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EBITDA, earnings before interest, taxes, depreciation and amortization, is used by many firms as a measure of performance in financial covenants and incentive compensation agreements. In 2009, when the FASB, in conjunction with the IASB, likely begins requiring firms to report virtually all leases as capital leases, we expect calculated measures of EBITDA to increase. As a result, firms may find unexpected slack in financial covenants and increases in incentive compensation that are unrelated to real improvements in performance. In anticipation of the change in accounting for leases, companies will want to revise contracts that employ EBITDA to ensure that unanticipated consequences are avoided.

This research report examines the effects of lease capitalization on EBITDA in cases where it is employed in financial agreements. Our focus is on companies noted to employ EBITDA in financial covenants or incentive compensation agreements with significant exposure to operating leases. For a sample of 25 companies we recalculated EBITDA, treating operating leases as though they were capital-lease commitments. For some firms, we found significant increases in EBITDA, with a sample-wide median increase of 7.7%.


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Under current GAAP, initial bargain-purchase amounts, also known as negative goodwill
(NGW) or the excess of the fair value of acquired net assets over the cost of an acquisition, are typically reduced or eliminated altogether by being allocated against the fair values of certain acquired assets such as property, plant and equipment and intangible assets. Any negative goodwill that is not offset against these assets is reported in the income statement as an extraordinary gain. However, in a joint effort with the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB) has developed a replacement for current GAAP, which, among other things, requires that all NGW, without
offset, is to be immediately recognized as a gain.

This report outlines the current and proposed accounting treatment of negative goodwill and their impact upon financial statements as well as their implications for financial analysis. For a sample of companies, we find material increases in assets, shareholders’ equity and net income under the proposed new treatment.


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In this research report we discuss (1) why firms swap interest payments, (2) the essentials of swap accounting, (3) the reasons for swap terminations, (4) swap-termination accounting, and (5) the classification of cash receipts and payments from swap terminations. The study also includes company input on cash flow classification decisions and recommendations for GAAP changes.

There is significant diversity in the cash flow classification of payments and receipts arising from the termination of interest rate swaps. We find evidence that both an operating and a financing designation are often used. Differences in the nature of the underlying transactions or in the circumstances surrounding them do not explain the diversity in reporting practices noted. Given that interest rate swaps are motivated primarily by the desire to manage interest rate risk, we think that an operating designation is the more appropriate classification. We identify a sample of firms that employ a financing designation for swap termination payments and receipts and adjust reported operating cash flow to include them. Significant changes to operating cash flow are noted in several cases.


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With recent market volatility, investors are understandably concerned about where blue-chip stocks are headed next. An interesting long-term perspective on the subject can be gained by examining the extent to which Nominal Gross Domestic Product has explained the movement of share prices, in particular, the Dow Jones Industrial Average, over time. In this report, we look at the relationship between the two metrics since 1916, updated with data through the second quarter, 2007. We find strong support for the Dow to be trading in the vicinity of 13,700 to 14,000.

The authors appreciate the assistance provided by HyungSuk Choi.


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The Cash Flow Growth ProfileTM measures the capacity of a firm to generate cash flow as it grows revenue. The metric is forward looking and reports the amount of incremental cash flow that can be expected for any measured amount of growth in revenue. In this report we examine the Cash Flow Growth ProfileTM of five technology industries, computer hardware, computer software, information technology services, telecommunications equipment, and semiconductors and related capital equipment. We look at trends in the Profile for eleven individual companies, two in each industry plus Microsoft Corp. In examining the Cash Flow Growth ProfileTM, the drivers or determinants of core operating cash flow and free cash flow are highlighted.

Data for this research was provided by Cash Flow Analytics, LLC. Charles Mulford is a principal in Cash Flow Analytics, LLC.


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The FASB, in conjunction with the International Accounting Standards Board, is currently in the planning stages of a project that would revise SFAS 13, Accounting for Leases. What is proposed is that leases that are presently accounted for as operating leases, that is, those leases that do not meet the current requirements for on-balance-sheet treatment, would be accounted for as capital leases and brought onto the financial statements. For companies that use a significant amount of operating leases to finance operations, the financial statement impact could be far-reaching, including material effects on various measures of profitability, financial leverage, debt coverage and cash flow.

In this research report, we look at the retail industry, an industry that uses operating leases extensively, to evaluate how certain key measures of financial performance and position might be affected by the capitalization of operating leases. Among the findings are an increase in EBITDA, though reductions in income from continuing operations and earnings per share. Financial leverage is increased and debt coverage measures are reduced. Measures of profitability, such as return on assets and return on equity are reduced. Finally, we find an increase in operating cash flow and free cash flow.


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In this research report we look at how U.S. companies might prepare financial statements in a principles-based accounting environment and how comparability of financial statements may be affected. We identify the statement of cash flows as a principles-based financial statement where only limited reporting rules are provided and use it to analyze how different companies are currently reporting similar transactions in a principles-based setting. We then use the results to comment on how U.S. companies might prepare their financial statements under principles-based standards and how overall comparability might be affected.

We look at four types of transactions, book overdrafts, sale and leaseback transactions, capitalized software costs and short-term investments, and find that companies are not consistent in their classification of cash flows. This lack of consistency is due to the principles-based nature of the cash flow statement and the associated lack of rules-based guidance. Due to the lack of consistency, it is difficult to compare among companies an important performance metric, cash provided by operating activities. This lack of comparability could be expected to extend to other financial statements in a principles-based environment.


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While there are many advantages to a simple and readily available proxy for operating cash flow, there are inherent shortcomings as well. Such is the case with net income plus depreciation & amortization, a metric sometimes referred to as "cash earnings." In particular, net income plus depreciation & amortization does not take changes in operating working capital into account.

This report identifies several companies where in recent years, net income plus depreciation & amortization has been growing but where reported operating cash flow has been lagging. At these companies, operating working capital, including accounts receivable and especially, inventory, is not being realized and is increasing, in some cases, rapidly. The rapid growth in such accounts calls into question the sustainability of future earnings as the risk of write down and accompanying loss increases. While a write-down can be averted if accumulating operating working capital is ultimately realized, such was not the case at KB Home, or DR Horton, Inc., where write-downs of the companies' inventory of landholdings were recently announced.


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