The Classifi cation of Expenses Matsushita Electric Industrial Co., Ltd., best known for its Panasonic brand name, is one of the world’s leading manufacturers of electronic and electric products for a wide range of consumer, business, and industrial uses,

Question

The Classifi cation of Expenses

Matsushita Electric Industrial Co., Ltd., best known for its Panasonic brand name, is one of the world’s leading manufacturers of electronic and electric products for a wide range of consumer, business, and industrial uses, as well as a wide variety of components.
Excerpted below are Matsushita’s income statements for the years ended 31 March.

As shown, Matsushita includes a line “other deductions,” which would be understood to be nonoperating items because it appears below such items as “other income” and “interest expense.” Without further examination, analysts may be inclined to treat this item as nonoperating or nonrecurring. However, the deductions amount to a high percentage of pretax income (as high as 70 percent in 2005) and revenue (2 percent in 2005.) Clearly the distinction is worth further analysis. Consider the associated notes, which are excerpted below:

4. Investments in and Advances to, and Transactions with Associated Companies
During the years ended March 31, 2006 and 2005, the Company incurred a write down of 30,681 million yen and 2,833 million yen, respectively, for other than-temporary impairment of investments and advances in associated companies.

5. Investments in Securities
During the years ended March 31, 2007, 2006 and 2005, the Company incurred a write down of 939 million yen, 458 million yen and 2,661 million yen, respectively, for other-than-temporary impairment of available-for-sale securities, mainly reflecting the aggravated market condition of certain industries in Japan.

7. Long-Lived Assets
The Company periodically reviews the recorded value of its long-lived assets to determine if the future cash flows to be derived from these assets will be sufficient to recover the remaining recorded asset values. . . .

8. Goodwill and Other Intangible Assets
The Company recognized an impairment loss of 27,299 million yen during fiscal 2007 related to goodwill of a mobile communication subsidiary. This impairment is due to a decrease in the estimated fair value of the reporting unit caused by decreased profit expectation and the intensification of competition in a domestic market which was unforeseeable in the prior year.

The Company recognized an impairment loss of 3,197 million yen during fiscal 2007 related to goodwill of JVC due primarily to profit performance in JVC’s consumer electronics business being lower than the Company’s expectation.

The Company recognized an impairment loss of 50,050 million yen during fiscal 2006 related to goodwill of a mobile communication subsidiary. This impairment is due to a decrease in the estimated fair value of the reporting unit caused by decreased profit expectation and the closure of certain businesses in Europe and Asia.

15. Restructuring Charges
The Company has provided early retirement programs to those employees voluntarily leaving the Company. The accrued early retirement programs are recognized when the employees accept the offer and the amount can be reasonably estimated. Expenses associated with the closure and integration of locations include amounts such as moving expense of facilities and costs to terminate leasing contracts incurred at domestic and overseas manufacturing plants and sales offices.
An analysis of the accrued restructuring charges for the years ended March 31, 2007, 2006 and 2005 is as follows:

16. Supplementary Information to the Statements of Income and Cash Flows
Foreign exchange gains and losses included in other deductions for the years ended March 31, 2007, 2006 and 2005 are losses of 18,950 million yen, 13,475 million yen and 7,542 million yen, respectively.Included in other deductions for the year ended March 31, 2006 are claim expenses of 34,340 million yen.

Based on the information given, address the following problems:

1. Based on the description in the notes for each item, comment on whether it is appropriate to treat the following charges as nonoperating or nonrecurring:
A. Investments in and advances to and transactions with associated companies.
B. Investments in securities.
C. Long-lived assets.
D. Goodwill and other intangible assets.
E. Restructuring charges.
F. Supplementary information to the statements of income and cash flows.
2. How would analyzing balance-sheet-based or cash-flow-statement-based accruals ratios help in assessing the impact of movements in the accounts above? (No calculations are needed.)

Accepted Answer

Solutions to 1. Discretion is required in analyzing many items. When in doubt, analysts may wish to prepare separate sets of financial statements to understand the effect of treating individual items in different manners.

A. Classifying changes in the value of the investments as nonoperating is appropriate for a nonfinancial company such as Matsushita.
B. Securities held available for sale are typically used as alternatives to investing in low-yielding cash. Treating losses on such securities as nonoperating is appropriate. Again, however, persistent losses raise the question of whether management is capable of selecting worthwhile alternative investments.
C. The value of long-lived assets is typically charged to expense over time as depreciation, which is considered to be an operating item. The impairment charges shift future depreciation expense into the current year, which reduces the future depreciation and also suggests that past depreciation charges were too low. Analysts should reclassify the impairment expense to treat it on par with normal depreciation.

D. Accounting principles call for periodic testing of goodwill for impairment. No amortization expense is otherwise charged. Because the impairment does not offset a normal operating expense, it can be appropriate to classify it as nonoperating, as Matsushita does. However, analysts should pay attention to goodwill impairment. Large impairments can appear conservative at the time they are announced, but the need for them can result from previous aggressive accounting (aggressive at least from an after the-fact perspective). In the case of Matsushita, it appears that management overpaid for its past investments.
E. Early retirement programs and expenses associated with the closure and integration of locations include amounts such as moving expense of facilities and costs to terminate leasing contracts. Given that these expenses would be incurred from time to time as part of normal business operations, they should be reclassified as operating expenses.
F. Matsushita is an international operation and should thus be expected to incur foreign currency gains and losses as part of normal operations, although they are typically considered outside management’s control. Foreign exchange gains are typically treated as adjustments to net financing costs and are treated as nonoperating.

Solution to 2. Marketable securities (if treated as short-term investments) and equity investments would not be included in either net operating assets or cash flow from operating activities, so the accruals ratios would provide the correct interpretation of these items. Foreign currency and goodwill may appear in a balance sheet driven accruals ratio, but not in the ratio based on the cash flow statement. These were also items of questionable operating significance, so the mixed treatment in an accruals ratio reflects the ambiguity. The charges to long-lived assets and for restructuring would deservedly be reflected in the accruals ratios.

	Yen (millions)
Years ended 31 March	2007	2006	2005
Revenues, costs and expenses:
Net sales:
Related companies (Note 4)	250,863	204,740	192,489
Other	8,857,307	8,689,589	8,521,147
Total net sales	9,108,170	8,894,329	8,713,636
Cost of sales (Notes 4 and 16)	(6,394,418)	(6,155,297)	(6,176,046)
Selling, general, and administrative expenses (Note 16)	(2,254,211)	(2,324,759)	(2,229,096)
Interest income	30,553	28,216	19,490
Dividends received	7,597	6,567	5,383
Gain from the transfer of the substitutional portion of Japanese Welfare Pension Insurance (Note 10)	__	__	31,509
Other income (Notes 5, 6, 16 and 17)	114,545	147,399	82,819
Interest expense	(20,906)	(21,686)	(22,827)
Goodwill impairment (Note 8)	(30,496)	(50,050)	(3,559)
Other deductions (Notes 4, 5, 7, 8, 15, 16 and 17)	(121,690)	(153,407)	(174,396)
Income before income taxes	439,144	371,312	246,913
Provision for income taxes (Note 11):
Current	119,465	96,341	96,529
Deferred	72,398	70,748	56,805
	191,863	167,089	153,334
Income before minority interests and equity in earnings (losses) of associated companies	247,281	204,223	93,579
Minority interests	31,131	(987)	27,719
Equity in earnings (losses) of associated companies (Note 4)	1,035	(50,800)	(7,379)
Net income	217,185	154,410	58,481

	Yen (millions)
	2007	2006	2005
Balance at beginning of the year	1,335	3,407	__
New charges	19,574	48,975	110,568
Cash payments	(10,889)	(51,047)	(107,161)
Balance at end of the year	10,020	1,335	3,407

Question 17.6: The Classifi cation of Expenses Matsushita Electric Industri...

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