Case 1.1: NIKE: Somewhere Between a Swoosh and a Slam Dunk
I. Objectives
A. Review the purpose, format, terminology and accounting principles
underlying the balance sheet, income statement, and statement of cash
flows.
B. Introduce common size and percentage change income statements and
balance sheets and the insights such statements provide.
II. Teaching Strategy -- We have taught this case with two approaches. If an
opportunity exists to distribute the case prior to the first class session, we give
students the solution to the questions involving the income statement, balance
sheet, statement of cash flows, and relations between financial statement items.
We ask them to review these parts on their own and then prepare the questions
under the section labeled interpreting financial statement relationships. We devote
the first class session to discussing this last section of the case. If we cannot
distribute the case ahead of time, we devote approximately three hours of class to
discussing the case. Alternatively, the instructor can choose to emphasize certain
questions based on the amount of time available and refer students to the solution
for the remaining parts.
Income Statement
a. NIKE apparently recognizes revenues from the sale of products at the time of sale.
It recognizes revenue from license fees as earned, which is probably at the time of
delivery of products to licensees. The criteria for revenue recognition are (1)
substantial performance of services to be provided, and (2) receipt of cash or a
receivable whose cash-equivalent value a firm can measure with reasonable
accuracy. The sale of products to retailers constitutes substantial performance
unless NIKE is required to take back unsold items. There is no indication that
returns are substantial. The Futures purchasing program likely matches products
to specific customer needs. NIKE carries substantial accounts receivable from its
customers. Accounts receivable increased at a higher rate than the growth rate of
sales during Year 7 but at a slower rate during Year 8 , so there is no indication of
a substantial buildup of uncollectible accounts. The allowance for uncollectible
accounts had a balance equal to 3.0 percent of gross accounts receivable
[$33/($1,053+ $33)] at the end of Year 7 and 3.1 percent [$43/($1,346 + $43)] at
the end of Year 8. Thus, NIKE’s revenue recognition appears appropriate.
b. The Notes indicate that NIKE uses LIFO for domestic inventories and FIFO for
international inventories. Firms are free to select their inventory cost-flow
assumption from the set deemed acceptable by standard-setting bodies. These
bodies do not provide a set of criteria that firms must apply to determine which
inventory cost-flow assumption is “appropriate”. The Financial Accounting
Standards Board permits firms in the United States to use FIFO, LIFO, weighted
average, and several other methods. NIKE’s use of LIFO saves income taxes
during periods of rising production costs. Given the requirement in the U.S. that
firms using LIFO for tax reporting must also use LIFO for financial reporting
likely explains NIKE’s use of LIFO in the U.S. Most other countries do not
permit firms to use LIFO. Thus, NIKE’s choice set in these countries includes
FIFO and weighted average. NIKE’s probably uses FIFO because the physical
flow of its inventory is FIFO. Also, NIKE saves record keeping costs by using
FIFO for both reporting to foreign governments and reporting to its shareholders
in the U.S.
c. NIKE does not conduct any of its own manufacturing. Thus, depreciation expense
relates to buildings and equipment used in selling and administrative activities.
NIKE’s income statement classifies expenses by their function instead of by their
nature. Thus, NIKE includes depreciation expense in selling and administrative
expenses.
d. The Notes indicate that income tax expense of $346 includes $418 payable
currently and an increase in deferred tax assets or a reduction in deferred tax
liabilities of $72. Firms recognize deferred taxes for temporary differences
between taxable income and income for financial reporting. The taxable income
of NIKE for Year 8 exceeds its income before taxes for financial reporting. This
probably occurred because NIKE recognized revenues for tax reporting in Year 8
that it recognized in earlier years for financial reporting and because it recognized
expenses during Year 8 for financial reporting that it will not recognize as a tax
deduction until later years. The basis for measuring the amount of income tax
expense is the amount of revenues and expenses recognized during the year for
financial reporting. The basis for measuring income tax payable is the amount of
revenues and expenses recognized during the year for tax reporting. Because these
amounts are usually different, firms are required to recognize deferred tax assets
and deferred tax liabilities on their balance sheets. Governmental laws dictate the
manner of measuring taxable income. As long as firms apply these laws correctly
in measuring their taxable income each year and pay the required taxes, they have
no additional obligation to governmental entities at this time. The presence of a
deferred tax asset or a deferred tax liability on the balance sheet is not an
indication that governmental bodies have permitted firms to delay paying taxes.
Rather, it indicates the desire of standard-setters to match income tax expense with
income before taxes for financial reporting.
Balance Sheet
a. The allowance for uncollectible accounts account arises because NIKE recognizes
revenue earlier than the time when it collects cash. Because NIKE is not likely to
collect 100 percent of the amount reported as sales revenue, it must recognize an
expense for estimated uncollectible accounts and reduce gross accounts receivable
to the amount it expects to collect in cash. NIKE increases the balance in the
allowance account for estimated uncollectible accounts arising from sales each
year. It reduces the balance in the allowance account for actual customers’
accounts deemed uncollectible. NIKE reports the balance in the allowance account
as a subtraction from gross accounts receivable.
b. Use of a LIFO cost-flow assumption results in reporting the most recent purchase
prices in cost of goods sold on the income statement each year and the oldest
purchase prices in inventories on the balance sheet. The longer a firm has been on
LIFO, the more out-of-date the book value of the inventories will be relative to
current replacement costs. To avoid misleading users of the financial statements,
the Securities and Exchange Commission requires firms using LIFO to report the
difference between the current replacement cost and the book value for
inventories. The relatively small difference between these two amounts for NIKE
might reflect (1) small changes over time in the purchase prices of inventory
items, (2) purchase price decreases in recent years to offset purchase price
increases in earlier years, (3) adoption of LIFO only in recent years, (4) liquidation
of LIFO layers of earlier years as NIKE changed its product lines, or (5) use of
LIFO for only a portion of its inventories.
c. The Notes indicate that NIKE uses the straight line method for buildings and
leasehold improvements and the declining balance method for machinery and
equipment. As with the inventory cost-flow assumption, standard-setting bodies
give firms freedom to select any depreciation method from the set deemed
acceptable. These bodies do not provide criteria as to which method is more
“appropriate” for a particular firm. The methods that NIKE uses for financial
reporting closely coincide with the methods it uses for tax reporting. Thus, NIKE
saves record keeping costs by using the same depreciation methods for financial
and tax reporting.
d. Generally accepted accounting principles in the United States require firms to
expense in the year incurred any expenditures (for example, advertising,
promotion, quality control) to develop intangibles (patents, trademarks, goodwill).
Thus, expenditures made to develop the NIKE name or its trademarks will not
appear on the balance sheet as assets. Expenditures made to purchase intangibles
from other firms will appear on the balance sheet as assets (subject to
amortization). Most of the identifiable intangible assets and goodwill appearing
on NIKE’s balance sheet arose from the acquisition of Bauer, Inc. during Year 7.
e. Deferred tax assets arise when a temporary difference provides a future tax benefit
for a firm. This occurs either (1) when a firm recognizes revenue earlier for tax
reporting than for financial reporting (subsequent recognition of the revenue for
financial reporting will not give rise to a tax payment), or (2) when a firm
recognizes expenses earlier for financial reporting than for tax reporting
(subsequent recognition of the expense for tax reporting will reduce income tax
payments). Deferred tax liabilities arise when a temporary difference will require a
firm to make a tax payment in the future. This occurs either (1) when a firm
recognizes revenue earlier for financial reporting than for tax reporting
(subsequent recognition of the revenue for tax reporting will require the firm to
pay taxes), or (2) when a firm recognizes an expense earlier for tax reporting than
for financial reporting (subsequent recognition of the expense for financial
reporting does not give rise to a tax deduction, thereby increasing taxable income
and taxes payable). Note that the classification of deferred taxes on the balance
sheet depends on (1) whether temporary differences give rise to a deferred tax
asset or deferred tax liability, and (2) the timing of the likely reversal of the
temporary difference (less than one year or longer than one year).
Statement of Cash Flows
a. Firms use the accrual basis of accounting in measuring net income. Firms usually
recognize revenue at the time of sale of goods and services, not necessarily when
they receive cash from customers. Firms attempt to match expenses with
associated revenues, regardless of when they expend cash. The accrual basis gives
a better indication of a firm’s operating performance than the cash basis because of
the matching of inputs and outputs. The statement of cash flows reports the
amount of cash received from customers net of amounts paid to suppliers of goods
and services.
b. Depreciation expense reduces net income but does not require a cash expenditure
in the year of their recognition (the cash effect occurred in the year a firm acquired
the property, plant, equipment; the firm classified the cash outflow as an investing
activity in the statement of cash flows at that time). The addition adds back to net
income the amount subtracted in calculating earnings for the year.
c. Question d. in the Income Statement questions indicated that NIKE paid more
income taxes during Year 8 than it recognized as income tax expense. Net income
on the first line of the statement of cash flows reflects a subtraction only for the
amount of income tax expense.
d. Net income on the first line of the statement of cash flows includes revenues
recognized each year. NIKE does not necessarily collect cash each year in an
amount exactly equal to revenues. It may collect cash during Year 8 from sales
made in prior years and it may not collect cash on some sales made Year 8 until
later years. The subtraction for the increase in accounts receivable means that
NIKE received less cash than it recognized as sales revenue.
e. Net income on the first line of the statement of cash flows includes a subtraction
for the cost of goods sold during each year. NIKE will likely purchase a different
amount of inventory than it sells. An increase in inventories means that NIKE
purchased more than it sold. Thus, the cash outflow for purchases potentially
exceeds cost of goods sold and requires a subtraction from net income for the
additional cash required. Whether additional cash was in fact required in any year
depends on the change in accounts payable, discussed next.
f. Accounts payable reflects amounts owed to suppliers for inventory items
purchased. Purchases of inventory items increase this liability and cash payments
reduce it. The adjustment for inventory in part e. above converted cost of goods
sold to purchases. The adjustment for accounts payable converts purchases to cash
payments to suppliers. An increase in accounts payable means that NIKE
purchased more than its cash expenditure for purchases. Thus, the adjustments for
the change in inventories and the change in accounts payable convert cost of goods
sold included in net income to cash payments to suppliers for inventory items.
The accrued liabilities and income tax payable accounts reflect amounts owed to
suppliers of various services. Purchases of these services increase these liabilities
and cash payments reduce them. Net income on the first line of the statement of
cash flows includes an expense for the cost of these services consumed during the
year. An increase in the liability for these items means that the cash expenditure
during the year was less than the amount recognized as an expense. The addition
to net income indicates that the cash outflow was less than the expense. Cash flow
from operations did not decrease by the full amount of the expense.
g. The Financial Accounting Standard Board requires firms to report the proceeds
from selling property, plant and equipment as an investing activity. Their rationale
for this classification is two-fold: (1) selling such noncurrent assets is not the
primary operating activity of most companies, and (2) cash expenditures to
purchase these assets appear as investing activities. If a firm sells such assets at a
gain or loss, it must subtract the gain from net income or add back the loss to net
income when computing cash flow from operations. This subtraction or addition
nets the effect of the gain or loss to zero in the operating section of the statement
of cash flows and shows the full cash proceeds as an investing activity. Any gains
or losses for NIKE were sufficiently small that it did not disclose them separately.
h. The Financial Accounting Standards Board requires firms to report changes in
short-term bank borrowing as a financing activity. Their rationale for not
including such borrowing as an operating activity, which is the classification of
changes in other current liabilities, is that a firm does not generate operating cash
flows by borrowing from banks. Operating cash flows come from selling goods
and services to customers. Changes in other current liabilities on the other hand
relate directly to purchases of goods and services used in operations, justifying
their inclusion in the operating section of the statement of cash flows.
Relations between Financial Statement Items (amounts in thousands)
a. Sales Revenue.......................................................................... $ 6,471
Increase in Accounts Receivable ($1,346–$1,053) ................. (293)
Cash Collected from Customers .............................................. $ 6,178
b. FIFO/LIFO Excess All FIFO
Beginning Inventory ............................ $ 630 $ 20 $ 650
Purchases (plug) .................................. 4,208 4,208
Goods Available for Sale .................... $ 4,838 $ 4,858
Less Ending Inventory......................... (931) (16) (947)
Cost of Goods Sold.............................. $ 3,907 $ 4 $ 3,911
c. Cost of Goods Sold.................................................................. $ 3,907
Increase in Inventories ($931–$630) ....................................... 301
Cost of Inventories Purchased ................................................. $ 4,208
Increase in Accounts Payable ($455–$298) ............................ (157)
Cash Paid for Purchases of Inventory ..................................... $ 4,051
d. Property, Plant and Equipment (at cost):
Balance, May 31, Year 7 ($555 + $336) ................................. $ 891
Purchases of Property, Plant and Equipment .......................... 216
Book Value of Property, Plant and Equipment Disposed
(plug) ..................................................................................... (60)
Balance, May 31, Year 8 ($643+$404) ................................... $ 1,047
Accumulated Depreciation:
Balance, May 31, Year 7 ......................................................... $ 336
Depreciation Expense for Year 8 ............................................ 97
Accumulated Depreciation of Property, Plant and Equipment
Disposed during Year 8 (plug) .............................................. (29)
Balance, May 31, Year 8 ......................................................... $ 404
Cash Proceeds from Disposal of Property, Plant and
Equipment ............................................................................. $ 12
Book Value of Property, Plant and Equipment Disposed:
($60–$29) .............................................................................. (31)
Loss on Sale of Property, Plant and Equipment ...................... $ (19)
NIKE likely includes the loss in Other Expenses on the income statement. It will
add back the loss to net income in calculating cash flow from operations, probably
on its line labeled “other.”
e. Long-term Debt (current and noncurrent portions):
Balance, May 31, Year 7 ($32+$11) ....................................... $ 43
Plus New Long-term Debt Issued During Year 8 ................... 5
Less Book Value of Long-term Debt Redeemed During
Year 8 (plug) ......................................................................... (31)
Balance, May 31, Year 8 ($7+$10) ......................................... $ 17
The statement of cash flows shows that NIKE used $30 million to reduce long-
term debt during Year 8. The slight difference from the book value of long-term
debt redeemed of $31 million suggests a gain of $1 million (= $31 – $30), but
rounding errors may explain why this amount is not zero.
f. Net income increased retained earnings by $553 million, dividends reduced
retained earnings by $79 million, and the repurchase and retirement of NIKE
common stock must have resulted in a charge against retained earnings of $22
million. Note that most companies report the cost of treasury stock purchased on a
separate line in the shareholders’ equity section of the balance sheet. NIKE
chooses to report such repurchases as the retirement of the stock. The charge
against retained earnings reflects the increases in the stock price in previous years
resulting from the retention of earnings.
Interpreting Financial Statement Relationships
a. The improved net income/sales percentage between Year 6 and Year 7 results
primarily from a reduction in the cost of goods sold to sales percentage. The
decrease in sales between Year 5 and Year 6 suggests that NIKE may have had to
reduce selling prices or absorb manufacturing cost increases in order to move its
products. The increase in sales between the Year 6 and Year 7 suggests a more
attractive pricing environment for NIKE, resulting in a reduction in the cost of
goods sold to sales percentage. NIKE may also have experienced a shift in its
sales mix between these two years toward higher margin products. NIKE does not
provide profit margin information for its various products. The improved profit
margin between the Year 7 and Year 8 results primarily from a reduction in its
selling and administrative expense/sales percentage. NIKE experienced a 35.9
percent increase in sales between these two years in contrast to a 6.1 percent sales
increase for Reebok and a 9.3 percent increase for Adidas. Part of the increase for
NIKE comes from including a full year of sales for Bauer, Inc. The remainder of
the increase comes from increased footwear and apparel sales. NIKE probably
realized benefits of economies of scale as it spread the relatively fixed cost of its
sales and administrative organization over a much larger sales base.
b. The income tax percentages are expressed as a percentage of sales. The income
tax is a tax on net income, not sales. Thus, it is more appropriate to examine the
relation between income tax expense and net income before taxes. We refer to this
percentage as the average, or effective, tax rate. The effective tax rates are as
follows:
Year 6: $192/$491 = 39.1%
Year 7: $250/$650 = 38.5%
Year 8: $346/$899 = 38.5%
Thus, the effective tax rate was relatively steady during the three years. The
increase in the income tax/sales percentage occurred because of the increase in
profitability (that is, the income before taxes/sales percentage increased each year).
c. The close similarity between the change in sales percentage and the change in cost
of goods sold percentage suggests that this cost items is primarily a variable cost.
Given that NIKE outsources its manufacturing and sells most of its footwear at
pre-established selling prices under its Futures program, one would expect a
variable cost relationship. Also, NIKE does not have any manufacturing facilities
of its own that would give rise to fixed manufacturing costs.
d. The three companies outsource production of footwear and apparel to plants
primarily in East Asia. Given that these three companies dominate the footwear
industry, they probably have similar bargaining power with suppliers. Thus, each
firm probably pays a similar amount for its products. Furthermore, the market for
athletic footwear and sports apparel is highly competitive. In terms of their
physical characteristics, products are largely commodities. Although each firm
attempts to distinguish its products on image characteristics, these three companies
face competitive pressures to keep prices in line with each other. Thus, we would
expect the three firms to have similar cost of goods sold/sales percentages.
e. NIKE’s profit margin advantage comes from a lower selling and administrative
expense/sales percentage. Perhaps the larger sales level of NIKE permits it to
realize greater scale economies than Reebok and Adidas. These firms likely need a
certain minimum level of selling and administrative personnel to compete on a
international level. The firm with the larger sales will likely realize greater sales
economies.
f. These companies outsource their manufacturing and also outsource the retailing of
their products. Thus, the principal fixed assets are corporate headquarters,
research facilities, warehouses, and transportation equipment. One might think of
these companies as serving essentially a wholesaling function along with product
development and promotion.
g. These firms have few fixed assets to serve as collateral for borrowing. Also, the
firms generate more than sufficient cash flow from operations to finance the small
amount of investments in fixed assets. Thus, the firms do not need significant
long-term debt financing.
h. NIKE acquired Bauer, Inc. for $409 million. It allocated approximately $73
million to identifiable tangible net assets and $336 million to identifiable
intangibles and goodwill. Thus, the principal resource acquired was the name and
reputation of Bauer for quality hockey products. The statement of cash flows
shows cash of $430 was used for acquisitions. Thus, NIKE probably made
additional small acquisitions during the year. The use of cash in these acquisitions
means that NIKE accounted for the acquisitions under the purchase method.
i. The analyst cannot interpret the common size percentages in the balance sheet
independently of the remaining assets since their sum must add to 100 percent
each year. Thus, the increasing proportions of assets comprised of accounts
receivable and inventories do not necessarily suggest an unreasonable buildup of
these two assets. The analyst should compare the increases in accounts receivable
and inventories to the increase in sales or some other measure of operating
activity. Accounts receivable increased 49.7 percent while sales increased 25.6
percent during Year 7. Accounts receivable increased 27.8 percent while sales
increased 35.9 percent during Year 8. For the two years as a whole, accounts
receivable increased a total of 91.3 percent [= (1.278 x 1.497) - 1] while sales
increased a total of 70.7 percent [= (1.359 x 1.256) - 1]. Inventories increased
34.0 percent during Year 7 and 47.9 percent during Year 8, a total increase during
the two years of 98.2 percent [= (1.479 x 1.340) - 1]. Thus, there was some
buildup of accounts receivable and inventories during these two years. (Chapter 3
discusses the accounts receivable and inventory turnover ratios, which provide
better signals as to whether these assets are managed properly.)
j. The comments above regarding the common size percentages for accounts
receivable and inventories apply as well to current operating liabilities. Accounts
payable increased 41.4 percent during Year 7 and 52.9 percent Year 8, a total two-
year increase of 116.2 percent [= (1.529 x 1.414) - 1]. Other current liabilities
increased 73.0 percent during Year 7 and 47.0 percent during Year 8, a two-year
total increase of 154.3 percent [= (1.470 x 1.730) - 1]. Thus, these current
liabilities increased significantly more than sales.
k. Adidas appears the most risky from a financial structure perspective. It has the
highest proportion of liabilities in its capital structure, with most of its debt in the
form of short-term borrowing. Adidas, like most German companies, maintains
close relations with its banks and engages in more short-term bank borrowing than
is common in the U.S. Adidas has the smallest excess of current asset over current
liabilities of the three companies. Although Adidas gained market share on
Reebok during Year 7 and experienced a higher net income/sales percentage, its
debt load still places it as more risky than Reebok.
l. NIKE experienced a substantial increase in accounts receivable that exceeded the
increase in sales (see the answer to part i. above). NIKE apparently stretched its
current liabilities to help finance the buildup of accounts receivable (see the
answer to part j. above), but the buildup in accounts receivable exceeded the
increase in current operating liabilities. Cash flow from operations therefore
declined between the two years.
m. NIKE experienced significantly increased net income between Year 7 and Year 8.
Although both accounts receivable and inventories increased substantially, the
increased earnings and increases in current operating liabilities resulted in an
increase in cash flow from operations between the two years.
n. Cash flow from operations is less than net income during both Year 7 Year 8, a
typical pattern for a growing firm because of the need to finance the increases in
accounts receivable and inventories. The opposite pattern occurred during Year 6
when sales and earnings both decreased. NIKE collected accounts receivable from
the higher level of sales in Year 5 and did not replace them with as many
additional receivables from the lower level of sales in Year 6. Likewise, NIKE
purchased less inventory than it sold during Year 6, suggesting that the cash
inflow from sale of inventory to customers exceeded the cash outflow to replace
the inventory.
o. Cash flow from operations exceeded expenditures on property, plant and
equipment each year, so NIKE did not need to rely on external financing for its
capital expenditures. NIKE has reduced its long-term debt during the three years.
p. It appears that NIKE engaged in short-term bank borrowing or simply reduced its
cash account to finance the Bauer, Inc. acquisition. Because NIKE also made
substantial repurchases of its common stock during this year, one cannot trace
specific sources and specific uses of cash.
q. The repurchases of common stock substantially exceeded the issue of new stock
under stock option plans in Year 6 and Year 7. Thus, repurchasing shares to
maintain a level number of shares outstanding to avoid dilution does not appear to
be the primary reason for the stock repurchases. It is likely that NIKE had excess
cash and felt that its stock price was undervalued. Such stock repurchases often
result in an increase in the market price of the stock.