02. Analyzing Financing Activities

7/30/2019 02. Analyzing Financing Activities

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Overview of the Chapter

Current and Noncurrent Liabilities

Lease Obligations

Pension Liabilities

Contingent Liabilities & Commitments

Deferred credits or income

Off-Balance-Sheet Financing

Liabilities at the Edge of Equity

Equity Financing

Book Value per Share



Analysis of Liabilities

Areas of observations:

We need to make sure that companies account for all

of them with proper details as to their amounts, due

dates including conditions, encumbrances and

limitation

Most companies look for ways to reduce the amount

of liabilities reported in the financial statements

We must recognize that companies can misclassify

or inadequately describe liabilities



Where and How to Look?

Auditors are one source of assurance in our search

Auditors tools include; direct confirmation, review

board minutes, reading contract and agreement,

inquiry

In double entry system helps auditors and us

Most difficult item includes commitment and

contingent liabilities require no entry

To understand it, we need to study management

discussion, reconciliation, notes



Example of motivated transactions

SEC determined Ampex Corporation failed to fully

disclose:

Its obligation to pay royalty guarantees of 80 million

A several million dollar understatement in the

allowance for doubtful accounts receivable

Income overstatement from inadequate credit

allowances for returned tapes



Important Features in Analyzing Liabilities

Terms of indebtedness ( maturity, interest rate)

Restrictions on deployment of resources and freedom

in business activities

Ability and flexibility in pursuing further financing

Working capital, debt to equity

Dilutive conversion features that liabilities are subject

to

Prohibition on certain disbursements such as

dividends



Current Liabilities

Commercial paper borrowings should be separately

disclosed in the balance sheet

Average interest rate and terms to be separately

stated for short term bank and commercial paper borrowings at the balance sheet date

Disclosure of amounts and terms of unused line sfor

credit for short term borrowings arrangements



Noncurrent Liabilities

Information on noncurrent liabilities should include

interest rate, maturity date, conversion privileges, call

features, subordination provision, and restrictions

Companies must disclose any defaults of debtprovisions, including defaults of interest and principal

repayments

Important items: purchase commitments which is

unconditional purchase obligations. Footnotedisclosure is required



Purchase Obligations

Description and term of obligation

Total fixed in determinable obligation

Description of any variable obligation

Amounts purchased under obligation

For purchase obligations that are recognized on

purchaser’s balance sheet, a company must reportpayment for each of the next five years



Analysis Implications of Liabilities

Since liabilities are claims against a company’s

assets, we need to assure that all of them are shown

in details including conditions, encumbrances, and

limitation s they impose on a company We must also recognize that companies can

misclassify or inadequately describe liabilities

Most difficult items are those relating to commitments

and contingent liabilities requiring no entry In this case we must rely on management comment

and information provided in the notes



Lease Obligations

Lease obligations are contractual agreements

between a lessor and a lessee giving the lessee a

right to use assets owned by a lessor for the lease

term in return for rental payments Most common classification is: capital lease,

operating lease

Conditions for a lease to qualify as capital lease or

finance lease Sale and lease-back

Leveraged lease-when lessor borrows heavily



Pension Liabilities

Pension Liabilities are obligation of an employer

US size is 25 percent of NYSE common stock and

nearly one third of the daily trading volume

Pension invites costs for the organizations and alsoattracts accounting issues

Pension expense is a measure of the current cost of

providing for future promised benefits under plan

Pension expense derives from accrual accountingand is distinct from funding of pension

Funding refers to transfer of cash or assets to the

fund



Pension Liabilities

Defined benefit pension plans specify the amount of

pension benefits, where company bears the risk of

pension fund performance

Defined contribution pension plans specifycontributions required of the company. Benefits

depends on performance

Our concern is accounting for defined benefit pension

plans Usually the benefits are determined by actuarial

variables like age, life expectancies, turnover rate,

future salary levels, future return on funds



Nature of Pension Liabilities

There are three different estimates of pension

obligations:

Projected benefit obligation (PBO)

Accumulated benefit obligation (ABO)

Vested benefit obligation (VBO)

Example in the Table…………

Disclosure requirements include: Desccription of coverage, Net periodic pension cost for the period,

Reconciliation of funded status, various assumption

Show Table in the book for detail



Analysis Implications of Pension Liabilites

Benefits on future pay, sometimes understates

liability

It ignores inflation impact, future pay increase

Discount rate is also an important issue

Preferred measure-difference between PBO and fair

value of pension assets

High performing equity market reduce or eliminate

pension liabilities and vice versa

Unfunded pension obligations are continually subject

to change



Contingent Liabilities

Contingencies refer to potential gains or losses

whose resolution depends on one or more future

events

It may arise from litigation, collectivity of receivables,claims against product warranty, guarantees of

performance, tax assessments, self insured risks etc.

Two criteria: (1) must be probable, (2) the loss must

be reasonably estimable….like uncollectiblereceivables or product warranty

Companies usually do not recognizes gain

contingency



Off-Balance Sheet Financing

It refers to non recording of certain financing

obligations like operating lease

Example: Through-put agreement,

Take or pay arrangement

Creating separate entity with less than 50 percent

ownership and not consolidation with balance sheet

Product financing arrangements-Sells and agrees to

either repurchase or guarantee selling price to third

parties

Receivable selling with or without recourse



Liabilities at the “Edge” of Equity

We need to be alert to equity securities (typically

preferred stock) that may become liability

Company may need to pay funds at specific dates

Redeemable preferred stock significantly different

from equity stock and should not be included in the

shareholders’ equity

Company should disclose the redemption terms and

five year maturity data

They are an obligation to pay cash at a future date



Treasury Stock

It represents shares of a company’s stock reacquired

after previously issued.

Purchasing treasury stock reduces both assets and

shareholders equity

Treasury stock is not an asset it is a contra equity

account

Treasury stock is typically recorded at cost

In rare cases, it is reported as assets when

companies reserves it for purposes like profit sharing,

acquiring another company



Deferred Tax

Deferred taxes are postponed tax effects attributed to

temporary difference between taxable and

accounting income

Major items cause deferred tax are; depreciation,inventory, pensions, Nonpension benefits,

discontinued segments

A company may choose accelerated depreciation for

tax purpose and straight line for accounting Result: tax deferral in early years and tax catch up in

later years



Book Value Par Share

Book value per share is the per share amount

resulting from company’s liquidation at amounts

reported on its balance sheet

In other words net asset value-total assets reducedby claims against them

The book value of common stock is equal to total

assets less liabilities and claims of securities senior

to common stock such as preferred stok Liquidation premium on preferred stock can

significantly impact book value of common stock

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02. Analyzing Financing Activities