SECTOR PREVENCION Y ATENCION DE DESASTRES

The second step in a business valuation and analysis is an accounting analysis. In order to understand the intrinsic reality of the business, one must understand the degree to which a firm’s accounting reports reflect such. Firms have the opportunity to distort accounting numbers in order to make the business more appealing to investors. An accounting analysis will “evaluate accounting quality by assessing accounting policies and estimates” (Palepu Healy 2008).

Executing an accounting analysis involves a series of steps. The first step is to identify the key accounting policies that a firm chooses to represent the risks and success components of the business. Step two involves assessing the accounting flexibility. Managers’ degree of flexibility differs among firms

depending on rules and regulations. Generally speaking, the more flexibility a manager is granted in choosing accounting policies, the more informative the accounting numbers are to an investor, pertaining to the economics of the firm. Step three in the analysis of accounting is to evaluate the accounting strategy the firm has chosen. Strategies will vary depending on the manager’s flexibility and whether or not the firm is trying to cover up actual performance or provide to the outside the economic standing of the firm. Evaluating the quality of disclosure is the next step in the accounting analysis process. There is a minimum disclosure requirement by law, so it is important to determine the quality of the disclosure by concluding if a firm reported beyond the minimum or not. The fifth and sixth steps are composed of identifying potential “red flags” and undoing the accounting distortions respectively (Palepu Healy 2008).

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Key Accounting Policies

Family Dollar’s key success factors (KSF’s), as identified in the Firm Competitive Advantage Analysis, are economies of scale, reduced input costs, low-cost distribution, and a tight cost control system. These KSF’s are in line with FDO’s competitors as well, albeit they have their own methods for achieving a cost leadership strategy. All four of the KSF’s are geared toward reducing costs which is in line with FDO’s and the industry’s strict cost leadership strategy. This emphasis on cost leadership spawns the following Key Accounting Policies (KAP’s) for the “dollar” store industry: lease treatment, merchandise inventories, intangible assets (particularly goodwill), and employee retirement programs.

Lease Treatment

The retail industry as a whole has a potentially huge liability related to their store locations. Every one of the large “dollar” store chains leases the majority of their store properties (FDO 2007 10-K, DLTR 2007 10-K, NDN 2007 10-K), even if most own their distribution centers. These leases can be treated in one of two ways, as operating leases or as capital leases.

Operating leases treat lease payments as rent that is expensed when incurred. Family Dollar uses this method because it keeps these expenses of the balance sheet and recognizes these expenses much later. In addition, operating lease terms are generally shorter than capital lease terms. This allows FDO to more quickly vacate overpriced lease contracts for more cost effective leases which is in line with its emphasis on cost leadership.

Capital leases are similar to mortgages from a financing perspective. They do affect the balance sheet and both short and long term liabilities. Unlike

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FDO, Dollar Tree and 99¢ Only do show capital lease liabilities on their respective balance sheets. Dollar Tree’s capital lease obligation for 2007 was $400,000 compared with an operating lease obligation in the same year of $284 million (DLTR 10-K 2007). Ninety-nine Cent Only’s total capital lease obligation in 2007 was $699,000 compared with a total operating lease obligation of $196 million (NDN 10-K 2007). These figures show that the “dollar” store industry heavily favors the use of operating leases due to the fact that they keep significant liabilities of the balance sheet and their compatibility with the cost cutting KSF’s. Operating and capital lease will be discussed in detail in the “Potential

Accounting Flexibility” section.

Merchandise Inventories

Merchandise inventories represent the second KAP because they make up such a huge part of the total assets of retail stores.

Merchandise Inventory as a percentage of

Total Assets 2007 2006 2005 DLTR (millions) Merchandise Inventory $ 605.00 $ 576.60 $ 615.50 Total Assets $ 1,873.30 $ 1,798.40 $ 1,792.70 Percentage 32% 32% 34% NDN (thousands) Merchandise Inventory $ 152,793.00 $ 139,901.00 $ 147,609.00 Total Assets $ 643,135.00 $ 628,708.00 $ 629,611.00 Percentage 24% 22% 23% FDO (thousands) Merchandise Inventory $ 1,065,898.00 $ 1,037,859.00 $ 1,090,791.00 Total Assets $ 2,624,156.00 $ 2,523,029.00 $ 2,409,501.00 Percentage 41% 41% 45%

37 Dollar General (thousands)

Merchandise Inventory $ 1,432,336.00 $ 1,474,414.00 $ 1,376,537.00

Total Assets $ 3,040,514.00 $ 2,980,275.00 $ 2,841,004.00

Percentage 47% 49% 48%

Consistency in these figures is more important that growth, as growth can represent inefficiency in the Day Supply of Inventory and Inventory Turnover metrics. Also, any unnecessary growth in inventory is an increase is an expense as it costs money to carry additional inventory. A slight decline in the

percentage figures is positive in the discount store inventory and runs parallel to a tight cost control KSF.

Goodwill

Goodwill is the third KAP because Family Dollar and its direct competitors chain stores and always looking for cheap expansion. The easiest way for them to expand is to purchase slower growing chains, or acquire, “store leases

through bankruptcy proceedings” (DLTR 10-K 2007). These purchases allow for goodwill to find its way on to the balance sheet as an asset. Neither Family Dollar nor 99¢ Only record any goodwill, even in their “other asset” sections of the balance sheet, according to their respective 10-K’s. Both Dollar Tree and Dollar General do, however, record goodwill as an asset on the balance sheet. While Dollar Tree’s disclosure is very good, with a separate line item displayed for goodwill, Dollar General lumps their goodwill in with the “other assets” section of their balance sheet. Investors must beware of any goodwill as it is aggressive accounting because it inflates assets but usually does not provide any revenue for the company.

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The final KAP for the “dollar” store inventory is employee retirement programs. FDO and its competitors are required to have a “voluntary

compensation federal plan, under section 401(k) of the Internal Revenue Code” (FDO 10-K 2007). Even with a strictly voluntary program, the company’s

required investment in such plan can be substantial given the large number of workers employed by retail chains. All retirement contributions by their

respective firms were available in the 10-K’s for at least three years; however, even when Dollar Tree, which paid the most contributions, with $16.8 million being paid out in 2007, this number was only 0.423% of their $3.9 billion in net sales for 2007. Judging from this figure it becomes clear that the “dollar” stores’ goal of low cost keeps these retirement contributions to a minimum. The three other companies analyzed were significantly below 0.423% as a percentage of net sales. While, retirement programs could potentially represent a significant cost to the “dollar” stores, their relatively small size and good discloser keep their affect low.

Conclusion

The firms of the discount retail industry measures success by their ability to implement a strong cost leadership strategy. The Key Accounting Policies for Family Dollar and its competitors are based off the Key Success Factors of a cost leadership strategy. Careful attention must be paid to the KAP’s, especially leasing and merchandise inventories, when evaluating the quality of financial statements. Fortunately disclosure is relatively good for all the KAP’s excluding the leasing and goodwill sections for some companies.

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In the early 21st _{century the failure of several fortune 500 companies, due}

to exceedingly “flexible” accounting practices, caused a wave of federal

legislation. This new legislation gave the Securities and Exchange Commission (SEC) more power to police fraudulent and unethical accounting. In accordance with new laws, like the Sarbanes-Oxley Act of 2002, all companies were required to report with a higher degree of disclosure than before. Despite this new

legislation; however, Family Dollar, like the rest of the major players in the

discount, variety segment, still has the potential to add biased and/or speculative data to its financial statements. This additional information can either serve to add value and practical substance to the accounting statements, or serve as a shroud to keep outsiders ignorant of the company’s true financial condition. The areas that most often are subject for flexible accounting in the discount, retail segment are: lease treatment, merchandise inventories, intangible assets (primarily goodwill), and retirement programs.

Leases

Most of the potential for accounting flexibility in firms that operate large retail chains comes from a few particular items. In companies that have such a large proportion of operating income tied up in store locations and property, lease treatment becomes the most significant of these items. Generally

Accepted Accounting Principles (GAAP) requires that these leases be reported in one of two ways: as operating leases or as capital leases. Family Dollar’s use of leases will be discussed in detail later.

Operating Leases

The operating lease is generally utilized for short term leases (5 years or less) and as there is no transfer of ownership the rent is expensed when incurred as a necessary cost of doing business. The lessee pays for the right to use the lessor’s property as a place of business. Because the rent in this type of lease is expensed it never shows on the balance sheet and only impacts the income

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statement. This treatment of the leases has the potential to significantly understate liabilities and inflate retained earnings.

Capital Leases

Capital leases, in contrast, are typically used for long term leases (10 years or more) and treat the asset as if it were being purchased by the firm. A long-term asset is placed on the balance sheet with a corresponding entry being made to long-term liabilities. Although not used by Family Dollar Inc. for any of their retail stores because expenses are recognized so much earlier, capital leases do offer some unique benefits. They afford to company the right to, “claim depreciation each year on the asset and also deduct the interest expense component of the lease payment each year.” (pages.stern.nyu.edu). They also can boost the CFFO of a firm that opts for a capital lease over an operating lease because the capital lease payments are divided between operating and financing activities, while operating lease payments show as cash outflows from

operations, (Investopedia.com).

Merchandise Inventories

The second major area for potential accounting flexibility in the discount, retail industry arises in the merchandise inventories item of the balance sheet. Not surprisingly the merchandise inventories makes up a significant, if not dominant, proportion of current assets on the balance sheets of chains that make all their money selling merchandise. In 2006, Family Dollar’s merchandise inventory accounted for 41% of total assets (FDO 10-K 2007). There is so much room for flexibility in this component because not this entire inventory remains sellable all of the time. Food perishes, trends subside, technology causes obsolescence, and things break. How and whether or not a firm impairs or writes down these assets after such occurrences determines the transparency and usability of its financial statements. The “dollar” stores have the luxury of not having to dwell on advancing technology and trendiness as the goods they

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sell are neither high-tech, nor high fashion. They also have the unique advantage of purchasing other companies unwanted merchandise at deep discounts making a positive margin very easy to attain. The “dollar” stores do, however, have to worry about perishables and damaged goods. Perishables are becoming an increasing concern of the “dollar” store, especially with the advent of refrigerated coolers which has greatly expanded to amount of amount of these goods that the stores keep in inventory.

Goodwill

The frequent acquisitions of smaller or struggling retail stores and chains that compete in the same segment as the nationwide retailers affords many opportunities for goodwill to be recorded. This represents the third area of potential flexibility. Family Dollar, unlike its competitors, does not recognize any goodwill. When goodwill is recognized it is treated as an intangible asset on the balance sheet and according to FAS 142, 2001 this asset need not be amortized, but simply tested annually by the company for impairment (Investopedia.com). This allows goodwill to be kept on the books till the respective company decides otherwise; this presents a potential problem because there is no real way to subjectively and objectively measure the market value of this goodwill. As a result, it can serve as a booster seat that falsely inflates firms’ assets, retained earnings, and earnings per share making it look much more attractive to potential investors.

Retirement Plans

Pensions or compensation deferral plans represent the final area that is most often subject to flexible accounting by firms in the discount retail business. While these plans are offered to employees on a strictly voluntary basis, potential problems arise when companies use too large a discount rate to calculate the present value of future obligations. This estimation error in the discount rate will understate the present value of the future obligation the company has to its

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employees in a defined benefit plan. Future expenses associated with these pension plans will far out pace the growth of funds that the company has invested to match against these expenses leading to a shortfall between revenues and expenses in the future.

Actual Accounting Strategy

Overview

The analysis of a company’s actual accounting strategy involves both determining the transparency of its financial statements as high or low disclosure, and evaluating how aggressively or conservatively it utilizes its accounting flexibilities in the Key Accounting Policies. A high disclosure company’s financial statements will contain a wealth of data that divulges the true financial disposition of the company, both good and bad, to the public regardless of any effects on stock price. High disclosure financial statements will contain an unconsolidated balance sheet, income statement, statement of

retained earnings, and statement of cash flows accompanied by detailed notes to the financial statements. Conversely, low disclosure financial statements report limited information using consolidated accounting statements, which can

potentially mask the financial shortfalls of the company. They often bury the pertinent information deep within a complicated set of notes to the financials leaving much to be desired by investors. A company that uses its accounting flexibilities in an aggressive manner will boost assets, while minimizing liabilities and expenses in order to pad the financials and ultimately improve net income. A company practicing conservative use of its accounting flexibilities will

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depreciate assets, and perform write-downs, regardless of the effects on net income. It is important to note that neither are the correct way and that

extreme use of either aggressiveness or conservatism will degrade the quality of the financial statements.

Level of Diclosure

Family Dollar Inc. (FDO) reports with a high degree of disclosure, which is in line with the rest of the companies in the industry segment. Their financial statements are complete and readily accessible to the public. Although FDO displays consolidated accounting statements in their 10-Ks, they are always accompanied by a comprehensive set of notes. It is important to note that no major discrepancies were found in almost any of the danger zones for

accounting flexibility. FDO does not record any goodwill or any other intangible assets for that matter. Also, sales growth and inventory levels have grown together which suggests that FDO keeps its inventory assets at acceptable levels to meet a genuine growth in customer base; not just growth in inventory which could be a harbinger of substantial inventory write-downs in future periods. FDO’s does have a voluntary employee retirement plan; however, the company’s contribution expense related to this plan was less than 2% of net income for the last three fiscal years and properly disclosed in the financial notes (FDO 10-K 2007). FDO’s lease reporting is the last of the disclosure areas and, coincidently, the only area that FDO seems limit their disclosure. They appear to finance most of their store expansion and property acquisition using a leaseback method. This information is displayed in the notes to the financial statements, but significant computation is required to compute the magnitude of potential liabilities that are kept off the books by using this method. A complete estimation of these latent liabilities is performed later in the “Undo Accounting Distortions” section of this report.

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As could be derived from its relatively good disclosure in financial

statements, Family Dollar Inc. takes a more conservative disposition on much of its Key Accounting Policies. As prior stated FDO’s inventory and asset growth has stayed in line with sales growth and even decreased compared with sales growth in fiscal 2005 to 2006.

Comparison 2002-2003 2003-2004 2004-2005 2005-2006 Company Average Family Dollar

% Sales Growth 14.11% 11.19% 10.28% 9.79% 11.34% % Asset Change 13.17% 12.02% 8.32% 4.71% 9.56%

This can be interpreted as streamlining inventory forecasting and replenishment systems. While a decrease in overall asset could be seen as negative, when the decrease is primarily in merchandise inventory this leads to an increase in inventory turnover which is generally positive and on the

conservative side. FDO does not have any goodwill recorded on the books but they have acquired other smaller chain and thus, have had the opportunity to recognize goodwill. The fact that they do not recognize this is a sign of

conservatism because it does not drive up assets. Pensions are recorded in the notes but to not represent a significant expense for FDO. Lease treatment is the only KAP that FDO reports aggressively. The lease obligations for the leaseback financing if capitalized would nearly quadruple their long term liabilities of $329 million. A figure of this magnitude would change the entire outlook of the financials, not to mention many of the diagnostic ratios, current ratio and quick asset ratios in particular. The only redeeming factor is that leasebacking of this extent is the norm for the main competitors of FDO and becoming a norm for

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any high-growth industry with substantial amounts of PPE.

Conclusion

Family Dollar Inc.’s transparency and disclosure are generally very good. Conservatism is practiced for most of the Key Accounting Policies and throughout the financial statements. The only area where conservatism and disclosure are lacking is that of lease treatment. This can and should conjure some

apprehensiveness by investors, but is not abnormal for the industry.

Quality of Disclosure Qualitative Analysis

The Family Dollar overall has presented its financial statements with formidable disclosure and transparency. Throughout the financial statements there are many notes thoroughly explaining key company policies and reasons