International Standards vs. U.S. GAAP: Return Analysis

Case 2:  Group Case

ACC 301 Fall 2018 Anderson

International Standards vs. U.S. GAAP:  Return Analysis

Many firms issue convertible securities that have features of both debt and equity (e.g., convertible debt).  These are sometimes referred to as “hybrids.” 

Your group should select from either the computer (or related) industry group:   Google (GOOG; Alphabet); Hewlett-Packard (HPQ); Microsoft (MSFT); Apple Computer (AAPL); and IBM Corp (IBM); or the pharmaceutical industry group:  Pfizer (PFE), Bristol Myers Squibb (BMY), Eli Lilly (LLY), GlaxoSmithKline (GSK), and Merck (MRK).  The firm’s financials for the 2017 fiscal year should be used to address the questions below.  This means that most of the economic activity must occur during the 2016 year (1/1/2017 – 12/31/2017; e.g., a year ended 2/29/2017, would not qualify; a period ending 2/29/18 would.  Note that in the latter case (a year ending in 2018) the report would be referred to as the  2018 Annual Report).  THE CASE MUST BE TYPED.  Each person in the group should analyze the data, etc. of one firm from the industry group selected.  The group should meet to discuss the questions in the case (you need analyze only as many firms as there are people in your group).

For each group firm (for your group), compute

1. i) Return on C/S equity ratio (ROE) defined as: [Net Income – P/S dividends)]/ [Average C/S equity], where (see pages 232 & 802 in text)

Average C/S equity = ([beginning total equity less P/S equity] + [ending total equity less P/S equity])/2

1. ii) Provide the entry that the firm would have made for bonds under U.S. GAAP, assuming that 30% of total long-term liabilities (not simply long term debt) had been issued as convertible debt (bonds). Assume that these bonds have a face rate of 3% for each case firm, are sold at par, and annual interest payments (ignore any rates in the F/S’s).  Term is 5 years.  Determine the annual cash interest payment for the bonds for your firm, given the terms outlined.

iii)  Now, assuming that the same 30% of total long-term liabilities had been issued as convertible debt, provide the entry that the firm would make for the bonds under I-GAAP (IFRS).  Assume that the conversion feature implies that the firm could issue the bonds at the 3% rate.  However, similar bonds without the conversion feature would carry a market rate of 6% (IFRS appendix – end of chapter 16 is a useful guide to how the accounting is done; pgs. 891-893).

Required:  Each person should compute what the present value of the bonds would be for their particular firm if the interest rate is changed from 3% to 6% to account for the value of the equity conversion feature.  Assume the bonds are sold at par, with the 3% face rate, annual interest payments, and a 5 year term.  You should apply the 6% rate to the periodic cash interest payments derived using the 3% rate – as well as to the face, or principal amount, using the 5 year term. The equity component is the difference between the bonds’ present value at 3% (the same amount you derived by determining 30% of L-T liabilities) compared to the lower present value at 6%.  Note that future interest expense would be based on the bond liability at 6%. Determine the interest expense for year 1.  It should be greater than the amount on the bonds at 3%.

1. iv) Using the reported net income of your firm, and the net-of-tax interest effect, discuss (explicitly using numbers, and as a group) how Return on C/S equity (ROE) might change if I-GAAP had been used to compute the ROE ratio instead of U.S. GAAP. Do not worry about how big the change in the ratio is per se (the effect is small); instead, discuss the direction of the effect (up, down, no change . . .).  How might the change in the C/S equity (ROE) ratio impact analysis of the profitability of the firm (your group’s view)?

Note:  you will have to subtract the new net-of-tax interest amount from net income under IFRS, as well as add in the new equity amount.