Ch 03 - O Analyzing Financing Activities.pdf

Chapter 03 - Analyzing Financing Activities

Chapter 3 Analyzing Financing Activities REVIEW Business activities are financed through either liabilities or equity. Liabilities are obligations requiring payment of money, rendering of future services, or dispensing of specific assets. They are claims against a company's present and future assets and resources. Such claims are usually senior to holders of equity securities. Liabilities include current obligations, long-term debt, capital leases, and deferred credits. This chapter also considers securities straddling the line separating liabilities from equity. Equity refers to claims of owners to the net assets of a company. While claims of owners are junior to creditors, they are residual claims to all assets once claims of creditors are satisfied. Equity investors are exposed to the maximum risk associated with a business, but are entitled to all residual rewards associated with it. Our analysis must recognize the claims of both creditors and equity investors, and their relationship, when analyzing financing activities. This chapter describes business financing and how this is reported to external users. We describe two major sources of financing—credit and equity—and the accounting underlying reports of these activities. We also consider off-balance-sheet financing, including Special Purpose Entities (SPEs), the relevance of book values, and liabilities "at the edge" of equity. Techniques of analysis exploiting our accounting knowledge are described.

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OUTLINE 

Liabilities Current Liabilities Noncurrent Liabilities Analyzing Liabilities

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Leases Lease Accounting and Reporting – Lessee Analyzing Leases

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Postretirement benefits Pension Accounting Other Postretirement Benefits (OPEBs) Analyzing Postretirement Benefits

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Contingencies and Commitments Contingencies Commitments

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Off-Balance-Sheet Financing Through-put and Take-or-pay agreements Product financing arrangements Special Purpose Entities (SPEs)

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Shareholders’ Equity Capital Stock Retained Earnings Computation of Book Value Per Share

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Liabilities at the ―Edge‖ of Equity Redeemable Preferred Stock Minority Interest

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Appendix 3A: Lease Accounting – Lessor

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Appendix 3B: Accounting Specifics for Postretirement Benefits

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ANALYSIS OBJECTIVES 

Identify and assess the principal characteristics of liabilities and equity.

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Analyze and interpret lease disclosures and explain their implications and the adjustments to financial statements.

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Analyze postretirement disclosures and assess their consequences for firm valuation and risk.

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Analyze contingent liability disclosures and describe risks.

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Identify off-balance-sheet financing and its consequences to risk analysis.

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Analyze and interpret liabilities at the edge of equity.

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Explain capital stock and analyze and interpret its distinguishing features.

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Describe retained earnings and their distribution through dividends.

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QUESTIONS 1. The two major source of liabilities, for both current and noncurrent liabilities, are operating and financing activities. Current liabilities of an operating nature—such as accounts payable and operating expense accruals—represent claims on resources from operating activities. Current liabilities such as notes payable, bonds, and the current maturities of long-term debt reflect claims on resources from financing activities. 2. The major disclosure requirements (in SEC FRR, Section 203) for financing-related current liabilities such as short-term debt are: a. Footnote disclosure of compensating balance arrangements including those not reduced to writing b. Balance sheet segregation of (1) legally restricted compensating balances and (2) unrestricted compensating balances relating to long-term borrowing arrangements if the compensating balance can be computed at a fixed amount at the balance sheet date. c. Disclosure of short-term bank and commercial paper borrowings: i. Commercial paper borrowings separately stated in the balance sheet. ii. Average interest rate and terms separately stated for short-term bank and commercial paper borrowings at the balance sheet date. iii. Average interest rate, average outstanding borrowings, and maximum monthend outstanding borrowings for short-term bank debt and commercial paper combined for the period. d. Disclosure of amounts and terms of unused lines of credit for short-term borrowing arrangements (with amounts supporting commercial paper separately stated) and of unused commitments for long-term financing arrangements. Note that the above disclosures are required for filings with the SEC but not necessarily for disclosures in published annual reports. It should also be noted that SFAS 6 states that certain short-term obligations should not necessarily be classified as current liabilities if the company intends to refinance them on a long-term basis and can demonstrate its ability to do so. 3. The conditions required by SFAS 6 that demonstrate the ability of the company to refinance it short-term debt on a long-term basis are: a. The company has actually issued a long-term obligation or equity securities to replace the short-term obligation after the date of the company's balance sheet but before its release. b. The company has entered into an agreement with a bank or other source of capital that permits the company to refinance the short-term obligation when it becomes due. Note that financing agreements that are cancelable for violation of a provision that can be evaluated differently by the parties to the agreement (such as ―a material adverse change‖ or ―failure to maintain satisfactory operations‖) do not meet the

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second condition. Also, an operative violation of the agreement should not have occurred.

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4. Since the interest rate that will prevail in the bond market at the time of issuance of bonds can never be predetermined, bonds usually are sold in excess of par (premium) or below par (discount). This premium or discount represents, in effect, an adjustment of the coupon rate to the effective interest rate. The premium received is amortized over the life of the issue, thus reducing the coupon rate of interest to the effective interest rate incurred. Conversely, the discount also is amortized, thus increasing the effective interest rate paid by the borrower. 5. The accounting for convertibility and warrants impacts income and equity as follows: a. The convertible feature is attractive to investors. As a result, the debt will be issued at a slightly lower interest rate and the resulting interest expense is less (and conversely, equity is increased). Also, diluted earnings per share is reduced by the assumed conversion. At conversion, a gain or loss on conversion may result when equity instruments are issued. b. Similarly, warrants attached to bonds allow the bonds to pay a lower interest rate. As a result, interest expense is reduced (and conversely, equity is increased). Also, diluted earnings per share is affected because the warrants are assumed converted. 6. It is important to the analysis of convertible debt and stock warrants to evaluate the potential dilution of current and potential shareholders if the holders of these options choose to convert them to stock. This potential dilution would represent a real wealth transfer for existing shareholders. Currently, this potential dilution is given little formal recognition in financial statements. 7. SFAS 47 requires note disclosure of commitments under unconditional purchase obligations that provide financing to suppliers. It also requires disclosure of future payments on long-term borrowings and redeemable stock. Required disclosures include: For purchase obligations not recognized on purchaser's balance sheet: a. Description and term of obligation. b. Total fixed and determinable obligation. If determinable, also show these amounts for each of the next five years. c. Description of any variable obligation. d. Amounts purchased under obligation for each period covered by an income statement. For purchase obligations recognized on purchaser's balance sheet, payments for each of the next five years. For long-term borrowings and redeemable stock: a. Maturities and sinking fund requirements for each of the next five years. b. Redemption requirements for each of the next five years. 8. a.

Information about debt covenant restrictions are available in the details of the bond indentures of a company. Moreover, key restrictions usually are identified and discussed in the financial statement notes. b. The margin of safety as it applies to debt contracts refers to the slack that the company has before it would violate any of the debt covenant restrictions and be in technical default. For example, if the debt covenant mandates a maximum debt to assets ratio of 50% and the current debt to assets ratio is 40%, the company is said to have a margin of safety of 10%. Technical default is costly to a company.

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Thus, as the margin of safety decreases, the relative level of company risk increases.

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9. Analysis of the terms and conditions of recorded liabilities is an area deserving an analyst's careful attention. Here, the analyst must examine critically the description of debt, its terms, conditions, and encumbrances with a desire to satisfy him/her as to the ability of the company to meet principal and interest payments. Important analyses in the evaluation of liabilities are the examination of features such as:  Contractual terms of the debt agreement, including payment schedule  Restrictions on deployment of resources and freedom of action  Ability to engage in further financing  Requirements relating to maintenance of working capital, debt to equity ratio, etc.  Dilutive conversion features to which the debt is subject.  Prohibitions on disbursements such as dividends Moreover, we review the audit report since we expect auditors to require satisfactory recording and disclosure of all existing liabilities. Auditor tests include the scrutiny of board of director meeting minutes, the reading of contracts and agreements, and inquiry of those who may have knowledge of company obligations and liabilities. The analysis of contingencies (and commitments) also is aided by financial statement analysis. However, the analysis of contingencies and commitments is more challenging because these liabilities typically do not involve the recording of assets and/or costs. Here, the analyst must rely on information provided in notes to the financial statements and in management commentary found in the text of the annual report and elsewhere. Due to the uncertainties involved, the descriptions of commitments, and especially contingent liabilities, in the notes are often vague and indeterminate. This means that the burden of assessing the possible impact of contingencies and the probabilities of their occurrence is passed to the analyst. Yet, the analyst assumes that if a contingency (and/or commitment) is sufficiently serious, the auditor can qualify the audit report. The analyst, while utilizing all information available, must nevertheless bring his/her own critical evaluation to bear on the assessment of all existing liabilities and contingencies to which the company may be subject. This process must draw not only on available disclosures and reports, but also on an understanding of industry conditions and practices.

10. a. A lease is classified and accounted for as a capital lease if at the inception of the lease it meets one of four criteria: (1) the lease transfers ownership of the property to the lessee by the end of the lease term; (2) the lease contains an option to purchase the property at a bargain price; (3) the lease term is equal to 75 percent or more of the estimated economic life of the property; or (4) the present value of the rentals and other minimum lease payments, at the beginning of the lease term, equals 90 percent of the fair value of the leased property less any related investment tax credit retained by the lessor. If the lease does not meet any of those criteria, it is to be classified and accounted for as an operating lease. With regard to the last two of the above four criteria, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, neither the 75 percent of economic life criterion nor the 90 percent recovery criterion is to be applied for purposes of classifying the lease and as a consequence, such leases will be classified as operating leases.

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b. Summary of accounting for leases by lessees: 1. The lessee records a capital lease as an asset and an obligation at an amount equal to the present value of minimum lease payments during the lease term, excluding executory costs (if determinable) such as insurance, maintenance, and taxes to be paid by the lessor together with any profit thereon. However, the amount so determined should not exceed the fair value of the leased property at the inception of the lease. If executory costs are not determinable from provisions of the lease, an estimate of the amount shall be made. 2. Amortization, in a manner consistent with the lessee's normal depreciation policy, is called for over the term of the lease except where the lease transfers title or contains a bargain purchase option; in the latter cases amortization should follow the estimated economic life. 3. In accounting for an operating lease the lessee will charge rentals to expenses as they become payable, except when rentals do not become payable on a straight-line basis. In the latter case they should be expensed on such a basis or on any other systematic or rational basis that reflects the time pattern of benefits serviced from the leased property. 11. a. The major classifications of leases by lessors are: 1. Sales-type leases 2. Direct financing leases 3. Operating leases The criteria for classifying each type are as follows: If a lease meets any one of the four criteria for capitalization (see question 10a above) plus two additional criteria (see below), it is to be classified and accounted for as either a sales-type lease (if manufacturer or dealer profit is involved) or a direct financing lease. The additional criteria are (1) collectibility of the minimum lease payments is reasonable predictable, and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. A lease not meeting these criteria is to be classified and accounted for as an operating lease. b. The accounting procedures for leases by lessors are: Sales-type leases 1. The minimum lease payments plus the unguaranteed residual value accruing to the benefit of the lessor are recorded as the gross investment in the lease. 2. The difference between gross investment and the sum of the present value of its two components is recorded as unearned income. The net investment equals gross investment less unearned income. Unearned income is amortized to income over the lease term so as to produce a constant periodic rate of return on the net investment in the lease. Contingent rentals are credited to income when they become receivable. 3. At the termination of the existing lease term of a lease being renewed, the net investment in the lease is adjusted to the fair value of the leased property to the lessor at that date, and the difference, if any, recognized as gain or loss. The same procedure applies to direct financing leases (see below.) 4. The present value of the minimum lease payments discounted at the interest rate implicit in the lease is recorded as the sales price. The cost, or carrying amount, if different, of the leased property, and any initial direct costs (of negotiating and consummating the lease), less the present value of the unguaranteed residual value is charged against income in the same period.

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5. The estimated residual value is periodically reviewed. If it is determined to be excessive, the accounting for the transaction is revised using the changed estimate. The resulting reduction in net investment is recognized as a loss in the period in which the estimate is changed. No upward adjustment of the estimated residual value is made. (A similar provision applies to direct financing leases.) Direct-financing leases 1. The minimum lease payments (net of executory costs) plus the unguaranteed residual value plus the initial direct costs are recorded as the gross investment. 2. The difference between the gross investment and the cost, or carrying amount, if different, of the leased property, is recorded as unearned income. Net investment equals gross investment less unearned income. The unearned income is amortized to income over the lease term. The initial direct costs are amortized in the same portion as the unearned income. Contingent rentals are credited to income when they become receivable. Operating leases The lessor will include property accounted for as an operating lease in the balance sheet and will depreciate it in accordance with his normal depreciation policy. Rent should be taken into income over the lease term as it becomes receivable except that if it departs from a straight-line basis income should be recognized on such basis or on some other systematic or rational basis. Initial costs are deferred and allocated over the lease term. 12. Where land only is involved the lessee should account for it as a capital lease if either of the enumerated criteria (1) or (2) is met. Land is not usually amortized. In a case involving both land and building(s), if the capitalization criteria applicable to land (see above) are met, the lease will retain the capital lease classification and the lessor will account for it as a single unit. The lessee will have to capitalize the land and buildings separately, the allocation between the two being in proportion to their respective fair values at the inception of the lease. If the capitalization criteria applicable to land are not met, and at the inception of the lease the fair value of the land is less than 25 percent of total fair value of the leased property both lessor and lessee shall consider the property as a single unit. The estimated economic life of the building is to be attributed to the whole unit. In this case if either of the enumerated criteria (3) or (4) is met the lessee should capitalize the land and building as a single unit and amortize it. If the conditions above prevail but the fair value of land is 25 percent or more of the total fair value of the leased property, both the lessee and the lessor should consider the land and the building separately for purposes of applying capitalization criteria (3) and (4). If either of the criteria is met by the building element of the lease it should be accounted for as a capital lease by the lessee and amortized. The land element of the lease is to be accounted for as an operating lease. If the building element meets neither capitalization criteria, both land and buildings should be accounted for as a single operating lease. Equipment which is part of a real estate lease should be considered separately and the minimum lease payments applicable to it should be estimated by whatever means are appropriate in the circumstances. Leases of certain facilities such as airport, bus 3-10

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terminal, or port facilities from governmental units or authorities are to be classified as operating leases.

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13. In the books of the lessee, the primary consideration regarding leases is the appropriate classification of operating leases. When leases are classified as operating leases, the lease payment is recorded as rent expense. However, lease assets and liabilities are kept off the balance sheet. Because of this, many companies avail themselves of operating lease treatment even when the underlying economics justify capitalizing the leases. If this is done, the asset and liabilities of a company are underreported and its debt-to-equity ratios are biased downward. Often such leases are a form of ―off balance sheet‖ financing. Therefore, an analyst must carefully examine the classification of operating leases and capitalize the leases when the underlying economic justify. 14. For the lessor, when a lease is considered an operating lease, the leased asset remains on its books. For the lessee, it will not report an asset or an obligation on its balance sheet. 15. When a lease is considered a capital lease for both the lessor and the lessee, the lessor will report lease payments receivable on its balance sheet. The lessee will report the leased asset and a lease obligation totaling the present value of future lease payments. 16. a. Rent expense b. Interest expense and depreciation expense 17. a. Leasing revenue b. Interest revenue (and possibly gain on sale in the initial year of the lease) 18. Property, plant, and equipment can be financed by having an outside party acquire the facilities while the company agrees to do enough business with the facility to provide funds sufficient to service the debt. Examples of these kinds of arrangements are through-put agreements, in which the company agrees to run a specified amount of goods through a processing facility or "take or pay" arrangements in which the company guarantees to pay for a specified quantity of goods whether needed or not. A variation of the above arrangements involves the creation of separate entities for ownership and the financing of the facilities (such as joint ventures or limited partnerships) which are not consolidated with the company's financial statements and are, thus, excluded from its liabilities. Companies have attempted to finance inventory without reporting on their balance sheets the inventory or the related liability. These are generally product financing arrangements in which an enterprise sells and agrees to repurchase inventory with the repurchase price equal to the original sales price plus carrying and financing costs or other similar transactions such as a guarantee of resale prices to third parties. 19.

In a defined contribution plan, the employer promises to currently contribute a fixed sum of money to the employee’s retirement fund, so it is the contribution that is defined. In a defined benefit plan, the employer promises to pay a periodic pension benefit to the employee after retirement (typically until death), so it is the benefit that is defined. The risk (or reward) of the investment performance in the former case is borne by the employee and in the latter by the employer.

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Accounting for defined contribution plans is simple: whenever a contribution is made it is recorded as an expense. Defined benefit plans’ accounting is complex and involves currently recording a liability based on future expected benefit payments and an asset to the extent the plan is funded. Pension expense in this case depends on the changes in pension obligation and the return on plan assets. 21.

(a) Pension obligation: This is the present value of expected benefit payments to the employee based on current service. (b) Pension asset: this is the fair market value of the plan assets on the date of the balance sheet. (c) Net economic position of the plan: This is the difference between the fair market value of the pension assets and the pension obligation. When this difference is positive the plan is referred to as overfunded and when negative the plan is termed underfunded. (d) Economic pension cost: Economically, pension cost is equal to the change (increase) in pension obligation minus return on plan assets. This is called the funded status. Typically, pension obligation changes because of additional employee service (service cost) and present value effects (interest cost).

22.

The common non-recurring components are: (a) Actuarial Gain/Loss: This arises because of changes in actuarial assumptions such as discount rates and compensation growth rates. (b) Prior Service Cost: This arises because of changes in pension formulas, usually because of renegotiation of pension contracts. In addition, the return on plan assets can have a recurring or expected component and an unexpected component that is not expected to persist into the future. SFAS 158 has a complex method by which the non-recurring amounts are first deferred, i.e., excluded from current income, and then the opening net deferrals are amortized over the remaining employee service. For this purpose, the excess of actual plan asset return over expected return is netted against actuarial gains or losses and then deferred/amortized using something called the corridor method. Prior service cost is deferred and amortized separately on its own.

23.

The net periodic pension cost is a smoothed version of the economic pension cost. For determining net periodic pension cost, all non-recurring or unusual components of economic pension cost (e.g., actuarial gain/loss, prior service cost, excess of actual plan return over expected return) are deferred and amortized using a complex corridor method. The rationale for this smoothing mechanism is that the economic pension cost is very volatile. Including this in income would cause income to be very volatile and also hide the true operating profitability of the firm.

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24.

Under the current standard (SFAS 158), the balance sheet recognizes the funded status of the plan. The income statement, however, does not recognize the net economic cost, but a net periodic pension cost in which unusual or non-recurring pension cost components are deferred and amortized. The cumulative net deferrals are included in accumulated other comprehensive income. Under the older standard, SFAS 87, the net periodic pension cost is recognized on the income statement. The balance sheet however, merely recognized the accrued (or prepaid) pension cost, which was simply the cumulative net periodic pension cost. The accrued (or prepaid) pension cost was equal to the funded status minus cumulative net deferrals.

25.

Under SFAS 158, the difference between the economic pension cost (which articulates with the change in the funded status which is recorded in the balance sheet) and the smoothed net periodic pension cost (which is essentially the net deferral for the period) is included in other comprehensive income for the period, which is transferred to accumulated other comprehensive income on the balance sheet.

26.

Other post employment benefits (OPEBs) are retirement benefits other than pensions, such as post retirement health care benefits. OPEBs differ from pension on two dimensions: (1) most of them are non-monetary and therefore create difficulties in estimation and (2) because of tax laws, companies rarely fund these benefits.

27.

The pension note consists of five main parts: (1) an explanation of the reported position in the balance sheet, (2) details of net periodic benefit costs, (3) information regarding actuarial and other assumptions, (4) information regarding asset allocation and funding policies, and (5) expected future contributions and benefit payments.

28.

Since the funded status of the plan is reported on the balance sheet under SFAS 158, there is no adjustment to the balance sheet that is required. However, some analysts note that netting pension assets and obligations tends to mask the underlying pension risk exposure and thus recommend showing pension assets and liabilities separately without netting them out. Adjustments to the income statement depend on the purpose of the analysis. The net periodic benefit cost that is reported under SFAS 158 is appropriate if the objective of the analysis is identifying the permanent or core component of income. However, to estimate a period’s economic income it is advisable to use the economic pension cost which includes all non-recurring items.

29.

The major actuarial assumptions underlying pension accounting are: (a) discount rate (b) compensation growth rate and (c) expected rate of return on pension assets. Less important assumptions include life expectancy and employee turnover. In addition OPEBs also make assumptions about healthcare cost trends. Managers can affect both the post-retirement benefit economic position (or economic cost) and the reported cost. For example, choosing a higher discount rate can reduce the pension obligation and thus improve economic position (funded status). Also, increasing the expected rate of return on plan assets can reduce the reported pension cost (net periodic pension cost).

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31.

Pension risk exposure is the risk that a company is exposed to from its pension plans. This risk arises because of a mismatch of the risk profiles of pension assets and liabilities, primarily because companies invest pension assets whose returns are not correlated with those of long-term bonds which form the basis for the discount rate assumption affecting the measurement of the pension obligation. The pensions ―crisis‖ in the early 2000s in the U.S. was precipitated by an unusual combination of declining equity values (which lowered the value of pension assets) and declining long-term interest rates, which increased the pension obligations. The net effect was a steep reduction in pension funded status which even resulted in some companies filing for bankruptcy. The three factors that an analyst needs to consider when evaluating pension exposure are: (1) the plan’s funded status relative to the company’s assets (2) the pension intensity, i.e., the size of the pension obligation and assets (without netting) relative to total assets and (3) the extent to which the assets and obligation is mismatched, which can be determined by the proportion of pension assets invested in non-debt securities or assets.

32.

Current cash flows for pensions (or OPEBs) measure the extent of company contributions into the plan during the year. For pensions, this is obviously not a good indicator of future cash contributions since contributions are affected by complex factors which eventually affect the funded status of the plan. For OPEBs, current contributions are a somewhat better indicator of future contributions since contributions in a period typically equal benefits paid (since most OPEB plans are unfunded), and benefits are more predictable over time.

33.

Accumulated benefit obligation (ABO): This is the present value of estimated future pension benefit payments assuming current compensation. Projected benefit obligations (PBO): This is the present value of estimated future pension benefit payments assuming future compensation on the date of retirement. ABO is closer to the legal obligation.

34.

The ―corridor method‖ is used for determining the amount of amortization for net gain or loss. Net gain or loss for the period is determined by netting the actuarial gain/loss for the period with the difference between actual and expected return on plan assets. Then the net gain or loss for the period is added to the cumulative net gain or loss at the start of the period. Next a ―corridor‖ for cumulative net gain/loss is determined as the greater of 10% of PBO or 10% of plan assets (whichever is greater). Only the amount of cumulative net gain/loss beyond this corridor (in either direction) is amortized.

35.

Like the pension obligation, the OPEB obligation is the present value of expected future benefits attributable to employee service to-date. The present value of the expected future benefits is termed EPBO and that portion which is attributable to service to-date is termed the APBO. The APBO is the obligation that is used to estimate the funded status or the economic position of the plan reported on the balance sheet.

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While the estimation process for OPEB costs is similar to that of estimating pension costs it is more difficult and more subjective. First, data about costs are more difficult to obtain. Pension benefits involve either fixed dollar amounts or a defined dollar amount, based on pay levels. Health benefits, by contrast, are estimates not easily computed by actuarial formula. Many factors enter in to such estimates, including deductibles, ages, marital status, number of dependents, etc. Second, more assumptions than those governing pension calculations are needed. For example, in addition to retirement dates, life expectancy, turnover, and discount rates, there is a need for estimates of the medical costs trend rate, Medicare reimbursements, etc. 34. a. A loss contingency is any existing condition, situation, or set of circumstances involving uncertainty as to possible loss that will be resolved when one or more future events occur or fail to occur. Examples of loss contingencies are: litigation, threat of expropriation, uncollectibility of receivables, claims arising from product warranties or product defects, self-insured risks, and possible catastrophe losses of property and casualty insurance companies. b. The two conditions that must be met before a provision for a loss contingency can be charged to income are: (1) it must be probable that an asset had been impaired or a liability incurred at a date of a company’s financial statements. Implicit in that condition is that it must be probable that a future event or events will occur confirming the fact of the loss. (2) the amount of loss must be reasonably estimable. The effect of applying these criteria is that a loss will be accrued only when it is reasonably estimable and relates to the current or a prior period. 35.

When a company decides to ―take a big bath,‖ the company will recognize as many discretionary expenses and losses as possible in the current year. Such a strategy usually accompanies a period of unusually poor operating results—the managerial belief is that the market will not further downgrade the stock from the ―one-time‖ charge and that the market will be less scrutinizing of such a charge. A major result of a big bath is the inflated increase in future periods’ net income figures. Also, when a company takes a big bath, it often causes reserves and/or liabilities to be overstated. For example, the company might record an overstated restructuring charge or contingent liability. When a company employs a ―big bath‖ strategy, analysts should assess whether certain reserves and liabilities are actually overstated and adjust their models accordingly. (The income statement loss is probably overstated as well).

36. Commitments are potential claims against a company’s resources due to future performance under a contract. Examples of commitments include contracts to purchase products or services at specified prices, purchase contracts for fixed assets calling for payments during construction, and signed purchase orders. 37. Commitments are not recorded liabilities because commitments are not completed transactions. Commitments become liabilities when the transaction is completed. For example, consider a commitment by a manufacturer to purchase 100,000 units of materials per year for 5 years. Each time a purchase is made at the agreed upon price, part of the purchase commitment expires and a purchase is recorded. The remaining part continues as an obligation by the manufacturer to purchase materials.

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39. Off-balance-sheet financing refers to the nonrecording of certain financing obligations. Examples of off-balance-sheet financing include operating leases when they are in-substance capital leases, joint ventures and limited partnerships, and many recourse obligations on sold receivables. 39. Under SFAS 105, companies are required to disclose the following information about financial instruments with off-balance-sheet risk of accounting loss: a. The face, contract, or notional principal amount. b. The nature and terms of the instruments and a discussion of their credit and market risk, cash requirements, and related accounting policies. c. The accounting loss the company would incur if any party to the financial instruments failed completely to perform according to the terms of the contract, and the collateral or other security, if any, for the amount due proved to be of no value to the company. d. The company's policy for requiring collateral or other security on financial instruments it accepts, and a description of collateral on instruments presently held. Information about significant concentrations of credit risk from an individual counter-party or groups of counterparties for all financial instruments is also required. These disclosures help financial analysis by revealing existing economic events that can reduce the relevance and reliability of the balance sheet as reported by management. With the information in these disclosures, the analyst can revise his/her personal models to factor in the impact of off-balance-sheet items or otherwise adjust the analyses for these items. 40. SFAS 140 replaced SFAS 125 and defines new rules for the sale of accounts receivable to special purpose entities (SPEs). In order to treat the transfer as a sale (rather than a borrowing), the SPE must be a Qualifying SPE. Otherwise, the SPE must be consolidated unless third-party investors make equity investments that are,  Substantive (more than 3% of assets)  Controlling (e.g., more than 50% ownership)  Bear the first dollar risk of loss  Take the legal form of equity If any of the above conditions is not met, the transfer of the receivable is considered as a loan with the receivables pledged as security for such loan. 41. Analysts should identify off-balance-sheet financing arrangements and either factor these arrangements into their models or otherwise adjust the analyses for the additional risk created by off-balance-sheet financing arrangements. 42. Some equity securities have mandatory redemption provisions that make them more akin to debt than they are to equity—a typical example is preferred stock. Whatever their name, these securities impose upon the issuing companies various obligations to dispense funds at specified dates. Such provisions are inconsistent with the true nature of an equity security. The analyst must be alert to the existence of such ―equity securities‖ and examine for substance over form when making financial statement adjustments.

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43. In order to facilitate their understanding and analysis, reserves and provisions can be redivided into a number of major categories. The first category is most correctly described as comprising provisions for obligations that have a high probability of occurrence, but which are in dispute or are uncertain in amount. As is the case with many financial statement descriptions, neither the title nor the location in the financial statement can be relied upon as a rule-of-thumb guide to the nature of an account. The best key to analysis is a thorough understanding of the business and the financial transactions that give rise to the account. The following are representative items in this group: provisions for product guarantees, service guarantees, and warranties that are established in recognition of future costs that are certain to arise although presently impossible to measure. Another type of obligation that must be provided for is the liability for ―unredeemed coupons‖ such as trading stamps. To the company issuing these coupons, there is no doubt about the liability to redeem them for merchandise or cash. The only uncertainty concerns the number of coupons that will be presented for redemption. Consequently, a provision is established for these types of items by a charge to income at the time products covered by guarantees (or related to these coupons) are sold—the amount is established on the basis of experience or on the basis of any other reliable factor. The second category comprises reserves for expenses and losses, which by experience or estimates are very likely to occur in the future and that should properly be provided for by current charges to operations. One group within this category is comprised of reserves for operating costs such as maintenance, repairs, painting, or overhauls. Thus, for example, since overhauls can be expected to be required at regularly recurring intervals, they are provided for ratably by charges to operations to avoid charging the entire cost to the year in which the actual overhaul takes place. A third category comprises provisions for future losses stemming from decisions or actions already taken. Included in this group are reserves for relocations, replacement, modernization, and discontinued operations. A fourth category includes reserves for contingencies. For example, reserves for self-insurance are designed to provide the accumulation against which specific types of losses, not covered by insurance, can be charged. Although the term self-insurance contradicts the very concept of insurance, which is based on the spreading of risks among many business units, it nevertheless is a practice that has a good number of adherents. Other contingencies provided against by means of reserves are those arising from foreign operations and exchange losses due to official or de facto devaluations. A fifth group of future costs that must be provided for is that of employee compensation. These costs, in turn, give rise to provisions for vacation pay, deferred compensation, incentive compensation, supplemental unemployment benefits, bonus plans, welfare plans, and severance pay. The related category of estimated liabilities includes provisions for claims arising out of pending or existing litigation.

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Chapter 03 - Analyzing Financing Activities

Of importance to the analyst is the adequacy of the reserves and provisions that are often established on the basis of prior experience or on the basis of other estimates. Concern with adequacy of amount is a prime factor in the analysis of all reserves and provisions, whatever their purpose. Reserves and provisions appearing above the equity section are almost invariably created by means of charges to income. They are designed to assign charges to the income statement based on when they are incurred rather than when they are paid in cash. 44. Reserves for future losses represent a category of accounts that require particular scrutiny. While conservatism in accounting calls for recognition of losses as they can be determined or clearly foreseen, companies tend, particularly in loss years, to over-provide for losses not yet incurred. Such ―losses not yet incurred‖ often involve disposal of assets, relocations, and plant closings. Overprovision shifts expected future losses to the present period, which likely already shows adverse results. One problem with such reserves is that once established there is no further accounting for the expenses and losses that are charged against them. Only in certain financial statements required to be filed with the SEC (such as Form 10-K) are details of changes in reserves required. Recent requirements have, however, tightened the disclosure rules in this area.

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The reason why over-provisions of reserves occur is that the income statement effects are often accorded more importance than the residual balance sheet effects. While a provision for future expenses and losses establishes a reserve account that is analytically in the "never-never land" between liabilities and equity accounts, it serves the important purpose of creating a cushion that can absorb future expenses and losses. This shields the all-important income statement from them and their related volatility. The analyst should endeavor to ascertain that provisions for future losses reflect losses that can reasonably be expected to have already occurred rather than be used as a means of artificially benefiting future income by adding excessive provisions to present adverse results. 45. An ever increasing variety of items and descriptions are included in the "deferred credits" group of accounts. In many cases these items are akin to liabilities; in others, they either represent deferred income yet to be earned or serve as income-smoothing devices. A lack of agreement among accountants as to the exact nature of these items or the proper manner of their presentation compounds the confusion confronting the analyst. Thus, regardless of category or presentation, the key to their analysis lies in an understanding of the circumstances and the financial transactions that brought them about. At one end of the spectrum we find those items that have characteristics of liabilities. Here we can find items such as advances or billings on uncompleted contracts, unearned royalties and deposits, and customer service prepayments. The outstanding characteristics of these items is their liability aspects even though, as in the case of advances of royalties, they may, after certain conditions are fulfilled, find their way into the company's income stream. Advances on uncompleted contracts represent primarily methods of financing the work in progress while deposits of rent received represent, as do customer service prepayments, security for performance of an agreement. At the other end of the spectrum are deferred credits that exhibit many qualities similar to equity. The key to effective analysis is the ability to identify those items most like liabilities from those most like equity. 46. The accounting for the equity section as well as its presentation, classification, and note disclosure have certain basic objectives. The most important of these are: a. To classify and distinguish among the major sources of owner capital contributed to the entity. b. To set forth the priorities of the various classes of stockholders and the manner in which they rank in partial or final liquidation. c. To set forth the legal restrictions to which the distribution of capital funds are subject to for whatever reason. d. To disclose the contractual, legal, managerial, and financial restrictions that the distribution of current and retained earnings is subject to. The accounting principles that apply to the equity section do not have a marked effect on income determination and, as a consequence, do not hold many pitfalls for the analyst. From the analyst's point of view, the most significant information here relates to the composition of the capital accounts and to the restrictions that they are subject to.

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The composition of equity capital is important because of provisions affecting the residual rights of common equity. Such provisions include dividend participation rights, and the great variety of options and conditions that are characteristic of the complex securities frequently issued under merger agreements, most of which tend to dilute common equity. Analysis of restrictions imposed on the distribution of retained earnings by loan or other agreements will usually shed light on a company's freedom of action in such areas as dividend distributions and the required levels of working capital. Such restrictions also shed light on the company's bargaining strength and standing in credit markets. Moreover, a careful analysis of restrictive covenants will enable the analyst to assess how far a company is from being in default of these provisions. 47. Preferred stock often carries features that make it preferred in liquidation and preferred as to dividends. Also, it is often entitled to par value in liquidation and can be entitled to a premium. On the other hand, the rights of preferred stock to dividends are generally fixed—although they can be cumulative, which means that preferred shareholders are entitled to arrearages of dividends before common stockholders receive any dividends. These features of preferred stock as well as the fixed nature of the dividend give preferred stock some of the earmarks of debt with the important difference that preferred stockholders are not generally entitled to demand redemption of their shares. However, there are preferred stock issues that have set redemption dates and require sinking funds to be established for that purpose—these issuances are essentially debt. Characteristics of preferred stock that make them more akin to common stock are dividend participation rights, voting rights, and rights of conversion into common stock. 48. Accounting standards state (APB 10): ―Companies at times issue preferred (or other senior) stock which has a preference in involuntary liquidation considerably in excess of the par or stated value of the shares. The relationship between this preference in liquidation and the par or stated value of the shares may be of major significance to the users of the financial statements of those companies and the Board believes it highly desirable that it be prominently disclosed. Accordingly, the Board recommends that, in these cases, the liquidation preference of the stock be disclosed in the equity section of the balance sheet in the aggregate, either parenthetically or in short rather than on a per share basis or by disclosure in notes." Such disclosure is particularly important since the discrepancy between the par and liquidation value of preferred stock can be very significant. 49. This question is answered in a SEC release titled Pro Rata Distribution to Shareholders: Several instances have come to the attention of the Commission in which registrants have made pro rata stock distributions that were misleading. These situations arise particularly when a registrant makes distributions at a time when its retained earnings or its current earnings are substantially less than the fair value of the shares distributed. Under present generally accepted accounting rules, if the ratio of distribution is less than 25 percent of shares of the same class outstanding, the fair value of the shares issued must be transferred from retained earnings to other capital accounts. Failure to make this transfer in connection with a distribution or making a distribution in the absence of retained or current earnings is evidence of a misleading 3-21

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practice. Distributions of over 25 percent (which do not normally call for transfers of fair value) may also lend themselves to such an interpretation if they appear to be part of a program of recurring distribution designed to mislead shareholders.

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It has long been recognized that no income accrues to the shareholder as a result of such stock distributions or dividends, nor is there any change in either the corporate assets or the shareholders' interest therein. However, it is also recognized that many recipients of such stock distributions, which are called or otherwise characterized as dividends, consider them to be distributions of corporate earnings equivalent to the fair value of the additional shares received. In recognition of these circumstances, the American Institute of Certified Public Accountants has specified in Accounting Research Bulletin No. 43, Chapter 7, paragraph 10, that "... the corporation should in the public interest account for the transaction by transferring from earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions. Both the New York and American Stock Exchanges require adherence to this policy by their listed companies. 50. Accounting standards require that, except for corrections of errors in financial statements of a prior period and adjustments that result from realization of income tax benefits of preacquisition operating loss carry forwards of purchased subsidiaries, all items of profit and loss recognized during a period (including accruals of estimated losses from loss contingencies) be included in the determination of net income for that period. The standard permits limited restatements in interim periods of a company's current fiscal year. 51. a. Minority interests are the claims of shareholders of a majority owned subsidiary whose total net assets are included in a consolidated balance sheet. b. Consolidated financial statements often show minority interests as liabilities: however, they are fundamentally different in nature from legally enforceable obligations. Minority shareholders do not have any legally enforceable rights for payments of any kind from the parent company. Therefore, the financial analyst can justifiably classify minority interest as equity funds in most cases.

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EXERCISES Exercise 3-1 (20 minutes) a. Long-term debt [46] A B

159.7 0.3

G H

24.3 250.3

805.8

beg

0.1 99.8 100.0 199.6

C D E F

1.9 772.6

I end

A = Retirement of 13.99% Zero Coupon Notes. B = Repayment of 9.125% Note. C = Additional borrowing on 7.5% Note. D = Borrowing on 9% Note E = Borrowing on Medium-Term Notes. F = Borrowing on 8.875% Debentures G = Repayment of Other Notes H = Reclassification of Note I = Increase in capital lease obligation

b. Campbell Soup’s debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt matures in excess of 5 years. Given Campbell’s operating cash flow of $805.2 million, solvency does not appear to be a problem. Further, Campbell reports net income of $401.5, well in excess of its interest expense of $116.2 in Year 11, an interest coverage ratio of 6.7 [$667.4 + $116.2]/ $116.2). The company should also be able to meet its interest obligations. Campbell reports total liabilities of $2,355.6 million ($1278+$772.6+$305) against stockholders’ equity of $1,793.4 million, a 1.3 times multiple. The amount of debt does not appear to be excessive. Nor does the company appear to be underutilizing its equity. Given present debt levels that are not excessive and adequate cash flow, the company should be able to finance additional investments with debt if desired by management.

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Exercise 3-2 (20 minutes) a. The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent terms, the lease should be capitalized. b. A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of the payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value. c. A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation. d. Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain purchase option.

Exercise 3-3 (15 minutes) a. A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the obligation and interest expense. The asset would be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets, except that in some circumstances the period of amortization would be the lease term. b. No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense nevertheless would be recognized on a straight-line basis unless another systematic or rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be used.

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Exercise 3-4 (18 minutes) a. The gross investment in the lease is the same for both a sales-type lease and a direct-financing lease. The gross investment in the lease is the minimum lease payments (net of amounts, if any, included therein for executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value accruing to the benefit of the lessor. b. For both a sales-type lease and a direct-financing lease, the unearned interest income would be amortized to income over the lease term by use of the interest method to produce a constant periodic rate of return on the net investment in the lease. However, other methods of income recognition may be used if the results obtained are not materially different from the interest method. c. In a sales-type lease, the excess of the sales price over the carrying amount of the leased equipment is considered manufacturer's or dealer's profit and would be included in income in the period when the lease transaction is recorded. In a direct-financing lease, there is no manufacturer's or dealer's profit. The income on the lease transaction is composed solely of interest.

Exercise 3-5 (25 minutes) A number of major companies have a meager debt ratio. Still, even when a company shows little if any debt on its balance sheet, it can have considerable long-term liabilities. This situation can reflect one or more of several factors such as the following: Lease commitments, while detailed in notes, are not recorded in the balance sheets of many companies. This could be a critical problem for companies that have expanded by leasing rather than buying property. These lease commitments, while reflecting different attributes of pure debt, are just as surely long-term obligations. Many companies have very large unfunded postretirement liabilities. These often are not recorded on the balance sheet, but are disclosed in the notes. At one time, a case could have been made that such obligations were not a problem, for as long as the business operated, payments would be made, and if it went bankrupt, the liability would end. Now, under most laws, the company has a real long-term obligation to employees. Several companies guarantee the debt of another company. The most typical is a nonconsolidated lease subsidiary. Although disclosed in the notes, this debt, which is real and can be large, is not recorded on the parent's balance sheet. 3-26

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Exercise 3-5—continued Off-balance-sheet debt—such as industrial revenue bonds or pollution control financing where a municipality sells tax-free bonds guaranteed for payment—are cases where a supposedly debt-free balance sheet could look much worse if these obligations were recorded. Finally, the practice of deferred taxes—such as taking some expenses for tax, but not book purposes, or through differences in timing for recognition of sales—is one that, while recorded on the balance sheet, is normally not recognized as a long-term obligation. However, if the rate of investment slows dramatically for some reason or if the sales trend is reversed, the sudden coming due of these tax liabilities could be a major problem. (CFA Adapted)

Exercise 3-6 (20 minutes) a. An estimated loss from a loss contingency is accrued with a charge to income if both of the following conditions are met: 

Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.



The amount of loss can be reasonably estimated.

b. In this case, disclosure should be made for an estimated loss from a loss contingency that need not be accrued by a charge to income when there is at least a reasonable possibility that a loss may have been incurred. The disclosure should indicate the nature of the contingency and should estimate the possible loss or range of loss or state that such an estimate cannot be made. Disclosure of a loss contingency involving an unasserted claim is required when it is probable that the claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable.

Exercise 3-7 (15 minutes) a. One reason that managers might want to resist recording a liability related to an ongoing lawsuit is that the recorded liability can cause deterioration in the financial position of the company. A second reason is that the opposing attorneys may use the disclosure inappropriately as an admission of liability.

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Exercise 3-7—continued b. If a manager believes that it is inevitable that a liability will be recorded, the manager may want to time the recognition of the liability opportunistically. For example, if the company has a relatively bad period, the liability can be recorded in conjunction with a ―big bath.‖ If the company has a very good period, the manager might find that the liability can be recorded in that period without causing an unexpectedly bad earnings report.

Exercise 3-8 (40 minutes) [Note: Unless otherwise indicated, much of the information to answer this exercise can be found in item [68] of Campbell’s financial statements.]

a. The causes of the $101.6 million increase are identified in the table below (see Campbell’s Consol. Statement of Owners’ Equity and Changes in Number of Shares): Millions Net Income .......................................................... Cash Dividends ................................................... Treasury Stock Purchase ................................... Treasury Stock Issued Capital Surplus .............................................. Treasury Stock............................................... Translation Adjustment ...................................... Sale of foreign operations .................................. Increase in Stockholders' Equity ....................... a

1,793.4 - 1,691.8 101.6

[54]

b

11 $401.5 (142.2) (89) (175.6)

10 $ 4.4 (28) (126.9) (87) (41.1) (87)

45.4 (91) 12.4 (91) (29.9) (92) (10.0) (93)

11.1 (87) 4.6 (87) 61.4 (87)

101.6a

(86.5)b

1,691.8 [54] 1,778.3 [87] (86.5)

b. The average price for treasury share purchases is computed as: [($175.6 million1 / 3.395 million treasury shares purchased)] = $51.72 1

Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders’ Equity

c. Book Value per Share of Common Stock is computed as: [$1,793.4 [54] / 127.0* ] = $14.12 *135.6 [49] - 8.6 [52] – note: There is no preferred stock outstanding (Note: This value equals the company's computed amount [185] of $14.12.)

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Exercise 3-8—continued d. The book value per share of common stock is $14.12. However, shares were purchased during the year at an average of about $52 per share (an indicator of market value during the year). In fact, according to note 24 to the financial statements the stock traded in the $70 - $80 range in the fourth quarter of Year 11. There are several reasons why the market value of the stock is much higher than the book value of the stock. First, the market value impounds the investors’ beliefs about the future earning power of the company. Investors apparently have high expectations regarding future profitability. Second, the book value is recorded using accounting conventions such as historical cost and conservatism. Each of these conventions is designed to optimize the reliability of the information but can cause differences between the market and book values of a company’s stock.

Exercise 3-9 (30 minutes) a. The principal transactions and events that reduce the amount of retained earnings include the following: 1. Operating losses (including extraordinary losses and other debit adjustments). 2. Stock dividends. 3. Dividends distributing corporate assets such as cash or in-kind. 4. Recapitalizations such as quasi-reorganizations. b. The principal reason for making the distinction between contributed capital and retained earnings (earned capital) in the stockholders' equity section is to enable stockholders and creditors to identify dividend distributions as actual distributions of earnings or as returns of capital. This identification also is necessary to comply with most state statutes that provide that there should be no impairment of the corporation's legal or stated capital by the return of such capital to owners in the form of dividends. This concept of legal capital provides some measure of protection to creditors and imposes a liability upon the stockholders in the event of such impairment. Knowledge of the distinction between contributed capital and earned capital provides a guide to the amount of dividends that can be distributed by the corporation. Assets represented by the earned capital, if in liquid form, may properly be distributed as dividends; but invested assets represented by contributed capital should ordinarily remain for continued operation of the corporation. If assets represented by contributed capital are distributed to shareholders, the distribution should be identified as a return of capital and, hence, is in the nature of a liquidating dividend. Knowledge of the amount of capital that has been earned over a period of years after adjustment for dividends also is of value to stockholders in judging dividend policy and obtaining an indication of past profits to the extent not distributed as dividends. 3-29

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Exercise 3-9—continued c. The acquisition and reissuance of its own stock by a firm results only in the contraction or expansion of the amount of capital invested in it by stockholders. In other words, an acquisition of treasury shares by a corporation is viewed as a partial liquidation and the subsequent reissuance of these shares is viewed as an unrelated capital-raising activity. To characterize as gain or loss the changes in equity resulting from a corporation's acquisition and subsequent reissuance of its own shares at different prices is a misuse of accounting terminology. When a corporation acquires its own shares, it is not "buying" anything nor has it incurred a "cost." The price paid represents the amount by which the corporation has reduced its net assets or "partially liquidated." Similarly, when the corporation reissues these shares it has not "sold" anything. It has increased its total capitalization by the amount received. It is the practice of referring to the acquisition and reissuance of treasury shares as a buying and selling activity that gives the superficial impression that, in this process, the firm is acquiring and disposing of assets and that, if different amounts per share are involved, a gain or loss results. Note, when a corporation "buys" treasury shares it is not acquiring assets; nor is it disposing of any assets when these shares are subsequently "sold."

Exercise 3-10 (25 minutes) a. There are four basic rights inherent in ownership of common stock. The first right is that common shareholders may participate in the actual management of the corporation through participation and voting at the corporate stockholders meeting. Second, a common shareholder has the right to share in the profits of the corporation through dividends declared by the board of directors (elected by the common shareholders) of the corporation. Third, a common shareholder has a pro rata right to the residual assets of the corporation if it liquidates. Fourth, common shareholders have the right to maintain their interest (percent of ownership) in the corporation if the corporation issues additional common shares, by being given the opportunity to purchase a proportionate number of shares of the new offering. This fourth right is most commonly referred to as a "preemptive right." b. Preferred stock is a form of capital stock that is afforded special privileges not normally afforded common shareholders in return for giving up one or more rights normally conveyed to common shareholders. The most common right given up by preferred shareholders is the right to participate in management (voting rights). In return, the corporation grants one or more preferences to the preferred shareholders. The most common preferences granted to preferred shareholders are these:

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Chapter 03 - Analyzing Financing Activities

Exercise 3-10—continued 1. Dividends are paid to common shareholders only after dividends have been paid to preferred shareholders. 2. Claims of preferred shareholders are senior to common shareholders for residual assets (after creditors have been paid) in the case of corporation liquidation. 3. Although the board of directors is under no obligation to declare dividends in any particular year, preferred shareholders are granted a cumulative provision stating that any dividends not paid in a particular year must be paid in subsequent years before common shareholders are paid any dividend. 4. Preferred shareholders are granted a participation clause that allows them to receive additional dividends beyond their normal dividend if common shareholders receive dividends of greater percentage than preferred shareholders. This participation is on a one-to-one basis (fully participating); common shareholders are allowed to exceed the rate paid to preferred shareholders by a defined amount before preferred shareholders begin to participate: or, the participation clause can carry a maximum rate of participation to which preferred shareholders are entitled. 5. Preferred shareholders have the right to convert their preferred shares to common shares at a set future price no matter what the current market price of the common stock is. 6. Preferred shareholders also can agree to have their stock callable by the corporation at a higher price than when the stock was originally issued. This item is generally coupled with another preference item to make the issue appear attractive to the market. c. 1. Treasury stock is stock previously issued by the corporation but subsequently repurchased by the corporation. It is not retired stock, but stock available for issuance at a subsequent date by the corporation. 2. A stock right is a privilege extended by the corporation to acquire additional shares (or fractional shares) of its capital stock. 3. A stock warrant is physical evidence of stock rights. The warrant specifies the number of rights conveyed, the number of shares to which the rightholder is entitled, the price at which the rightholder can purchase additional shares, and the life of the rights (time period over which the rights can be exercised).

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Chapter 03 - Analyzing Financing Activities

Exercise 3-11 (12 minutes) a. These cash distributions are not dividends. Instead, they are returns of capital. Dividends are distributions of past earnings of the company. Since this company has not earned any net income, there are no retained earnings from which dividends could be paid. Thus, these cash distributions are being made from capital previously contributed to the company by the owners. b. There are at least a couple of reasons why a return of capital might be made. First, the company may be going out of business. Second, in a closely held company, influential owners may have mandated the payments. A distribution of capital is usually the result of special circumstances confronted by a company.

Exercise 3-12 (12 minutes) a. Purchasing its own shares is similar to the payment of dividends in that cash assets are reduced in both situations. That is, in each case, the company is distributing cash to shareholders. In the case of dividends, all shareholders are receiving cash in a proportionate manner. In the case of share repurchases, only selected shareholders receive cash distributions from the company. b. Managers might prefer to purchase its own company’s shares because this serves to increase financial performance measures such as earnings per share and return on shareholders equity. c. Investors are taxed on dividends received from companies. The tax rate on dividends is often quite high. Investors also are taxed on gains on the sale of shares. Thus, investors often would prefer that companies buy back shares rather than pay a dividend. In this way, investors that are happy with the performance of the company can maintain or increase their ownership (it can increase as a percent of the total). Investors that would like to reduce their investment in the company can choose to do so by selling shares back to the company pursuant to the offer of the company to repurchase shares. Also, the gain on sale of stock by investors is usually taxed at a lower rate than dividends.

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Exercise 3-13 (15 minutes) a. Defined contribution plans are not affected by variables such as stock market performance and employee tenure and life span. As a result, pension expense and liability associated with defined contribution plans is more predictable and less variable than are pension expense and liability associated with defined benefit plans. b. If managers can attract adequate talent with defined contribution plans, they would prefer the defined contribution plans because of the predictability of and less volatility associated with pension expense. c. Defined contribution plans place the investment risk on the employee whereas defined benefit plans place the risk on the company. Under a defined contribution plan, the company pays a defined contribution into the employees’ pension plan and then the employee invests the assets according to their tolerance for risk and investment strategy. Thus, employees with a low tolerance for risk might prefer the defined benefit plan because they would not have to bear any of the investment risk. Conversely, employees with a high tolerance for risk might prefer the defined contribution plan because they might feel that they can invest the funds better and reap higher benefits at retirement.

Exercise 3-14 (25 minutes) a. Two major accounting challenges resulting from the use of a defined benefit pension plan are:  Estimates or assumptions must be made concerning the future events that will determine the amount and timing of benefit payments.  Some method of attributing the cost of pension benefits to individuals’ years of service must be selected. These two challenges arise because a company must recognize pension costs before it pays pension benefits. b. Carson determines the service cost component of the net pension cost as the actuarial present value of pension benefits attributable to employee services during a particular period based on the application of the pension benefit formula. c. Carson determines the interest cost component of the net pension cost as the increase in the projected benefit obligation due to the passage of time. Measuring the projected benefit obligation requires accrual of an interest cost at an assumed discount rate. d. Carson determines the actual return on plan assets component of the net pension cost as the change in the fair value of plan assets during the period, adjusted for (1) contributions and (2) benefit payments.

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PROBLEMS Problem 3-1 (30 minutes) a. 1. $200 million 2. As the maturity date approaches the liability will be shown at increasingly larger amounts to reflect the accrual of interest that will be due at maturity. 3. The annual journal entry is: Interest expense ...................................................... Unamortized discount ................................... [Note: No cash is involved since it is a zero coupon note.]

# #

b. This amount represents repayment of principal along with interest—it is also equal to the present value of the future principal and interest payments, discounted at the interest rate in effect at the time of issuance. Cash outflows will mimic the principal repayment and interest payment schedules per the debt contract(s).

c. The $28 million amount will be paid out. This amount will include $6.5 million of interest implicit in the leases.

d. This is reported in the notes—Note 10 to the financial statements (the Lease footnote). The lease payments will be expensed as they occur over the years.

e. The company paid an average interest rate of 11.53% on the beginning balance of interest-bearing debt [($116.2 /($202.2 + $805.8)]. The debt structure did not change substantially during Year 11. At the beginning of Year 12, the company has interest bearing debt totaling $1,054.8 ($282.2 + $772.6). The relative mix of debt has not changed substantially. Thus, it is reasonable to predict interest expense by multiplying this beginning balance by the 11.53% average rate experienced in the previous year. Therefore, the interest expense projection is $121.6 million. (Note that the short-term debt is a bit larger in percent of the total debt burden so the company may pay an average interest amount of slightly less than the 11.53% paid in the previous year.)

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Chapter 03 - Analyzing Financing Activities

Problem 3-2 (40 minutes)

a. 1/1/Year 1 Enter into Lease Contract Leased Property under Capital Leases ............................... Lease Obligation under Capital Leases .......................... 39,930

12/31/Year 1 Payment of Rental Interest on Leases ................................................................ Lease Obligations under Capital Leases ............................ Cash ................................................................................. 10,000

Amortization of Property Rights Amor. of Leased Property under Capital Leases ............... Leased Property under Capital Leases .........................

39,930

3,194.40 (1) 6,805.60

7,986 (2) 7,986

(1) $39,930 x .08 = $3,194.40 (2) $39,930  5 = $7,986

b.

ASSETS Leased property under capital leases…………… (2)

Balance Sheet December 31, Year 1 LIABILITIES Lease Obligations under $31,944 (1) capital leases……. $33,124.40

Income Statement For Year Ended December 31, Year 1 Amortization of leased property ................................................. Interest on leases.......................................................................... Total lease-related cost for Year 1 ..............................................

$ 7,986.00 3,194.40 $11,180.40 (3)

(1) $39,930 - $7,986 = $31,944 (2) $39,930 - $6,805.60 = $33,124.40 (3) To be contrasted to rental costs of $10,000 when no capitalization takes place.

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Chapter 03 - Analyzing Financing Activities

Problem 3-2—continued c. Payments of Interest and Principal Total Interest Payment of Payment at 8% Principal

Year 1 2 3 4 5

10,000 10,000 10,000 10,000 10,000 $50,000

$3,194.40 2,649.95 2,061.95 1,426.90 736.80 $10,070.00

$6,805.60 7,350.05 7,938.05 8,573.10 9,263.20 $39,930.00

Principal Balance $39,930.00 33,124.40 25,774.35 17,836.30 9,263.20 —

d.

Year 1 2 3 4 5

Expenses to Be Charged to Income Statement Lease Total Expense Amortization Interest Expenses $10,000 $ 7,986.00 $ 3,194.40 $11,180.40 10,000 7,986.00 2,649.95 10,635.95 10,000 7,986.00 2,061.95 10,047.95 10,000 7,986.00 1,426.90 9,412.90 10,000 7,986.00 736.80 8,722.80 $50,000 $39,930.00 $10,070.00 $50,000.00

e. The income and cash flow implications from this capital lease are apparent in the solutions to parts c and d. The student should note that reported expenses exceed the cash flows in earlier years, while the reverse occurs in later years.

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Chapter 03 - Analyzing Financing Activities

Problem 3-3 (30 minutes) a. A lease should be classified as a capital lease when it transfers substantially all of the benefits and risks inherent to the ownership of property by meeting any one of the four criteria for classifying a lease as a capital lease. Specifically:  Lease J should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent or more criterion.  Lease K should be classified as a capital lease because the lease contains a bargain purchase option.  Lease L should be classified as an operating lease because it does not meet any of the four criteria for classifying a lease as a capital lease. b. Borman records the following liability amounts at inception:  For Lease J, Borman records as a liability at the inception of the lease an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. However, if the amount so determined exceeds the fair value of the equipment at the inception of the lease, the amount recorded as a liability should be the fair value.  For Lease K, Borman records as a liability at the inception of the lease an amount determined in the same manner as for Lease J, and the payment called for in the bargain purchase option should be included in the minimum lease payments.  For Lease L, Borman does not record a liability at the inception of the lease. c. Borman records the MLPs as follows:  For Lease J, Borman allocates each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability.  For Lease K, Borman allocates each minimum lease payment in the same manner as for Lease J.  For Lease L, Borman charges minimum lease (rental) payments to rental expense as they become payable. d. From an analysis viewpoint, both capital and operating leases represent economic liabilities as they involve commitments to make fixed payments. The fact that companies can structure leases as "operating leases" to avoid balance sheet recognition is problematic from the perspective of analysis of assets. If the leased assets are used to generate revenues, they should be considered in ratios such as return on assets and other measures of financial performance and condition.

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Chapter 03 - Analyzing Financing Activities

Problem 3-4 (25 minutes) a. Detachable stock purchase warrants are equity instruments that have a separate fair value at the issue date. Consequently, the portion of the proceeds from bonds issued with detachable stock purchase warrants allocable to the warrants should be accounted for as paid-in capital. The remainder of the proceeds should be allocated to the debt portion of the transaction. This usually results in issuing the debt at a discount (or, occasionally, a reduced premium). b. A serial bond progressively matures at a series of stated installment dates, for example, one-fifth each year. A term (straight) bond completely matures on a single future date. c. If a bond is issued at a premium, interest expense and the carrying value of the debt will decrease over the life of the bond as the premium is amortized towards zero. If a bond is issued at a discount, interest expense and the carrying value of the debt will increase over the life of the bond as the discount is amortized towards zero. In each case, the carrying value of the debt is the face value of the debt at the maturity date (plus or minus any premium or discount). d. The gain or loss from the reacquisition of a long-term bond prior to its maturity is the difference between the amount paid to settle the debt and the carrying value of the debt. The gain or loss should be included in the determination of net income for the period reacquired. These gains (losses) are no longer treated as extraordinary items, net of related income taxes, unless they meet the text of both unusual and infrequent. e. Accounting standards require many useful bond-related disclosures including: amounts borrowed, interest rates, due dates, encumbrances, restrictive covenants, and events of default. While bonds are reported at their fair value at the date of issuance, subsequent changes in fair value are not recognized on the balance sheet. If the analyst is interested in the fair value of a firm’s bonds, the analyst must examine the note disclosures and make appropriate adjustments to market. (AICPA Adapted)

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Chapter 03 - Analyzing Financing Activities

Problem 3-5 (45 minutes) a. Ratio calculations for Jerry’s Department Stores (JDS) and Miller Stores (MLS) 1. Price-to-book ratio: Ratio

JDS

MLS

Book value

= $6,000 / 250 shares = $24.00

= $7,500 / 400 shares = $18.75

Price/book value

= $51.50 / $24.00 = 2.15

= $49.50 / $18.75 = 2.64

2. Total debt to equity ratio: Ratio

JDS

MLS

Total debt to equity [Total debt = (S-T debt + L-T debt)] / Equity

= $0 + 2,700 / $6,000

=$1,000 + $2,500 / $7,500

= $2,700 / $6,000 = 45.00%

= $3,500 / $7,500 = 46.67%

3. Fixed-asset utilization (turnover): Ratio

JDS

MLS

Sales / fixed assets

= $21,250 / $5,700 = 3.73

= $18,500 / $5,500 = 3.36

b. Investment Choice and Justification Based on Part A Based on Westfield’s investment criteria for investing in the company with the lowest price-to-book ratio (P/B) and considering solvency and asset utilization ratios, JDS is the better purchase candidate. The analysis justification follows: Ratio

JDS

MLS

Company Favored

i.

Price-to-book ratio (P/B)

2.15

2.64

JDS: lower P/B

ii.

Total debt to equity

45%

47%

JDS: lower debt or ratios are very similar

iii.

Asset turnover

3.73

3.36

JDS: higher turnover

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Chapter 03 - Analyzing Financing Activities

Problem 3-5—continued c.

Investment Choice and Justification Based on Note Information Note: Details underlying the Balance Sheet Adjustments ($ millions): JDS: i. Leases – recognition of MDS’s present value lease payments will add $1,000 to JDS’s property, plant, and equipment (PP&E) and is offset by a $1,000 addition to JDS’s long-term debt. ii. Receivables – recognition of JDS’s sale of receivables with recourse will increase assets (accounts receivable) by $800 and short-term debt used to finance accounts receivable by $800. MLS: iii. Pension – recognition of current excess funding for the pension plan will add $1,600 to assets and $1,600 to owners’ equity ($3,400 plan assets - $1,800 projected benefit obligation).

Adjusted Calculations Made ($ millions) JDS: Needed adjustments: Assets (PP&E) +$1,000 (Accounts receivable) +$800 i.

ii.

Liabilities (Long-term debt [LTD]) +$1,000 (Short-term debt [STD]) +$800

Book value per common share: No net adjustment to JDS owners’ equity of $6,000; thus, $6,000 / 250 million shares = $24.00 book value per share Adjusted total debt-to-equity ratio: $2,700 +1,000 + 800 $4,500 Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%

iii.

Historical LTD LTD STD Adjusted total debt

Fixed-asset utilization (turnover) = $5,700 Historical fixed assets +1,000 PP&E (JDS leases) $6,700 JDS adjusted fixed assets Adjusted fixed-asset utilization (sales/adjusted fixed assets): $21,250 / $6,700 = 3.17

MLS: Needed adjustments: Assets (Pension) +$1,600

i.

Owner’s Equity +$1,600

Book value per common share: $7,500 historical equity + $1,600 = $9,100 Adjusted equity; thus, $9,100 / 400 million shares = $22.75 adjusted book value per share

ii.

Adjusted total debt-to-equity ratio: Debt (no adjustments) / Adjusted equity = Adjusted debt / equity $3,500 / $9,100 = 38%

iii.

Fixed-asset utilization (turnover): Sales / Fixed assets (no adjustments) $18,500 / $5,500 = 3.36

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Chapter 03 - Analyzing Financing Activities

Problem 3-5—continued Part c continued:

Summary of Adjustments Ratio Adjusted book value Adjusted debt to equity Fixed-asset utilization

JDS $24.00 75% 3.17

MLS $22.75 38% 3.36

Final Results of Analysis: Based on Westfield’s investment criteria of investing in companies with low adjusted Price-to-Book and considering the adjusted solvency and asset utilization ratios, MLS is the better purchase candidate. The analysis justification follows: Ratio

JDS

i.

Price to adjusted book

2.15

2.18

ii.

Adjusted debt to equity

75%

36%

MLS – lower adjusted debt to equity

iii.

Fixed-asset utilization

3.17

3.36

MLS – higher asset utilization

a

a

$51.50 / $24.00 = 2.15. $49.50 / $22.75 = 2.18.

b

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MLS b

Company favored approximately equal

Chapter 03 - Analyzing Financing Activities

Problem 3-6 (20 minutes) a. In the case of environmental liabilities, there are several unknowns that are especially difficult to predict. The unknowns relate to the clean up and to the lawsuits that result from the hazardous waste. Specifically:  The company cannot predict the timing of an environmental tragedy such as that which occurred in the Union Carbide factory.  The company doesn’t know if it will be identified as a potentially responsible party in a yet uncovered hazardous waste site. This can include a former site of the company.  If the company is identified as a potentially responsible party, we do not know the portion of the clean up costs that it will be required to pay.  The company doesn’t know what costs would be incurred in the actual clean up of the site.  The company needs to determine which internal costs should be included in the cost of the clean up. For example, if it uses its laborers for site clean up activities, the direct cost of labor can become a part of the overall cost of cleanup.  The company must guess whether lawsuits will be filed against the company related to the hazardous waste site.  The company must estimate the probability of loss or settlement in the lawsuit and the amount of the damages to be paid b. We must factor the possibility of catastrophic environmental loss into the pricing of the company. For some industries, the probability assigned to occurrence might be very small. Thus, we will not assign a large weighting factor. However, in some industries, the base-line probability can be significant. In addition, we will update these probabilities based on additional information. For example, after the Bhopal tragedy, analysts discounted the valuations of key competitors. This indicates that analysts revised their beliefs about the possibility of loss upwards from earlier estimations. In classic valuation models, an analyst can reflect this risk in the discount factor applied to future earnings or future cash flows. c. Some industries especially predisposed to environmental risks include: oil producers, chemical manufacturers, tobacco producers, insulation manufacturers and distributors, medical firms, bio-tech firms.

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Chapter 03 - Analyzing Financing Activities

Problem 3-7 (30 minutes) a. The service cost of $22.1 million for Year 11 is the present value of actuarial benefits earned by employees in Year 11. b. Year 11: Discount rate = 8.75% Year 10: Discount rate = 9.00% A higher discount rate will lead to a lower present value of service cost. In this case, with the reduction in discount rate from 9% to 8.75%, the service cost is increased. c. The interest cost is computed by multiplying the projected benefit obligation (PBO) as of the end of the prior year by the discount rate of 8.75%. d. The actual return on assets in Year 11 is $73.4 million [113]. It consists of investment income plus the realized or unrealized appreciation or depreciation of plan assets during the year. The expected return on plan assets is computed by multiplying the expected long-term rate of return (9%) on plan assets by the market value of plan assets at the beginning of the period or $773.9 million [120]. This means the expected return is $69.65 million (computed as $773.9 x 9%). The actual return subjects pension cost to more fluctuation from volatility in the financial market—and, accordingly, increasing volatility in the annual pension cost. As a result, expected return is used in determining pension expense. The difference between actual and expected return will be amortized over an appropriate period. e. Accumulated benefit obligation (ABO) is the employer's obligation to employees' pension based on current and past compensation levels rather than future levels. Therefore, it could amount to the employer's current obligation if the plan were discontinued presently. f. The projected benefit obligation (PBO) is the employer's obligation to employees' pension based on future compensation level. The difference between PBO and ABO is due to the inclusion of a provision of 5.75% increase in future compensation level by PBO. In Year 11, the difference between PBO and ABO is $113.3 million [120]. g. Yes; indeed, there is prepaid pension expense of $172.5 million in Year 11 [120].

Problem 3-8 (20 minutes) Periodic pension cost computation ($ millions) Service Cost ($586 x 1.10) .............................................................................. Interest Cost (PBO x Discount Rate = $2,212 x 0.085) ................................. Return on plan assets ($3,238 x 0.115).......................................................... Amortization of deferred loss ($48 / 30 years) .............................................. Periodic pension cost ....................................................................................

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$645 188 (372) 2 $463

Chapter 03 - Analyzing Financing Activities

CASES Case 3-1 (60 minutes) a. Colgate administers defined benefit plans for substantial majority of its employees. The primary OPEBs provided by Colgate and health care and life insurance benefits. b. 1. The economic positions are follows (in $ millions): Pensions

OPEB

Total

Domestic

International

2005

(225.6)

(303.0)

(400.8)

(929.4)

2006

(188.3)

(315.9)

(437.4)

(941.6)

Negative numbers indicate underfunded status. Colgate’s plans are underfunded and so are net liabilities. 2. The position reported in the balance sheet is as follows ($ million): Pensions

OPEB

Total

Domestic

International

2005

254.9

(142.2)

(200.5)

(87.8)

2006

(188.3)

(315.9)

(437.4)

(941.6)

Negative/positive numbers indicate liability/asset. Colgate’s postretirement benefit plans are net liabilities on the balance sheet. 3. The amounts are primarily reported as noncurrent liabilities, but also included in noncurrent assets and current liabilities. 4. In 2005, Colgate reported postretirement benefits under SFAS 87. This standard reports only accumulated (or prepaid) pension cost on the balance sheet instead of the net economic position (funded status). This causes the divergence. 5. The projected benefit obligation (PBO) and accumulated benefit obligation (PBO) are as follows ($ million):

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Chapter 03 - Analyzing Financing Activities

Projected Benefit Obligation (PBO) Domestic

International

Accumulated Benefit Obligation (ABO) Total

Domestic

International

Total

2005

1462.4

658.8

2121.2

1381.1

572.5

1953.6

2006

1582.0

720.4

2302.4

1502.0

625.2

2127.2

The accumulated benefit obligation is closer to the legal liability related to pensions. The PBO is used to determine the net funded status on the balance sheet under SFAS 158. 6. If the plans were terminated, Colgate will be liable to pay the ABO amounts to the employees for domestic plans. While it is unclear if such liability exists in other countries, we assume this is the case. Therefore, assuming that the assets can be sold at their reported fair value, the net economic position of the pensions plans if terminated are the difference between the fair value of plan assets and the ABO ($ million): Pensions

Total

Domestic

International

2005

(144.3)

(216.7)

(361.0)

2006

(108.3)

(220.7)

(329.0)

There is no clear basis for determining the company’s legal liability regarding OPEBs. There is no legal requirement to provide OPEBs to employees.

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Chapter 03 - Analyzing Financing Activities

7. The closing value of plan assets is as follows ($ million): Pensions

OPEB

Total

Domestic

International

2005

1236.8

355.8

12.2

1604.8

2006

1393.7

404.5

22.6

1820.8

Colgate invests its plan assets primarily in equity securities, with a lower proportion in debt securities and a much small proportion in real estate. 8. For 2006, Colgate net periodic benefit cost (reported cost) is $ 58.2 million ($ 37.6 million, $ 37.8 million) for its domestic pension (international pension, OPEB) plans. Therefore a total postretirement benefit expense of $ 133.6 million was charged to income. Its components are the service cost, interest cost, expected return on plan assets and amortization of actuarial gain/loss and prior service cost. In addition, it should be noted that Colgate also charged unusual items (largely termination benefits) termed ―other postretirement charges‖ totaling 115.3 million.

9. The two non-recurring items are actuarial gain/loss and prior service cost/plan amendments. The movement in these two items is given below ($ million):

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Chapter 03 - Analyzing Financing Activities

Pensions

OPEB

Total

Domestic

Internation

Opening Balance (unrecognized)

470.8

150.8

198.8

820.4

Acturial Gain for the year

(36.7)

(7.1)

30.9

(12.9)

Actual less Expected Return

(54.3)

(0.1)

(1.5)

(55.9)

Amortization

(24.4)

(7.9)

(12.3)

(44.6)

9.8

0.5

10.3

355.4

145.5

216.4

717.3

9.7

10.0

1.5

21.2

Plan ammendments during the year

36.7

(2.3)

0.0

34.4

Amortization

(4.1)

(1.5)

0.0

(5.6)

Adjustments

0.8

(2.6)

0.2

(1.6)

41.5

8.8

1.3

51.6

Movement in Actuarial (Gain)/Loss

Adjustments =

Closing Balance (Accumulated Other Compr Inc)

Movement in Prior Service Cost (Plan Ammendments) Opening Balance (unrecognized)

Closing Balance (Accumulated Other Compr Inc)

Note: Because of foreign exchange translation effects on international plans and the effects of first-time adoption of SFAS 158, the numbers do not articulate exactly and so there is a need to introduce adjustments. Also note that, while the cumulative net deferral was unrecognized, i.e., kept off the balance sheet, in 2005 (under SFAS 87), in 2006 the cumulative net deferrals are recorded as part of accumulated other comprehensive income. 10. Colgate’s actual return on plan assets and expected return—that is included in income—is given below ($ million): Pensions Domestic Actual plan return

OPEB

Total

International

153.2

25.1

2.8

181.1

Expected return

98.9

25.0

1.3

125.2

Difference

54.3

0.1

1.5

55.9

11. The economic benefit cost (excluding unusual items such as termination benefits, curtailments and settlements) and the reported benefit cost are compared below:

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Chapter 03 - Analyzing Financing Activities

2006

Pensions

OPEB

Total

Domestic

Internation

Service cost

45.2

21.1

11.9

78.2

Interest cost

83.4

32.1

28.7

144.2

(153.2)

(25.1)

(2.8)

(181.1)

(36.7)

(7.1)

30.9

(12.9)

Actual return on plan assets Actuarial gain Plan amendments (prior service cost) Economic benefit cost/(income) Net periodic benefit cost (reported cost) Difference

36.7

(2.3)

0.0

34.4

(24.6)

18.7

68.7

62.8

58.2

37.6

37.8

133.6

(82.8)

(18.9)

30.9

(70.8)

The differences between the reported and economic benefit costs arise primarily because of the treatment of the non-recurring items, actuarial gain/loss (also called net gain/loss) and prior service cost. See answer for (9) above for a detailed reconciliation of the balance sheet and income statement effects for these items. 12. The primary actuarial assumptions used by Colgate are: (a) discount rate (2) long-term rate of return on plan assets (3) long-term rate of compensation growth and (4) ESOP growth rate. In 2006, Colgate has changed only one assumption for domestic plans: it has reduced the discount rate to 5.5% from 5.75%. This reduction is expected to increase the pension obligation and create an actuarial loss (note Colgate reports an actuarial gain for domestic pension plans in 2006, probably because of changes in certain other unreported actuarial assumptions). For international plans, Colgate decreased discount rate and compensation growth rate. The decrease in discount rate will increase the pension obligation but the decrease in compensation growth rate will decrease the pension obligation. Colgate also reduced its expected return on plan assets for international plans which would have reduced the expected return recognized in the net periodic pension cost. 13. Colgate’s cash flows related to benefit plans are the contributions it makes to the plans. In 2006, Colgate contributed $ 173.9 million to its benefit plans ($ 113.6 million, $ 36.4 million and $ 23.9 million respectively for its domestic pension, international pension and OPEB plans). This contribution is a cash outflow.

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Chapter 03 - Analyzing Financing Activities

Case 3.2 (45 minutes) a.

The schedule below provides details of Colgate’s benefit plans’ economic position (funded status) and the net amount recognized in the balance sheet for 2006 and 2005 ($ million): 2006

Pensions

OPEB

Total

Domestic

Internatio n

Plan Assets

1393.7

404.5

22.6

1820.8

Benefit Obligation

1582.0

720.4

460.0

2762.4

Net Economic Position (Funded Status)

(188.3)

(315.9)

(437.4)

(941.6)

Reported Position on Balance Sheet

(188.3)

(315.9)

(437.4)

(941.6)

OPEB

Total

12.2

1604.8

NO ADJUSTMENTS

2005

Pensions

Plan Assets

Domestic

Internatio n

1236.8

355.8

Benefit Obligation

1462.4

658.8

413.0

2534.2

Net Economic Position (Funded Status)

(225.6)

(303.0)

(400.8)

(929.4)

254.9

(142.2)

(200.5)

(87.8)

(480.5)

(160.8)

(200.3)

(841.6)

Reported Position on Balance Sheet Adjustment

No adjustments are required in 2006, since the net economic position is reported on the balance sheet under SFAS 158. In 2005, under the older standard (SFAS 87) the balance sheet reported a net deficit of only $ 87.8 million compared to Colgate’s net underfunded status of $ 929.4 million. This necessitates an adjustment of $ 841.6 million, which will involve increasing noncurrent liabilities and reducing shareholder’s equity (retained earnings) by that amount. This adjustment needs to be made irrespective of the analysis objective. If the purpose of the analysis is to determine the liquidation value of Colgate, then it is appropriate to determine the funded status using the ABO, rather than the PBO. Using the ABO will improve the funded status by $ 167.6 million ($ 175.2 million) in 2005 (2006). Since we are proposing no adjustments in 2006 to the balance sheet, there will be no change to the debt-equity ratios. For 2005, Colgate’s total debt to equity ratio before and after adjustment is 5.3 and 5.9. Long-term debt to equity ratio will not be affected since postretirement benefits are not included in long-term debt.

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Chapter 03 - Analyzing Financing Activities

The schedule below gives details of Colgate’s economic and reported benefit costs for 2006 and 2005 ($ million): 2006

Pensions

OPEB

Total

Domestic

Internatio n

Service cost

45.2

21.1

11.9

78.2

Interest cost

83.4

32.1

28.7

144.2

(153.2)

(25.1)

(2.8)

(181.1)

(36.7)

(7.1)

30.9

(12.9)

36.7

(2.3)

0.0

34.4

(24.6)

18.7

68.7

62.8

58.2

37.6

37.8

133.6

(82.8)

(18.9)

30.9

(70.8)

OPEB

Total

10.3

77.7

Actual return on plan assets Actuarial (gain)/loss Plan ammendments (prior service cost) Economic benefit cost/(income) Net periodic benefit cost (reported cost) Difference

2005

Pensions

Service cost Interest cost

Domestic

Internatio n

47.4

20.0

76.1

33.3

26.4

135.8

(92.4)

(41.8)

(1.1)

(135.3)

83.4

49.4

63.7

196.5

2.6

0.0

10.2

12.8

117.1

60.9

109.5

287.5

Net periodic benefit cost (reported cost)

64.9

37.5

31.1

133.5

Difference

52.2

23.4

78.4

154.0

Actual return on plan assets Actuarial (gain)/loss Plan ammendments (prior service cost) Economic benefit cost/(income)

On an economic basis, Colgate costs pertaining to its postretirement benefit plans are $ 62.8 million and $ 287.5 million in 2006 and 2005 respectively. However, it recognized net periodic benefit cost of $ 133.6 million and $ 133.5 million during these years. If the analysis objective is to ascertain economic income, then pre-tax income increasing (decreasing) adjustments of $ 70.8 million ($ 154 million) should be made in 2006 (2005). No adjustments need to be made when the analysis objective is measuring permanent (or core) income.

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Chapter 03 - Analyzing Financing Activities

b. Overall, there is little to suggest that Colgate’s key actuarial assumptions are unusual or unreasonable. It also appears that Colgate is somewhat conservative in its assumptions choices. For example, the US discount rate is 5.5% which for 2006 is slightly below the yield on high yield bonds and closer to the treasury yield. (One reason for the lower discount rates could be that Colgate is benchmarking itself to shorter term bonds; being an old company, it has a mature work force that is expected to retire sooner than that of average companies). Colgate’s assumptions on expected rates of return are also conservative given the high proportion of equity in its plan assets and also given the actual returns in the recent past. Colgate has marginally lowered its discount rate in 2006, which would have increased the value of the PBO and lowered its funded status. Colgate uses somewhat lower discount rates and expected rates of return for its international plans. This could reflect the different economic environments that it operates in internationally. Colgate has also lowered both these rates in 2006, which would have had adverse effects both on the balance sheet and income statement, by increasing the pension obligation and decreasing expected return from plan assets respectively. Overall, there is little to suggest that Colgate is being aggressive in its choice of actuarial assumptions or that it is using changes in these assumptions to manage earnings. c. An analyst needs to examine three dimensions with respect to pension risk exposures:  The extent of underfunding: Colgate’s pension plans are underfunded, but not seriously. In 2006, the underfunding for pension plans is around $ 500 million, which translates to about 6% of total assets.  Pension intensity: In 2006, Colgate’s pension obligation (assets) are 15% (17%) of total assets, which is not very high. However, in light of Colgate’s high leverage, the pension risk is much higher. For example, the above percentages are around 100% of equity, which is very high.  Colgate also invests fairly heavily in equity securities: about 2/3 for domestic and ½ for international plans. This does create some pension risk exposure. Overall, Colgate has moderate risk exposure from its pension plans.

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Chapter 03 - Analyzing Financing Activities

d. In 2006, Colgate contributed $ 173.9 million to its benefit plans ($ 113.6 million, $ 36.4 million and $ 23.9 million respectively for its domestic pension, international pension and OPEB plans). The level of these contributions are somewhat higher than the reported postretirement benefit cost, which is something that an analyst needs to note. However, given Colgate’s copious operating cash flows, these contributions need not be cause for concern. Generally, it is difficult to use current contributions to predict future contributions. However, Colgate appears to follow a policy of slightly underfunding its plans and contributing amounts that are not very different from benefits paid. One can use the estimated benefits payable (which Colgate forecasts all the way up to 2016 in the footnote) to reasonably forecast future contributions.

Case 3-3 (30 minutes) e. Campbell Soup reports the following categories of liabilities  Interest bearing (short-term and long-term)  Non-interest-bearing short-term operating obligations (payables and accruals)  Other – primarily deferred taxes (non-interest-bearing) b. Long-term debt [46] A B

159.7 0.3

G H

24.3 250.3

805.8

beg

0.1 99.8 100.0 199.6

C D E F

1.9 772.6

I end

A = Retirement of 13.99% Zero Coupon Notes. B = Repayment of 9.125% Note. C = Additional borrowing on 7.5% Note. D = Borrowing on 9% Note E = Borrowing on Medium-Term Notes. F = Borrowing on 8.875% Debentures G = Repayment of Other Notes H = Reclassification of Note I = Increase in capital lease obligation

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Chapter 03 - Analyzing Financing Activities

f. Campbell Soup has issued a number of long-term Notes and Debentures, all of which appear to be fixed rate. Thus, the company does not require derivatives in order to manage interest rate risk. Further, Campbell Soup’s debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt matures in excess of 5 years. Given Campbell’s operating cash flow of $805.2 million, solvency does not appear to be a problem. Case 3-4 (30 minutes) a. Book value of common stock is equal to total assets less liabilities and claims of securities senior to the common stock (e.g., preferred stock) at amounts reported on the balance sheet. Book value can also be reduced by unrecorded claims of senior securities. Year 11 Analysis: Book value ($ millions) = ($1,793.4 - 0) = $1,793.4 Number of shares outstanding = 135,622,676-8,618,911=127,003,765 Book value per share = $14.12 b. The par value of Campbell’s common shares is $0.15. Its details follow: (in millions) Year 11 Authorized 140,000,000 Issued 135,622,676 Outstanding 127,003,765 (part a) c.

Year 11 175.6 million $175.6 million / $3.3954 million shares = $51.72

Common shares purchased (mil) Average share repurchase price

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Chapter 03 - Analyzing Financing Activities

Case 3-5 (75 minutes) a. Ratio Analysis Liquidity Current ratio Solvency Total debt to equity Long-term debt to equity Times interest earned Return on Investment Return on total assets Return on equity

1998

AMR 1997

1998

Delta 1997

1998

UAL 1997

0.865

0.895

0.735

0.702

0.513

0.562

2.330 1.488 6.817

2.356 1.459 4.867

2.630 1.492 9.310

3.237 1.879 7.509

4.657 2.929 4.463

5.617 3.371 6.220

7.17%

8.18%

6.21%

20.23%

28.17%

29.23%

Note: We treat preference share capital as debt and include preference dividend with interest.

All three companies appear to be in poor liquidity position. UAL’s liquidity is especially troubling. From a balance sheet perspective, all companies show an excess of creditor financing in their capital structure. Once again, UAL is the most worrisome with total debt (long-term debt) at 4.66 (2.93) times equity. Still, these ratios seem to be improving over this short time period. All three companies are profitable. The ROA is respectable and the ROE is extremely good—ROE is much higher than ROA partly because of extreme leverage. Because of good profitability, all companies seem to be in a good position to pay interest expenses, despite high debt-to-equity ratios. Overall, the three companies (in particular UAL) reveal higher than usual liquidity and solvency risk. Although the high profitability (at least at present) appears to mitigate these risks to a large extent. b. Sensitivity Analysis The sensitivity analysis examines the impact of both a 5% and a 10% drop in revenues on the profitability and key ratios of these companies during 1998. We assume that 25% of operating expenses are variable (75% are fixed). We also assume a 35% tax rate for the changes to income. Recast income statements appear below: AMR Drop in Revenue

5%

10%

Delta 10%

5%

10%

13,431 12,724 (12,289) (12,134) 1142 590 141 141 (197) (197) 1,086 534 (454) (261) 632 273 36% 72%

16,683 (15,882) 801 133 (361) 573 (192) 381 54%

15,805 (15,681) 124 133 (361) (104) 45 (59) 107%

5%

UAL

Revised Income Statement for Yr 8

Operating Revenue Operating Expenses Operating Income Other Income & Adjustments Interest Expense* Income before Tax Tax Provision (35% tax rate) Continuing Income % drop in Continuing Income

18,245 17,285 (16,656) (16,445) 1,589 840 198 198 (372) (372) 1,415 666 (596) (333) 819 332 37% 75%

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued Part b continued: The profitability of the airlines is reduced dramatically by moderate revenue shortfalls under our assumptions. A mere 5% drop in revenues can reduce income by a third (half for UAL), while a 10% drop in revenues can all but wipe out the airlines’ profits. This happens because of the high proportion of fixed costs in the cost structure. We also examine the impact of the changes on key 1998 ratios: AMR Drop in Revenue Liquidity Current Ratio Solvency Total Debt to Equity Long Term Debt to Equity Times Interest Earned Return on Investment Return on Total Assets Return on Equity

5%

10%

5%

Delta 10%

5%

UAL 10%

0.865

0.865

0.735

0.735

0.513

0.513

2.330 1.488 4.803

2.330 1.488 2.788

2.630 1.492 6.511

2.630 1.492 3.712

4.657 2.929 2.587

4.657 2.929 0.712

4.91% 12.68%

2.66% 5.14%

5.56% 17.97%

2.94% 7.77%

3.62% 13.56%

1.03% -2.10%

The balance sheet ratios do not change. The ROA and ROE mirror the drop in profitability. The most interesting change occurs in interest coverage, which drops significantly with reduced revenues. While AMR and Delta can still pay their interest in the event of a demand slump, UAL may have difficulty meeting its interest payments in the case of a 10% revenue drop. c. Because of the volatile nature of profitability and consequent risk, airline companies often find it difficult to raise debt at reasonable terms. Raising equity is a possibility, but the equity cost of capital is high in this industry (airline companies have some of the lowest P/E ratios in the market). Consequently, leasing offers a convenient alternative to financing the high capital investment requirements of this industry. The lessor is probably able to offer better terms than other creditors for several reasons: (1) the lessor may be connected to suppliers of capital equipment and can use leasing as a marketing tool; and (2) in the event of insolvency the lessor is often in a better position to recover the assets because ownership often rests with the lessor. Finally, the bigger airline companies (such as AMR, Delta and UAL) prefer to maintain a young fleet of aircraft, both because of obsolescence and because of the high maintenance cost associated with maintaining older aircraft. In such a scenario, it is easier to lease aircraft rather than purchase outright and sell it later. d. Examine Capital and Operating Leases and Their Classification: All three companies are increasingly structuring their leases to be operating leases. The outstanding MLP on operating leases for AMR, Delta and UAL is approximately $17 billion, $15 billion and $24 billion, respectively, compared to $2.7 billion, $0.4 billion and $3.4 billion for capital leases.

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued The lease classification appears arbitrary. The capital and operating leases do not seem to differ either on the basis of the type of asset leased or the length of the lease. The average remaining life on the operating leases, for all three companies, varies between 16 to 20 years, which is much more than those on capital leases (see part e below). Overall, there does not seem to be any logic underlying the lease classification, except that the companies have structured the leases to avail themselves of the benefits of operating lease accounting. e. Reclassification of Operating Leases as Capital Leases and Restatement of Financial Statements AMR Capital

Estimate Average Remaining Lease Term (1998) 1 MLP in Later Years 1261 2 MLP in Last Reported Year 191 3 # of later years (1)/(2) 7 4 Add # of reported years 5 5 Average Remaining Lease 12 (3)+(4)

Capital

Operating

UAL Capital

Operating

12480 919 14 5 19

71 48 1 5 6

10360 960 11 5 16

1759 242 7 5 12

17266 1305 13 5 18

13,366 887 15 5 20

118 57 2 5 7

9,780 850 12 5 17

1,321 277 5 5 10

19,562 1,357 14 5 19

1998

AMR 1997

1998

Delta 1997

1998

1997

273 154 119 1,918 6.20%

255 135 120 1,764 6.80%

100 63 37 312 11.86%

101 62 39 384 10.16%

317 176 141 2,289 6.16%

288 171 117 1,850 6.32%

Estimate Average Remaining Lease Term (1997) 1 MLP in Later Years 1,206 2 MLP in Last Reported Year 247 3 # of later years (1)/(2) 5 4 Add # of reported years 5 5 Average Remaining Lease 10 (3)+(4)

Estimate Interest Rate on Capital Leases 6 MLP During Next Year 7 Less Principal Component 8 Interest (6) - (7) 9 PV of Capital Leases 10 Interest Rate (8)/(9)

Delta

Operating

UAL

Note: The principal component is shown as a current liability on the balance sheet.

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued AMR 1997

1998

Delta 1997

1998

1997

Estimate Average MLP per year on Operating Leases 11 Total MLP 17,215 12 Average Remaining Lease 19 Term 13 Average MLP (11) / (12) 927

18,115 20

15,120 16

14,020 17

23,798 18

26,515 19

903

957

849

1,305

1,366

Estimate Present Value of Operating Leases 10.8505 14 Present Value Factor 15 Average MLP (13) 927 16 Present Value (14)X(15) 10,053

10.7762

6.9958

7.8515

10.7746

11.0047

903 9,727

957 6,698

849 6,669

1,305 14,065

1,366 15,029

1998

UAL

Note: Present value factor represents the present value of an annuity of $ 1 at a given interest rate and lease term from the annuity tables. We use the interest rate on capital leases (estimated in (10) above) as a surrogate interest rate for operating leases. The lease term for operating leases was estimated in (5) above. AMR 1998

Delta 1998

UAL 1998

E. Estimate Interest and Depreciation on Operating Lease 17 Present Value of Operating Leases 9,727 18 Interest Rate 7% 19 Interest Expense (17) X (18) 662

6,669 10% 677

15,029 6% 950

20

9,727

6,669

15,029

20 485

17 404

19 774

21 22

Value of Operating Lease Assets Average Remaining Lease Term (Lease Life) Depreciation Expense

F. Estimate Efect of Operating Lease Conversion on Income Statement 23 Increase in Depreciation Expense (485) (404) Decrease in Lease Rental 24 Expense 1,011 860 25 Effect on Operating Income 526 456

1,419 645

26 27

Increase in Interest Expense Effect on Income before Tax

(662) (135)

(677) (221)

(950) (306)

28 29

Decrease in Tax Provision (35%) Effect on Continuing Income

47 (88)

77 (144)

107 (199)

(774)

Note: For computing interest and depreciation for 1998, we use the lease asset/obligation we estimated at the end of 1997.

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued AMR

Delta

UAL

G. Determine Principal and Interest Component of Next Year's MLP 30 Next Year MLP (1999) 1,012 950 31 Estimated Interest Component 624 794 32 Estimated Principal Component 388 156

1,320 866 454

H. Decompose Operating Lease Liability into Current and Non-Current Components 33 Total Operating Lease Liability 10,053 6,698 14,065 34 Estimated Current Portion 388 156 454 35 Estimated Non-Current Portion 9,665 6,543 13,611 Restated Balance Sheet $ Millions Assets Current Assets Freehold Assets (Net) Leased Assets (Net) Intangibles & Other Total Liabilities Current Liabilities: Current Portion of Capital Lease Other Current Liabilities Long Term Liabilities: Lease Liability Long Term Debt Other Long Term Liabilities Preferred Stock Shareholder's Equity Contributed Capital Retained Earnings Treasury Stock Total Restated Income Statement $ Millions

Operating Revenue Operating Expenses Operating Income Other Income & Adjustments Interest Expense* Income before Tax Tax Provision Continuing Income * Includes preference dividends.

AMR 1998

Delta 1998

UAL 1998

4,875 12,239 12,200 3,042 32,356

3,362 9,022 6,997 1,920 21,301

2,908 10,951 16,168 2,597 32,624

542 5,485

219 4,514

630 5,492

11,429 2,436 5,766

6,792 1,533 4,046 175

15,724 2,858 3,848 791

3,257 4,729 (1,288) 32,356

3,299 1,776 (1,052) 21,301

3,518 1,024 (1,261) 32,624

AMR 1998

Delta 1998

UAL 1998

19205 (16396) 2809 198 (996) 2011 (805) 1207

14138 (11919) 2219 141 (991) 1369 (553) 815

17561 (15535) 2026 133 (1227) 932 (318) 614

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued f. We made several assumptions in estimating the effects of the lease classification. Some of the important assumptions are: 

Interest Rate Parity across Capital and Operating Leases. We use the average interest rate on the capital leases as a proxy for the interest rate on operating lease. To the extent capital and operating leases are dissimilar, the interest rate estimate is inaccurate or biased. This problem arises especially if the capital leases and the operating leases, on average, have been contracted during different time periods with different interest rate regimes. In this particular case, the interest rate on Delta’s capital leases is substantially higher than that on either AMR or UAL. While it is not impossible, it is improbable that lease rates could differ so markedly across similar companies in the same industry. The average remaining lease term offers a clue: for Delta’s capital leases it is 6-7 years compared to 10-12 years for AMR and UAL. Under the assumption that the average lease terms are similar across companies, this implies that Delta’s capital leases, on average, were contracted 4-5 years before AMR or UAL, which is consistent with the higher interest rate on Delta’s capital leases. To some extent, this problem is alleviated (at least on a comparative basis) because Delta’s operating leases also appear to have been contracted around three years earlier to AMR’s or UAL’s. It appears that the capital leases for all three companies were entered into at an earlier time than the operating leases. If these leases were entered at a time with a sufficiently different interest rate regime, we need to make appropriate corrections to our interest rate estimates.



Depreciation Policy. We set the lease asset and liability equal to each other. In reality, the depreciation of the asset seldom equals the lease principal payments. Some people use a simplifying assumption such as lease assets should be equal to 80% the liability. However, these ad hoc rules are no better than putting them equal to each other.

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued g. Ratio Analysis on Restated Financial Statements AMR

Delta

1998 Liquidity Current Ratio 0.809 Solvency Total Debt to Equity 3.831 Long Term Debt to Equity 2.931 Times Interest Earned 3.020 Return on Investment* Return on Total Assets 5.89% 18.69% Return on Equity *computed on adjusted yearend asset and equity balances

UAL

1998

1998

0.710

0.475

4.295 3.118 2.380

8.943 7.078 1.759

7.17%

4.47%

23.20%

21.87%

Note: We treat preference share capital as debt and include preference dividend with interest.

Capitalizing the operating leases significantly worsens the liquidity and solvency picture of all three companies. The impact on current ratio is not dramatic, but the current ratios are bad to start with. In particular UAL’s current ratio of less than 50% is cause for concern. The solvency picture deteriorates significantly after lease capitalization. We realize that all three companies are extremely reliant on creditor financing, particularly through lease financing that constitutes between 25% to 50% of the total assets. The debt to equity ratios are significantly above acceptable levels. UAL’s debt to equity is particular high. Part of the reason for the high debt equity ratios is that these companies had all but wiped out their retained earnings during the recession in the early 1990s, which makes their equity base very low. While this is an explanation for the high debt to equity ratios, it does not absolve the risk associated with such extreme debt orientation in the capital structure. Despite the excellent profitability of all three companies, the interest coverage ratios are not as impressive as they appeared before the operating leases were capitalized. By classifying a significant part of their leases as operating, all three companies were able to underreport interest expense by over twothirds. In particular, UAL’s interest coverage looks weak even when its profitability is spectacularly high. The ROA has not deteriorated significantly although total assets have increased by at least a third for all companies. The reason is that operating income was significantly underreported earlier because the interest costs pertaining to operating leases were being treated as operating expenses. ROE has reduced significantly for all three companies, mainly because of drop in continuing income. The ROE is still good although not as spectacular as reported.

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued

Sensitivity Analysis after lease capitalization AMR Drop in demand

5%

UAL

5%

10%

5%

10%

17285 (15986 ) 1298

13431 (11770 ) 1661

12724 (11621 ) 1103

16683 (15340 ) 1343

15805 (15146 ) 659

198 (996) 501 (276) 225

141 (991) 811 (358) 453

141 (991) 253 (162) 90

133 (1227) 248 (78) 170

133 (1227) (436) 161 (275)

81%

44%

89%

72%

145%

0.809

0.809

0.710

0.710

0.475

0.475

3.831

3.831

4.295

4.295

8.943

8.943

2.931 2.261

2.931 1.503

3.118 1.818

3.118 1.255

7.078 1.202

7.078 0.645

4.33% 10.69%

2.77% 3.36%

5.39% 11.26%

3.61% 2.24%

3.07% 5.18%

1.66% -8.37%

Revised Income Statement for 1998 Operating Revenue 18245 (16191 Operating Expenses ) Operating Income 2054 Other Income & Adjustments 198 Interest Expense* (996) Income before Tax 1256 Tax Provision (540) Continuing Income 716 % drop in Continuing Income 41% Revised Ratios (1998) Liquidity Current Ratio Solvency Total Debt to Equity Long Term Debt to Equity Times Interest Earned Return on Investment Return on Total Assets Return on Equity

Delta 10%

The sensitivity analysis after the capitalization of operating leases further highlights the high degree of risk in these companies. With a 10% drop in revenue all the three companies have little or no ―cushion‖ to pay their interest costs. UAL in particular is highly unlikely to be able to meet its interest commitments in such a scenario (also realize that for operating leases, both the interest and principal portions need to be paid). The results also highlight that the return on assets and equity will be considerably affected with a downturn in demand. In short, capitalizing operating leases shows that the solvency of the companies is clearly a risk, and this risk could come to the forefront if and when these companies experience even a moderate drop in revenues, which is not unlikely if history is any indicator.

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Chapter 03 - Analyzing Financing Activities

Case 3-5—continued h. Accounting Motivations for Leasing and Lease Classification: In (c) above we presented some economic arguments for the popularity of leasing in the airline industry. After the analysis in g and h, we added an important motivation that is purely related to financial reporting. By leasing a large proportion of their assets and successfully classifying most leases as operating, the airlines attempt to camouflage the high risk inherent in their capital structure. The big question is whether managers can fool the market with these accounting gimmicks. Research does indicate that the market seems to consider the additional risk imposed by operating leases and to reflect what is not shown on the financial statements. However, a surprising number of even ―sophisticated‖ investors fall prey to these window-dressing tactics—for example, many analyst reports and financial databases fail to adjust the solvency and other ratios for operating leases. This case highlights the importance for a financial analyst to understand the accounting issues. It also highlights the importance of ―getting ones hands dirty‖ by doing a detailed and careful accounting analysis before embarking on further financial analysis.

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Chapter 03 - Analyzing Financing Activities

Case 3-6 (75 minutes) a. Pension Benefits 1998 1997

Health and Life Benefits 1998 1997

Difference

43,447 38,742 27,572 25,874 15,875 12,868 7,752 6,574 8,123 6,294

2,121 5,007 (2,886) (2,420) (466)

Balance Sheets

Original 1998 1997

Totals 1998

1997

Net Economic Position Fair Market Value of Plan Assets

PBO Net Economic Position Reported Position on Balance Sheet

Assets Current Assets PP&E Intangible Assets Other Total Liabilities & Equity Current Liabilities Long Term Borrowing Other Liabilities Minority Interest Equity Share Capital Retained Earnings Total Relevant Ratios Debt to Equity Long-Term Debt to Equity Return on Equity

212,755

243,662

212,755

35,730 23,635 52,908

32,316 19,121 39,820

355,935

304,012

355,935

304,012

141,579

120,668

141,579

120,668

59,663 46,603

59,663

46,603

111,538

98,621

103,881

92,739

4,275 3,682 7,402 5,028 31,478 29,410

4,275 7,402 39,135

3,682 5,028 35,292

304,012

355,935

304,012

7.25 6.98 3.97 3.81 21.54% 21.52%

6.00 3.22

355,935

45,568 32,579 12,989

40,659

5,332 7,657

4,128 5,882

30,649 10,010

Restated 1998 1997

35,730 32,316 23,635 19,121 52,908 39,820

243,662

1,917 4,775 (2,858) (2,446) (412)

5.91 3.17 18.29% 18.64%

Inference: Net assets (other liabilities) are understated (overstated) by $7.66 billion in 1998 ($5.89 billion in 1997). Both the debt to equity and the return on equity ratios decrease when the true economic position is depicted in the balance sheet.

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Chapter 03 - Analyzing Financing Activities

Case 3-6—continued b. Post Retirement Expense Restatement

Permanent Income Reported Expense One-time charge Permanent Income Economic Income Actual Return on Assets Service Cost Interest Cost Actuarial Changes Early Retirement Costs Economic Income or Expense

1998

Pension Benefits Change 1997

Retiree Health and Life Benefits Total 1998 1997 Change 1998 1997

Change

1,016 0 1,016

331 412 743

685 (412) 273

(313) 0 (313)

(455) 165 (290)

142 (165) (23)

703 0 703

(124) 577 453

827 (577) 250

6,363 (625) (1,749) (1,050) 0 2,939

6,587 (596)

(224) (29) (63) 338 412 434

316 (96) (319) (268) 0 (367)

343 (107) (299) (301) (165) (529)

(27) 11 (20) 33 165 162

6,679 (721)

6,930 (703)

(2,068) (1,318)

(1,985) (1,689)

0 2,572

(577) 1,976

(251) (18) (83) 371 577 596

(367)

(529)

2,572

1,976

268 (167)

301 (206)

1,318

1,689

(3,506)

(4,072)

(8) 0 (39) (313)

11 0 (32) (455)

(161) 154 326 703

(134) 154 263 (124)

(1,686) (1,388)

(412) 2,505

Reconciliation of Economic and Reported Expense Economic Income 2,939 2,505 Less One-Time Charges Actuarial Changes 1,050 1,388 Diff. in expected & actual return (3,339) (3,866) Add Amortization Prior Service Cost (153) (145) SFAS 87 154 154 Net Actuarial Gain 365 295 Reported Pension Income 1,016 331

c. Under SFAS 158, the net economic position (funded status) of $ 12.99 ($ 10.01) billion in 1998 (1997) will be reported on the balance sheet (pension + OPEB). Therefore, the balance sheet will correctly depict the economic position of the plan. In contrast, the income statement under SFAS 158 will continue to reflect the smoothed net periodic benefit cost. For example, in 1998 $ 703 million will shown as net periodic benefit income under SFAS 158 instead of economic income $ 2.572 billion. The articulation of the income statement and balance sheet effects under SFAS 158 are done through movement in accumulated other comprehensive. For example in 1998 the following reconciliation will occur: Opening Accumulated Comprehensive Income (Difference between economic and SFAS 87 reported position in Balance sheet) Other Comprehensive Income for 1998 (Difference between economic and smoothed benefit income) Change in pension liability = Closing Accumulated Comprehensive Income * This is an unusual item that General Electric kept off the balance sheet.

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$ 5,882 1,869 (94)* $ 7,657

Chapter 03 - Analyzing Financing Activities

d. The actuarial assumptions appear reasonable. (1) The expected return on assets has been maintained at a steady 9.5%, which is marginally higher than the average. Yet, this return appears somewhat conservative when compared to the actual return on assets. (2) The discount rate has mirrored the long-term interest rate, which has been decreasing over this period. (3) The compensation rate has been slightly increased in 1998, which reflects the tighter labor market and wage cost escalation occurring in the U.S. economy. Both the increase in compensation rate and the reduction in discount rate have resulted in considerably increasing the PBO. The lower discount rates have marginally reduced interest cost by $64 million ($58 million) in 1998 (1997), when compared to previous year. Overall, there appears to be no evidence of earnings management using actuarial assumptions. e. To suggest that any change in the reported net pension income (or expense) must be excluded when determining the legitimate earnings growth rate implies either that pension plans are not an integral part of the company or that pension expense (or income) should be constant over time. Both assumptions are not necessarily correct. As explained in the textbook, while pension plans are administered by separate trustees, the net assets (or liabilities) of the plans are the employer’s responsibility. Moreover, while reported pension expense is generally not volatile, there is no reason why it must remain the same each year. Therefore, to determine whether the change in the pension income is warranted we need to examine the changes in the components of reported pension costs: Pension Benefits 1998 1997 Change

($ Millions) Effect on Operations Expected Return on Plan Assets Service Cost for Benefits Earned Interest Cost on Benefit Obligation Prior Service Cost SFAS 87 Transition Gain Net Actuarial Gain Recognized Special Early Retirement Cost Post Retirement Benefit Income(Cost)

3,024 (625) (1,749) (153) 154 365 1,016

2,721 (596) (1,686) (145) 154 295 (412) 331

303 (29) (63) (8) 0 70 412 685

This analysis reveals that the main reasons for the increase in pension income are the expected rate of return ($303 million) and the early retirement costs ($412 million). Both appear to be genuine. The higher return on plan assets is fully attributable to the increase in the beginning market value of plan assets (from $33.69 billion on January 1, 1997 to $38.742 billion on January 1, 1998). In reality, pension accounting has underreported the actual return on assets by over $3 billion (the actual return is $6,363 million versus reported $3,024 million). As our analysis in (b) indicates, the reported pension cost underreports the true economic cost by almost $3 billion. The $412 million increase in early retirement cost arises not because GE over-reported pension income for 1998, but rather

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Chapter 03 - Analyzing Financing Activities

because GE underreported pension income for 1997, by taking a one-time charge of $412 million. GE did reduce its discount rate by 0.25% in 1998, resulting in $64 million decrease in interest cost. However, this is less than 10% of the overall increase in pension income. Also, this decrease appears legitimate, considering that long-term interest rates dropped by more than 1% in 1998. Overall, Barron’s claim that the earnings growth rate for GE has been artificially inflated because of its pension plan appears to be unsubstantiated. Still, before we confidently conclude that GE is not managing its earnings, it might be interesting to examine pension income before and after excluding the one-time early retirement charge and then examine the pattern of reported earnings: Including One-Time Charge

Pension Income Net Earnings Earnings Growth Rate

1998 1,016 9,296 13.32%

1997 331 8,203 12.68%

Excluding One-Time Charge

1998 1,016 9,296 7.90%

1997 743 8,615 18.34%

When we examine the timing of the large one-time charge, it appears that there is a kernel of truth to the Barron’s complaint, although not in the sense that was implied. If GE had not taken the $412 million charge in 1997, its earnings growth would have been an outstanding 18.34% in 1997, thereby creating an expectation of similar growth in 1998. The real growth rate in 1998, however would have been a disappointing 8%, which may have had adverse market reactions. GE is adept at smoothing its income across periods so that it can show a steady 13% growth in earnings. By doing this, GE is not artificially increasing the long-term earnings growth rate (as the Barron’s editorial alleges), but rather it is reducing the volatility in reported earnings, thereby creating an impression of a more stable (and hence, less risky) company. For more details about GE’s earnings smoothing techniques, see the Wall Street Journal article (WSJ, 11/3/94). f. The pension related cash flows for GE are the employer’s contributions of $68 million ($64 million) in 1998 (1997). Evidently these cash flows have little to do with the economics of the pension plans or their effects on either GE’s performance or financial position. GE’s situation is not unusual. Because defined benefit pension plans can be either over or under funded, the actual cash contributions by the company to the pension plans are entirely arbitrary (in contrast, the cash contributions in the case of a defined contribution plan are a real expense). Therefore, the pension cash flows have no connection with the economic reality of the pension plans. The accounting standard setters understand this and have progressively developed better pension accounting standards that attempt to capture the economic reality

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Chapter 03 - Analyzing Financing Activities

Case 3-7 (60 minutes) a. The number of claims by categories are: (1) Smoking and health cases alleging personal injury brought on behalf of individual plaintiffs—510 cases; (2) Smoking and health cases alleging personal injury and purporting to be brought on behalf of a class of individual plaintiffs—60 cases; and (3) Health care cost recovery cases brought by governmental and nongovernmental plaintiffs seeking reimbursement for health care expenditures allegedly caused by cigarette smoking (actions by all 50 states, several commonwealths and territories of the United States—95 cases, as well as cases in several foreign countries—27 cases plus 6 foreign class actions suits).

b.

The company recorded the following pre-tax charges related to tobacco litigation: $3.081 billion and $1.457 billion during 1998 and 1997, respectively, to accrue for the company's share of all fixed and determinable portions of the company's obligations under the tobacco settlements with various states. In addition, the company accrued $300 million during 1998 and $1.359 billion in total for its unconditional obligations under an agreement in principle to contribute to a tobacco growers' trust fund. These amounts relate to the third category.

c. Charges totaling $3.381 billion were recorded as losses in the 1998 income statement related to tobacco litigation. d. The eventual losses will likely dwarf what is currently recorded on the Balance Sheet of Philip Morris. There are vast amounts of loss that are currently deemed to not meet one of the 2 requirements to accrue contingent liability. In most cases, the company likely contends that the amount of the loss is not yet reasonably estimable. e. While certain contingent losses do not meet the threshold for accrual and recognition in the balance sheet, analysts should adjust their models to reflect much greater exposure to losses from tobacco litigation. The current balance sheet should be adjusted to report much greater amounts of liability and tobacco litigation charges and losses.

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