Dispelling the Myth that Cash Flow Cannot be Manipulated, 4/1/03: Part 1 Tax Benefit from Stock Option Exercise and Asset Securitizations

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1 Dispelling the Myth that Cash Flow Cannot be Manipulated, 4/1/03: Part 1 Tax Benefit from Stock Option Exercise and Asset Securitizations In part due to the recent focus on earnings quality and the manipulation of various measures of income (EBITDA, Net Income, and the like), some have suggested that perhaps the best measure of a company s performance is operating cash flow, as provided by the cash flow statement. While CFRA certainly agrees that analysis of the cash flow statement is integral to an understanding of a company s financial performance and position as it often provides a check as to the quality of the earnings shown in the income statement, it is important to point out that certain shenanigans do exist that could artificially boost reported operating cash flow. The increased scrutiny has made people aware of some of the means by which companies mask declines in operating cash flow. For example, many have learned to be on the lookout for excessive capitalization of cash expenditures after reviewing the information provided about WorldCom Corporation. Others have begun to scrutinize the cash flow statement for nonrecurring sources of cash, such as the receipt of an income tax refund. However, we note that certain, more complex, situations can arise which could also cause reported cash flow from operations to appear higher than it would have otherwise. This report will discuss the situations noted below; a second report in this two-part series will detail further possible cash flow shenanigans. Impact of the tax benefit derived from the exercise of stock options Securitizations of assets, particularly accounts receivable Impact of the tax benefit derived from the exercise of stock options For a detailed explanation of accounting for stock options when granted and how to recognize compensation expense, please see our educational reports dated August 13, 2002 (Accounting for Stock Options Fair Value Method), December 11, 2001 (Repricing of Employee Stock Options) and August 6, 2001 (The Costs of Employee Stock Options). Most companies currently follow Accounting Principles Board Opinion No. 25 (APB 25), which generally allows companies to avoid recording stock options as an expense when granted. Current Internal Revenue Service (IRS) rules do not allow a company to take a deduction on their tax return when options are granted. However, at the time the stock option is exercised, the Company is permitted to take a deduction on its tax return for that year reflecting the difference between the strike price and the market price of the option. On the external financial statements reported to investors, that deduction reduces (i.e. debits) taxes payable on the balance sheet with the corresponding credit going to increase the equity section (additional paid in capital). Figure 1 below displays the journal entries and resulting financial statement impact of recording this tax benefit. An issue arose as to how to classify this tax benefit (reduction of the taxes payable) on the cash flow statement. Some companies had been including it as an add-back to net income in the operating section of the cash flow statement, while others included it as a financing activity. The, Rockville Pike, Suite 640, Rockville, MD, 20852; Phone: (301) ; Fax: (301) ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

2 Emerging Issues Task Force (EITF) took up this issue in EITF was released in July 2000 and specifically indicated that companies should, if significant, be shown as a separate line item on the cash flow statement in the OPERATING section (i.e. as a source of cash). If the tax benefit is not disclosed in the operating section or in the statement of changes in stockholders equity, EITF provided that if it is material, it should be disclosed somewhere in the footnotes to the Company s financial statements. CFRA notes that the tax benefit is sometimes disclosed only in the Statement of Stockholders Equity on an annual basis, without being disclosed as a separate line item on the Cash Flow Statement in the operating section for investors to analyze. Figure 1. Accounting Treatment for Stock Option Tax Benefit of $10,000 Generated by the Exercise of Employee stock options using APB No. 25 (e.g. Not Expensing the Options at Grant Date): Balance Sheet Impact Journal entry to record tax benefit of $10,000 Debit Taxes payable $10,00 Credit Shareholders' equity $10,000 Cash Flow Statement Impact Adjustment made to increase cash flow by $10,000, made to cash flow from operations CFRA believes that to the extent cash flow from operations (CFFO) is boosted in the current period by a growing impact from the tax benefit on stock options, an investor should question whether the reported CFFO growth is in fact sustainable and is indicative of improved operations. In fact, the boost to operating cash flow is often greatest in a period when the stock price has increased. In other words, when the stock is performing well, more stock options are exercised, resulting in a higher tax benefit which is included as a source of CFFO implying improving CFFO growth. As companies in the technology sector utilize stock options to a higher degree, these entities may require more attention to this issue. We encourage investors to thoroughly review the cash flow statement, the stockholders equity statement and the footnotes to the financial statements to glean the volume of options exercised during the period, and the related tax benefit included as a source of operating cash flow. Activision, Inc. ( ATVI ), is a company that received a boost to CFFO as a result of the tax benefit from stock option exercises in the June 2001 quarter. Specifically, after deducting the beneficial effects of tax benefits from employee stock options, CFFO plunged to negative $52.8 million in the June 2001 quarter, down $23.2 million from the reported negative $29.7 million. (See Table 1.) Table 1: ATVI Adjusted Cash Flows from Operations (CFFO) for June 2001 versus Pro-Forma Net Income (NI), Year -Over-Year ($ thousands) Q1, 6/01 Q1, 6/00 CFFO (29,666) (19,687) Less: Tax Benefit from Stock Options 23,153 3 Adjusted CFFO (52,819) (19,690)

3 Securitizations of assets, particularly accounts receivable Absent other factors, when current asset accounts increase in a given period, operating cash flow falls. For example, if accounts receivable increase, it is a use of cash, as one may infer that cash collections were lower in the period, resulting in less cash on hand at the end of the quarter. When companies sell or transfer assets, such as accounts receivable, to financial institutions or other parties including special purpose entities, the transaction may be referred to as a securitization of the assets. In essence, the company is packaging the assets as a bundle of securities and selling them. Securitizations effectively remove certain assets from the balance sheet and replace them with cash. Assuming that the assets securitized were sold at their carrying value, a simplified version of the journal entry made to record the transaction would be as shown in Figure 2 below. Figure 2: Journal Entry to Record the Securitization of Accounts Receivable Dr (Increase): Cash Cr (Decrease): Accounts Receivable To record the securitization of accounts receivable at carrying value with no recourse or retained interests Notwithstanding the simplified journal entry above, accounting for securitizations is quite complex, often involving off balance sheet entities which may or may not fall into the requirements of the Financial Accounting Standard Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities 1. However, the impact on the cash flow statement is not as complicated. As the assets securitized have been removed from the balance sheet, it appears that those assets have declined from period to period, a source of cash. In fact, those assets have decreased and have been replaced by cash in the period. This is portrayed in the operating section of the cash flow statement simply as part of the working capital changes which are shown as a component of CFFO. In many cases, therefore, the cash flow statement does not disclose the proceeds from the securitizations as a source of cash; instead, the disclosure simply indicates the decline in the working capital asset account which has been securitized. CFRA believes that to the extent cash flow from operations (CFFO) is boosted in the current period by a growing impact from the securitization of assets, an investor should question whether the reported CFFO growth is in fact sustainable and is indicative of improved operations. Our concern is heightened in this case as the timing and magnitude of asset securitizations fall under the discretion of management. Convergys Corporation (CVG) is a company which received a boost to CFFO in the September 2002 quarter from selling accounts receivable. CFRA believes CVG s receivables securitization program is essentially a financing transaction. However, CVG s treatment of it provides the Company a significant boost to reported operating cash flow during the period in which the securitization(s) occur. Specifically, as a result of the receivables securitization, CFFO increased by $100 million in the September 2002 quarter, as shown in Table 2. 1 See our educational reports FIN 46 - Consolidation of Variable Interest Entities dated 2/10/03 and Off Balance Sheet Entities: A Preliminary Look at the Effects of Interpretation 46 dated 3/27/03 for a discussion of the accounting for certain special purpose entities

4 Table 2: Cash Flows from Operations (CFFO), Reported and Adjusted to Exclude Receivables Securitization, Quarterly Trend ($ millions.) Q3, 9/02 Q2, 6/02 Q1, 3/02 Q4, 12/01 Q3, 9/01 Q2, 6/01 CFFO Reported Borrowing / (Repayments) of A/R Securitization (20.0) (40.0) (25.0) 10.0 CFFO CFRA Adjusted In conclusion, there are multiple ways that a focus by an investor on CFFO can be somewhat misleading. This report has detailed two specific ways that operating cash flow can appear stronger than it might have otherwise. A second report in this series will discuss other issues which might impact reported cash flow. Additionally, while CFRA believes that a thorough analysis of the cash flow statement can help an investor come to a conclusion about the quality of a company s earnings, the investor should not focus entirely on CFFO as a metric. Issues such as the ones described above as well as the fact that certain non-recurring items such as tax payments or receipts or contributions to pension plans may cause the reported CFFO to be a less-than-perfect benchmark on which to model.

5 Dispelling the Myth that Cash Flow Cannot be Manipulated, 4/2 /03: In part due to the recent focus on earnings quality and the manipulation of various measures of income (EBITDA, Net Income, and the like), some have suggested that perhaps the best measure of a company s performance is operating cash flow, as provided by the cash flow statement. While CFRA certainly agrees that analysis of the cash flow statement is integral to an understanding of a company s financial performance and position as it often provides a check as to the quality of the earnings shown in the income statement, it is important to point out that certain shenanigans do exist that could artificially boost reported operating cash flow. The increased scrutiny has made people aware of some of the means by which companies mask declines in operating cash flow. For example, many have learned to be on the lookout for excessive capitalization of cash expenditures after reviewing the information provided about WorldCom Corporation. Others have begun to scrutinize the cash flow statement for non-recurring sources of cash, such as the receipt of an income tax refund. However, we note that certain, more complex, situations can arise which could also cause reported cash flow from operations to appear higher than it would have otherwise. In Part 1 of this two-part series, we discussed operating cash flow benefits related to (1) the tax benefit from stock option exercise and (2) the securitization of assets. This report discusses operating cash flow benefits from deferred tax accounting for tax-deductible goodwill. CFRA believes that there is opportunity for companies to manipulate cash flow from operations by structuring acquisitions to take advantage of deferred tax accounting for tax-deductible goodwill. Specifically, if an acquisition is structured such that goodwill is deductible for tax purposes, the result may be the growth of a deferred tax liability. Since changes in deferred taxes affect operating cash flow (CFFO), the increase in deferred tax liability will create a corresponding boost to CFFO. This report answers the following questions: How does accounting for goodwill under GAAP differ from accounting for goodwill for tax purposes? What is a deferred tax liability and how is it generated from tax-deductible goodwill? How does the accounting for tax-deductible goodwill affect operating cash flow? What are the concerns surrounding the accounting for tax-deductible goodwill? How can investors determine the CFFO boost related to tax-deductible goodwill? How does accounting for goodwill under GAAP differ from accounting for goodwill for tax purposes? According to US GAAP, companies are not required to amortize indefinite-lived intangible assets such as goodwill. Specifically, Statement of Accounting Standard No. 142 Goodwill and Other Intangible Assets ( SFAS 142 ) dictates that goodwill should be periodically reviewed for impairment, rather than systematically amortized as a reduction of earnings. As a result, goodwill only affects GAAP earnings when it is impaired., Rockville Pike, Suite 640, Rockville, MD, 20852; Phone: (301) ; ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned. Dispelling the Myth that Cash Flow Cannot be Manipulated (4/2/03): 1

6 Conversely, US tax law allows goodwill to be amortized for tax purposes for certain types of acquisitions. Specifically, Section 197 of the US Tax Code 1 declares that goodwill acquired in an asset purchase 2 is tax-deductible using a 15-year amortization period. When goodwill is deductible for tax purposes, taxable earnings are reduced for the 15 years subsequent to the acquisition. CFRA notes that not all acquired goodwill is amortizable for tax purposes. Investors should review the disclosure about the tax-deductibility of goodwill that is generally provided in company filings (e.g. Forms 10-K) with the Securities and Exchange Commission. This report focuses on the discrepancy between GAAP and tax accounting for goodwill in the US, however, similar discrepancies are prevalent in non-us jurisdictions as well. The following discussion and principles can be applied to any jurisdiction in which rules surrounding the amortization of goodwill differ between local GAAP and tax law. What is a deferred tax liability and how is it generated from tax-deductible goodwill? A deferred tax liability is a tax expense that is incurred for GAAP purposes, but is not yet payable for tax purposes. In other words, a deferred tax liability represents a tax obligation that arises when a company s taxes payable to the government is less than the expense recorded on its books. A deferred tax liability generally reverses as a matter of timing in future years when the cash paid to the government is in excess of the company s GAAP income tax expense. Please refer to CFRA s September 2000 and January 2002 reports for further information surrounding the fundamentals of deferred taxes and the tax footnote. Deducting goodwill amortization for tax purposes results in a company recording lower income for tax purposes ( taxable income ) than for GAAP purposes ( pre-tax earnings ). SFAS 142 addresses how GAAP financial statements should reflect differences arising from tax-deductible goodwill. Specifically, SFAS 142 states that differences arising from tax-deductible goodwill are temporary differences for which a deferred tax liability must be recognized 3. Since these differences are temporary differences, the company uses the same tax rate for GAAP purposes as it does for tax purposes in order to calculate income tax expense. Consequently, as a result of the differing taxable income and GAAP pre-tax earnings, the company s taxes payable (i.e. cash owed to the government) will differ from its GAAP income tax expense (i.e. expense recorded on the income statement); this difference is recorded as a deferred tax liability. In the section below, this accounting is explained in further detail, and the related journal entries are provided. 1 Section 197 of the US Tax Code was created by the Omnibus Reconciliation Act of 1993 ( the 1993 Tax Act ). 2 According to the 1993 Tax Act, goodwill amortization is tax-deductible for goodwill acquired in an asset purchase or goodwill acquired in a stock purchase that, under Section 338 of the Internal Revenue Code, is treated as an asset purchase. 3 SFAS 142 cites Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes (SFAS 109) in its requirement to record a deferred tax liability for this temporary difference. Dispelling the Myth that Cash Flow Cannot be Manipulated (4/2/03): 2

7 How does the accounting for tax-deductible goodwill affect operating cash flow? A deferred tax liability resulting from the tax-deductibility of goodwill directly improves cash flow from operations (CFFO) because it essentially represents a lower cash payment to the government for taxes. The presentation of this cash flow benefit on the statement of cash flows varies and often times gets lost through the aggregation of several accounts. However, the benefit is usually buried as either a decrease in operating assets/liabilities (i.e. increase in deferred tax liability), an add-back to net income or a combination of both. The following example walks through the accounting and CFFO effect of an acquisition with taxdeductible goodwill, and contrasts the treatment with an acquisition that does not include goodwill. In this fictional example, the acquiring company ( Acquirer ) purchases the target company ( Target ). For simplicity purposes, this example assumes (1) a constant tax rate of 40%, (2) all taxes are paid at the time they are accrued and (3) there are no changes to assets and liabilities between periods, other than the deferred tax liability. 1/1/x1: Acquirer purchases Target for $1000. In Table 1, Situation A shows the journal entries for this purchase assuming the acquisition resulted in the creation of tax-deductible goodwill amounting to $150. The presentation under Situation B is such that the acquisition did not result in the creation of goodwill. There is no CFFO impact at the time of Acquirer s purchase of Target; any cash expended in the acquisition transaction is generally recorded as an investing cash flow activity. Table 1: Journal Entries Surrounding Acquirer s Purchase of Target 1/1/x1: To Record Acquirer s purchase of Target: Situation A: Purchase includes tax-deductible goodwill Situation B: Purchase does not include goodwill Dr. Net Assets 850 Dr. Net Assets 1000 Dr. Goodwill 150 Cr. Cash 1000 Cr. Cash /31/x1: Acquirer records pre-tax income of $50. As shown in Table 2, under Situation A, taxable income is less than pre-tax income because goodwill amortization is deductible for tax purposes. Since goodwill can be amortized over 15 years for tax purposes, deductible amortization expense amounts to $10 per year ($150 / 15 years). Consequently, taxes paid is less than income tax expense, which results in the recording of a deferred tax liability. The boost to CFFO can be thought of in one of two ways: (a) CFFO is greater because there is an increase to a liability account, which is considered a source of cash or (b) CFFO is greater because less cash was expended during the year to pay taxes. Dispelling the Myth that Cash Flow Cannot be Manipulated (4/2/03): 3

8 Table 2: Journal Entries to Record Acquirer s Income Tax Expense and its Resulting Effect on CFFO 12/31/x1: To Record Acquirer s Income Tax Expense for the year ended 12/31/x1: Situation A: Purchase includes tax-deductible goodwill Tax rate = 40% GAAP: Pre-tax income = 50 Income Tax Expense (50 x 40%) = (20) Net Income = 30 TAX: Taxable income (50-10) = 40 Taxes Paid (40 x 40%) = 16 GAAP Journal Entry: Situation B: Purchase does not include goodwill Tax rate = 40% GAAP: Pre-tax income = 50 Income Tax Expense (50 x 40%) = (20) Net Income = 30 TAX: Taxable income = 50 Taxes Paid (50 x 40%) = 20 GAAP Journal Entry: Dr. Tax Expense 20 Dr. Tax Expense 20 Cr. Cash 16 Cr. Cash 20 Cr. Deferred Tax Liability (DTL) 4 Statement of CFFO: Statement of CFFO: Net Income 30 Net Income 30 Increase in DTL 4 Increase in DTL 0 Total CFFO 34 Total CFFO 30 Acquirer will receive a boost to CFFO in each year that goodwill amortization is deducted. In this example, total goodwill of $150 would be amortized as a tax deduction in the amount of $10 each year for 15 years. As such, the deferred tax liability would increase by $4 every year, which results in an annual $4 boost to CFFO. CFFO would continue to benefit until such time that the goodwill is impaired or otherwise disposed of (sold). What are the concerns surrounding the accounting for tax-deductible goodwill? CFRA s concern does not rest with the tax-deductibility of goodwill. Rather, we are concerned with (1) the quality of the CFFO boost related to tax-deductible goodwill and (2) the ability for management to create this CFFO boost via goodwill manipulation. CFRA believes that the CFFO benefit received by deducting goodwill amortization is not comparable to CFFO obtained through the normal course of operations. Since this CFFO benefit results only from the structure of an acquisition, CFRA cautions investors not to rely on this benefit as an indicator of true operating growth of a business. This CFFO benefit is more representative of a temporary tax shelter than it is a source of operating earnings. Dispelling the Myth that Cash Flow Cannot be Manipulated (4/2/03): 4

9 CFRA also expresses concern that company management may have the ability to influence this CFFO boost. Specifically, the valuation of goodwill is subject to management discretion, and as such, so too is the related CFFO boost. As discussed in the above sections, by using its discretion in the allocation of an acquisition purchase price, management may have the ability to generate a 15-year CFFO annuity by simply recording tax-deductible goodwill. CFRA calculates that this CFFO annuity is approximately 2.7% of the total amount of tax-deductible goodwill (assuming a 40% tax bracket). That is to say, if management over-estimates its tax-deductible goodwill by $100 million, the company will receive an estimated $2.7 million benefit to CFFO in the subsequent 15 years. (See Table 3.) Table 3: Calculation of the CFFO Boost Resulting from Tax-Deductible Goodwill Tax-Deductible Goodwill Amortization Period $100 mil 15 years Annual Deduction $6.7 mil Tax Rate 40% CFFO Boost* $2.7 mil * As discussed in the sections above, this CFFO boost can also be thought of as an increase in deferred tax liability or the difference between income tax expense and taxes payable. How can investors determine the CFFO boost related to tax-deductible goodwill? In practice, the disclosure surrounding the accounting for tax-deductible goodwill is rather opaque. The CFFO boost related to tax-deductible goodwill is not always apparent on the statement of cash flows because it is easily lost in the aggregation of the effect of all deferred taxes. In order to gauge whether a company is receiving a CFFO boost related to tax-deductible goodwill, investors should review the income tax footnote. If a company is amortizing goodwill for tax purposes, the income tax footnote should show a deferred tax liability related to goodwill. The CFFO boost should approximate the increase in this deferred tax liability. Unfortunately for investors, the income tax footnote is usually presented only on an annual basis, and as such the quarterly effect on CFFO is not always evident. Additionally, disclosure surrounding the tax-deductibility of goodwill may be provided in other sections of a company s SEC filings. Specifically, in paragraphs or footnotes that discuss acquisitions and related goodwill, companies may disclose the amount of goodwill that is expected to be deductible for tax purposes. The CFFO boost resulting from tax-deductible goodwill is particularly concerning for highly acquisitive companies. Investors should scrutinize the footnotes of highly acquisitive companies to determine if there are any CFFO boosts resulting from the tax-deductibility of goodwill amortization. CFRA points to L-3 Communications Inc. (LLL) as an example of a company whose CFFO benefits from tax-deductible goodwill. Table 4 presents a selected portion of LLL s tax footnote as presented on its 2002 Form 10-K. The footnote discloses that deferred tax liabilities related to tax-deductible goodwill increased by $22.8 million in As such, CFRA estimates that LLL received a boost to CFFO in 2002 by approximately that amount. Table 5 shows a selected paragraph from LLL s acquisition footnote disclosing that the Company recorded $508.4 million in tax-deductible goodwill related to a recent acquisition. Applying the 2.7% ratio discussed above (assuming a 40% tax rate), CFRA estimates that the Company will receive a $13.7 million CFFO annuity for the 15 years that goodwill is amortized for tax purposes. Dispelling the Myth that Cash Flow Cannot be Manipulated (4/2/03): 5

10 Table 4: Disclosure from LLL s 2002 Form 10-K, Footnote 13 Income Taxes (in $000 s). The significant components of the Company's net deferred tax assets and liabilities are presented in the table below. DECEMBER 31, Deferred tax assets: Inventoried costs... $ 43,678 $ 8,520 Compensation and benefits... 15,796 11,460 Pension and postretirement benefits ,699 59,397 Property, plant and equipment... 33,669 16,579 Income recognition on contracts in process... 59,663 16,670 Net operating loss carryforwards... 6,579 32,480 Tax credit carryforwards... 38,385 31,943 Other, net... 24,533 21, Total deferred tax assets , , Deferred tax liabilities: Goodwill... (49,317) (26,493) Other, net... (18,861) (11,263) Total deferred tax liabilities... (68,178) (37,756) Net deferred tax assets... $ 290,824 $ 160,848 ========= ========= The following table presents the classification of the Company's net deferred tax assets. Current deferred tax assets... $ 143,634 $ 62,965 Long-term deferred tax assets ,190 97, Total net deferred tax assets... $ 290,824 $ 160,848 ========= ======== Note: Bold and shaded emphasis was added by CFRA. Table 5: Disclosure from LLL s 2002 Form 10-K, Footnote 3 Acquisitions Divestiture and Other Transactions. (This disclosure discusses the deductibility of goodwill related to the Company s acquisition of Aircraft Integration Systems ( IS ).) (in $000 s). (e) The increase to goodwill represents the effect of the final adjustments to the purchase price allocation. Goodwill in the amount of $518,412 was assigned to the Secure Communications & ISR segment and $243,958 was assigned to the Aviation Products & Aircraft Modernization segment. Approximately $508,350 of the IS goodwill is expected to be deductible for income tax purposes, which is less than the amount of goodwill for financial reporting purposes because of differences in the financial statement amounts and income tax basis amounts for certain of the acquired asset and liabilities, pertaining primarily to contracts in process, property, plant and equipment, other current liabilities and pension and postretirement benefits. Note: Bold and shaded emphasis was added by CFRA. Dispelling the Myth that Cash Flow Cannot be Manipulated (4/2/03): 6