Chapter 09 - The Analysis of the Balance Sheet and Income Statement

CHAPTER NINE The Analysis of the Balance Sheet and Income Statement Concept Questions
C9.1. Without the reformulation, operating profitability is confused with financing profitability, and the return on financial assets (and borrowing cost for financial obligations) is typically different from operating profitability. Operations add value whereas financing typically does not, so financing activities need to be separated out to uncover the operating profitability. C9.2. (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) operating operating operating financing financing financing operating (these are investments in the operations of another company) operating operating operating

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

C9.3. (a) (b) (c) (d) (e) (f) operating operating financing operating financing financing if interest is at market rates.

C9.4. Not correct. In a sense, minority interest is an obligation for common shareholders to give the minority in a subsidiary a share of profits. But it is not, like debt, an obligation that is satisfied by free cash flow from operations. Rather, it is equity that shares in a portion of profits after net financing costs. C9.5. Interest is deductible for taxes so issuing debt shields the firm from taxes. C9.6 A firm losses the tax benefit of debt when it cannot reduce taxable income with interest on

debt. This can happen if a firm has losses in operations (and thus has no income to reduce with the interest deduction). In the U. S. this situation is unlikely because firms can carry losses forward or backward against future or past income.

C9.7. The operating profit margin is the profitability of sales, the percentage of a dollar of sales that ends up in operating income after operating expenses.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Exercises Drill Exercises

E9.1. Basic Calculations a. Reformulated balance sheet Operating assets Operating liabilities Net operating assets $547 132 $415 Financial obligations $190 Financial assets 145 Net financial obligations 45 Common shareholders equity 370 $415

Operating liabilities = $322 190 = $132 million. b. Reformulated income statement Revenue Cost of goods sold Gross margin Operating expenses Operating income Net financing expense: Interest expense Interest income Earnings E9.2 Tax Allocation Net interest after tax = $140 x 0.65 = $91 million Operating income after tax = Net income + net interest after tax = $818 + $91 = $909 million (This is the bottom-up method on Box 9.2) E9.3 Tax Allocation: Top-Down and Bottom-Up Methods Top-down method: Revenue Cost of goods sold Operating expenses Operating income before tax $6,450 3,870 2,580 1,843 737 $4,356 3,487 869 428 441 $132 56 76 $ 365

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Tax expense: Tax reported Tax on interest expense Operating income after tax Net interest: Interest expense Tax benefit at 37% Earnings Bottom-down method: Earnings Net interest: Interest expense Tax benefit at 37% Operating income after tax

$181 50

231 506

135 50

85 421

$421 135 50 85 $506

E9.4 Reformulation of a Balance Sheet and Income Statement Balance sheet: Operating cash Accounts receivable Inventory PPE Operating assets Operating liabilities: Accounts payable Accrued expenses Deferred taxes Net operating assets Net financial obligations: Cash equivalents Long-term debt Preferred stock Common shareholders equity $ 23 1,827 2,876 3,567 8,293 $1,245 1,549 712

3,506 4,787

$( 435) 3,678 432 3,675 $1,112

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Income statement: Revenue Operating expenses Operating income before tax Tax expense: Tax reported $295 Tax on interest expense 80 Operating income after tax Net financial expense: Interest expense Tax benefit at 36% Preferred dividends Net income to common 221 80 141 26 $7,493 6,321 1,172 375 797

167 $630

E9.5. Reformulation of a Balance Sheet, Income Statement, and Statement of Shareholders Equity a. Reformulated balance sheet Operating cash Accounts receivable Inventory PPE Operating assets Operating liabilities: Accounts payable Accrued expenses Net operating assets Net financial obligations: Short-term investments Long-term debt Common shareholders equity $ 60 940 910 2,840 4,750 $1,200 390

1,590 3,160

$( 550) 1,840 1,290 $1,870

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Reformulated equity statement: Balance, end of 2008 Net transactions with shareholders: Share issues Share repurchases Common dividend Comprehensive income: Net income Unrealized gain on debt investments Balance, end of 2009 $1,430 $ 822 (720) (180) $ 468 50

78)

518 $1,870

b. Reformulated statement of comprehensive income Revenue Operating expenses, including taxes Operating income after tax $3,726 3,204 522

Net financing expense: Interest expense $ 98 Interest income 15 Net interest 83 Tax at 35% 29 Net interest after tax 54 Unrealized gain on debt investments 50 4 Comprehensive income $ 518 After calculating the net financial expense, the bottom-up method is used to get operating income after tax. That is, net interest expense is calculated first (= $4 million). Then, as comprehensive income is $518 million, operating income must be 518 + 4 = 522. The number for operating expense (3,204) is then a plug to get back to the $3,726 million revenue number. Bottom up.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

E9.6. Testing Relationships in Reformulated Income Statements The solution has to be worked in the following order: = Operating revenues operating expenses = 5,523 4,550 = 973 E = Interest expense after tax/ (1 tax rate) = 42/0.65 = 64.6 F = E 42 = 22.6 D = 610 + 42 = 652 C = F = 22.6 B = A C D = 973 22.6 652 = 298.4 Effective tax rate on operating income = Tax on operating income/ Operating income before tax = (B + C)/A = 33.0% A

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Applications
E9.7. Price of Cash and Price of the Operations: Realnetworks, Inc. a. Total price of equity = $3.96 142.562 million shares = $564.5 million Book value of shareholders equity = 876.0 million Price/book = 564.5/876 = 0.64 b. NOA = CSE NFA = 876 454 = 422 million c. Price of operations = Price of equity Price of net financial assets As the price of net financial assets are close to their market value, Price of operations = 564.5 454 = 110.5 million

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

E9.8. Analysis of an Income Statement: Pepsico Inc. a. The reformulation:

Net Sales Operating expenses Operating income from sales (after tax)tax) (before Tax reported Tax benefit of debt Tax on non-core items income on other operating Operating income from sales (after tax) Other operating income Gain on asset sales Restructuring charge Tax on other operating income(37%) income, 36.1 Operating income (after tax) 20,367 17,484 2,883 1,606 88 (367)

1,327 1,556

1,083 65 1,018 367

651 2,207

Net financial expense: Interest expense Interst income

c.

Tax on net interest (37%) interest (36.1%) Net Income tax 1,327 = 46 .0% operating from sales = 2,883

363 118 245 88

157 2,050

Effective rate on

You might ask why the tax rate is so high: Pepsico had a special 10.6 percent extra tax charge on its bottling operations in 1999.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

E9.9. Financial Statement reformulation for Starbucks Corporation a. Reformulated Statement of Shareholders Equity (in millions) Balance, October 1, 2006 Net payout to shareholders: Stock repurchase Sale of common stock Issue of shares for employee stock options Comprehensive Income: Net income from income statement Unrealized loss on financial assets Currency translation gains Balance, September 30, 2007 1,012.8 (46.8) (225.2) 672.6 (20.4) 37.7 $ 2,228.5

(740.8)

689.9 $2,177.6

Note: The closing balance excludes $106.4 million for Stock-based compensation expense which is a liability rather than equity. (It is added to operating liabilities in the reformulated balance sheet).

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

b. Reformulated Comprehensive Income Statement, 2007 (in millions) Net revenues $ 9,411.5 Cost of sales and occupancy costs 3,999.1 Store opening expenses 3,215.9 Other operating expenses 294.1 Depreciation and amortization 467.2 General and administrative expenses 489.2 Operating income from sales (before tax) 946.0 Tax reported $ 383.7 Tax benefit of net interest 5.6 Tax on other operating income (6.6) 382.7 Operating income from sales (after tax) Other operating income, before-tax item Gain on asset sales Other operating charges Tax at (38.4%) Operating income, after tax-items Income from equity investees Currency translation gains Operating income (after tax) Net financing expenses Interest expense Interest income Net interest expense Realized gain on financial assets Tax (at 38.4%) Unrealized loss on financial assets Comprehensive income 38.2 (19.7) 18.5 (3.8) 14.7 5.6 9.1 20.4 563.3

26.0 (8.9) 17.1 6.6 10.5 108.0 37.7

156.2 719.5

29.5 689.9

Note: Interest income and interest expense are given in the notes to the financial statements in the exercise. That note also identifies the other operating income here.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Reformulated Balance Sheets (in millions) 2007 Operating Assets Cash and cash equivalents Short-term investmentstrading securities Accounts receivable, net Inventories Prepaid expenses and other current assets Deferred income taxes, net Equity and other investments Property, plant and equipment, net Other assets Other intangible assets Goodwill Total operating assets Operating liabilities Accounts payable Accrued compensation and related costs Accrued occupancy costs Accrued taxes Other accrued expenses Deferred revenue Other long-term liabilities Total operating liabilities Net operating assets Net financial obligations Short-term borrowing Current maturities of long-term debt Long-term debt Cash equivalents (281.3-40.0 in 2008) Short-term investments (available for sale) Long-term investments (available for sale) Net financial obligations Common shareholders equity Notes: 1. Short-term investment (trading securities) is operating assets connected to employees. 2. Stock-based compensation, excluded from the equity statement, has been added to other liabilities. 40.0 73.6 287.9 691.7 148.8 129.5 258.8 2,890.4 219.4 42.0 215.6 4,997.7 390.8 332.3 74.6 92.5 257.4 296.9 460.5 1,905.0 3,092.7 710.2 0.8 550.1 (241.3) (83.8) (21.0) 915.0 2,177.6 2006 40.0 53.5 224.3 636.2 126.9 88.8 219.1 2,287.9 186.9 37.9 161.5 4,063.0 340.9 288.9 54.9 94.0 224.2 231.9 262.9 1,497.7 2,565.3 700.0 0.8 2.0 (272.6) (87.5) (5.8) 336.9 2,228.5

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

c. ROCE = 689.9 / 2,228.5 = 30.96% RNOA = 719.5 / 2,565.3 = 28.05% NBC = 29.5 / 336.9 = 8.76%

E9.10. Reformulation and Effective Tax Rates: Home Depot, Inc. First establish the firms marginal tax rate. This is the statutory rate (federal plus state) at which interest income is taxed (or interest expense gets a tax saving). The footnote gives the effective rate (36.8% for 2005), which is the effective rate from the income statement (2,911/7,912 = 36.8%). But this is not the marginal rate for it includes tax credits and foreign tax benefits, amongst other things. The marginal rate is the statutory rate, federal and state combined (with the state rate recognizing that state taxes are deductible in federal tax returns). The federal statutory rate is 35%, but the state rate is not given. (Many firms do report it.) Home Depot operates in many states; without more information, the statutory rate is somewhat of a guess. Home Depot reports a ratio of state-to-federal taxes of 215/2,769 = 7.79% for 2005. Applied to the federal rate of 35%, this implies a state rate of 2.72%, or a total rate of 37.72%. In the reformulation below, this 37.72% rate is used for the tax allocation. The top-down approach proceeds as follows:

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Reformulated Income Statement, January 30, 2005 ($ millions) Net sales Cost of sales Gross profit Selling and store operating costs General and administrative Operating income before tax Tax as reported Tax benefit of net debt Operating income after tax Interest expense Interest income Net interest expense Tax on net interest (37.72%) Net income Effective tax rate on operating income = 73,094 48,664 24,430 15,105 1,399 2,911 5 70 56 14 5 16,504 7,926 2,916 5,010

9 5,001

2,916 = 36.79% 7,926 This effective rate is almost the same as the reported rate because the net interest is almost zero. The bottom-up approach proceeds as follows (in millions of dollars): Net income Interest expense Interest income Net interest expense Tax on net interest (37.72%) Operating income after tax 70 56 14 5 5,001

9 5,010

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Minicases M9.1 Financial Statement Analysis: Procter & Gamble

This is the first in a series of cases on Procter and Gamble that end in Chapter 12. This first installment asks the student to reformulate the financial statements, compare them to statements for General Mills, Nike, and Dell in the chapter, and to make some elementary calculations that start the financial statement analysis that continues in Chapter 11. Students should be encouraged to put the reformulated statements into a spreadsheet to facilitate the later analysis. BYOAP on the books web site provides a guide.

Reformulated Statement of Common Shareholders Equity Year ended June 30, 2008
Balance, June 30, 2007 reported Less Preferred Stock1 Plus ESOP reserve2 Balance of common equity Transactions with common shareholders Dividends Share repurchase Share issue Preferred stock conversion4 Comprehensive income Net income Other comprehensive income3 Loss for FIN48 Preferred dividend 5 Loss on conversion of preferred stock4 Balance, June 30, 2008 (4,479) (10,047) 2,480 329 12,075 3,129 (232) (176) (289) 66,760 (1,406) 1,308 66,662

(11,717)

14,507 69,453

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Notes: 1. Preferred stock is moved to debt portion of the balance sheet. 2. An ESOP is an Employee Stock Ownership Plan. In the reformulation, the ESOP reserve is taken out of the equity statement and netted against the ESOP loan in the balance sheet. P&G is guaranteeing the loan to the ESOP, and accounting rules (SOP 76-3) require the firm record the loan as a liability and to set up a reserve in equity for this contingency. However, it is highly unlikely that P&G will have to honor the guarantee (and, in any case, the reserve is not a reduction of equity to the full face amount). If one deemed that P&G has a reasonable probability of having to honor the guarantee, the liability would be retained, but with the debit recorded as an asset (claim on the ESOP) rather than in equity. 3. Other comprehensive income is listed in the equity statement (largely foreign currency translation gains and hedging losses). 4. Preferred stock was converted into equity with a loss to shareholders. The loss from issuing 4.982 million common shares is calculated as follows (based on an average of $66 per share during the year): Market value of common shares issued, $66 x 4.982 million = 329 Preferred cancelled 40 289 million Details of common issued and preferred cancelled are in the equity statement. Note that the common shares are issued at the market price in transaction with shareholders. The conversion of the preferred shared was done by the ESOP, so the cost of conversion is essentially wage cost: P&G pays employees by using common shares in conversion of preferred shares held by ESOP. So we treat the $289 million as an expense of operations in the reformulated income statement. (The ESOP loan is a loan to purchase the preferred shares.) 5. Preferred dividends are after tax. Preferred dividends get a tax deduction because they are paid to the ESOP.

One could reformulate the equity statement for 2007 and 2006, but we need only extract the comprehensive income:

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

The comprehensive income for 2007 and 2006 is as follows:

Net income OTC Effect of accounting charge Preferred dividends Loss on conversion of preferred stock by ESOP 2007 10,340 1,468 (333) (161) (261) 11,053 2006 8,684 1,048 ---(148) (173) 9,411

The reformulated income statements for 2006-2008 follow:

Reformulated Income Statements

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Net sales Cost of products sold Gross margin Advertising Research and development General and administrative Loss on ESOP preferred stock conversion Operating income (from sales before tax) Tax reported Tax on net interest Tax on other OI Operating income from sales (after tax) Other operating income: Gains on asset sales Tax at 38% Other operating income after tax: Other comprehensive income Effect of accounting change Operating income Net Financing Expense Interest expense Interest income Net interest expense Tax at 38% Preferred dividends Net financial expense Comprehensive income 4,003 480 (98)

2008 83,50 3 40,69 5 42,80 8 8,667 2,226 14,83 2 28 9 16,79 4 4,370 4,385 12,40 9 386 (105)

2007 76,476 36,686 39,790 7,937 2112 14,291 261 15,189 3,72 9 286 32

2006 68,22 2 33,12 5 35,09 7 7,122 2,075 12,65 1 17 3 13,07 6

4,651 10,538

4,047 9,029

258 (98)

160 3,129 (232) 15,46 6 1,467 204 1,263 480 783 176 959 14,50 7

277 (105)

172 1,468 (333) 11,845

(84) 32

(52) 1,048 -----10,02 5 1,119 367 752 286 466 148 614 9,411

1,304 287 1,017 386 631 161 792 11,053

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Notes: Loss on conversion of preferred shares by ESOP (Employee Stock Option Plan) is effectively wages paid to employees, so is included in operating expenses. OTC items are listed in the equity statement. They are all after tax. Here are the reformulated balance sheets:

Reformulated Balance Sheets

2008 Operating Assets: Operating cash1 Accounts receivable Inventories Deferred income taxes Prepaid expenses and other Property, Plant and Equipment Accumulated depreciation Goodwill Other intangibles Other assets Operating Liabilities: Accounts payable Accrued liabilities Taxes payable Deferred taxes Other liabilities Net Operating Assets (NOA) Financial Obligations: Debt due in one year Long-term debt Less ESOP reserve Preferred stock Financial Assets: Cash equivalents Investment securities Net financial obligations Common Equity 120 6,761 8,416 2,012 3,785 38,086 (17,446) ) 59,767 34,233 4,837 140,571 6,775 10,154 945 11,805 8,154 37,833 102,738 13,084 23,581 (1,325) 1,366 36,706 3,193 228 3,421 33,285 69,453 2007 120 6,629 6,819 1,727 3,300 34,721 (15,181) ) 56,552 33,626 4,265 132,578 5,710 9,586 3,382 12,015 5,147 35,840 96,738 12,039 23,375 (1,308) 1,406 35,512 5,234 202 5,436 30,076 66,662 2006 120 5,725 6,291 1,611 2,876 31,881 (13,111) ) 55,306 33,721 3,564 127,989 4,910 9,587 3360 12,354 4,472 34,685 93,306 2,128 35,976 (1,288) 1,451 38,267 6,573 1,133 7,706 30,561 62,745 2005 120 4,185 5,006 1,081 1,924 26,325 (11,993) ) 19,816 4,347 2,703 53,494 3,802 7,531 2,265 1,896 3,230 18,724 34,770 11,441 12,887 (1,259) 1,483 24,552 6,269 1,764 8,033 16,519 18,251

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Note: ESOP reserve in equity has been offset against ESOP loan (in long-term debt). See notes to equity statement. $120 million of cash on cash equivalents has been treated as working cash. Other liabilities are largely pension obligations and other employee benefits and thus operating liabilities.

Comparison with General Mills, Inc. (GIS) (Note that some analysis is done on GIS in Exhibits 9.12 and 9.13) Although P&G is a considerably larger firm (by asset and sales) than General Mills, the two firms have similar balance sheets. This, of course, reflects their similar (consumer brand) business. P&G sales in 2008 were 6.2 times the sales for GIS; if one multiplies each line item for GIS operating assets and liabilities by 6.2, one gets approximately the amount for which that line item is carried on the PG balance sheet. So, PG carries assets and liabilities in the same proportion to sales as GIS. In 2005, PG had proportionally less goodwill and intangibles assets on its balance sheet than GIS, but subsequent acquisitions of other consumer product companies (notably Gillette) and purchase of brands led to goodwill and intangibles significantly above those for GIS (as a percentage of sales and assets). PG moved to growth through acquisition rather than internal development and maintenance of brands. This difference in strategy shows up in the comparison of their strategic balance sheets. Otherwise the operating parts of the balance sheets very similar (standardizing for scale). (Students may calculate and compare the various turnover ratios for the two companies, for example, the inventory turnover ratio, the PPE turnover. You will find these numbers for GIS in the body of Chapter 11, and for PG in the solution to the Minicase M11.1.) As for financing strategy, both firms are positively levered; they borrow to finance operations. However, PG is less highly levered, with a financing leverage ratio, FLEV of 0.479 compared to almost 1.0 for GIS. Note that PG issued considerable equity for the Gillette purchase in 2006, reducing its leverage. Both firms maintain about the same amount of cash on hand (relative to debt). The two reformulated income statements also look similar. Note the advertising expense and R&D lines, important to brand companies. Go down the income statement and calculate common-size ratios. Those for GIS are in Exhibit 9.12. Some of the most pertinent ratios for PG (with comparison to GIS) are:

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

2008 Gross margin ratio Advertising-to-sales R&D-to-sales Operating PM from sales (after tax) Operating PM (after tax)

PG 51.3% 10.4% 2.7% 14.9% 18.5%

GIS 35.7% 4.6% 1.5%* 10.6% 13.9%

*The other expense in Exhibit 9.12 is R&D expense. PG is more profitable, per dollar of sales, than GIS, but spends more on advertising and R&D to maintain that profitability. PG benefited more from exchange rate gains in 2008 (reported in other comprehensive income) than did GIS. Comparison with Nike, Inc. The comparison here is between firms with different types of products. Note, however, that the types of assets and liabilities on the balance sheet are quite similar. See Exhibits 9.12 and 9.13 do some Nike analysis and compare to PG. The two firms differ in their financing: Nike is a net creditor (it has net financial assets) and thus has a negative FLEV. Comparison with Dell, Inc. Again, a different product and, in this case, quite a different strategic balance sheet. Note the considerably low turnover ratios for Dell and, most importantly, its negative net operating assets. See the commentary on both its strategic balance sheet and income statement in the text. The firms are organized to add value (ReOI) in very different ways. Also note that the difference in financing position: Like Nike, Dell has net financial assets (and a pile of cash). Answers to Questions To calculate profitability measures, first calculate average balance sheet amounts for each year: 2008 2007 2006

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Operating assets Operating liabilities NOA NFO CSE

136,575 36,837 99,738 31,681 68,057

130,284 35,262 95,022 30,319 64,703

109,366 30,695 78,672 27,051 51,621

PG acquired Gillette on October 1, 2005. Thus Gillette in included in the financial statements for 9 months of the year ending June 30, 2006. Accordingly, the average balance sheet amounts for 2006 are calculated as (0.25 Beginning balance) + (0.75 Ending balance). A. B. C. D. ROCE (CI/CSE) 2008 21.32% 15.51% 14.86% 10.38% 2.67% 2007 17.08% 12.47% 13.78% 10.38% 2.76% 2006 18.23% 12.74% 13.33% 10.44% 3.04%

RNOA (OI/NOA) Operating PM from sales Advertising/Sales R&D/Sales

Advertising/sales has been very constant while R&D/Sales has declined somewhat. Is PG acquiring new products and brands through acquisition rather than through internal R&D -- and then maintain the brands with advertising? E. F. 168.35% Clearly the Gillette acquisition in 2008 added substantially to NOA. G. H. I. FLEV (end of year) FLEV (ave. for year) 0.479 0.466 Sales growth rate 9.19% OI (from sales) growth rate 17.75% NOA growth rate 12.10% 15.90% 6.20% 3.68%

PG has many overseas subsidiaries whose assets and liabilities are converted to US$ in the consolidation. During 2008, the US $ value of net assets overseas increased as exchange rates changed. The equity statement for 2006 shows $53,371 million common stock issued for the acquisition. This was a pure acquisition by a share exchange (no cash), so $53,371 is the purchase price. (If cash had been involved, it would show up in the cash flow statement as part of cash investment.) The increase in goodwill is from the Gillette acquisition. Review acquisition accounting in Accounting Clinic V.

J.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

The financial statements for the case are below, to be used in the presentation of the case:

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

M9.2 Understanding the Business Through Reformulated Financial Statements: Chubb Corporation
Introduction This case is well worth covering if you plan to work the Chubb valuation case, M13.1 in Chapter 13. It sets up the reformulated financial statements for that case and, more importantly, gets students to understand (via those reformulated statements) how an insurance company adds value. This case and M13.1 can be rolled into one presentation. Take the students through the business model for a property-casualty insurer and how that business model should be reflected in the (reformulated) financial statements: A property-casualty insurer underwrites losses by collecting cash from insurance premiums and paying out cash for loss claims. There is a timing difference between cash in (from premiums) and cash out (in claims paid) the float and the insurer plays the float by investing it in securities and other investments. Effectively the policyholders provide cash that is invested in investment assets. In the reformulated balance sheet, the float is represented by negative net operating assets. So the reformulated balance sheet depicts the two aspects of the business the negative net operating assets in underwriting and the positive investment in securities (which is also part of operations). Accordingly, the reformulated balance sheet takes the following form: Net operating assets in underwriting operations + Net operating assets in investments = Total net operating assets - Financing debt = Common equity NOA in underwriting is negative. The investment assets also serve as reserves against claims in the underwriting business and the type of investments are constrained by regulation to make sure the reserves are not too risky.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Corresponding to the reformulated balance sheet, the reformulated income statement separates income from underwriting activities from income from investment activities. The reformulated income statement combines net income with other comprehensive income (of course), which is quite important for insurance companies (and other institutions with investment portfolios): This negates any effects of cherry picking into the income statement. The Reformulated Balance Sheet Here is Chubbs reformulated statement. It follows the reported statement closely as that statement clearly separates investment assets from operating assets used in underwriting and real estate.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Chubb Corp. Reformulated Balance Sheet, December 31, 2007 ($ millions)

2007 Underwriting operations Operating assets: Cash Premiums receivable Reinsurance recoverable on unpaid claims Prepaid reinsurance premiums Deferred policy acquisition costs Deferred income tax Goodwill Other assets Operating liabilities: Unpaid claims and loss expenses Unearned premiums Accrued expenses and other liabilities Net operating assets- underwriting Investment operations: Short-term investments Fixed maturity investment-held to maturity Fixed maturity investment-available for sale Equity investments Other invested asets Accrued investment income Total net operating assets Long-term debt Common shareholders' equity As reported Dividends payable 1,839 33,871 2,320 2,051 440 2,254 135 31,831 1,957 1,516 411 22,623 6,599 2,090 22,293 6,546 2,385

49 2,227 2,307 392 1,556 442 467 1,366 8,806

2,3 2,5 3 1,4 5 4 1,7

9,5

31,312 (22,506)

31,2

(21,6

40,521 18,015 3,460 14,555 14,455 110 14,565

38,1

16,4

2,4

13,9

13,8 1 13,9

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Notes: 1. Dividends payable has been reclassified as shareholders equity. 2. Other invested assets ($2,051 in 2007) are investments in private equity limited partnerships are carried in the balance sheet as Chubbs share in the partnership based on valuation provided by the private equity manager. Changes in these valuations are recorded as part of realized investment gains and losses in the income statement. The negative NOA in underwriting activities represents the float. The investment assets, though they look like financial assets, are operating assets because a firm cannot run a risk underwriting business without the reserves in the assets. Indeed, insurers typically make their money from investing the float in these assets. The separation identifies two aspects of the business, one where value is created (or lost) through underwriting and one where value is created (or lost) in investment operations.

The Reformulated Income Statement Rather than reporting other comprehensive income within the equity statement, Chubb reports a separate comprehensive income statement (below the income statement in the case). The reformulated statement combines the two statements and separates the two types of operations. Like the reformulated balance sheet, it separates the earnings from investing from earnings from insurance underwriting. With this reformulation, one gets a better insight into the business.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Reformulated Income Statement, Year Ended December 31, 2007 (in $ millions)

Underwriting operations: Premiums earned Claims and expenses: Insurance losses Amortization of deferred policy acquisition costs Other operating costs Operating income before tax-underwriting Corporate and other expenses Operating income before tax, underwriting and other Income tax reported Tax on investment income Core operating income after tax - underwriting Currency translation gain, after tax Additional pension cost Operating income after tax, underwriting and other Investment operations: Before-tax revenues: Investment income-taxable Realized investment gains Other revenue
2

11,946

6,299 3,092 444

9,835 2,111 300 1,811

1,130 663

(467) 1,344

125 (17)

108 1,452

(1738-232)

Investment expenses Income before tax Tax (at 35%) Income after tax Investment income-tax exempt Unrealized investment gain after tax Comprehensive income

1,506 374 49 1,929 35 1,894 663 1,231 232 134

1,597 3,049

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

Notes: 1. Currency translation gains are identified with underwriting in other countries. These gains are reported after tax in the comprehensive income statement. 2. Realized investment gains include gains and losses from revaluations of interests in private equity partnerships. See note to the reformulated balance sheet. 3. Taxable investment income is total investment income minus tax-exempt income of $232 million. The $232 million of tax-exempt income is added after tax is assessed. Note the following: 1. Placing the income statement on a comprehensive basis gives a more complete picture. The net income is misleading because it omits unrealized gains and losses from available-for-sale securities. A firm can cherry pick realized gains by selling the securities in its portfolio that have appreciated. Comprehensive income includes the income from (available-for-sale) securities that have dropped in value, so one gets the results for the whole investment portfolio. For Chubb in 2007, unrealized gains (not losses) are reported, so there is no indication of cherry picking (at least on a net basis). 2. Taxes are allocated between the investment operations and the underwriting (and other) operation. The tax rate of 35% is applied only to taxable investment income (not the tax exempt income). Note further, that the income from underwriting is usually quite small. Indeed, in many years, insurance firms make losses on underwriting. Yet they add value: Minicase M13.1 provides the explanation.

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Here are answers to the questions in the case: A. All available-for-sale securities and trading securities must be market to market. Only held-to-maturity securities are carried at cost. See Accounting Clinic III. B. See the explanation in the discussion above: insurance companies generate a float which they then invest in securities. C. The two types of income come from activities that add value quite differently. Further, the investment activity can usually be valued using mark to market accounting, not so the underwriting activity. Minicase 13.1 takes this a lot further. D. Yes, to pick up any cherry picking. Comprehensive income reporting gives the performance for the whole investment portfolio, whether returns were realized or not. E. The value of the equity is made up as follows: Value of equity = Value of underwriting operation + Value of investments Debt As the investment operation is marked to market (for the large part), its value is approximately its book value ($40,521 million). (There is a question regarding the private equity investments in other invested assets that are revalued by the private equity manager (but may not always to marked to market of fair value.) Similarly, the book value of the debt is close to market value. The market value of the equity can be calculated by looking up the per-share price ($54) of the 374.65 million outstanding shares: $54 374.65 = $20,231 million. Thus $20,231 = Value of underwriting business + $40,521 - $3,460 Accordingly, the value of the underwriting business is -$16,830. How can the value be negative?? Well, it can. This is a case of operating liability leverage adding value. Go to Minicase 13.1.

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Chapter 09 - The Analysis of the Balance Sheet and Income Statement

The original financial statements are below, for use in the case presentation:

(continued)

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