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Web Case 1 Hewlett-Packard: A Pack Ard (of) Mess H ewlett-Packard Corporation (HP) designs, manufactures, and distributes computer systems and imaging and printing products and offers information technology services. Before performing a financial statement analysis, it is appropriate that we adjust the financial statements for items considered unusual or nonrecurring and therefore unlikely to affect ongoing assessments of the firm. This case asks you to identify data issues in the financial statements and notes of HP and to make appropriate adjustments. The statutory income tax rate is 35 percent. You may find it useful to use FSAP4, a financial statement analysis program available in the website for this book. You should download the file “HPReported” available on the website and load it into FSAP following the commands on the menu. You can then make changes to the financial statements that you consider appropriate. Note that changes made do not automatically work through each of the financial statements. For pedagogical reasons, you must identify the impact of any adjustment on all three financial statements and decide if and how you would adjust for it. Exhibit 1 Hewlett-Packard — Income Statements (amounts in millions) 1999 $43,047 31 (29,720) (6,479) (2,440) --(202) --(43) (1,090) $ 3,104 387 -- Revenues……………………………………………. Net Investment Gains (losses)………………………. Cost of Goods Sold………………………………….. Selling and Administrative………………………….. Research and Development…………………………. Restructuring Charges*………………………………. Litigation Settlement*……………………………….. Interest……………………………………………….. In-Process Research and Development Charge*……… Acquisition-Related Charge*…………………………. Intangibles Amortization*…………………………….. Income Taxes………………………………………… Income from Continuing Operations………………… Income from Discontinued Operations (net)…………. Extraordinary Gain on Bond Retirement (net)……….. Cumulative Effect of Change in Accounting Principles…………………………………………….. -Net Income……………………………………………. $ 3,491 * Fiscal Year Ended October 31 2000 2001 $49,734 $45,376 41 (455) (34,864) (33,240) (7,195) (7,085) (2,646) (2,670) (102) (384) -(400) (257) (266) ----(86) (174) (1,064) (78) $ 3,561 $ 624 136 --56 -$ 3,697 Included on the line, Other Expense and Losses II, in the FSAP data file. $ (272) 408 2002 $56,657 (106) (41,390) (9,019) (3,312) (1,780) -(206) (793) (701) (402) 129 $ (923) -20 -$ (903) 2 Exhibit 2 Hewlett-Packard — Balance Sheets (amounts in millions) Assets 1998 Cash…………………………………… $ 4,046 Marketable Securities…………………. 21 Accounts Receivable…………………. 6,598 Inventories……………………………. 4,699 Prepayments………………………….. 3,143 Total Current Assets……………… $18,507 Property, Plant, and Equipment (cost). $ 9,038 Accumulated Depreciation…………… (4,161) Property, Plant, and Equipment (net)… $ 4,877 Net Assets of Discontinued Business… $ 3,084 Investments and Other Assets………… $ 5,240 Total Assets……………………….. $31,708 Liabilities and Shareholders' Equity Accounts Payable…………………….. $ 2,768 Notes Payable………………………… 1,245 Other Current Liabilities…………….. 7,861 Total Current Liabilities………….. $11,874 Long-term Debt……………………… 2,063 Other Noncurrent Liabilities………… 852 Total Liabilities………………….. $14,789 Common Stock……………………… $ 10 Additional Paid-in Capital………….. 0 Accumulated Other Comprehensive Income…………………………. 0 Retained Earnings…………………. 16,909 Total Shareholders' Equity…….. $16,919 Total Liabilities and Shareholders' Equity…………. $31,708 1999 $ 5,411 179 7,847 4,863 3,342 $21,642 $ 8,920 (4,587) $ 4,333 $ 3,533 $ 5,789 $35,297 2 October 31 2000 $ 3,415 592 8,568 5,699 4,970 $23,244 $ 9,505 (5,005) $ 4,500 $ 0 $ 6,265 $34,009 2001 $ 4,197 139 6,671 5,204 5,094 $21,305 $ 9,808 (5,411) $ 4,397 $ 0 $ 6,882 $32,584 2002 $11,192 237 11,909 5,797 6,940 $36,075 $12,536 (5,612) $ 6,924 $ 0 $27,711 $70,710 $ 3,517 3,105 7,699 $14,321 1,764 917 $17,002 $ 10 0 $ 5,049 1,555 8,593 $15,197 3,402 1,201 $19,800 $ 19 0 $ 3,791 1,722 8,451 $13,964 3,729 938 $18,631 $ 19 0 $ 7,012 1,793 15,505 $24,310 6,035 4,103 $34,448 $ 30 24,660 0 18,285 $18,295 93 14,097 $14,209 41 13,893 $13,953 (401) 11,973 $36,262 $35,297 $34,009 $32,584 $70,710 3 Exhibit 3 Hewlett-Packard — Statements of Cash Flows (amounts in millions) Fiscal Year Ended October 31 1999 2000 2001 $ 3,104 $ 3,561 $ 624 1,316 1,368 1,369 (31) (41) 455 289 495 16 (171) (689) (970) --491 (76) (514) -(1,637) (1,312) 566 (171) (845) 1,096 751 1,544 (1,249) 2002 $ (923) 2,119 106 21 (351) 3,932 -899 765 395 (278) $ 3,096 $ (62) (107) $ 3,460 $ 965 163 $2,561 $ -- (1,519) $ 5,444 $ -- $1,048 (1,015) 542 (1,134) (69) $ (628) $ 1,004 (1,131) 420 (1,737) 318 $(1,126) $ 742 (434) 447 (1,527) 223 $ (549) $ Financing Increase (Decrease) in Short-term Borrowing……… Increase in Long-term Borrowing………………….. Issue of Common Stock…………………………….. Decrease in Long-term Borrowing…………………. Acquisition of Common Stock……………………… Dividends…………………………………………… Cash Flow from Financing……………………… $ 2,399 240 660 (1,047) (2,643) (650) $(1,041) $(1,297) 1,936 748 (474) (5,570) (638) $(5,295) $ 303 904 354 (930) (1,240) (621) $(1,230) $ (2,402) 2,529 377 (599) (671) (801) $ (1,567) Change in Cash……………………………………… Cash - Beginning of Year…………………………… Cash - End of Year………………………………….. $ 1,365 4,046 $ 5,411 $(1,996) 5,411 $ 3,415 $ $ 6,995 4,197 $11,192 Operations Income from Continuing Operations………………… Depreciation and Amortization………………………. Net Investment (Gains) and Losses………………….. Tax Benefit of Employee Stock Plans……………….. Deferred Taxes on Earnings…………………………. Other Addbacks……………………………………… Other Subtractions…………………………………… (Increase) Decrease in Accounts Receivable………… (Increase) Decrease in Inventories…………………… Increase (Decrease) in Accounts Payable…………… Increase (Decrease) in Other Current Assets and Current Liabilities…………………….. Cash Flow from Continuing Operations………. Cash Flow from Discontinued Operations…….. Investing Sale of Marketable Securities……………………….. Acquisition of Marketable Securities……………….. Sale of Property, Plant, and Equipment…………….. Acquisition of Property, Plant and Equipment……… Other Investing Transactions……………………….. Cash Flow from Investing……………………… 3 782 3,415 $ 4,197 381 (351) 362 (1,710) 4,436 $ 3,118 4 Selected Notes to the Financial Statements Note 1: Revenue Recognition: HP recognizes revenue at the time of delivery of products to customers, at the same time providing for estimated returns. HP recognizes revenues from services when it performs the services. HP adopted Securities and Exchange Commission Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” in fiscal 2001. Prior to adoption, HP had recognized revenues at the time of shipment to customers. The cumulative effect of changing the method of revenue recognition was $272 million, net of $108 million of income taxes, and is recognized in earnings for 2001. Note 2: Corporate Acquisition: HP acquired Compaq Computer Company (Compaq) on May 3, 2002 for $24,170 million. HP gave shares of its common stock in exchange for the outstanding common stock of Compaq and accounted for the acquisition using the purchase method. In addition to allocating the purchase price to the tangible assets acquired and the liabilities assumed, HP allocated $793 million to in-process technologies, $3,517 million to intangibles with a limited life (for example, customer lists, distribution agreements, developed technologies, and patents), $1,422 million to intangibles with an indefinite life (the Compaq brand name), and $14,450 to goodwill. GAAP requires firms to expense amounts allocated to in-process technologies in the year acquired. Charges related to in-process technologies acquired do not give rise to tax benefits in any year. During fiscal 2002 and prior years, GAAP also required firms to amortize all intangibles acquired in corporate acquisitions prior to July 1, 2001 over their expected useful lives. Such amortization does not give rise to a tax benefit. GAAP will no longer require firms to amortize goodwill and other intangibles with indefinite lives beginning with its fiscal 2003 year. GAAP does require firms, however, to test such assets annually for possible impairment and to recognize impairments losses if they arise. Firms must continue to amortize intangibles with limited lives. To consummate the acquisition of Compaq, HP incurred acquisition-related charges totaling $701 million ($529 million after taxes) for professional services, advertising, and proxy solicitation costs. Note 3: Restructuring Charge: In fiscal 2000, HP’s management approved “an enhanced early retirement program designed to balance the workforce with HP’s long-term business strategy.” HP recorded a restructuring charge of $102 million, making payments during the year to employees accepting the offer of $76 million. HP’s management approved restructuring actions in fiscal 2001 “to respond to the global economic downturn and to improve HP’s cost structure by streamlining operations and prioritizing resources in strategic areas of HP’s business.” HP recorded a restructuring charge of $384 million to reflect these actions. This charge consisted of severance and other employee benefits related to the planned termination of approximately 7,500 employees, as well as costs related to the consolidation of excess facilities. As of the end of fiscal 2001, HP has made payments of $264 million related to the restructuring and expected to pay the remainder of the accrual in fiscal 2002. In fiscal 2002, HP recognized a $1,780 million restructuring charge prior to its acquisition of Compaq. The charge included employee severance and early retirement benefits, costs of vacating duplicate facilities, and asset impairment losses related to HP’s activities. Be the end of fiscal 2002, HP had made payments of $502 million and incurred non-cash charges from asset writedowns of $650 million related to this restructuring. In addition, Compaq made a provision for restructuring prior to its acquisition by HP for the same types of items as HP. The provision totaled $960 million, which Compaq 4 5 included in current and noncurrent liabilities on its balance sheet on the date of its acquisition by HP. HP allocated a portion of the purchase price to this restructuring liability. During the last six months of fiscal 2002, restructuring costs of $631 million related to the restructuring were charged against these liabilities. Note 4. Net Investment Gains and Losses: HP’s investments include debt and equity securities in public and privately-held emerging technology companies. HP realized gains on sales of these investments during fiscal 1999 of $31 million. It realized gains from sales of $104 million in fiscal 2000, offset by impairment losses of $63 million. HP realized gains of $16 million in fiscal 2001, offset by impairment losses of $471 million. It recognized impairment losses of $106 million in fiscal 2002. Note 5: Litigation Settlement: On June 4, 2001, HP and Pitney Bowes announced that they had entered into agreements that resolved all pending patent litigation between the parties without admission of infringement and in connection therewith HP paid Pitney Bowes $400 million in cash on June 7, 2001. Note 6: Discontinued Operations: On March 2, 1999, HP announced its intention to launch a new company, Agilent Technologies, through a distribution of Agilent Technologies common stock to HP shareholders in the form of a tax-free spinoff. Agilent Technologies comprises HP’s former test and measurement business. HP distributed its interest in Agilent Technologies through a dividend to HP shareholders on June 2, 2000, resulting in a $4.2 billion reduction of retained earnings. HP reports Agilent Technologies as a discontinued operation prior to the distribution. Note 7: Early Extinguishment of Debt: HP occasionally repurchases its debt prior to maturity based on its assessment of current market conditions and financing alternatives. During fiscal 2001, HP repurchased notes with a face value of $1.2 billion and a book value of $729 million, resulting in an extraordinary gain of $56 million (net of related taxes of $33 million). Repurchases during fiscal 2002 resulted in a gain of $20 million net or related taxes. Beginning in 2003, firms will include gains and losses form early extinguishment of debt in income from continuing operations instead of reporting it as an extraordinary item. Note 8: Leases: HP has signed leases for various items of property and equipment. It accounts for these leases as operating leases. Generally accepted accounting principles treat operating leases as mutually unexecuted contracts and therefore do not report them in the balance sheet. The income statement includes rent expense of $340 million in fiscal 1999, $325 million in fiscal 2000, $354 million in fiscal 2001, and $566 million in fiscal 2002. The present value of operating lease commitment when discounted at 8 percent are as follows: October 31, 1998: $715 million; October 31, 1999: $640 million; October 31, 2000: $715 million; October 31, 2001: $720 million; October 31, 2002: $1,575 million. 5