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Chapter 4
Implementing Accounting Analysis
Discussion Questions 7 & 9

7.The cigarette industry is subject to litigation for health hazards

posed by its products. The industry has been in an ongoing process of
negotiating a settlement of these claims with state and federal
governments. As the CFO for Altria Group, the parent company of
Philip Morris, one of the larger firms in the industry, what information
would you report to investors in the annual report on the firms
litigation risks? How would you assess whether the firm should record a
liability for this risk, and if so, what approach would you use to assess
the value of this liability? As a financial analyst following Philip Morris,
what questions would you raise with the CEO over the firms litigation
liability?
The litigation risks that Philip Morris faces are reported as contingent
liabilities defined in SFAS 5. Contingent liabilities arise from events or
circumstances occurring before the balance sheet date, here the filling of
lawsuits against Philip Morris, the resolution of which is contingent upon a
future event, the court ruling or a potential settlement.
The accounting treatment for Philip Morris pending litigation depends on
the likelihood that it will lose or settle the lawsuit and whether the amount of
damages the firm will be liable for is reasonably estimable. Accounting rules
on required disclosure for these types of liabilities depend on whether the
loss is probable, reasonable possible, or remote.
Probable If it is probable that Philip Morris will lose the lawsuit and the
loss can be reasonably estimated, the estimated loss should be reported as a
charge to income and as a liability. If the loss is probable but no specific
reasonable estimate can be agreed upon, rather only a range of possible
losses can be estimated without any amount being more reasonable than the
other, the amount that should be accrued by Philip Morris is the minimum
amount in the range. Note that this contradicts the conservatism principle of
accounting.

Reasonably possible Where the likelihood that Philip Morris will lose the
lawsuit is reasonably possible, no amount needs to be accrued as a liability
but the nature of the suit needs to be disclosed in the footnotes of the annual
report.
Remote Where the likelihood that Philip Morris will lose the lawsuit is
remote, no amount needs to be recorded as a liability nor is any disclosure
required in the footnotes of the annual report.
The CFO of Philip Morris faces a dilemma. It is widely recognized that the
company faces huge potential litigation costs. It is therefore important that
the CFO confront these issues in the annual report, explaining the nature of
the suits, the amount of the claims against the company, and the companys
plans for responding to the suits. To fail to provide adequate disclosure about
these issues, potentially leads investors to fear the worst, reducing the value
of the firms stock. However, the CFO also has to be careful not to make
statements that could undermine the companys legal position or its
negotiating position with the claimants.
As a financial analyst following Philip Morris I would push the CEO for as
much information as possible about the likelihood that the company will
lose the lawsuits or come to a settlement with the claimants. This requires
that the analysts understand the law and case history for the industry. It also
requires information on the companys plans to either take the cases to trial
or to settle, as well as the costs of a legal battle, the companys assessment
of its chances of victory, and the costs of a potential settlement.
In addition, given that the companys stock is depressed due to fears of
losing these suits, analysts can probe management on what actions the
company is considering to increase the stock price and maximize
shareholder value. For example, is Philip Morris considering spinning off
the Kraft food division? What is the firm doing to maintain employee moral
and retain Kraft executives that might be inclined to accept jobs with similar
food companies not tied to tobacco products? Is Philip Morris considering
raising the annual dividend payment to compensate shareholders for lower
stock prices?

9. In early 2003, Bristol-Myers Squibb announced that it would have to

restate its financial statements as a result of stuffing as much as $3.35
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billion worth of products into wholesalers warehouses from 1999

through 2001. The companys sales and cost of sales during this period
was as follows:
2001

2000

1999

Net sales

$18,139

$17,695

$16,502

Cost of products sold

5,454

4,729

4,458

The companys marginal tax rate during the three years was 35%.
What adjustments are required to correct Bristol-Myers Squibbs
balance sheet for December 31, 2001? What assumptions underlie your
adjustments? How would you expect the adjustments to affect BristolMyers Squibbs performance in the coming few years?

In the Bristol-Myers Squibb example, the firms Accounts Receivable, Sales,

and Income are overstated. To correct for this problem in the 2001 balance
sheet, Accounts Receivable need to be decline by $3.35 billion, and
Inventory needs to increase by an amount that reflects the effect of gross
profit margins. The Inventory adjustment can be achieved by multiplying the
Accounts Receivable adjustment by the ratio of Cost of Sales to Sales. The
increase in Inventory is approximately $1 billion (3.35 . (5,454/18,139)).
The $3.35 billion decline in Accounts Receivable is mirrored by a decline in
2001 Sales of the same amount.
Similarly, the $1 billion increase in Inventory reflecting unsold product
corresponds to a decline in the Cost of Sales by the same amount.
Multiplying the $2.35 difference between the reduction in Sales and the
reduction in Cost of Sales by the firms 35% marginal tax rate results in a
$.82 billion reduction in Tax Expense, with the remaining $1.53 billion
($2.35 .82) difference being charged to Net Income.

The declines in both Tax Expense and in Net Income are reflected in the
Balance Sheet by a decline in Deferred Taxes and in Common Shareholders
Equity, respectively.
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Adjustments for Dec.31,

2001
($billions)

Assets

Liabilities &
Equity

Balance Sheet
Accounts Receivable

3.35

Inventory

+1.00

Deferred Taxes

82

Common Shareholders
Equity

1.53

Income Statement
Sales

3.35

Cost of Sales

1.00

Tax Expense

.82

Net Income

1.53