UU Accounting Operating and Non Operating Items Questions

Vignette 1: Zions Bancorporation, N.A.
Shown below is a simplified balance sheet for Zions Bancorporation, N.A. (Zions,
hereafter) for the years 2019 and 2018 followed by a description of Zions’ business,
which is based on excerpts from Item Zions’ Annual Report to Shareholders.
2019
2018
2019
2018
Cash and cash
equivalents
1,932
2,694 Total deposits (3)
57,085
54,101
Investment securities
(1)
14,499
15,617 Short-term borrowings
2,053
5,653
Loans, net of loan loss
reserve
48,343
46,312 Long-term debt
1,723
724
Other investments (2)
898
1,046 Other liabilities
958
690
Long-lived tangible
assets
1,142
1,124 Total liabilities
61,819
61,168
Goodwill and
intangibles
1,014
1,015
Other assets
1,344
7,353
7,578
Total assets
69,172
69,172
68,746
938 Total equity
68,746 Liabilities & equity
1. Investment securities primarily consist of debt instrument that Zions has
purchased.
2. Other investments represent Zions’ equity interest in the Federal Agriculture
Mortgage Corporation (FAMC).
3. Deposits consist of both non-interest-bearing demand deposits and interestbearing deposits.
Excerpts from Item 1 of Zions 10-K
Zions is a national commercial bank headquartered in Salt Lake City, Utah. The Bank
owns and operates 434 branches at year-end 2019. The Bank provides a full range of
banking and related services, primarily in Arizona, California, Colorado, Idaho, Nevada,
New Mexico, Oregon, Texas, Utah, Washington, and Wyoming.
The Bank focuses on providing community banking services by continuously
strengthening its core business lines of (1) small- and medium-sized business and
corporate banking; (2) commercial and residential development, construction and term
lending; (3) retail banking; (4) treasury cash management and related products and
services; (5) residential mortgage lending and servicing; (6) trust and wealth
management; (7) capital markets activities, including municipal finance advisory and
underwriting; and (8) investment activities.
In addition to providing a wide variety of commercial products and services, the Bank
provides a range of personal banking services to individuals, including home mortgages,
bankcard, other installment loans, home equity lines of credit, checking accounts, savings
accounts, certificates of deposit of various types and maturities, trust services, safe
deposit facilities, and internet and mobile banking. The Bank provides services to key
market segments through its Private Client Services and Executive Banking groups. It
offers self-directed brokerage services through Zions Direct and it also offers
comprehensive and personalized wealth management and investment services. The Bank
has built specialized lines of business in capital markets and public finance and is a leader
in small business administration (“SBA”) lending. The Bank is one of the nation’s largest
providers of SBA 7(a) and SBA 504 financing to small businesses. The Bank owns equity
interests in FAMC and is one of its top originators of secondary market agricultural real
estate mortgage loans. The Bank provides finance advisory and corporate trust services
for municipalities. The Bank also provides bond transfer, stock transfer, and escrow
services nationally in its corporate trust business.
Question 1
Based on the business description provided above, how would you describe Zions’ value
proposition? Be brief and use simple terminology.
Question 2
Based on the information given to you and your answer to question one, what are Zion’s:
(1) operating assets; (2) operating liabilities; and, (3) net operating assets. Explain.
Vignette 2: Walmart’s Investment in JD.com
Please download and read the .pdf named Walmart’s Investment In JD.com
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, which contains a press release issued by Walmart on June 20, 2016 regarding its
investment in JD.com.
After making its initial investment, Walmart purchased additional shares of JD.com; and,
as of January 31, 2020, Walmart owned roughly 12 percent of JD.com’s common equity.
Walmart’s recognizes its investment in JD.com as an asset on its balance sheet. This
asset is recognized at fair value, which equals the number of shares held by Walmart on
the balance sheet date multiplied by JD.com’s contemporaneous share price. Walmart
includes this asset in “other long-term assets.” Walmart recognizes changes in the fair
value of this asset as gains (losses) on its income statement. Note, Walmart recognizes
these gains (losses) even if it has not sold any its JD.com shares – i.e., these gains (losses)
are both realized and unrealized. Walmart includes these gains (losses) in the line item
“other gains and (losses).” For example, in fiscal year 2019 (2018) Walmart recorded a
gain (loss) of $1.9 Bil. ($3.5 Bil.).
Question 3
Does Walmart’s investment in JD.com relate to an operating activity or a financing
activity? Explain.
Question 4
Do you agree with the way that Walmart accounts for its investment in JD.com? Explain.
When answering this question, you might want to consider the discussion in the lecture
videos relating to intercompany investments.
Question 5
Should the gains (losses) recognized by Walmart on its investment in JD.com be included
in Walmart’s net operating profit after tax? Explain.
Question 6
When managers make earnings releases, they often discuss an earnings measure that
they refer to either as “proforma” earnings or “core” earnings. To arrive at core earnings,
managers will use their judgment and identify certain revenues, expenses, gains, and
losses that they believe investors should either ignore or, at least, emphasize less
because these amounts are transitory (i.e., “one-time”) and/or unrelated to the core
business. What are the advantages and disadvantages of managers reporting core
earnings? Do you think that the gains and losses Walmart recognized on its investment
in JD.com should be excluded from core earnings?
Vignette 3: Walmart’s Derivatives
Walmart holds derivatives, which are a type of financial contract. The payoff on a
derivative is a function of (i.e., it is derived from) the payoff on an underlying asset,
group of assets or an index. For example, Walmart holds interest rate swaps. These
swaps are contracts between Walmart and a counterparty (typically a financial
institution) in which Walmart has swapped floating for fixed. Specifically, Walmart and
the counterparty agree on a notional amount (e.g., $10 Mil.) and an expiry date (e.g., one
year). Walmart then agrees to make a monthly payment to the counterparty that is equal
to a variable percentage of the notional amount (i.e., a floating rate). The floating rate is
based on an index rate of interest such as the prime rate, which is the average interest
rate that U.S. commercial banks charge their most creditworthy customers. The
counterparty, on the other hand, agrees to pay Walmart a fixed amount (e.g., 0.3
percent) each month. Hence, if the prime rate in a specific month is less (greater) than
0.3 percent, Walmart will pay less (more) to the counterparty than the amount that it will
receive from the counterparty.
Note that the above arrangement allows Walmart to convert its fixed rate debt into
floating rate debt. Walmart often borrows money from lenders that prefer to receive a
fixed rate of interest. However, Walmart might prefer to pay a variable rate and it can do
this by swapping floating for fixed. Specifically, Walmart can enter into an interest rate
swap: (1) in which Walmart agrees to pay floating and receive fixed and (2) that has a
notional amount equal to the face value of the loan and an expiry date that matches the
maturity date of the loan. Hence, Walmart will now make variable monthly payments
while receiving monthly fixed payments that it can use to pay the interest on the loan.
Consequently, by swapping floating for fixed, Walmart will have essentially converted
the fixed rate loan into a variable rate loan.
Finally, note that derivatives are shown on the balance sheet at their fair value. Hence, in
the above example, if the floating payment that Walmart is required to make is less
(greater) than the fixed payment Walmart is entitled to receive, Walmart recognizes an
asset (liability).
Question 7
Suppose the above accurately describes Walmart’s interest rate swaps, are the assets
(liabilities) relating to these swaps operating assets (liabilities) or financial assets
(obligations)?
Question 8
Suppose that Walmart recognizes the changes in the fair value of its interest rate swaps
as gains (losses) on its income statement. Should these gains (losses) be included in
Walmart’s net operating profit after tax?
Question 9
Suppose Zions is the counterparty that Walmart contracts with – i.e., Zions agrees to pay
fixed to Walmart and receive floating from Walmart. Hence, Zions also holds derivative
contracts and would report derivative assets or liabilities. Would the assets (liabilities)
recognized by Zions relating to these derivative contracts be operating assets (liabilities)
or financial assets (liabilities)? Similarly, should the income effects relating to changes in
the fair values of these assets (liabilities) be included in Zions’ net operating profit after
tax?
Vignette 4: Walmart’s Deferred Tax Assets and Deferred Tax Liabilities
U.S. generally accepted accounting principles (GAAP, hereafter) require companies to
report tax expense based on their GAAP pre-tax income. It is often the case that GAAP
pre-tax income does not equal taxable income per the tax return. Temporary
differences are the primary reason for this. A temporary difference arises when a
particular transaction or event effects GAAP income and taxable income in different
years. For example, the U.S. tax code allows companies to use accelerated depreciation
for fixed assets whereas GAAP requires companies to depreciate fixed assets over their
useful lives. Moreover, most companies use straight-line depreciation for financial
reporting. Consequently, early in the life of a fixed asset tax depreciation is higher than
GAAP depreciation, and thus taxes paid is lower than GAAP tax expense. However, this
pattern eventually reverses, and thus later in the life of the same fixed asset tax
depreciation is lower than GAAP depreciation and taxes paid is higher than GAAP tax
expense. Consequently, over the life of the fixed asset the cumulative depreciation per
the tax return is the same as the cumulative depreciation per GAAP; and, the cumulative
difference between GAAP tax expense and taxes paid is zero. This is the reason we use
the term temporary differences.
Given that for any specific year tax expense and taxes paid might not be equal, the
balance sheet will not balance unless additional accounting entries are made. Specifically,
the change in cash attributable to the payment of taxes will not equal the change in
retained earnings attributable to tax expense, and thus assets will not equal the sum of
liabilities and equity. To eliminate this problem accountants report deferred tax assets
and deferred tax liabilities. To understand how this works, consider the depreciation
example discussed above. Early in the life of the fixed asset taxes paid (and the reduction
in cash) is less than tax expense (and the reduction in retained earnings). Hence, to make
the balance sheet balance we record a deferred tax liability. This liability will grow during
the years when tax depreciation exceeds GAAP depreciation. However, GAAP
depreciation will eventually become larger than tax depreciation and when it does the
liability will begin to decline until it eventually disappears.
Per GAAP, companies must report the various sources of their deferred tax assets and
deferred tax liabilities. For example, in its Annual Report to Shareholders for the 2019
fiscal year, Walmart provided the following table in Note 9 to its financial statements.
January 31,
2020
2019
Tax credit carryforwards
(1)
Accrued liabilities
Share-based
compensation
January 31,
2020
2019
9,056
2,964 Property and equipment
4,621
4,175
2,483
2,135 Acquired intangibles
1,152
2,099
1,414
1,354
250
245 Inventory
Lease obligations
4,098
Other operating items
1,020
Total deferred tax assets
16,907
Lease right of use
assets
1,131 Investment in JD.com
Total deferred tax
6,475
liabilities
0
3,998
0
1,424
899
12,609
8,527
1. These are excess credits that Walmart can use to reduce future taxable
income. Walmart obtained them because it generated operating losses in
certain jurisdictions.
When reading the table keep in mind that it shows the sources of deferred tax assets
and deferred tax liabilities. Hence, it may initially seem confusing that “Accrued
liabilities” and “lease obligations” are in the column relating to deferred tax assets.
However, this is correct. Specifically, it reflects the fact that Walmart recognized
expenses relating to accrued liabilities and lease obligations in its GAAP income.
However, these expenses have not be recognized in Walmart’s taxable income yet.
Hence, GAAP tax expense is currently lower than taxes paid, and thus Walmart
recognizes a deferred tax asset to make the balance sheet balance. This difference will
eventually reverse when the liability and related expense are recognized for tax
purposes.
Question 10
Which items in the list of Walmart’s deferred tax assets are operating assets?
Question 11
Which items in the list of Walmart’s deferred tax liabilities are operating liabilities?
https://corporate.walmart.com/newsroom/2016/06/20/walmart-and-jd-com-announce-strategic-alliance-to-serve-consumers-across-china
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Walmart and JD.com Announce Strategic Alliance to Serve Consumers across China
https://corporate.walmart.com/newsroom/2016/06/20/walmart-and-jd-com-announce-strategic-alliance-to-serve-consumers-across-china
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Walmart and JD.com Announce Strategic Alliance to Serve Consumers across China
https://corporate.walmart.com/newsroom/2016/06/20/walmart-and-jd-com-announce-strategic-alliance-to-serve-consumers-across-china
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