The article discusses three accounting changes issued by the Financial Accounting Standards Board (FSAB). The Statement of Financial Accounting Standards (SFAS) No. 158  Employers\u27 Accounting for Defined Benefit Pension and Other Retirement Plans  and the SFAS No. 160  Noncontrolling Interests in Consolidated Financial Statements  are mentioned. Financial Interpretation 48  Accounting for Uncertainty in Income Taxes, an Interpretation of FSAB Statement No. 109  is mentioned.
The takeaway? Financial analysts, investors, and creditors need to carefully interpret ratios and measures, including debt to equity, liabilities to equity, and return on equity. Financial ratios used in loan covenants should be clearly designed and defined, and, in some cases, equity may be more meaningfully defined as adjusted for certain changes in other comprehensive income

Lyons, Bridget

Paliwal, Rupendra

Pannese, Danny A.

English

Sacred Heart University: DigitalCommons@SHU

Sacred Heart UniversityDigitalCommons@SHUWCOB Faculty Publications Jack Welch College of Business4-2010Interpreting Financial ResultsBridget LyonsSacred Heart University, lyonsb@sacredheart.eduRupendra PaliwalSacred Heart University, paliwalr@sacredheart.eduDanny A. PanneseSacred Heart University, pannesed@sacredheart.eduFollow this and additional works at: http://digitalcommons.sacredheart.edu/wcob_facPart of the Accounting Commons, and the Finance and Financial Management CommonsThis Article is brought to you for free and open access by the Jack Welch College of Business at DigitalCommons@SHU. It has been accepted forinclusion in WCOB Faculty Publications by an authorized administrator of DigitalCommons@SHU. For more information, please contactferribyp@sacredheart.edu.Recommended CitationLyons, B., Paliwal, R., & Pannese, D. (2010). Interpreting financial results. Strategic Finance, 91(10), 49-53.A p r i l  2 0 1 0 I S T R AT E G IC  F I N A N C E 49FINANCIAL ANALYSISILLUSTRATION: JON ALLEN/BRAND X PICTURESInterpretingFinancialResultsBe aware of the impact of the economic crisis and recent accountingchanges on financial ratios.By Bridget Lyons, Rupendra Paliwal, and Danny Pannese, CPA, CVASince 2005, many companies, including those comprising the Dow JonesIndustrial Average (DJIA), have experienced deterioration in commoncredit ratios, including the debt-to-equity and liability-to-equity ratios.At the same time, the current financial crisis has increased focus oncredit analysis and credit metrics. Complicating credit analysis is theimplementation of three Financial Accounting Standards Board (FASB)accounting pronouncements: Statement of Financial Accounting Stan-dards (SFAS) No. 158, “Employers’ Accounting for Defined Benefit Pen-sion and Other Postretirement Plans—an amendment of FASBStatements No. 87, 88, 106, and 132(R)”; SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements—an amendment of ARBNo. 51”; and Financial Interpretation 48 (FIN 48), “Accounting forUncertainty in Income Taxes, an Interpretation of FASBStatement No. 109.” SFAS No. 158 and FIN 48 were issuedin 2006 and SFAS No. 160 in 2007. Although they haven’tgarnered much attention, they have materially affectedthe balance sheets of many companies and have had asignificant impact on common credit ratios and returnmeasures, including return on equity (ROE).In fact, SFAS No. 158 and FIN 48 continue to impactfinancial statements, so, as 2009 financial information isreleased, we recommend that financial professionals andinvestors interpret credit and return measures carefully.Further complicating the analysis of 2009 financial reportsis SFAS No. 160, which was effective in 2009 for mostcompanies. (See “Accounting for Noncontrolling Interests”on p. 53 for more information about SFAS No. 160.)To learn more about the effects of all these factors, weexamined the companies in the DJIA from 2005 through2009 and analyzed the impact of SFAS No. 158 and FIN48. Then we calculated financial ratios for each companyand for the overall sample. The average ratios for thecompanies in our sample are shown in Table 1.These ratios receive a great deal of attention fromfinancial analysts and investors and frequently are used indesigning loan covenants. The twocredit metrics, debt to equity and lia-bilities to equity, deteriorate from2005 to 2008 since the firms appear tobe much more highly leveraged andthen improve in 2009 as the relativelevel of debt falls. Average ROE movesbetween 20% and 23% from 2005 to2008 before dropping dramatically in2009. Return on equity is a commonmeasure of profitability, so the ROEin Table 1 suggests that 2008 was anespecially profitable year and that per-formance in 2009 was much weaker.Here’s a key question: Do these ratios reflect changesprimarily in financial position and performance, or haveaccounting changes played a role?We find that accounting changes have had a significantimpact on the results.Table 2 shows the average ratios for the companies inour sample after adjusting for implementation and ongo-ing compliance with SFAS No. 158 and FIN 48.Let’s take a deeper look at the effects of the accountingchanges. Although we'll continue our discussion using ref-erences to SFAS No. 158, SFAS No. 160, and FIN 48, onJuly 1, 2009, the FASB formally adopted its AccountingStandards Codification™ (ASC) that superseded these andall other prior pronouncements of U.S. Generally AcceptedAccounting Principles (GAAP), thus becoming the singleofficial source of authoritative, nongovernmental U.S.GAAP and reorganizing the previous guidance under top-ics instead of single pronouncement numbers. The guid-ance that was originally in SFAS No. 158 is now under ASCTopics 715, Compensation-Retirement Benefits, and 958,Not-for-Profit Entities. Guidance originally in SFAS No. 160is now under ASC Topic 810, Consolidation, and guidanceunder FIN 48 is now under ASC Topics 740, Income Taxes;50 S T R AT E G IC  F I N A N C E I A p r i l  2 0 1 0FINANCIAL ANALYSISTable 1: Average Ratios for Sample Companies2005 2006 2007 2008 2009Debt/Equity* 0.73 0.78 0.76 1.11 0.84Liabilities/Equity** 3.20 3.48 3.58 3.77 3.09Return on Equity** 20% 23% 21% 23% 14%*Banks were excluded from the debt/equity ratio because the ratio isn’t relevant for banks.**This sample is composed of the firms in the Dow Jones Industrial Average as of January 2010,excluding The Home Depot and Microsoft because the accounting changes at these two firmsweren’t significant.Table 2: Average Ratios After Adjustments2005 2006 2007 2008 2009Debt to equity – as reported 0.73 0.78 0.76 1.11 0.84Debt to adjusted equity (no adj. req. for 2005) 0.73 0.66 0.82 0.87 0.87Liabilities to equity – as reported 3.20 3.48 3.58 3.77 3.09Liabilities to equity – adjusted (no adj. req. for 2005) 3.20 3.06 3.84 3.20 3.14Return on equity – as reported 20% 23% 21% 23% 14%Return on equity – adjusted (no adj. req. for 2005) 20% 21% 23% 19% 14% 805, Business Combinations; and 835, Interest. Any changesto the Codification are made via Accounting StandardsUpdates (ASU). All the pertinent information about theCodification can be found at the FASB's website atwww.fasb.org under the heading “Standards.”SFAS No. 158The accounting for defined pension and postemploy-ment benefits has long been controversial. SFAS No. 158,which was approved in September 2006 and was effectivefor most firms that year, requires full balance-sheetrecognition of the net pension liability (or asset). Com-panies with year-ends after December 15, 2006, had toshow the funded status of defined pension and otherpostemployment benefits on the balance sheet. Sincemost firms with such plans hadn’t fully funded the plans,particularly in terms of other postemployment benefits(OPEB), implementation of SFAS No. 158 generally ledto an increase in liabilities and a reduction in equity. Onaverage, our sample firms reported a decline of about7% in equity in 2006.Adjusting for the impact of SFAS No. 158 indicates thatthe three ratios we examined provided somewhat mis-leading information for 2006 since debt to equity andliabilities to equity actually improved rather than dete-riorated and return on equity showed only a marginalimprovement.The implementation of SFAS No. 158 isn’t a one-timeadjustment because ongoing compliance with the State-ment continues to significantly impact equity valuesthrough adjustments to other comprehensive income.During 2007, most companies had relatively high assetreturns so reported positive adjustments to other com-prehensive income and a corresponding increase in equi-ty. The reverse occurred in 2008 as the value of pensionassets at most firms dropped dramatically, leading tolarge drops in other comprehensive income and totalequity. In 2009, the average adjustment to other compre-hensive income for pension and other postemploymentbenefits was relatively small, so there isn’t much of a dif-ference between the reported and adjusted ratios.We found that, for our sample firms, the averageadjustment to the other comprehensive income compo-nent of equity related to SFAS No. 158 was significantover the 2006-2009 period (see Table 3).FIN 48Financial Interpretation 48 was released in July 2006 toprovide more transparency in reporting and to enhancecomparability across firms. It includes a statement thatsays that, upon adoption, firms must record any effect ofa change in reserves for uncertain tax benefits as anadjustment to shareholders’ equity. The adoption of FIN48, in 2007 for most firms, led to adjustments in equityA p r i l  2 0 1 0 I S T R AT E G IC  F I N A N C E 51Table 3: Average Adjustment2007 2008 2009Average Adj. to OCI for Pension OPEB in millions of $ 900 (3,413) 23Average change in Value of Pension Assets 7.8% (21.3)% 20.8%Table 4: IBM—Key Valuesin millions of $ 2005 2006 2007 2008 2009Retained earnings 44,734 52,432 60,640 70,353 80,900Other Comprehensive Income (2,016) (8,901) (3,414) (21,845) (18,830)Total Equity 33,098 28,506 28,470 13,465 22,637Net income 7,934 9,492 10,418 12,334 13,425Debt 22,641 22,682 31,093 33,925 26,100Liabilities 72,650 74,728 91,962 96,058 86,267Adj. to OCI for initial adoption of SFAS No. 158 (9,498) 4,678 (14,857) 1,838related to reserves for uncertain taxbenefits, which impacted the firms’credit ratios. For example, IBM adopt-ed the provisions of FIN 48 on Jan-uary 1, 2007. The cumulative effect ofadopting the Interpretation was adecrease in tax reserves and anincrease of $117 million to the Jan-uary 1, 2007, retained earnings bal-ance. In our sample, the firms werealmost evenly split between positiveand negative adjustments to equity.Case Study: IBMSo how does the accounting work? Let‘s look at an analy-sis of IBM over the 2006-2009 period. Key values are pro-vided in Table 4.Note that, at IBM, retained earnings increased from2005 to 2006 but that debt was flat over this period. Froma credit perspective, this is a positive trend. Still, the debt-to-equity and liabilities-to-equity ratios at IBM increasedsignificantly (see Table 5). We also see a significant increasein return on equity from 2005 to 2006. These ratios reflect,in part, implementation of SFAS No. 158, which led to areported adjustment to other comprehensive income of$9.498 billion and recognition of the full value of pensionand OPEB liabilities on the balance sheet. Again, the FIN48 impact on IBM was $117 million in 2007.If we adjust for the implementation of SFAS No. 158 by“undoing” the accounting transactions related to imple-mentation, IBM would have reported the “adjusted” ratios(no adjustment required for 2005) shown in Table 5.At IBM, the apparent deterioration in credit metricsand improvement in return on equity from 2006 through2008 can be attributed in large part to the adoption ofSFAS No. 158. The adjusted ratios are less volatile overtime.ImplicationsAccounting changes can lead toone-time impacts on financialstatements and ratios when imple-mented and should be consideredin financial analysis by investors,analysts, rating agencies, and credi-tors. Perhaps more important forforward-looking analysis, however,is the impact of ongoing imple-mentation of these accountingchanges.The debt-to-equity, liabilities-to-equity, and return-on-equity ratiosfor the DJIA firms we examined were impacted signifi-cantly by market conditions but also by implementationof SFAS No. 158 and, to a lesser extent, FIN 48. This mayhave led to a perceived deterioration of creditworthiness.Further, some firms may have faced a situation wherebond and loan covenants were triggered, leading to seri-ous consequences. When there’s a technical default in aloan covenant, this can lead to the loan becoming payableupon demand, restricted ability to pay dividends, and thepotential for a qualified audit.In addition to the implementation of these accountingchanges, ongoing compliance with SFAS No. 158 contin-ues to significantly impact equity values through adjust-ments to other comprehensive income. As noted earlier,this ongoing compliance resulted in significant positiveimpact on other comprehensive income in 2007 and asignificant negative impact in 2008. In 2009, pensionasset values rose significantly.A key consideration is that when profitability and mar-ket ratios deteriorate because of market conditions, theimpact of SFAS No. 158 generally has an impact on othercomprehensive income that worsens credit metrics in badtimes and strengthens these metrics in good times. This52 S T R AT E G IC  F I N A N C E I A p r i l  2 0 1 0FINANCIAL ANALYSISTable 5: IBM—Adjusted Ratios2005 2006 2007 2008 2009Debt to equity – as reported 0.68 0.80 1.09 2.52 1.15Debt to adjusted equity 0.60 1.31 1.20 1.25Liabilities to equity – as reported 2.19 2.62 3.23 7.13 3.81Liabilities to equity – adjusted 1.72 4.09 2.87 4.24Return on equity – as reported 24% 33% 37% 92% 59%Return on equity – adjusted 25% 44% 44% 65%was the rationale for changing SFAS No. 157, “Fair ValueMeasurement,” during the recent crisis. It was argued thatSFAS No. 157 forced banks to write down asset values toextraordinarily low values even when those assets weren’tfor sale. Then the FASB issued the following clarificationon SFAS No. 157: “FSP FAS 157-4 relates to determiningfair values when there is no active market or where theprice inputs being used represent distressed sales. It reaf-firms what Statement 157 states is the objective of fairvalue measurement—to reflect how much an asset wouldbe sold for in an orderly transaction (as opposed to a dis-tressed or forced transaction) at the date of the financialstatements under current market conditions. Specifically,it reaffirms the need to use judgment to ascertain if a for-merly active market has become inactive and in deter-mining fair values when markets have become inactive.”This clarification helped financial institutions avoid fur-ther write-downs of asset values and the need for addi-tional capital.The takeaway? Financial analysts, investors, and credi-tors need to carefully interpret ratios and measures,including debt to equity, liabilities to equity, and returnon equity. Financial ratios used in loan covenants shouldbe clearly designed and defined, and, in some cases, equi-ty may be more meaningfully defined as adjusted for cer-tain changes in other comprehensive income. SFBridget Lyons is chair of the Department of Economics andFinance at the John F. Welch College of Business at SacredHeart University. She has more than 20 years of researchand consulting experience in corporate finance, valuation,financial modeling, and performance metrics. You can reachher at lyonsb@sacredheart.edu.Rupendra Paliwal, Ph.D., is associate dean at the John F.Welch College of Business. Previously he was an officer withthe National Stock Exchange of India. You can reach him atpaliwalr@sacredheart.edu.Danny Pannese, CPA, CVA, ABV, CFF, is a member of theAccounting & Information Systems Department at the John F.Welch College of Business. He has more than 30 years of con-sulting and research experience in taxation, accounting, andvaluation. You can reach him at pannesed@sacredheart.edu.A p r i l  2 0 1 0 I S T R AT E G IC  F I N A N C E 53Effective for reporting in 2009, SFAS No. 160, “Noncon-trolling Interests in Consolidated Financial Statements,”addresses the accounting for noncontrolling interests ina subsidiary and for the deconsolidation of a subsidiary. Key Features:◆ SFAS No. 160 requires that the ownership interests insubsidiaries held by parties other than the parent beclearly identified, labeled, and presented in the equitysection of the balance sheet. In the past, these inter-ests were often referred to as minority interest and weredisplayed within the liability section of the balance sheetor in between the liability and equity sections.◆ On the income statement, the amount of consoli-dated net income attributable to the noncontrollinginterest must be presented clearly, and the incomeattributable to the parent also must be shown. Prior toSFAS No. 160, income attributable to the noncontrollinginterest could be shown as an expense or deduction.◆ The Statement also provides guidance on changesin parent ownership interest and accounting fordeconsolidation.◆ SFAS No. 160 aligns the accounting for noncon-trolling interests more closely with the reporting by firmsreporting under International Financial ReportingStandards (IFRS).Implications:◆ The book value of equity will increase because thenoncontrolling interest is now included in total equity.◆ The market-value-of-equity-to-book-value-of-equity ratio is meaningless without carefulcalculation since if the book value of equity is calculat-ed using total shareholders’ equity, it includes both thecontrolling (parent) and noncontrolling interest, but themarket value of equity includes only the equity of theparent or controlling interest.◆ Return on equity must be calculated carefullyusing net income attributable to the parent and equityof the parent (only) or total net income and total equity.◆ Liability-to-equity ratios may change, especiallyif the firm included minority interest in the liability sec-tion of the balance sheet in prior years.Accounting for Noncontrolling Interests Copyright of Strategic Finance is the property of Institute of Management Accountants and its content may notbe copied or emailed to multiple sites or posted to a listserv without the copyright holder's express writtenpermission. 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Interpreting Financial Results

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