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Chapter 3 O Analyzing Financing Activities PDF
Chapter 3 O Analyzing Financing Activities PDF
Chapter 3 O Analyzing Financing Activities PDF
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 financingcredit and equityand
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
Leases
Lease Accounting and Reporting Lessee
Analyzing Leases
Postretirement benefits
Pension Accounting
Other Postretirement Benefits (OPEBs)
Analyzing Postretirement Benefits
Off-Balance-Sheet Financing
Through-put and Take-or-pay agreements
Product financing arrangements
Special Purpose Entities (SPEs)
Shareholders Equity
Capital Stock
Retained Earnings
Computation of Book Value Per Share
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ANALYSIS OBJECTIVES
Analyze and interpret lease disclosures and explain their implications and the
adjustments to financial statements.
Explain capital stock and analyze and interpret its distinguishing features.
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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 naturesuch as
accounts payable and operating expense accrualsrepresent 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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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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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.
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(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 periods 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 plans funded status relative to the companys 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.
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.
3-15
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 companys 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 resultsthe 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 companys 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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3-17
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 soldthe 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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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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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
3-24
3-25
Exercise 3-5continued
Off-balance-sheet debtsuch as industrial revenue bonds or pollution control
financing where a municipality sells tax-free bonds guaranteed for paymentare
cases where a supposedly debt-free balance sheet could look much worse if
these obligations were recorded.
Finally, the practice of deferred taxessuch as taking some expenses for tax, but
not book purposes, or through differences in timing for recognition of salesis
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)
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.
3-27
Exercise 3-7continued
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.
a. The causes of the $101.6 million increase are identified in the table below (see
Campbells 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]
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)
Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders
Equity
3-28
Exercise 3-8continued
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
companys stock.
Exercise 3-9continued
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."
3-30
Exercise 3-10continued
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).
3-31
3-32
3-33
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.]
#
#
c. The $28 million amount will be paid out. This amount will include $6.5 million
of interest implicit in the leases.
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.)
3-34
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
39,930
3,194.40 (1)
6,805.60
7,986 (2)
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)
3-35
Problem 3-2continued
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
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.
3-36
3-37
3-38
JDS
MLS
Book value
Price/book value
= $51.50 / $24.00
= 2.15
= $49.50 / $18.75
= 2.64
JDS
MLS
= $0 + 2,700 / $6,000
= $2,700 / $6,000
= 45.00%
= $3,500 / $7,500
= 46.67%
JDS
MLS
= $21,250 / $5,700
= 3.73
= $18,500 / $5,500
= 3.36
JDS
MLS
Company Favored
i.
2.15
2.64
ii.
45%
47%
iii.
Asset turnover
3.73
3.36
3-39
Problem 3-5continued
c.
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
MLS:
Needed adjustments:
Assets
(Pension) +$1,600
i.
Owners Equity
+$1,600
ii.
iii.
3-40
Problem 3-5continued
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
JDS
i.
2.15
2.18
ii.
75%
36%
iii.
Fixed-asset utilization
3.17
3.36
3-41
MLS
b
Company favored
approximately equal
3-42
3-43
$645
188
(372)
2
$463
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)
OPEB
Total
Domestic
International
2005
254.9
(142.2)
(200.5)
(87.8)
2006
(188.3)
(315.9)
(437.4)
(941.6)
3-44
International
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
Total
Domestic
International
2005
(144.3)
(216.7)
(361.0)
2006
(108.3)
(220.7)
(329.0)
3-45
OPEB
Total
Domestic
International
2005
1236.8
355.8
12.2
1604.8
2006
1393.7
404.5
22.6
1820.8
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):
3-46
Pensions
OPEB
Total
Domestic
Internation
470.8
150.8
198.8
820.4
(36.7)
(7.1)
30.9
(12.9)
(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
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
Adjustments
=
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
3-47
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)
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)
3-48
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
(188.3)
(315.9)
(437.4)
(941.6)
(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
(225.6)
(303.0)
(400.8)
(929.4)
254.9
(142.2)
(200.5)
(87.8)
(480.5)
(160.8)
(200.3)
(841.6)
3-49
The schedule below gives details of Colgates 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
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
64.9
37.5
31.1
133.5
Difference
52.2
23.4
78.4
154.0
3-50
b. Overall, there is little to suggest that Colgates 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). Colgates 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: Colgates 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, Colgates pension obligation (assets) are
15% (17%) of total assets, which is not very high. However, in light of
Colgates 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 for international plans. This does create some
pension risk exposure.
Overall, Colgate has moderate risk exposure from its pension plans.
3-51
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 Colgates 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.
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
3-52
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 Soups 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 Campbells 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 Campbells 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
3-53
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.
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
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%
3-54
Case 3-5continued
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.
3-55
Case 3-5continued
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
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%
Delta
Operating
UAL
Note: The principal component is shown as a current liability on the balance sheet.
3-56
Case 3-5continued
AMR
1997
1998
Delta
1997
1998
1997
18,115
20
15,120
16
14,020
17
23,798
18
26,515
19
903
957
849
1,305
1,366
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
6,669
10%
677
15,029
6%
950
20
9,727
6,669
15,029
20
485
17
404
19
774
21
22
1,419
645
26
27
(662)
(135)
(677)
(221)
(950)
(306)
28
29
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.
3-57
Case 3-5continued
AMR
Delta
UAL
1,320
866
454
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
3-58
Case 3-5continued
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 Deltas 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 Deltas 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 Deltas capital leases, on
average, were contracted 4-5 years before AMR or UAL, which is consistent
with the higher interest rate on Deltas capital leases. To some extent, this
problem is alleviated (at least on a comparative basis) because Deltas
operating leases also appear to have been contracted around three years
earlier to AMRs or UALs. 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.
3-59
Case 3-5continued
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.
3-60
Case 3-5continued
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%
Delta
10%
3-61
Case 3-5continued
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 tacticsfor
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.
3-62
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
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%
3-63
Case 3-6continued
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
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
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.
3-64
$ 5,882
1,869
(94)*
$ 7,657
($ 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
3-65
Pension Income
Net Earnings
Earnings Growth Rate
1998
1,016
9,296
13.32%
1997
331
8,203
12.68%
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 Barrons 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 Barrons 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 GEs earnings smoothing techniques, see the Wall Street
Journal article (WSJ, 11/3/94).
f. The pension related cash flows for GE are the employers 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 GEs
performance or financial position. GEs 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
3-66
b.
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.
3-67