1. In 2013, several data server companies took a dramatic decision to begin using energy surcharges to recapture rising energy costs. However, customers are critical of how the energy surcharges are being allocated. Specifically, the data server companies allocate costs based on bandwidth available to customers. Customers however prefer allocations to be based on actual usage metrics such as data-bytes transferred or data-stored in servers. The US Department of Energy has hired your team to provide a recommendation on the allocation. How would you allocate and provide an illustrative example

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2. One of the super-quants on your team was able to adapt the learning curve formula to predict the failure rate of servers in the server farm.

F(x) = Ae^(Gx) ? 8.8e^(0.08(10x) F(x) = number of failures in a population of 100,000 servers of age x A = Initial mortality rate G = Exponential rate of increase mortality for an increase in age x e = Mathematical expression (Function EXP in excel) which approximates 2.71828...

Based on the equation above derive failure rate from age 2.5 to 9.0 years.

Assume the average server costs $100,000 and the average age of your server farm is 7 years. Your ops team suggest that they are reducing the average failure rate of your server farm from 4% to 1% in order to service enterprise customers ? what would this mean to your cost basis?

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3.

Read ?One Number to Manage Your SaaS Sales &Marketing Spend: The CAC ratio? ? by Bessemer Ventures

Read ?The unprofitable SaaS business model trap? ? by Jason Cohen

Review Workday?s non-GAAP financial data and answer the key questions below

Calculate: i. CAC ratio for Workday for year ended JAN 31, 2013. ii. Compare Workday?s performance against Cohen?s analysis below:

Say the average customer represents R dollars in annual revenue. That?s:

iii. What in Workday?s cost structure do you think is driving Workday?s stock performance?

? $4R of revenue over the lifetime of the customer. But: ? $1.5R is spent to acquire the customer (the pay-back period). ? $1.2R is spent in gross margin to service the customer (4 years times 30% cost). ? $0.6R spent on R&D (15% over 4 years). ? $0.6R spent on Admin (15% over 4 years).

So out of the original $4R, we?re left with $0.1R in profit. That?s 1/40th of the revenue making its way to actual bottom-line profitability, and even that takes 4 years to achieve.

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4.Review FY 2012 results for ITT Educational Services.

Calculate break-even point based on number of student enrollments based on 2012 results. Show all of the exclusions and assumptions made (e.g. exclusion of non-cash charges, revenue per student etc.)

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5.Review the article Idle Capacity Costs: It Isn?t Just the Expense.

• ? Explain the authors? statement: ?Under an accounting system that assigns excess capacity costs to current production and an incentive system that rewards short-term decision making, companies produce more vehicles than they can sell.?
• ? How does the authors? proposal for additional disclosure reconcile GAAP vs. Non-GAAP [1.5 page limit]

CAPSTONE PROJECT With a rockstar consulting team assembled ACCY320, LLC has set you lose on solving a set of cases. The cases are meant to test core concepts in the class. Rules of engagement 1. Presentation: Times New Roman, 12 font size, 1 inch margins 2. Length: Please stay within the suggested length of the problem. (e.g. Case ABC: [0.5 page limit]- means the solution should be 0.5 pages) 3. Back-up/Support: If you have appendices/files etc. - these MUST be in excel format and in ONE FILE with each problem in its own tab. Referencing should be based on the following convention: Problem#.Subsection reference.CellX#. For example: \"We derived a variance of $100 [Problem 1.Part a.CellD2]\" PROBLEM 1: Allocation of Fuel Charges In 2013, several data server companies took a dramatic decision to begin using energy surcharges to recapture rising energy costs. However, customers are critical of how the energy surcharges are being allocated. Specifically, the data server companies allocate costs based on bandwidth available to customers. Customers however prefer allocations to be based on actual usage metrics such as data-bytes transferred or data-stored in servers. The US Department of Energy has hired your team to provide a recommendation on the allocation. How would you allocate and provide an illustrative example. [0.5 page limit] PROBLEM 2: Assessment of Regression Analysis A team for SFSU, LLC performed an analysis of predicting overhead costs for a data center utilizing labor and/or machine hours. SE R-Squared T-values Machine-Hours Labor-Hours Regression 1 33,844 0.55 Regression 2 45,383 0.35 Regression 3 31,044 0.58 1.1 1.9 0.8 2.3 Which regression would you chose and why? [0.5 page limit] PROBLEM 3: Adapting the Learning Curve One of the super-quants on your team was able to adapt the learning curve formula to predict the failure rate of servers in the server farm. F(x) = Ae^(Gx) 8.8e^(0.08(10x) F(x) = number of failures in a population of 100,000 servers of age x A = Initial mortality rate G = Exponential rate of increase mortality for an increase in age x e = Mathematical expression (Function EXP in excel) which approximates 2.71828... Based on the equation above derive failure rate from age 2.5 to 9.0 years. Assume the average server costs $100,000 and the average age of your server farm is 7 years. Your ops team suggest that they are reducing the average failure rate of your server farm from 4% to 1% in order to service enterprise customers - what would this mean to your cost basis? [0.5 page limit] PROBLEM 4: Cost Volume Profit In the Face of Uncertainty A niche server manufacturer (the Company) is exploring changing its manufacturing practice. Its current product, DX38 is priced at $100. If demand picks up, it can raise prices, but competition may cap its ability of how much. Sales are expected to be 150,000 units for next year. Currently, the Company leases plant from HP using some of their equipment. The Company manufactures about 70% of the parts of this circuit board. It is considering a significant reengineering project to change the plant and manufacturing process. The project's objective is to increase the number of purchased parts (to about 55%) and reduce complexity of the process. This would enable the company to remove some leased equipment and to sell some of the most expensive equipment in the Plant. The per-unit manufacturing costs for 150,000 units for DX38 are as follows: Current Manufacturing Costs Proposed Manufacturing Costs Materials & purchased parts $6.00 $15.00 Direct Labor $12.50 $13.75 Variable Overhead $25.00 $30.00 Fixed Overhead $40.00 $20.00 Info. On DX38 Setups 3,000 2,300 Batch size 50 50 Cost per Setup $300 $300 Machine Hours 88,000 55,000 There are $10/unit commission costs and $1.25 million fixed costs for SG&A. These costs will remain under both circumstances. Your client has asked you for the following: i. Contribution margin per unit current vs. proposed? ii. At what level of unit sales would the Company be indifferent to the alternatives. iii. What is the Company's strategy & what does your team recommend it should be? (Support w/any external research on server pricing and demand) iv. Should the Company undertake the reengineering? Support your answer using sensitivity analysis. [2.0 page limit] PROBLEM 5: Target Costing With its booming server business, your client has increased the scope of its services to now sell insurance on its server farm. Unlike a traditional fee-for-service model, your client charges based on usage and fees incurred. The monthly rate is determined by the cost per enrolled company within an industry vertical. The average cost of insurance in the Tech sector is $368/month, irrespective of the amount of data stored/at-risk. HP wants to enter and offer a similar plan for Tech sector companies for $325/month. Your client wants to maintain its position and increase market share. Latest data on enrollments is as follows: Gigabytes stored 1 -to- 4 5 -to- 14 15 -to- 19 20 -to- 24 25 -to- 34 35 -to- 44 45 -to- 54 55 -to- 64 65 -to- 74 75 -to- 84 85 and above # of Customers Projected # of Customers Average Monthly Costs 45,688 48,977 $11,147,872 82,456 84,663 $10,059,632 95,873 95,887 $8,436,824 66,246 67,882 $9,539,424 133,496 132,554 $26,432,208 166,876 175,466 $38,882,108 85,496 90,899 $22,741,936 99,624 101,923 $28,691,712 156,288 161,559 $48,918,144 67,895 72,465 $33,132,760 23,499 26,849 $24,086,475 1,023,437 1,059,124 $262,069,095 i. Calculate the target cost required to maintain current market share & profit per enrollee. ii. Costs in the server industry applicable to the Company and HP are expected to increase 6% next year. The Company expects competitors to raise prices by $15, to $340. What's the new target cost assuming that the Company wants to maintain same profit per customer? [1.0 page limit] PROBLEM 6: It's all about variance There's significant pricing pressure in the client's market place. To compensate, a new incentive scheme has been released to compensate the team based on increase manufactured units and reducing costs. In response, the manufacturing unit is now pushing well over \"normal levels\". The assembly team puts together the parts for both the blades and the data readers. To hit the production levels, the assembly team simply rejects anything that comes through that is sub-par as opposed to reworking / modifying them. The team has also shifted to \"emergency maintenance\" only. The data below emerges. [3 page limit] Standard cost per manufactured unit: Cost System Materials Shelf Blade Data Reader Labor Assembly Blade Data Reader Std Cost / Unit Qty Cost 1.0 2.0 4.0 2.0 hrs 1.0 hrs 1.5 hrs Total $20 $15 $10 $20 $30 $40 $10 $11 $12 $20 $11 $18 COST PER UNIT $139 Contribution Margin report by Product Line: Budget Units Revenue 2000.0 Actual Variance 2200.0 200F $400,000 $396,000 $4,000U Materials Labor $180,000 $220,400 $40,000U $98,000 $112,260 $14,260U Total Variable Cost $278,000 $332,660 $54,660U Contribution Margin $122,000 $63,340 $58,660U Cost Detail: Item Materials Assembly (shelf) Blade Data Reader Labor Assembly Blade Data Reader Qty 2200.0 4700.0 9200.0 3,900 hrs 2,400 hrs 3,500 hrs Contribution Margin Actual Cost $44,000 $75,200 $101,200 $31,200 $31,060 $50,000 $332,660 Management Observations from plant interviews: Shelf and Blade groups adjusted to support production levels, however, both units had abnormal machine downtime and required increased overtime to keep up w/demand. Overtime was charged to direct labor Managers seemed to prefer part rejection as opposed to rework Assembly team compensated by increasing production by utilizing fewer hrs (Show all your formulas and calculation) i. Calculate Direct Materials price variance and usage variance. ii. Calculate Direct Labor efficiency and rate variance. iii. Sales price and volume variance. iv. Map out the components of the $58,660U variance. v. What's the conflict of interest between the groups here that is driving the variances? vi. What would you recommend to align interest? PROBLEM 6: Sales Productivity & Efficiency Read \"One Number to Manage Your SaaS Sales &Marketing Spend: The CAC ratio\" - by Bessemer Ventures Read \"The unprofitable SaaS business model trap\" - by Jason Cohen Review Workday's non-GAAP financial data and answer the key questions below: [ 3 page limit] Calculate: i. CAC ratio for Workday for year ended JAN 31, 2013. ii. Compare Workday's performance against Cohen's analysis below: Say the average customer represents R dollars in annual revenue. That's: $4R of revenue over the lifetime of the customer. But: $1.5R is spent to acquire the customer (the pay-back period). $1.2R is spent in gross margin to service the customer (4 years times 30% cost). $0.6R spent on R&D (15% over 4 years). $0.6R spent on Admin (15% over 4 years). So out of the original $4R, we're left with $0.1R in profit. That's 1/40th of the revenue making its way to actual bottom-line profitability, and even that takes 4 years to achieve. iii. What in Workday's cost structure do you think is driving Workday's stock performance? PROBLEM 7: Education & Profitability Review FY 2012 results for ITT Educational Services. Calculate break-even point based on number of student enrollments based on 2012 results. Show all of the exclusions and assumptions made (e.g. exclusion of non-cash charges, revenue per student etc.) [1.5 page limit] PROBLEM 8: GAAP vs. Cost Management Review the article Idle Capacity Costs: It Isn't Just the Expense. Explain the authors' statement: \"Under an accounting system that assigns excess capacity costs to current production and an incentive system that rewards short-term decision making, companies produce more vehicles than they can sell.\" How does the authors' proposal for additional disclosure reconcile GAAP vs. Non-GAAP [1.5 page limit] Idle Capacity Costs: It Isn't Just the Expense BY BRUCE BETTINGHAUS, PH.D.; MARINUS DEBRUINE, PH.D.; A N D PA RV E Z R . S O PA R I WA L A , P H . D . SFAS NO. 151 CALLS FOR MANUFACTURING FIRMS TO REPORT THE ABNORMAL LEVEL OF UNUSED FIXED COSTS AS A PERIOD COST AND NOT INCLUDE THESE COSTS IN PRODUCTS. WE FIND THAT NORMAL IDLE CAPACITY COSTS ARE QUITE LARGE AND RELEVANT TO INVESTORS. WE ALSO ARGUE THAT THESE UNUSED FIXED COSTS ARE MADE UP OF PAST, CURRENT, AND FUTURE CASH OUTLAYS, THE COMPOSITION OF WHICH SHOULD VARY WIDELY ACROSS FIRMS. BASED ON THESE OBSERVATIONS, WE ARGUE THAT THE CURRENT REPORTING STANDARD DOES NOT GO FAR ENOUGH. WE PROPOSE A STANDARD THAT REQUIRES FIRMS TO RECOGNIZE THE EXPENSE ON THE INCOME STATEMENT AND THE IDLE ASSETS ON THE BALANCE SHEET AND TO INCLUDE DISCLOSURES DETAILING THE BREAKDOWN OF THE EXPENSE BETWEEN CASH FLOWS AND ACCRUALS. of inventory produced, but we do not believe that they went far enough in advocating for improved disclosure of these costs of idle capacity. We further argue that the current standard does not go far enough. For many companies, the amount of abnormal unused capacity is not a material amount, but what many users of financial statements would be surprised to discover is the level of normal unused capacity. Consider the example of two firms, each which usually operates at less than 100% capacity. Firm A consistently operates at 95% capacity utilization (CU), and firm B ased on the changes in accounting for inventory costs created by Statement of Financial Accounting Standards (SFAS) No. 151, \"Inventory Costsan amendment of ARB No. 43, Chapter 4,\" Sid Ewer, Craig Keller, and Stevan Olson argued in a 2010 Strategic Finance article that more firms should be recognizing a line-item expense for the cost of abnormal idle capacity.1 We agree with their arguments that companies producing at an abnormally low level should not include the amount of unused fixed costs in the value B M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 1 WINTER 2012, VOL. 13, NO. 2 investors were given this information in a timely fashion, they would be better able to predict the future cash flows of the firm. We also provide data on idle capacity for General Motors North America (GMNA) operations for 2002 through 2008. During this period, GMNA reported losses of $27.6 billion, and, at the same time, the costs of its idle capacity totaled at least $32 billion. This demonstrates that, at least for GM, these costs clearly are material. consistently operates at 75% CU. If each of these firms had a down year and operated at 5% less, Ewer, Keller, and Olson would suggest that the companies each record a period expense of the 5% of fixed costs that they did not use that year. While this would be a step in the right direction, we believe that recording a period expense of 10% of fixed costs for firm A and 30% of fixed costs for firm B would be much more informative to investors and would be strong motivation to the managers of firm B to trim (or justify) their capacity costs. The current standard that calls for the reporting of abnormal idle capacity seems to result in no disclosure, even when idle capacity is quite large. We were surprised to find out that of the two U.S. and two Japanese companies we reviewed for this articleGeneral Motors (GM) and Ford, headquartered in the United States, and Toyota and Honda, headquartered in Japanonly Toyota included any mention of SFAS No. 151 as part of its footnote on newly adapted SFAS. Not surprisingly, Toyota anticipated that the new rule would have no material impact on its financial statements. Additionally, we argue that the recognition of the expense is not enough because not all expenses are created equal. If a company's unused capacity is primarily depreciation, then it has little impact on future operations. But if the expense for idle capacity primarily includes charges for taxes, utilities, insurance, and fixed labor costs, then these cash outflows preclude the company from investing in other activities that would bring it future returns. Finally, we agree with Ewer, Keller, and Olson that if a firm has separable asset groups that are idle, it should not include these assets in property and plant but should report them in an investment category. We believe that a complete standard should require companies to recognize the expense on the income statement and the idle assets on the balance sheet and, perhaps most important, to include a footnote disclosure detailing the breakdown of the expense between cash flows and accruals.2 To support our arguments, we analyzed the four automakers. This analysis demonstrates that capacity utilization is informative in predicting future operating profitability. We find that changes in current year CU are negatively related to the next year's gross margin. If M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY A R E C A PA C I T Y U T I L I Z AT I O N R AT E S R E L E VA N T TO I N V E STO R S ? Under an accounting system that assigns excess capacity costs to current production and an incentive system that rewards short-term decision making, companies produce more vehicles than they can sell. In a 2011 article, Alexander Brggen, Ranjani Krishnan, and Karen Sedatole found that, compared to one-year-ahead forecasted production numbers, the Big Three automakers increase production by one-half percent for each one percent increase in excess capacity.3 Because this extra production needs to be moved, they argue that such excess production increases the need for advertising and price discounting. They find a positive relationship between excess production and advertising expenditures, rebate percentages, and inventory build-up. Finally, they argue that the price discounting damages brand imagean intangible asset that the current accounting system ignores. Brand image is important to companies and investors to the extent that it translates into company value and share price. Even as current price discounting affects brand image negatively, it also affects a company's current performance. Together with increased inventory carrying costs associated with excess production, current price discounting should affect current selling prices and current gross margins negatively. Of course, selling prices may also decrease asover timecompanies change the lineup of vehicles they produce. In addition, if, over time, there is a move toward smaller vehicles that demand lower selling prices without a proportionate decrease in production costs, then gross margins will decline as well. But if price discounting drives down gross margins, then a review of the auto industry's performance and production numbers should reveal that relationship. 2 WINTER 2012, VOL. 13, NO. 2 of the cost of idle capacity (i.e., no recognition). We compare this to our recommended treatment, where the cost of idle capacity is recognized as a separate line item in the income statement for financial reporting. Our goal is to demonstrate that the normal costs of idle capacity are quite large and that, by anyone's definition, they meet the materiality standards for recognition. We compiled GMNA's sales revenues, pre-tax net incomes, and two-shift rated capacity utilization ratios for fiscal years 2002 through 2008 from GM press releases reporting the unaudited annual results.5 During this period, GMNA was responsible for 58% to 75% of the entire company's total auto revenue. GMNA was profitable in the first three years of this period but was in a loss position for the remaining four years. During the whole period, it operated between 75% and 92% of capacity based on the capacity potential of two shifts per plant. While GM reports its capacity as a percentage, it does not calculate a dollar value for the unused capacity. Using both press releases and annual reports, we were able to estimate the dollar value of fixed costs for GMNA to be between $40 billion and $29 billion (see Table 1). We also extracted GMNA's pro-forma income statements for fiscal years 2002 through 2008 from GM's press releases, which revealed that GMNA lost about $27.5 billion during that time. We use the reported capacity utilization ratios and our estimates of total fixed costs to separate total costs into the cost of resources used and the cost of idle capacity.6 These estimates of idle capacity range from $2.5 billion in 2006, when GMNA had made drastic cuts in fixed costs, to $7.3 billion in 2008, when GMNA sales fell by more than 25% from the year before (see Table 2). Over the period of fiscal years 2002 through 2008, GMNA's total operating income, i.e., sales revenue less the cost of resources used to earn the sales revenue, was about $4.4 billion, whereas its cost of idle capacity over the same period was about $32 billion. These amounts are clearly material to the interpretation of financial performance. Might General Motors Corporation have taken, or been forced to take, the appropriate corrective actions to reduce its idle capacity and avoid bankruptcy if financial reporting had required disclosure of the cost of idle capacity? To test the relationship between current and future gross margins, we obtained select capacity, production, and sales volume data from AutomotiveNews.com and PWC Autofacts for GM, Ford, Toyota, and Honda over nine years.4 The time period we studied was from 1999 through 2007, which resulted in 36 company-year observations. The gross margin data for those company-years came from the COMPUSTAT database. Our review of the data from those auto manufacturers found that current-year excess production (and thus current-year higher capacity utilization) was associated with currentyear and next-year gross margins. Our results support the hypothesis that companies' gross margins suffer while they produce and sell more vehicles than the market can sustain. The results of our study are based on normal capacity utilization numbers. We believe that capacity utilization numbers should be based on practical or even theoretical capacity, which we suspect would significantly decrease the reported capacity utilization for the domestic auto manufacturers. Because such numbers currently are not reported, we can only speculate how those utilization numbers would have affected the relationship between production and reported gross margins. Armed with the knowledge that low capacity utilization fuels excess production that lowers gross margins, we believe that capacity utilization disclosures of any kind will alert investorsand thus company managementto the need for bringing these numbers in line with the rest of the industry. The current accounting system rewards behavior that affects current and future gross margin levels negatively. Because (projected) gross margin factors heavily into the determination of company value and share price, company executives and investors should pay close attention to production and capacity levels. A change in the accounting for idle capacity costs would result in costs that are not affected by production levels, thus breaking the link between excess capacity and excess production and averting the downward spiral effect of rewarding dysfunctional behavior. I D L E C A PA C I T Y AT GMNA We use the North American Operations of General Motors Corporation to illustrate the current treatment M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 3 WINTER 2012, VOL. 13, NO. 2 Table 1: General Motors North America (GMNA) Operations Estimates of Fixed Costs Panel A: Details Extracted from General Motors Press Releases [amounts in millions] GMNA sales revenue GMNA pre-tax income GMNA capacity utilization [two-shift rated] [two-shift rated, annualized] 2002 $114,444 $ 4,198 2003 $116,310 $ ,915 2004 $114,582 $ 1,137 88.4% 89.7% 85.8% 2005 $104,755) $ (9,747) 2006 $109,779) $ (6,903) 2007 $112,448) $ (3,290) 2008 $( 86,187) $ (13,903) 89,80% 92.40% 88.30% 74.70% 2005 $40,000 2006 $33,200 2007 $31,000 2008 $29,000 Panel B: Estimation of GMNA's Fixed Costs [amounts in millions] GMNA fixed costs 2002 $40,000 2003 $40,000 2004 $40,000 Jobs Bank program effectively converted labor costs from a variable cost to a fixed cost. During the time period under study here, the Jobs Bank participation approached 15,000 in early 2006 when the labor force at several factories converted to that program.9 At the same time, and in order to protect high-paying jobs, the UAW resisted the introduction of capital-intensive robotics already used in the U.S. plants of Japanese and German car manufacturers. While more than two-thirds of the transplants' production lines accommodated different vehicles, only one-third of the Big Three plants were expected to get similarly equipped by 2005.10 Taken together, this suggests a significant difference in the makeup of the fixed costs at U.S. plants when comparing domestic to foreign automakers. Fixed costs at the domestic plants require more current and future cash outlays than those at the foreign automaker plants with more capital-intensive assembly lines. Except as outlined in the next paragraph, this difference in cash outlays for fixed costs applies equally to the fixed costs associated with excess capacity. Moreover, if the domestic automakers have more excess capacity than the foreign automakers, then their cash outlays associated with the excess capacity still would be higher. GMNA's annual fixed costs from 2002 through 2008 ranged from $29 billion to $40 billion. Its depreciation W H Y C A S H F L O W I S I M P O R TA N T Operating expenses on the income statement represent the variable and fixed costs incurred (or allocated) to generate that period's revenues. Some fixed costs represent outlays in prior periods (e.g., capital investments), some represent outlays in future periods (e.g., postretirement costs other than pensions), and the remainder represent current outlays (e.g., labor costs, insurance, utilities). Costs representing prior-period cash outlays, such as depreciation, are sunk; most other fixed costs represent current and future cash outflows, which compete with those meant for other purposes, such as reducing debt or paying dividends. This section will illustrate that, in the years before 2008, the domestic automakers faced proportionately more current and future cash outlays related to their excess capacity than did their \"transplant\" competitors. (Transplants are companies owned abroad with plants in the United States.) During the 1980s, the UAW negotiated the installation of a Jobs Bank with the Detroit Big Threea program under which laid-off workers would continue to receive up to 95% of their wages; that lasted until the end of 2008.7 At that time, domestic car makers required 40 to 50 hours to build a typical vehicle almost twice the hours required by the Japanese.8 The M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 4 WINTER 2012, VOL. 13, NO. 2 Table 2: GMNA OperationsEstimates of Idle Capacity Panel A: Income StatementExtracted from Information in General Motors Press Releases [amounts in millions] Sales revenue Total costs Pre-tax net income 2002 $114,444 $110,246 $ 4,198 2003 $116,310 $115,395 $ 915 2004 $114,582 $113,445 $ 1,137 2005 $104,755) $114,502) $ (9,747) 2006 $109,779) $116,682) $ (6,903) 2007 $112,448) $115,738) $ (3,290) 2008 $ 86,187) $100,090) $ (13,903) 2002-2008 total Amount % $758,505) 100.0% $786,098) 103.6% $ (27,593) -3.6% Panel B: Income StatementUsing Estimated Fixed Costs and GMNA's Two-Shift Rated Capacity Utilization [amounts in millions] 2002-2008 total 2002 2003 2004 2005 2006 2007 2008 Amount % Sales revenue $114,444 $116,310 $114,582 $104,755) $109,779) $112,448) $ 86,187) $758,505) 100.0% Cost of resources used $105,606 $111,275 $107,765 $110,422) $114,159) $112,111) $ 92,753) $754,091) 99.4% Operating income $ 8,838 $ 5,035 $ 6,817 $ (5,667) $ (4,380) $337) $ (6,566) $ 4,414) 0.6% Cost of idle capacity $ 4,640 $ 4,120 $ 5,680 $ 4,080) $ 2,523) $ 3,627) $ 7,337) $ 32,007) 4.2% Pre-tax net income $ 4,198 $ 915 $ 1,137 $ (9,747) $ (6,903) $ (3,290) $(13,903) $ (27,593) -3.6% Panel C: Notes to the Financial Statements [amounts in millions] GMNA depreciation % of estimated fixed costs Cost of idle capacity components Cash outflows Accruals Total 2002 $4,751 11.9% 2003 $6,199 15.5% 2004 $6,381 16.0% 2005 $7,605 19.0% 2006 $5,691 17.1% 2007 $5,612 18.1% 2008 $5,844 20.2% $4,089 $ 551 $4,640 $3,482 $ 638 $4,120 $4,774 $ 906 $5,680 $3,304 $ 776 $4,080 $2,091 $ 433 $2,523 $2,970 $ 657 $3,627 $5,858 $1,479 $7,337 $26,568 $ 5,439 $32,007 outlays from each vehicle soldcash outlays that the transplants did not face and that could have been used to lower prices, pay down debt, make investments in new technology, or pay dividends (see Table 2). Instead of dedicating all current and future cash outlays to current and future production, GMNA committed a substantial portion of its annual cash outlays to support its excess capacity. Besides having the cost of idle capacity shown separately from its cost of goods sold, it would be useful to require a further division of those idle capacity costs in the notes to the financial statements. Not all costs of idle capacity are incurred ranged from about 12% to 20% of its annual fixed costs during this period. Using the reported depreciation and our estimated fixed costs, we calculate how the cost of idle capacity was divided between current and future cash flow. On average, only 17% of the estimated $32 billion was depreciation, which leaves $26.5 billion that GMNA lost in cash over this period. To illustrate how this translates to the cost of each vehicle, we look at a single year: 2005. In that year, GMNA produced 4.6 million vehicles and sold 5.1 million vehicles. Based on its two-shift capacity utilization, its idle capacity costs took away about $650 in current and future cash M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 2002-2008 total Amount % 5 WINTER 2012, VOL. 13, NO. 2 83.0% 17.0% 100.0% posed earlier meets these four criteria. The cost of idle capacity is a relevant figure for both managers and investors. Some companies calculate the information for internal purposes, and analysts spend their resources estimating the costs of idle capacity. The fact that analysts try to estimate this expense, combined with the predictive value, and the clear materiality of idle capacity costs tell us that this is relevant information. Currently, outside analysts can measure this reliably enough to publish estimates of firms' capacity, and investors rely on these estimates. The techniques to measure these costs would only benefit from the FASB's due process of standard setting. equally, nor do they have the same impact on current and future cash outflows. Users reading such disclosures would realize thatat least in GMNA's casethe majority of those idle capacity costs represent very real (and perhaps avoidable) cash outlays. In turn, this should encourage management to negotiate contract changes in a more timely fashion. O U R S TA N DA R D M E E T S THE CRITERIA The fundamental premise of our article is that a reporting standard that required a period expense on the income statement, a separate line item on the balance sheet for idle assets, and a footnote disclosure detailing the cash flow portion of the expense might have saved General Motors from bankruptcy if it and others had been required to disclose the cost of idle capacity in their financial statements.11 Such disclosure of the cost of idle capacity, which amounted to billions of dollars, might have prompted the automakers to fix the idle capacity problem instead of allowing it to fester until it was too late. We maintain that recognition of the cost of idle capacity would have been beneficial for the bankrupt automaker and would be beneficial for investors and creditors of all manufacturers in the future. We have seen where a new required disclosure changes managers' real economic decisions. Perhaps the best example of this is the requirement to report a liability for postretirement benefits. After this standard became effective, employers moved quickly to curtail these plans. The objective of financial reporting is to help investors and creditors assess the amount, timing, and uncertainty of future cash flows for the compoany.12 We believe that removing the cost of idle capacity, if material, from the cost of goods sold and reporting the two separately will meet this objective. We maintain that this separation is worthy of recognition, not just disclosure. Statement of Financial Accounting Concepts No. 5, \"Recognition and Measurement in Financial Statements of Business Enterprises,\" explains that to qualify to be recognized, an item should meet four criteria. The item should meet the definition of an element, be measurable, be relevant to financial statement users, and reliably represent the economics of the transaction.13 We believe that the reporting standard pro- M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY Bruce Bettinghaus, Ph.D., is an assistant professor in the School of Accounting at the Seidman College of Business at Grand Valley State University in Allendale, Mich. He can be reached at (616) 331-7154 and bettingb@gvsu.edu. Marinus Debruine, Ph.D., is an associate professor in the School of Accounting at Grand Valley State University and can be reached at debruinm@gvsu.edu. Parvez Sopariwala, Ph.D., is a professor in the School of Accounting at Grand Valley State University and is a member of the Grand Rapids Chapter of IMA. He can be reached at sopariwp@gvsu.edu. E N D N OT E S 1 Sid R. Ewer, Craig Keller, and Stevan Olson, \"No Equivocating: Expense Those Idle Capacity Costs, Strategic Finance, June 2010, pp. 55-59. Note: Although the actual SFAS No. 151 does not show up in the cross reference of the FASB Accounting Standards Codification, the standard it modified, ARB No. 43, does. It is now in Inventories (330-10-30-(3-7)). The particular language is in paragraphs 6 and 7. 2 Ideally we would like to see a line item on the statement of cash flows, but with the resistance in the preparer community to a direct statement of cash flows, we think that it is unlikely that level of recognition would be generally accepted. 3 Alexander Brggen, Ranjani Krishnan, and Karen L. Sedatole, \"Drivers and Consequences of Short-Term Production Decisions: Evidence from the Auto Industry,\" Contemporary Accounting Research, Spring 2011, pp. 83-123. 4 \"Global Market Data,\" Automotive News, June 25, 2007; retrieved April 16, 2010, from www.automotivenews.com. 5 We recognize that the sales revenues and pre-tax net incomes reported in the press releases are unaudited. Because capacity utilization ratios are revealed only in press releases, however, we also use the sales revenues and pre-tax net incomes from the press releases for consistency. 6 WINTER 2012, VOL. 13, NO. 2 6 For example, GMNA's cost of used resources and cost of idle capacity for 2007 are computed as follows. As GMNA's capacity utilization ratio for 2007 is 88.30% and its estimated total fixed costs are $31 billion, its 2007 cost of idle capacity is $3.627 billion [(100% - 88.30%)($31 billion)]. As GMNA's 2007 total costs are $115.738 billion, its 2007 cost of used resources is $112.111 billion [$115.738 billion - $3.627 billion]. 7 Mike Ramsey, \"GM, Chrysler Win Union Concessions to Bolster Aid Bid,\" Bloomberg News, December 3, 2008; retrieved July 3, 2010, from www.Bloomberg.com. 8 Laurie Harbour-Felax, \"State of the Industry,\" Automotive Design & Production, December 2006, pp. 22-24. 9 Jeffrey McCracken, \"Detroit's Symbol of Dysfunction: Paying Employees Not to Work,\" The Wall Street Journal Online, March 1, 2006; retrieved July 3, 2010, from http://online.wsj.com/ article/SB114118143005186163.html. 10 Daren Fonda, \"Why the Most Profitable Cars Made in the U.S.A. Are Japanese and German,\" TIME, May 11, 2003; retrieved July 3, 2010, from http://www.time.com/time/ magazine/article/0,9171,451002,00.html. 11 We suspect that Chrysler had many of the same issues with idle capacity and might have been better off with these proposed reporting rules. Because they were part of Daimler or held by a private firm during the period we studied, we cannot make the same type of estimates of their idle capacity costs. 12 Financial Accounting Standards Board (FASB), Statement of Financial Accounting Concepts No. 1, \"Objectives of Financial Reporting by Business Enterprises,\" 1978, superseded by Statement of Financial Accounting Concepts No. 8, \"Conceptual Framework for Financial Reporting,\" 2010. 13 Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, \"Recognition and Measurement in Financial Statements of Business Enterprises,\" 1984. M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 7 WINTER 2012, VOL. 13, NO. 2 1/1/14 ITT Educational Services, Inc. Reports 2012 Fourth Quarter and Full-Year Results - Jan 24, 2013 Over 140 campuses nationwide News Releases ITT Educational Services, Inc. Reports 2012 Fourth Quarter and Full-Year Results Jan 24, 2013 CARMEL, Ind., Jan. 24, 2013 /PRNewswire/ -- ITT Educational Services, Inc. (NYSE: ESI), a leading provider of technology-oriented postsecondary degree programs, today reported that new student enrollment in the fourth quarter of 2012 decreased 11.4% to 13,398 compared to 15,125 in the same period in 2011. Total student enrollment decreased 16.6% to 61,059 as of December 31, 2012 compared to 73,255 as of December 31, 2011. The company provided the following information for the three and twelve months ended December 31, 2012 and 2011: Financial and Operating Data for the Three Months Ended December 31st, Unless Otherwise Indicated (Dollars in millions, except per share and per student data) Increase/ 2012 2011 (Decrease) Revenue $300.8 $368.3 (18.3)% Operating Income/(Loss) $(16.0) $126.6 N/M Operating Margin (5.3)% 34.4% (3,970) basis points Net Income/(Loss) $(9.5) $76.0 N/M Earnings/(Loss) Per Share (diluted) $(0.41) $2.87 N/M New Student Enrollment 13,398 15,125 (11.4)% Continuing Students 47,661 58,130 (18.0)% T otal Student Enrollment as of December 31st 61,059 73,255 (16.6)% Persistence Rate as of December 31st (A) 72.6% 73.4% (80) basis points Revenue Per Student $4,582 $4,649 (1.4)% Cash and Cash Equivalents, Restricted Cash and Investments as of December 31st $246.9 $379.6 (34.9)% Bad Debt Expense as a Percentage of Revenue 6.9% 4.7% 220 basis points Days Sales Outstanding as of December 31st 23.6 days 12.0 days 11.6 days Deferred Revenue as of December 31st $135.9 $226.5 (40.0)% Debt as of December 31st $140.0 $150.0 (6.7)% Weighted Average Diluted Shares of Common Stock Outstanding 23,360,000 26,527,000 (B) Shares of Common Stock Repurchased 0 570,000 Number of New Colleges in Operation 0 5 Capital Expenditures, Net $2.4 $6.8 (65.1)% Financial and Operating Data for the Twelv e Months Ended December 31st (Dollars in millions, except per share and per student data) Revenue Operating Income Operating Margin Net Income Earnings Per Share (diluted) Bad Debt Expense as a Percentage of Revenue Revenue Per Student Weighted Average Diluted Shares of Common Stock Outstanding Shares of Common Stock Repurchased Number of New Colleges in Operation 2012 $1,287.2 $232.8 18.1% $140.5 $5.85 6.1% $18,625 2011 $1,500.0 $507.1 33.8% $307.8 $11.13 4.1% $18,370 23,999,000 3,025,700(C) 6 27,655,000 4,040,000(D) 11 $17.2 $26.9 Increase/ (Decrease) (14.2)% (54.1)% (1,570) basis points (54.4)% (47.4)% 200 basis points 1.4% Capital Expenditures, Net (35.9)% N/M means not meaningful. (A) Represents the number of Continuing Students in the academic term, divided by the T otal Student Enrollment in the immediately preceding academic term. (B) For approximately $34.6 million or at an average price of $60.71 per share. (C) For approximately $207.9 million or at an average price of $68.72 per share. (D) For approximately $282.7 million or at an average price of $69.98 per share. The attached Schedule A summarizes the company's: charges related to private student loan programs in the three months ended December 31, 2012; contingency reserve roll-forward in the three months ended December 31, 2012; and internal goals for the twelve months ending December 31, 2013. ITT Educational Services, Inc. will conduct a conference call with financial analysts to discuss its 2012 fourth quarter earnings at 11:00 am (ET) this morning. The public is invited to listen to a live webcast of the conference call. The webcast may be accessed by following the "Live Webcast" directions on ITT/ESI's website at www.ittesi.com. Except for the historical information contained herein, the matters discussed in this press release, including in the attached Schedule A, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements are made based on the current expectations and beliefs of the company's management concerning future developments and their potential effect on the company. The company cannot assure you that future developments affecting the company will be those anticipated by its management. These forward-looking statements involve a number of risks and uncertainties. Among the factors that could cause actual results to differ materially are the following: changes in federal and state governmental laws and regulations with respect to education and accreditation standards, or the interpretation or enforcement of those laws and regulations, including, but not limited to, the level of government funding for, and the company's eligibility to participate in, student financial aid programs www.ittesi.com/2013-01-24-ITT-Educational-Services-Inc.-Reports-2012-Fourth-Quarter-and-Full-Year-Results 1/5 1/1/14 ITT Educational Services, Inc. Reports 2012 Fourth Quarter and Full-Year Results - Jan 24, 2013 utilized by the company's students; business conditions and growth in the postsecondary education industry and in the general economy; the company's failure to comply with the extensive education laws and regulations and accreditation standards that it is subject to; effects of any change in ownership of the company resulting in a change in control of the company, including, but not limited to, the consequences of such changes on the accreditation and federal and state regulation of its campuses; the company's ability to implement its growth strategies; the company's failure to maintain or renew required federal or state authorizations or accreditations of its campuses or programs of study; receptivity of students and employers to the company's existing program offerings and new curricula; loss of access by the company's students to lenders for education loans; the company's ability to collect internally funded financing from its students; the company's exposure under its guarantees related to private student loan programs; the company's ability to successfully defend litigation and other claims brought against it; and other risks and uncertainties detailed from time to time in the company's filings with the U.S. Securities and Exchange Commission. The company undertakes no obligation to update or revise any forward-looking information, whether as a result of new information, future developments or otherwise. ITT EDUCATIONAL SERVICES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data) As of December 31, 2012 (unaudited) Assets Current assets: Cash and cash equivalents Short-term investments Restricted cash Accounts receivable, net Deferred income taxes Prepaid expenses and other current assets T otal current assets Property and equipment, net Deferred income taxes Other assets T otal assets Liabilities and Shareholders' Equity Current liabilities: Accounts payable Accrued compensation and benefits Other current liabilities Deferred revenue T otal current liabilities Long-term debt Other liabilities T otal liabilities Shareholders' equity: Preferred stock, $.01 par value, 5,000,000 shares authorized, none issued Common stock, $.01 par value, 300,000,000 shares authorized, 37,068,904 issued Capital surplus Retained earnings Accumulated other comprehensive (loss) T reasury stock, 13,744,395 and 10,969,425 shares, at cost T otal shareholders' equity T otal liabilities and shareholders' equity $246,342 0 601 77,313 44,547 16,162 384,965 189,890 56,112 41,263 $672,230 $228,993 148,488 2,128 48,106 9,759 18,814 456,288 201,257 33,267 38,006 $728,818 63,304 21,023 86,722 135,900 306,949 140,000 98,327 545,276 78,876 21,438 18,190 226,543 345,047 150,000 64,972 560,019 0 0 371 206,703 959,072 (7,930) (1,031,262) 126,954 $672,230 371 189,573 827,675 (9,479) (839,341) 168,799 $728,818 ITT EDUCATIONAL SERVICES, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data) Three Months Ended December 31, (unaudited) 2012 2011 $300,843 $368,263 Rev enue Costs and expenses: Cost of educational services Student services and administrative expenses Settlement cost * Loss related to private student loan programs ** T otal costs and expenses Operating income (loss) Interest income Interest (expense) Income (loss) before provision for income taxes Provision for income taxes Net income (loss) Earnings (loss) per share: Basic Diluted Supplemental Data: Cost of educational services Student services and administrative expenses Settlement cost Loss related to private student loan programs Operating margin Student enrollment at end of period Campuses at end of period Shares for earnings per share calculation: Basic Diluted Effective tax rate * See Schedule A attached hereto for additional information relating to the settlement cost. ** See Schedule A attached hereto for additional information relating to the loss related to private student loan programs. 129,394 94,566 21,750 71,102 316,812 (15,969) 40 (901) (16,830) (7,362) $(9,468) Twelv e Months Ended December 31, (unaudited) 2012 2011 $1,287,209 $1,499,949 131,605 110,087 0 0 241,692 126,571 561 (383) 126,749 50,701 $76,048 539,223 422,345 21,750 71,102 1,054,420 232,789 1,348 (3,723) 230,414 89,949 $140,465 553,065 439,808 0 0 992,873 507,076 2,902 (1,825) 508,153 200,401 $307,752 $(0.41) $(0.41) $2.89 $2.87 $5.88 $5.85 $11.22 $11.13 43.0% 31.4% 7.2% 23.6% (5.3%) 61,059 147 35.7% 29.9% 0.0% 0.0% 34.4% 73,255 141 41.9% 32.8% 1.7% 5.5% 18.1% 61,059 147 36.9% 29.3% 0.0% 0.0% 33.8% 73,255 141 23,360,000 23,360,000 43.7% 26,354,000 26,527,000 40.0% 23,880,000 23,999,000 39.0% 27,429,000 27,655,000 39.4% ITT EDUCATIONAL SERVICES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Cash flows from operating activ ities: Net income (loss) Adjustments to reconcile net income to net cash flows from operating activities: Depreciation and amortization Provision for doubtful accounts Deferred income taxes Excess tax benefit from stock option exercises Stock-based compensation expense Settlement cost December 31, 2011 Three Months Ended December 31, (unaudited) 2012 2011 Twelv e Months Ended December 31, (unaudited) 2012 2011 $(9,468) $76,048 $140,465 $307,752 7,305 20,827 (42,543) 0 3,612 21,750 7,518 17,290 4,017 (21) 4,236 0 29,350 78,307 (58,640) (1,382) 16,658 21,750 27,886 61,308 (8,991) (1,166) 17,074 0 www.ittesi.com/2013-01-24-ITT-Educational-Services-Inc.-Reports-2012-Fourth-Quarter-and-Full-Year-Results 2/5 1/1/14 ITT Educational Services, Inc. Reports 2012 Fourth Quarter and Full-Year Results - Jan 24, 2013 Asset impairment Other Changes in operating assets and liabilities: Restricted cash Accounts receivable Accounts payable Other operating assets and liabilities Deferred revenue Net cash flows from operating activities Cash flows from inv esting activ ities: Facility expenditures and land purchases Capital expenditures, net Proceeds from sales and maturities of investments and repayment of notes Purchase of investments and note advances Net cash flows from investing activities Cash flows from financing activ ities: Excess tax benefit from stock option exercises Proceeds from exercise of stock options Debt issue costs Proceeds from revolving borrowings Repayments of revolving borrowings Repurchase of common stock and shares tendered for taxes Net cash flows from financing activities Net change in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equiv alents at end of period 15,166 6,895 0 1,301 15,166 6,992 0 (1,936) 119 (8,715) (13,054) 67,882 16,811 86,587 (1,715) (9,256) (9,949) 6,047 497 96,013 1,527 (107,514) (15,572) 68,890 (90,643) 105,354 (1,873) (40,477) 10,956 35,118 (17,819) 387,832 (553) (2,384) 577 (12,342) (14,702) (924) (6,834) 24,323 (21,889) (5,324) (1,046) (17,204) 217,301 (75,887) 123,164 (4,053) (26,847) 337,032 (352,195) (46,063) 0 0 0 0 0 (1) (1) 71,884 174,458 $246,342 21 313 0 0 0 (34,607) (34,273) 56,416 172,577 $228,993 1,382 8,345 (1,525) 175,000 (185,000) (209,371) (211,169) 17,349 228,993 $246,342 1,166 5,599 0 0 0 (283,320) (276,555) 65,214 163,779 $228,993 Sche dule A (Dollars in millions, except per share data) T he following table sets forth the charges recorded by the company in the three months ended December 31, 2012, related to the 2009 RSA (a), the PEAKS Program(b) and the 2007 RSA (c). T he charges included: additional reserves recorded for the 2009 RSA and PEAKS Guarantee; an accrual for the settlement related to the 2007 RSA; and the impairment of certain assets related to the 2009 RSA and PEAKS Program. Charges Related to the Priv ate Student Loan Programs in the Three Months Ended December 31, 2012 Reserve for 2009 RSA and PEAKS Guarantee 2007 RSA Settlement Accrual 2009 RSA- and PEAKS Program-Related Asset Impairment Totals Rev enue Offset Operating Expense $10.2 Total Charges $55.9 21.8 15.2 $92.9 $10.2 $66.1 21.8 15.2 $103.1 T he following table sets forth the roll-forward of the company's contingency reserves in the three months ended December 31, 2012, which primarily related to the 2009 RSA, the PEAKS Guarantee and the 2007 RSA. T he changes to the company's contingency reserves included: additional reserves recorded for the 2009 RSA and PEAKS Guarantee; an accrual for the 2007 RSA settlement; guarantee and other payments made (net of recoveries) related to the 2009 RSA and PEAKS Program; and estimated recoverable amounts under the PEAKS Guarantee. Contingency Reserv e Roll-forward in the Three Months Ended December 31, 2012 Balance at September 30, 2012 Additional Reserves Payments, net Estimated Recovery Balance at December 31, 2012 2007 RSA All Other $24.2 21.8 0.0 0.0 $46.0 $20.1 66.1 (15.1) 6.7 $77.8 Total $44.3 87.9 (15.1) 6.7 $123.8 T he following table sets forth the range of the company's internal goals with respect to certain cash flow items and available borrowings in the twelve months ending December 31, 2013. Internal Goals for the Twelv e Months Ending December 31, 2013 Cash and Available Borrowings at January 1, 2013 Cash Flows from Operations before 2007 RSA Settlement and 2009 RSA and PEAKS Program Payments (CFOBRSA) (d) 2007 RSA Settlement Payment (actual) Payments Related to the 2009 RSA and PEAKS Program Cash Flows from Operations Capital Expenditures Cash and Available Borrowings at December 31, 2013 Low End of Range $430 141 (46) (20) High End of Range $430 151 (46) 75 (25) $480 (15) 90 (15) $505 T he following table sets forth the range of the company's internal goals for the twelve months ending December 31, 2013 with respect to: the percentage increase/(decrease) in New Student Enrollment in 2013 compared to 2012; the percentage increase/(decrease) in Revenue per Student in 2013 compared to 2012; Earnings Before Interest, T axes, Depreciation and Amortization ("EBIT DA")(e); and Earnings per Share (diluted). Internal Goals for the Twelv e Months Ending December 31, 2013 New Student Enrollment in 2013 compared to 2012 Revenue per Student in 2013 compared to 2012 Earnings Before Interest, T axes, Depreciation and Amortization (EBIT DA) Earnings per Share (diluted) Low End of Range (5.0)% (6.0)% High End of Range $165 $3.50 5.0% (4.0)% $190 $4.00 (a) On February 20, 2009, the company entered into agreements with an unaffiliated entity (the "2009 Entity") to create a program that made private education loans available to its students (the "2009 Loan Program"). Under the 2009 Loan Program, an unaffiliated lender originated private education loans to the company's eligible students and, subsequently, sold those loans to the 2009 Entity. No new private education loans were or will be originated under the 2009 Loan Program after December 31, 2011, but immaterial amounts related to loans originated prior to that date were disbursed by the lender through June 2012. In connection with the 2009 Loan Program, the company entered into a risk sharing agreement (the "2009 RSA") with the 2009 Entity. Under the 2009 RSA, the company guarantees the repayment of any private education loans that are charged off above a certain percentage of the private education loans made under the 2009 Loan Program, based on the annual dollar volume. During the three months ended December 31, 2012, the company made guarantee payments, net of recoveries, related to the 2009 RSA in the amount of approximately $0.6. In addition, the company has made advances to the 2009 Entity under a revolving promissory note (the "Revolving Note"). T he Revolving Note bears interest, is subject to customary terms and conditions and may be repaid at any time without penalty prior to its 2026 maturity date. T he company has no immediate plans to significantly increase the amount of advances that it makes to the 2009 Entity under the Revolving Note, but the company may decide to do so in the foreseeable future. T he face value of the Revolving Note as of December 31, 2012 was approximately $8.2. T he carrying value of the Subordinated Note (defined below in footnote (b)) and Revolving Note as of December 31, 2012 was approximately $2.9 and is included in Other assets on the company's Consolidated Balance Sheet. For additional information about the 2009 RSA, see the company's Form 10-Q filed with the Securities and Exchange Commission ("SEC") on October 29, 2012. (b) On January 20, 2010, the company entered into agreements with unrelated third parties to establish the PEAKS Private Student Loan Program ("PEAKS Program"). Under the PEAKS Program, an unaffiliated lender originated private education loans to the company's eligible students and, subsequently, sold those loans to an unaffiliated trust ("PEAKS T rust"). T he PEAKS T rust issued senior debt in the aggregate principal amount of $300 ("PEAKS Senior Debt") to investors. T he lender disbursed the proceeds of the private education loans to the company for application to the students' account balances, and the company transferred a portion of each disbursement to the PEAKS T rust in exchange for a subordinated note issued by the PEAKS T rust ("Subordinated Note"). No new private education loans were or will be originated under the PEAKS Program after July 2011, but immaterial amounts related to loans originated prior to that date were disbursed by the lender through March 2012. T he Subordinated Note is non-interest bearing and has been recorded net of an unamortized discount based on an imputed interest rate of 9.0% in Other assets on the company's Consolidated Balance Sheets. T he maturity date of the Subordinated Note is in March 2026. T he face value of the Subordinated Note as of December 31, 2012 was approximately $73.2. T he PEAKS T rust utilized the proceeds from the issuance of the PEAKS Senior Debt and the Subordinated Note to purchase the private education loans made by the lender to the company's students. T he assets of www.ittesi.com/2013-01-24-ITT-Educational-Services-Inc.-Reports-2012-Fourth-Quarter-and-Full-Year-Results 3/5 1/1/14 ITT Educational Services, Inc. Reports 2012 Fourth Quarter and Full-Year Results - Jan 24, 2013 the PEAKS T rust (which include, among other assets, the private education loans owned by the PEAKS T rust) serve as collateral for, and are intended to be the principal source of, the repayment of the PEAKS Senior Debt and the Subordinated Note. T he PEAKS T rust is required to maintain assets having an aggregate value that exceeds the outstanding balance of the PEAKS Senior Debt. T he company guarantees payment of the principal, interest and certain call premiums owed on the PEAKS Senior Debt, the administrative fees and expenses of the PEAKS T rust and the required ratio of assets of the PEAKS T rust to outstanding PEAKS Senior Debt ("PEAKS Guarantee"). During the three months ended December 31, 2012, the company made guarantee and other payments related to the PEAKS Program to the PEAKS T rust in the amount of approximately $14.6, primarily related to maintaining the required ratio of assets of the PEAKS T rust to outstanding PEAKS Senior Debt. T he carrying value of the Subordinated Note and Revolving Note as of December 31, 2012 was approximately $2.9 and is included in Other assets on the company's Consolidated Balance Sheet. For additional information about the PEAKS Program, see the company's Form 10-Q filed with the SEC on October 29, 2012. (c) In 2007, the company entered into a Risk Sharing Loan Program Agreement with Sallie Mae, Inc. ("SMI"), dated July 17, 2007, for certain private education loans that were made to the company's students in 2007 and early 2008 (the "2007 RSA"). T he company guaranteed the repayment of any private education loans that SMI charged off above a certain percentage of the total dollar volume of private education loans made under the 2007 RSA. On December 28, 2012, the company entered into a Settlement Agreement and Release (the "Settlement Agreement") with SMI to settle the previously disclosed litigation matter between SMI and the company relating to the 2007 RSA. Under the terms of the Settlement Agreement, the company agreed to pay a one-time payment of $46 to SMI on or before January 29, 2013. SMI and the company each also agreed to release the other (and their respective affiliates) from any and all current and future claims arising out of, or directly or indirectly related to, the 2007 RSA, other than claims related to certain provisions of the 2007 RSA governing cooperation, confidentiality, the treatment of intellectual property and certain indemnification claims related to the FT C Holder Rule. SMI specifically agreed to release the company from any and all of its guarantee obligations arising under the 2007 RSA, and the company agreed to release all right, title and interest in and to the loans made pursuant to the 2007 RSA, including any right to receive any payments related to any of those loans. For additional information about the 2007 RSA and the Settlement Agreement, see the company's Form 10-Q filed with the SEC on October 29, 2012 and the company's Form 8-K filed with the SEC on January 4, 2013. (d) Projected CFOBRSA is an estimate of the company's cash flows from operations before: (i) the company's payment under the Settlement Agreement discussed above in footnote (c); (ii) any payments by the company related to its guarantee obligations associated with the 2009 RSA discussed above in footnote (a); and (iii) any payments by the company related to the PEAKS Program discussed above in footnote (b). CFOBRSA is not a measurement under Generally Accepted Accounting Principles ("GAAP") in the United States and may not be similar to CFOBRSA measures of other companies. Non-GAAP financial information should be considered in addition to, but not as a substitute for, information prepared in accordance with GAAP. T he company believes that CFOBRSA provides useful information to management and investors as an indicator of the company's operating cash flows before certain items. Projected CFOBRSA is only an estimate and contains forward-looking information. T he company has made a number of assumptions in preparing the projection, including assumptions as to the components of the projected CFOBRSA. T hese assumptions may or may not prove to be correct. In order to provide projections with respect to CFOBRSA, the company must estimate amounts for the GAAP measures that are components of the reconciliation of projected CFOBRSA. Projected CFOBRSA can be reconciled to the company's projected cash flows from operations for the period indicated, as follows: PROJECTED For the Twelv e Months Ending December 31, 2013 Cash Flows from Operations Plus: 2007 RSA Settlement Payment Payments Related to the 2009 RSA and PEAKS Program CFOBRSA Low End of Range $75 46 High End of Range 20 $141 $90 46 15 $151 (e) Projected EBIT DA is an estimate of the company's net income plus interest, taxes, depreciation and amortization for the twelve months ended December 31, 2013. EBIT DA is not a measurement under GAAP in the United States and may not be similar to EBIT DA measures of other companies. Non-GAAP financial information should be considered in addition to, but not as a substitute for, information prepared in accordance with GAAP. T he company believes that EBIT DA provides useful information to management and investors as an indicator of the company's operating performance. Projected EBIT DA is only an estimate and contains forward-looking information. T he company has made a number of assumptions in preparing the projection, including assumptions as to the components of the projected EBIT DA. T hese assumptions may or may not prove to be correct. In order to provide projections with respect to EBIT DA, the company must estimate amounts for the GAAP measures that are components of the reconciliation of projected EBIT DA. By providing these estimates, the company is in no way indicating that it is providing projections on those GAAP components of the reconciliation. Projected EBIT DA can be reconciled to the company's projected net income for the period indicated, as follows: PROJECTED For the Twelv e Months Ending December 31, 2013 Net Income Plus: Interest expense Income taxes Depreciation and amortization EBIT DA Low End of Range $83 2 52 28 $165 High End of Range $96 3 62 29 $190 SOURCE ITT Educational Services, Inc. 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