Hewlett-Packard Corporation (HP) designs, manufactures, and distributes computer systems and imaging and printing products and offers information technology services. The company's offerings span IT infrastructure, global services, business and home computing, and imaging and printing. HP is headquartered in Palo Alto, California, and serves customers throughout the world. It has approximately 150,000 employees worldwide and ranked among the top twenty Fortune 500 firms. HP dedicates significant amounts to research and development of products, solutions, and new technologies. For decades, it has been considered a leader in the IT industry. However, recent years have been turbulent ones for the firm, with effective leadership and the appropriate portfolio of products and services the most hotly debated topics within both the firm and the media.
Financial statements for HP are presented in Exhibits 6.28 (income statement), Exhibit 6.29 (balance sheet), and Exhibit 6.30 (statement of cash flows). Before performing any analysis of these statements, however, it is appropriate to adjust for items considered unusual or nonrecurring and therefore unlikely to affect ongoing assessments of the firm. Selected notes to the financial statements reveal the following information:
1. Revenue recognition. HP recognizes revenue at the time of delivery of products to customers, at the same time providing for estimated returns. HP recognizes revenues from services when it performs the services. HP adopted Securities and Exchange Commission Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," in fiscal Year 1. Prior to adoption, HP had recognized revenues at the time of shipment to customers. The cumulative effect of changing the method of revenue recognition was $272 million, net of $108 million of income taxes, and is recognized in earnings for Year 1. The cumulative-effect technique for reporting the accounting change was employed by HP because Statement No. 154 was not in effect in Year 1.
2. Corporate acquisition. HP acquired Compaq Computer Company (Compaq) on May 3, Year 2, for $24,170 million. HP gave shares of its common stock in exchange for the outstanding common stock of Compaq and accounted for the acquisition using the purchase method. In addition to allocating the purchase price to the tangible assets acquired and the liabilities assumed, HP allocated $793 million to in-process technologies, $3,517 million to intangibles with a limited life (such as customer lists, distribution agreements, developed technologies, and patents), $1,422 million to intangibles with an indefinite life (primarily the Compaq brand name), and $14,450 million to goodwill. GAAP requires firms to expense amounts allocated to in-process technologies in the year acquired. Charges related to in-process technologies acquired do not give rise to tax benefits in any year.


During fiscal Year 2 and prior years, GAAP required firms to amortize all intangibles acquired in corporate acquisitions over their expected useful lives. Such amortization did not give rise to a tax benefit. Beginning with fiscal Year 3, GAAP no longer requires firms to amortize goodwill and other intangibles with indefinite lives. However, GAAP does require firms to test such assets annually for possible impairment and to recognize impairment losses if they arise. Firms must continue to amortize intangibles with limited lives.
To consummate the acquisition of Compaq, HP incurred acquisition-related charges in Year 2 totaling $701 million ($529 million after taxes) for professional services, advertising, and proxy solicitation costs. HP incurred additional acquisition-related charges of $280 million ($212 million after taxes) in Year 3. 3. Restructuring charge. HP's management approved restructuring actions in fiscal Year 1 "to respond to the global economic downturn and to improve HP's cost structure by streamlining operations and prioritizing resources in strategic areas of HP's business." HP recorded a restructuring charge of $384 million to






reflect these actions. This charge consisted of severance and other employee benefits related to the planned termination of approximately 7,500 employees, as well as costs related to the consolidation of excess facilities. As of the end of fiscal Year 1, HP had made payments of $264 million related to the restructuring and expected to pay the remainder of the accrual in fiscal Year 2. In fiscal Year 2, HP recognized another restructuring charge ($1,780 million) prior to its acquisition of Compaq. The charge included employee severance and early-retirement benefits, costs of vacating duplicate facilities, and asset impairment losses related to HP's activities. By the end of fiscal Year 2, HP had made payments of $502 million and incurred noncash charges from asset write-downs of $650 million related to this restructuring. During both Year 3 and Year 4, HP recorded additional restructuring "with the intent of better managing HP's cost structure and aligning certain of its operations more effectively with current businesses conditions." Of the $800 million charge for Year 3, HP had paid out $233 million by the end of the year and reported asset write-downs of $180 million. Of the $114 million charge for Year 4, HP reports no payments or asset write-downs. 4. Gains/losses on investments and early extinguishment of debt. HP's investments include debt and equity securities in public and privately held emerging-technology companies. HP realized gains and losses on sales of these investments during Years 1 through 4. However, in Year 1 the firm recorded impairment losses of $471 million, which is included in the $419 million loss reported for the year. It recognized impairment losses of $106 million in fiscal Year 2 (included in the $56 million

gain for the year). This line item also includes small gains recorded by HP for early extinguishment of debt in Year 2 and Year 3. 5. Litigation dispute settlement. On June 4, Year 1, HP and Pitney Bowes announced that they had entered into agreements that resolved all pending patent litigation between the parties without admission of infringement; accordingly, HP paid Pitney Bowes $400 million in cash on June 7, Year 1. On May 14, Year 4, HP announced that it had resolved a dispute regarding certain contracts with the government of Canada. HP Canada, a wholly owned subsidiary of HP, made payments to the government of Canada resulting in a charge of $70 million in the second quarter of Year 4.
Required
a. For each of the five categories of income items described previously for Year 1 through Year 4, discuss whether you would eliminate it when using earnings to forecast future profitability of HP. Discuss the logic for your decision.
b. Prepare a pro forma income statement for Year 1 through Year 4, assuming that you make an adjustment for each of the five categories of income statement items.
c. Refer to Exhibit 6.30, which reports HP's statement of cash flows for Year 1 through Year 4. Note that cash flows from operations, under "adjustments to reconcile net earnings (loss) to net cash provided by operating activities," includes add backs for income items (1) through (3), but not for income items (4) and (5). Does this mean that no cash was used or received related to items (1) through (3), but cash was used or received related to items (4) and (5)? Explain your answer.
d. The majority of the goodwill reported at the end of Year 4 relates to the acquisition of Compaq by HP in Year 2. HP must test the Compaq goodwill for impairment every filing year. Refer to the HP web site (www.hp.com) and recap the firm's most recent disclosures for testing the goodwill generated by the Compaq acquisition in Year 2.