02. Analyzing Financing Activities
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Overview of the Chapter
Current and Noncurrent Liabilities Liabilities
Lease Obligations
Pension Liabilities
Contingent Liabilities & Commitments
Deferred credits or income
Off-Balance-Sheet Financing
Liabilities at the Edge of Equity
Equity Financing
Book Value per Share
Analysis of Liabilities Areas of observations: observations:
We need to make sure that companies account for all of them with proper details as to their amounts, due dates including conditions, encumbrances and limitation Most companies look for ways to reduce the amount of liabilities reported in the financial statements We must recognize that companies can misclassify or inadequately describe liabilities
Where and How to Look?
Auditors are one source of assurance in our search Auditors tools include; direct confirmation, review board minutes, reading contract and agreement, inquiry In double entry system helps auditors and us Most difficult item includes commitment and contingent liabilities require no entry To understand it, we need to study management discussion, reconciliation, notes
Example of motivated transactions SEC determined Ampex Corporation failed to fully disclose:
Its obligation to pay royalty guarantees of 80 million A several million dollar understatement in the allowance for doubtful accounts receivable Income overstatement from inadequate credit allowances for returned tapes
Important Features in Analyzing Liabilities
Terms of indebtedness ( maturity, interest rate) Restrictions on deployment of resources and freedom in business activities Ability and flexibility in pursuing further financing Working capital, debt to equity Dilutive conversion features that liabilities are subject to Prohibition on certain disbursements such as dividends
Current Liabilities
Commercial paper borrowings should be separately disclosed in the balance sheet Average interest rate and terms to be separately stated for short term bank and commercial paper borrowings at the balance sheet date Disclosure of amounts and terms of unused line sfor credit for short term borrowings arrangements
Noncurrent Liabilities
Information on noncurrent liabilities should include interest rate, maturity date, conversion privileges, call features, subordination provision, and restrictions Companies must disclose any defaults of debt provisions, including defaults of interest and principal repayments Important items: purchase commitments which is unconditional purchase obligations. Footnote disclosure is required
Purchase Obligations
Description and term of obligation
Total fixed in determinable obligation
Description of any variable obligation
Amounts purchased under obligation
For purchase obligations that are recognized on purchaser’s balance sheet, a company must report payment for each of the next five years
Analysis Implications of Liabilities
Since liabilities are claims against a company’s assets, we need to assure that all of them are shown in details including conditions, encumbrances, and limitation s they impose on a company We must also recognize that companies can misclassify or inadequately describe liabilities Most difficult items are those relating to commitments and contingent liabilities requiring no entry In this case we must rely on management comment and information provided in the notes
Lease Obligations
Lease obligations are contractual agreements between a lessor and a lessee giving the lessee a right to use assets owned by a lessor for the lease term in return for rental payments Most common classification is: capital lease, operating lease Conditions for a lease to qualify as capital lease or finance lease
Sale and lease-back
Leveraged lease-when lessor borrows heavily
Pension Liabilities
Pension Liabilities are obligation of an employer US size is 25 percent of NYSE common stock and nearly one third of the daily trading volume Pension invites costs for the organizations and also attracts accounting issues Pension expense is a measure of the current cost of providing for future promised benefits under plan Pension expense derives from accrual accounting and is distinct from funding of pension Funding refers to transfer of cash or assets to the fund
Pension Liabilities
Defined benefit pension plans specify the amount of pension benefits, where company bears the risk of pension fund performance Defined contribution pension plans specify contributions required of the company. Benefits depends on performance Our concern is accounting for defined benefit pension plans Usually the benefits are determined by actuarial variables like age, life expectancies, turnover rate, future salary levels, future return on funds
Nature of Pension Liabilities
There are three different estimates of pension obligations: Projected benefit obligation (PBO) Accumulated benefit obligation (ABO)
Vested benefit obligation (VBO)
Example in the Table…………
Disclosure requirements include: Desccription of coverage, Net periodic pension cost for the period, Reconciliation of funded status, various assumption Show Table in the book for detail
Analysis Implications of Pension Liabilites
Benefits on future pay, sometimes understates liability
It ignores inflation impact, future pay increase
Discount rate is also an important issue
Preferred measure-difference between PBO and fair value of pension assets High performing equity market reduce or eliminate pension liabilities and vice versa Unfunded pension obligations are continually subject to change
Contingent Liabilities
Contingencies refer to potential gains or losses whose resolution depends on one or more future events It may arise from litigation, collectivity of receivables, claims against product warranty, guarantees of performance, tax assessments, self insured risks etc. Two criteria: (1) must be probable, (2) the loss must be reasonably estimable….like uncollectible receivables or product warranty Companies usually do not recognizes gain contingency
Off-Balance Sheet Financing
It refers to non recording of certain financing obligations like operating lease
Example: Through-put agreement,
Take or pay arrangement
Creating separate entity with less than 50 percent ownership and not consolidation with balance sheet Product financing arrangements-Sells and agrees to either repurchase or guarantee selling price to third parties Receivable selling with or without recourse
Liabilities at the “Edge” of Equity
We need to be alert to equity securities (typically preferred stock) that may become liability Company may need to pay funds at specific dates Redeemable preferred stock significantly different from equity stock and should not be included in the shareholders’ equity Company should disclose the redemption terms and five year maturity data They are an obligation to pay cash at a future date
Treasury Stock
It represents shares of a company’s stock reacquired after previously issued. Purchasing treasury stock reduces both assets and shareholders equity Treasury stock is not an asset it is a contra equity account Treasury stock is typically recorded at cost In rare cases, it is reported as assets when companies reserves it for purposes like profit sharing, acquiring another company
Deferred Tax
Deferred taxes are postponed tax effects attributed to temporary difference between taxable and accounting income Major items cause deferred tax are; depreciation, inventory, pensions, Nonpension benefits, discontinued segments A company may choose accelerated depreciation for tax purpose and straight line for accounting Result: tax deferral in early years and tax catch up in later years
Book Value Par Share
Book value per share is the per share amount resulting from company’s liquidation at amounts reported on its balance sheet In other words net asset value-total assets reduced by claims against them The book value of common stock is equal to total assets less liabilities and claims of securities senior to common stock such as preferred stok Liquidation premium on preferred stock can significantly impact book value of common stock
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