobbying on Accounting Issues: Evidence from the Oil and Gas Industry,” The Accounting
Review, Jan. 1989, pp. 137“151.

The last reason applied primarily to regulated companies that were required by rate-making authorities to use FC accounting procedures.




income. Large oil companies tend to use the SE method as well because it is perceived to be
more conservative.2
For smaller companies, however, the differential impact of these two accounting meth-
ods can be considerable. Year-to-year variations in spending and success ratios mean that dry
hole expense can vary greatly. Under SE accounting, this variability is transmitted directly to
the income statement. Further, smaller companies (especially if growing rapidly) have small
reserve bases and low amortization of past capitalized costs. Dry hole costs from current
drilling activities often exceed the amortization of the capitalized costs of past drilling.

2
A more detailed analysis of the ¬nancial reporting effects of SE versus FC on ¬rms under different environments is
provided by Sunder (1976).
W23
SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES


Smaller companies are also less diversi¬ed as they concentrate on exploration. Widely ¬‚uc-
tuating patterns of earnings growth are considered a drawback for ¬rms attempting to obtain
external (equity or debt) ¬nancing. This problem is further exacerbated because, under suc-
cessful efforts, the balance sheet shows lower assets and equity, thus hurting reported sol-
vency ratios. As a result, smaller companies tend to use the FC method of accounting.

Changing Accounting Methods
The FC method has one drawback, however. When the price of oil causes the value of the re-
serves to fall below book value, the SEC requires that companies using the FC method write
down properties whose carrying cost exceeds the present value of future cash ¬‚ows of the
proved reserves attributable to that property.3 Companies using the SE method are required
to use the less stringent measure of undiscounted future cash ¬‚ows.4 In the 1980s, when
the price of oil fell drastically, some companies that had previously chosen FC accounting
(presumably to report higher income) were forced to take large write-offs, reducing reported
income.
One method of avoiding such large write-offs was to change reporting methods from FC
to SE, reducing the carrying amount of reserves. The change to or from the FC method is one
of those cases where retroactive adjustment for accounting changes is mandatory; all prior
years presented must be restated and the cumulative effect reported as an adjustment to the
beginning retained earnings. Note that this does not change the value of the reserves; it only
changes the carrying amount on the balance sheet. Sonat changed its accounting method sev-
eral times, re¬‚ecting changing industry conditions (see Problem 7B-1).
Adoption of the SE method of accounting requires the expensing of capitalized dry hole
costs, lowering reported income. On the other hand, the amortization of previously capital-
ized costs is also reduced, increasing reported earnings. The balance between increased ex-
pensing of current year expenditures and reduced amortization of past expenditures
determines the net effect on earnings for any given year.
What is the effect of the accounting change on cash ¬‚ow? There is no effect on actual
cash ¬‚ow as the change to the successful efforts method merely reallocates cash ¬‚ows for ¬-
nancial reporting purposes. (For income tax purposes, oil and gas companies expense the
maximum allowable; the accounting change has no impact on tax return income.)
However, components of reported cash ¬‚ows may be affected by the accounting change.
Lower reported capital expenditures are offset over time by lower reported operating cash
¬‚ows. Once again, we see how the classi¬cation of cash ¬‚ow components is affected by ac-
counting choice.


SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

A major drawback of both accounting methods is the lack of correspondence between the re-
ported cost of a producing oil or gas ¬eld and its economic value. Although this is true of vir-
tually all ¬xed assets, it is especially true of oil- and gas-producing assets because, even at
the time of drilling, there may be little relationship between the expenditures and results. An
expenditure of millions of dollars can result in a dry hole. Alternatively, a small expenditure
can result in a discovery of oil or gas worth many times its cost.
Neither method provides truly relevant data as to the value of reserves. This shortcom-
ing is addressed by the disclosure requirements of SFAS 69 (1982), which requires extensive
information about the results of operations for oil and gas activities and disclosure of a stan-
dardized measure of proved oil and gas reserves. Additional summary disclosures of these
activities by equity method investees and minority interests are also required.


3
The comparison of the carrying value of reserves with their present value is sometimes referred to as the ceiling
test.
4
See David B. Pariser and Pierre L. Titard, “Impairment of Oil and Gas Properties,” Journal of Accountancy, Dec.
1991, pp. 52“62.
W24 APPENDIX 7-B ANALYSIS OF OIL AND GAS DISCLOSURES


Disclosure of Physical Reserve Quantities
Texaco™s 1999 ¬nancial statements (included in the website and CD that accompany the text)
contain a section entitled, “Supplemental Oil and Gas Information.” Table I provides data on
the physical quantities of Texaco™s proved oil and gas reserves, including:

1. Separate disclosure of oil and gas reserves
2. Separate disclosure by geographic area
Separate disclosure of the reserves of equity af¬liates5
3.
4. Reconciliation of the year-to-year change in proved reserves
5. Disclosure of proved developed reserves

These data describe the company™s physical reserves at each balance sheet date. The ¬rst two
features listed help the user understand the nature of the reserves. For example, oil reserves
in the United States have different economic characteristics than gas reserves in Africa. Sep-
arate disclosure of the reserves of equity method af¬liates aids the evaluation of the invest-
ment in such companies.
The reconciliation is one of the most signi¬cant features as it enables us to understand
how estimated reserves change from year to year as a result of:

1. Production, which reduces reserves
2. Discoveries, which increase reserves
3. Purchases and sales of reserves
4. Revisions of estimates
Price changes, which can make reserves economically feasible to produce, or not6
5.

Each of these disclosures provides useful data because physical quantities can be related to
cash ¬‚ows. For example, the cost of ¬nding reserves can be derived by comparing explo-
ration expenditures with reserves discovered. This is considered an important measure of
management ability.
Revisions, as noted by Clinch and Magliolo (1992),7 are important indicators of the
“quality” of management estimates. Companies reporting predominantly downward revi-
sions are viewed with some skepticism, re¬‚ecting the apparent overoptimism of past esti-
mates. Investors prefer positive surprises, that is, upward revisions of estimated reserves.
Texaco™s disclosures show that worldwide oil reserves increased over the three-year pe-
riod, from 2,704 million barrels at December 31, 1996 to 3,480 million barrels at December
31, 1999. Most of the increase was in the United States and “Other East” geographic areas.
Gas reserves also rose, with the United States and “Other East” (the largest percentage in-
crease) again accounting for the gain.

5
See Chapter 13 for a discussion of the equity method.
6
For example, in 1985, Atlantic Rich¬eld removed 8.3 trillion cubic feet (trillion billion MCF) of natural gas re-
serves located in northern Alaska from its estimate of proved reserves, reducing its domestic gas reserves by more
than 50%. The company explained that this change was prompted by a review of economic factors, especially the
signi¬cant drop in oil and gas prices in that year. In its 1999 10-K, the company stated that:
ARCO is actively evaluating various technical options for commercializing North Slope gas. . . . Signi¬-
cant technical uncertainties and existing market conditions still preclude gas from such potential projects
being included in ARCO™s reserves.
7
Clinch and Magliolo argue that the value-relevance (informativeness) of the SFAS 69 data depends on the reliabil-
ity investors attach to it. As data are subject to constant revision, reliability suffers. They found that although the
market did not ¬nd reserve data to be value-relevant, production data were found to be informative. Production data,
they argue, are more objective as they re¬‚ect actual actions taken by management rather than just estimates. Further,
they found, for the subset of ¬rms whose quantity estimates appeared more reliable (less revision of estimates), that
proved reserve data were also value-relevant. (Greg Clinch and Joseph Magliolo, “Market Perceptions of Reserve
Disclosures Under SFAS No. 69,” The Accounting Review, Oct. 1992, pp. 843“861.)
W25
SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES


The reconciliations give us additional insights regarding the reserve increases:

• Revisions have generally been positive.8
• Improved recovery estimates also consistently made positive contributions to esti-
mated reserve quantities. These gains may re¬‚ect newer technologies that permit
higher recovery from existing oil and gas wells.
• Texaco purchased oil reserves in the U.S. in 1997 (Monterey Resources) and gas re-
serves in the “Other East” in 1998 and 1999.
• Discoveries and extensions, however, were below production levels in all three years
for oil and all but 1997 for gas

The data can also be used to measure the reserve life (end-of-year reserves divided by pro-
duction) of Texaco™s reserves, by type and geographic segment. The computations below in-
dicate that Texaco™s reserve lives increased over the period as U.S. oil production and
worldwide gas production failed to increase with reserves. Reserve lives in the United States
are higher that in other areas for oil, but lower for gas.

Reserve Lives in Years

United States Worldwide

1997 1998 1999 1997 1998 1999
Oil reserves 1,767 1,824 1,782 3,267 3,573 3,480
Production 157 144 144 317 351 336
Ratio 11.25 12.67 12.38 10.31 10.18 10.36

Gas reserves 4,022 4,105 4,205 6,242 6,517 8.108
Production 643 633 550 839 879 786
Ratio 6.26 6.48 7.65 7.44 7.41 10.32
Data from Table I; oil in millions of barrels, gas in billions of cubic feet


Disclosure of Capitalized Costs
Table IV reports the balance sheet carrying cost of the disclosed reserves and Table V the
current year costs incurred.
When reviewing Table IV (Capitalized Costs), note that:

• Capitalized costs depend on the accounting method followed: Companies using the
FC method will capitalize more exploration cost than companies employing the SE
method. Notice that the capitalized costs of equity af¬liates are disclosed separately,
just as their reserve quantities are disclosed separately.
• Costs are net of accumulated depreciation, amortization, and valuation allowances;
different accounting choices in these areas will affect the net carrying cost.
• Costs of unproved properties and support facilities are separately disclosed.
• Capitalized costs are aggregated for oil and gas, unlike reserve quantities.

These data give analysts a balance sheet cost to match against the physical reserves with all
oil and gas reserves combined into one measure, usually termed barrel of oil equivalent
(BOE). Quantities (of oil and gas reserves disclosed in Table I) can be combined into units of


8
There is a typographic error in the 1999 gas reserve change data. The worldwide revisions should be 915 and the
total changes 1,591; the negative signs are in error.
W26 APPENDIX 7-B ANALYSIS OF OIL AND GAS DISCLOSURES


BOE based on either energy equivalence (1 barrel of oil 6 MCF of gas)9 or the basis of rel-
ative price.10
Once this has been done, the balance sheet cost per BOE can be computed. At December
31, 1999, the calculation for Texaco™s reserves is (in millions of barrels):
No. of BOE No. of Barrels of Oil BOE Equivalent of Gas Reserves
8,108
3,480 BCF (billion cubic feet)
6
3,480 1,351
4,831
The capitalized cost per BOE is
$13,038
$
$2.70
4,831
BOE
Note that part of the capitalized cost represents out¬‚ows for unproved properties (for which
no reserves have yet been estimated) and for support facilities. This calculation, therefore,
overstates the capitalized cost per BOE.
With two years of data, we can look at the trend of capitalized cost per BOE as well as
variations by geographic area:

Capitalized Cost per BOE Equivalent

December 31 United States Europe Other East Equity Worldwide
1998

Oil reserves 1,824 419 598 684 3,573
Gas reserves 4,105 964 477 151 6,517
BOE 2,508 580 678 709 4,659
Capitalized costs $8,086 $1,436 $1,278 $1,072 $12,190
Costs per BOE 3.22 2.48 1.89 1.51 2.62

1999

Oil reserves 1,782 427 670 546 3,480
Gas reserves 4,205 962 1,866 134 8,108
BOE 2,483 587 981 568 4,831
Capitalized costs $7,933 $1,459 $2,056 $1,178 $13,038
Costs per BOE 3.20 2.48 2.10 2.07 2.70
Data from Tables I and IV. Oil reserves and BOE in millions of barrels, gas reserves in billion cubic feet, capitalized
costs in $millions


This table indicates that Texaco™s unit carrying costs are below even the cyclical low
points of recent oil prices (approximately $10 per barrel). Low capitalized costs are ex-
pected, given the use of successful efforts accounting. These amounts represent the costs that
Texaco must amortize as oil and gas reserves are produced; low capitalized costs equate to
low amortization and higher operating earnings. Low capitalized costs also indicate that the
risk of impairment write-downs is minimal.


9
Natural gas is measured in MCF (thousand cubic feet).
10
In recent years, in the United States, gas has usually sold at a lower relative price than its energy equivalent would
suggest. The relationship changes over time. In 2000, natural gas prices rose more rapidly than oil prices. While
some analysts combine oil and gas reserves based on relative price, such calculations may require frequent revision.
W27
SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES


The geographic differences are revealing. Capitalized costs per BOE are signi¬cantly
lower in the Other East segment and for Texaco™s equity af¬liate (also “Other East”). Higher
¬nding costs in the United States and Europe have driven exploration efforts for companies
such as Texaco increasingly to areas with lower costs.
These data also re¬‚ect historical costs, well below the cost of ¬nding new reserves. The
capitalized cost per BOE, moreover, is only a crude means of comparing the cost of reserves
for different companies. It re¬‚ects both the accounting method used and the “ef¬ciency” in
¬nding oil (the ¬nding cost per BOE). Companies that use the SE method and have low ¬nd-
ing costs have a low capitalized cost per BOE. Companies using the FC method or recording
higher ¬nding costs have higher capitalized cost per BOE.
The capitalized cost per BOE can also be compared with the market value of oil and gas
reserves, as revealed by market transactions. If the capitalized cost is higher than transaction
prices, this indicates that the balance sheet amount is overstated; if transaction prices are
higher, the reverse is true.
However, using the capitalized cost per BOE is, at best, only an approximation of the
value of reserves. It is de¬cient because it fails to recognize the following factors:

1. Reserves in different geographic markets vary in value.
2. Oil reserves have different values from natural gas reserves of equivalent energy
content.
3. The cost of producing reserves (bringing them to the surface) may vary with location.
4. A barrel of oil produced today is more valuable (assuming constant pricing) than one
produced in ¬ve years because of the time value of money.
5. Tax rates vary by jurisdiction and, within jurisdictions, may vary by location and
type of resource.

For these reasons, the aggregation of all reserves by physical quantities does not capture
the market value of reserves. Fortunately, better data are available.

Analysis of Finding Costs
Table V, “Costs Incurred,” reports Texaco™s exploration costs. This table includes all expen-
ditures, regardless of whether they are capitalized or expensed, making the data comparable
among companies with different accounting methods.
These expenditures can be compared with reserves found to compute the actual per unit
¬nding cost. Although annual ¬nding costs are volatile, over longer time periods they mea-

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