1

Objectives for today….

#1 Full-time only:1. Finish Cash Flow Statement

Cumulative returns 4 Greats Look at red flags.

2

Objectives for today….2.Look at a simple Enron

maneuver

3.Discuss four articles and some other Creative Accounting

4. Presentations

5. Begin discussion of costs

3

1. Accounts Receivable when Allowance

2. Sales and A/R

Or Sales and A/R

Red Flags

4

3. Sales when Inventory

4. Debt and Assets

5. Other

Red Flags continued

5

6. Goodwill

7. Given my skepticism about Goodwill….

Red Flags continued

6

Creative Accounting 101

7

The Birth of JEDI, an SPE

or….

Enron’s End run

8

Must Enron include SPEs on its balance sheet?

Not if……. a)not in control of SPE andb)outsiders invest & have at risk at least 3% of total capital………

Why does Enron not want to consolidate?

9

CALPERS

ENRON

JEDI

$250 Mil

EnronStock

1993

10

1997

•CALPERS wants to cash out of JEDI.

• Enron must figure out a way to redeem the CALPERS investment. They create Chewco to buy out CALPERS.

11

CALPERSENRON

JEDI

$383 Mil

CHEWCO

This is the plan….

12

CHEWCONeeds $383 million to give CALPERS ……It gets…..$240 mil loan from Barclay’s bank Guaranteed by Enron$132 mil credit from JEDI (only asset is Enron stock)

Must get 3% from outside sources to avoid consolidation.

13

CHEWCO Capital Structure The Outside 3%

$115,000 from M.Kopper (worked at time for Enron)

$11.4 mil loans from Big and Little River (two new LLCs formed for this purpose who get a loan from Barclay’s Bank)

14

CHEWCO

Big RiverLittle River

$11.4 mil.Kopper

$.115 m

CHEWCO Capital Structure Outside 3%

15

In the following slide…a solid line is actual cash transfer. A dashed line is aloan. All dollars are inmillions.

16

CALPERS

JEDIEnron now

sole partner

383

Little RiverBig River

Chewco

Barclay’s Bank

ENRON

11.4

Kopper

240 Enron guar.

.115

11.4

132

17

What causes trouble for Enron?• Barclay’s Bank begins to doubt the

strength of the new LLCs – Big River and Little River- and requires a CASH reserve to be deposited (as security) for the $11.4 million dollar loans. This Cash Reserve is paid by JEDI, which by this time consists solely of Enron stock, putting Enron in the at risk position for this amount.

• (See red arrow on the next slide.)

18

CALPERS

JEDIEnron now

sole partner

383

Little RiverBig River

Chewco

Barclay’s Bank

ENRON

11.4

Kopper

240 Enron guar.

.115

11.4

132

6.6

19

Revenue Recognition?I.e. Profit to Enron?

$10 mil in guarantee fee + fee based on loan balance to JEDI. A total of $25.7 mil revenues from this source.

20

Other Profit to Enron?

The increase in the price of Enron stock held by JEDI. Enron recognized $126 million in the first quarter of 2000 from this.

21

ING 1. Dutch and US Goodwill?

2. Difference in income greater under existing or prior US rules?

3. Which treatment provides a better , “more faithful” representation?

22

STAPLES 1. Changes??? 2. VENDOR ALLOWANCE definition?

Prior accounting method? 3. Current accounting for Vendor

Allowance? 4. How was change treated? 5. Why did market react as it did?

23

Contingent ConvertiblesMezzanineAccounting’s

Newest Addition ---

Contingent Convertibles

24

Contingent ConvertiblesLatest Accounting Magic – CoCosHow to borrow money for free

and let shareholders feel the pain later.

25

Contingent ConvertiblesTwo key Points:1. Exercise of option is NOT an expense

2. CoCo’s do not affect diluted EPS

26

Contingent ConvertiblesCompany issues debt at lower than market or NO interest rate. Why would lenders buy the bonds?

Because they contain a conversion option.

27

Contingent ConvertiblesRegular conversion option:You can buy the stock for $50/share when the price hits $50 per share.

28

Contingent ConvertiblesLoCos work slightly BUTSIGNIFICANTLY different:You can buy the stock for $56.50/share when the price hits $67.80 per share.

29

Contingent ConvertiblesProblem?

Another twist…Cephalon bought a hedge from Credit Suisse to protect against conversion.

30

Contingent Convertibles They paid $258 million, which is DEDUCTIBLE and saves them about $80 mil in taxes.

But that’s a big chunk of a $750 million issue, so……

31

Contingent ConvertiblesCredit Suisse gave back $178 when Cephalon agreed

to assume some risk of price variation. This is NOT taxable revenue.

32

1.Capitalizing vs. expensing

A. AOLB. World Com

2.Recognizing Revenues Prematurely….

More Creativity…..

33

C. Halliburton D. Microstrategy

long term software

contracts3.Pyramids.

1.ZZZZ Best

More Creativity…..

34

4.Rainy day reservesA. XeroxB. W. R. Grace

5.Book more than you earn..

Priceline

More Creativity…..

35

6.Channel stuffing Sunbeam….gladly sell

you a grill that you pay for next summer

Vendor financingSell to a warehouse

More Creativity…..

36

Costs, CVP and Leverage

37

Fixed Cost - Total

$

Activity Level

38

$

Activity Level

Variable Cost - Total

39

$

Activity Level

Mixed Cost - Total

40

$

Activity Level

Mixed Cost - Total

41

VOLUMEVolume = level of activity…But this concept is flexible.

Volume should be measurable and

Should relate to changes in costs...

42

Fixed versus Variable?

Not always easy…depends on point of view. Think of the passenger on the already scheduled flight….variable costs are minimal. But what about when the flight was originally scheduled?

43

Questions to answer with CVP1. Change in profit is NBC gets a new affiliate to run its evening news?2. How many patient days for IA Methodist Hospital to break even?3. What if hospital leases a new

computerized patient information system?4. What if nurses’ salaries change?

44

Uses of CVP…..When there are changes in… Selling Price Costs -- variable or fixed Income tax rates Product mix

Applies to non-profit orgs as well…How many services can be provided?

45

Assumptions

1. Linear, constant costs2. Costs only fixed or variable3. Sales and Production are equal4. No capacity additions during period5. Sales mix remains constant6. Inflation is ignored7. Technological assumptions remain unchanged..productivity same.

46

CVP as a Flow DiagramSlide 16-18

UR

UR

Fixed Costs Profits

UVC

UVC

UVC

Variable Costs ContributionC

C

47

Equation ApproachSales revenue – Variable expenses – Fixed expenses = Profit

48

Equation ApproachAssume Sales Price of $500Variable cost/unit of $300 and Fixed Costs of

$80,000

How many units must Curl Co.sell to break even?

49

Equation Approach($500 × X))

($300 × X)––

–– $80,000 = 0

X = Break Even in units

50

Contribution Margin Approach

CONTRIBUTION MARGIN =$500 - $300 or $200 per unit

At Break Even the TOTAL CMis equal to Total FIXED Costs…or.. $200 (X) = $80,000

X = Break Even in units

51

Contribution-Margin Approach

==

Break-even point(in units)

Fixed expenses Unit contribution margin

52

Contribution-Margin RatioWe can calculate the break-even point in sales

dollars rather than units by using the contribution-margin ratio.

Fixed expense CM Ratio

Break-even point(in sales dollars)==

53

Contribution-Margin Ratio Approach

CM Ratio = Sales Price - Var CoSales Price

I.E. What % of the selling priceis left after paying variable unitcost?

54

Contribution-Margin Ratio ApproachCM Ratio = Sales Price - Var Cost

Sales Price

In our example, $500 - $300 = $200 CM. $200 is 40% of SP.Fixed Costs of $80,000, dividedby 40% = ?

55

Cost-Volume-Profit Graphed

Units Sold

Sal

es in

Dol

lars

56

Cost-Volume-Profit GraphBreak-even

point

Units

$$$$

57

Increase selling price per unit (SP) Decrease variable cost per unit (UVC) Decrease fixed costs (TFC) Increase volume (X)

Improving Profit PerformanceSlide 16-19

58

Three more Important Cost Terms

1. Opportunity

2. Sunk

3. Differential or Incremental

59

Opportunity CostThe potential benefit that is given up

when one alternative is selected over another.Example: If you were not

attending college, you couldbe earning $15,000 per year. Your opportunity costof attending college for one year is $15,000.

60

Sunk Costs All costs incurred in the past that

cannot be changed by any decision made now or in the future.

Sunk costs should not be considered in decisions.

61

Sunk CostsExample: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

62

Sunk CostsExamples…..Beloved of politicians…Knee Deep…..

63

Sunk Costs Basketball players

64

Incremental CostsCosts that differ between

alternatives. Example: You can earn $1,500 per month in yourhometown or $2,000 per month in a nearby city.Your commuting costs are $50 per month in your

hometown and $300 per month to the city.

What is your incremental cost?

65

Incremental CostsCosts that differ between

alternatives. Example: You can earn $1,500 per month in yourhometown or $2,000 per month in a nearby city.Your commuting costs are $50 per month in your

hometown and $300 per month to the city.

What is your incremental cost? $300 - $50 = $250

66

Incremental or Diffferential or Marginal CostsOften these are related to

Variable and Fixed patterns, i.e.they are driven by volume changes….Another Boeing 757? Another Palm Pilot? Another Windows XT?

67

Marginal Costs and Average Costs

The extra costincurred to produceone additional unit.

The total cost toproduce a quantity

divided by thequantity produced.

Marginal and average costs arelargely a function of cost behavior

-- variable and fixed costs.

68

For next week…..

1. Homework

2. Read Cost material Part I It is on the Web site.