LECTURE 5:

INVESTING AND FINANCING ACTIVITIES

1
 Equity financing
 Debt financing
◦ Liability recognition
◦ Liability valuation
◦ Contingencies and commitments
◦ Off balance sheet financing

2
Equity financing
 Investments by shareholders:
◦ Common equity issuance
◦ Preferred stock
 Distributions to shareholders:
◦ Dividends
◦ Stock dividends and stock split
◦ Share repurchase
 Retained Earnings
 Accumulated Other Comprehensive income
 Reserves

3
 The obligation involves a probable future sacrifice
of resources
 The firm cannot avoid the transfer of resources
 The transaction giving rise to the obligation has

occurred

6
 Obligations with Fixed payment dates and amounts: Notes
payable, Interest payable, Bonds payable
 Obligations with Fixed payment amount but estimated
payment dates: Accounts payable, salaries payable, taxes
payable
 Obligations with estimated payment dates and amounts:
warranties payable
 Obligations arising from advances from customers on
unexecuted contracts and agreements: unearned revenues
 Obligations under mutually unexecuted contracts: purchase
commitments and employment commitments
 Contingent obligations: unsettled lawsuits

7
 Liabilities requiring future cash payments appear at present
value of the required future cash flows discounted at the
historical interest rate (bonds payable)
 Liabilities requiring the future delivery of goods and services
will appear at the estimated cost of those goods and
services (warranty liability)
 Liabilities representing advances from customers appear on
the balance sheet at the amount of the cash advance
(unearned revenue)

8
Contingent obligations
 Contingent obligation: an event whose future outcome is
unknown may create an obligation for the future transfer of
resources.
 Firms are required to recognise an estimated loss from a
contingency (loss contingency) if both conditions are met
◦ probable an asset is impaired or a liability incurred, and
◦ the amount of loss is reasonably estimable;
 To disclose a contingent liability (and loss) there must be at
least a reasonable possibility of incurrence

9
Hybrid securities
 Hybrid securities (compound financing instruments):
securities have both debt and equity characteristics
◦ Examples include mandatorily redeemable preferred stock,
convertible preferred stock, convertible debts
 US GAAP: Convertible debt is historically recorded
as a financial liability.
 IFRS: Debt and equity features are recorded

separately using fair value

 At conversion, the amount recorded in debt (&

equity under IFRS) is shifted to equity. (book value

method)

10
 Is the non-recording of financing obligations
 Incentives to keep debts off the balance sheet

◦ Improvement in the firm’s leverage ratios

◦ Increase borrowing capacity and lower borrowing costs
◦ Improve management compensation
 part of ever changing landscape, whereas one standard
tries to better reflect obligations from a certain off balance
sheet financing transaction, there are new and innovative
means to take its place.

11
 Transactions used as off-balance sheet financing:
◦ Operating leases that are indistinguishable from capital
leases
◦ Sale of Receivables with recourse
◦ Product financing arrangements
◦ R&D financing arrangements
◦ Take-or-pay or Throughput contracts
◦ Debt of unconsolidated subsidiaries

12
 A company may sell all or a portion of its receivables
to a third party to obtain short term financing
 If the sale effectively transfer risks and benefits of

ownership, the firm should recognize the transfer of

receivables
 If the sale does not effectively transfer risks and

benefits of ownership, the firm should recognize the

transaction as a collateralized loan

13
 Where a company sells and agrees to either
repurchase inventory or guarantee a selling price
 Firms must recognize product financing

arrangement as liabilities if
◦ The sponsoring firm must purchase the inventory or
processed goods at a specified price
◦ Payment cover all acquisition, holding and financing
costs

14
 Firms engaged in innovative means of financing
aimed at both keeping liabilities off balance sheet
and effectively exclude R&D from the income
statement.
◦ E.g. through creation of a joint venture where other party
will provide funds for the development of the initial
research finding, which is the firm’s contribution to the JV

15
 Take or pay or through put contract: Agreement in
which a purchaser agrees to pay a specified
amounts periodically to a seller for products or
services

16
 Lease – contractual agreement between a lessor
(owner) and a lessee (user or renter) that gives the
lessee the right to use an asset owned by the lessor
for the lease term

 MLP – minimum lease payments (MLP) of the

lessee to the lessor according to the lease contract

17
 Capital Lease: For leases that transfer substantially all benefits and risks
of ownership—accounted for as an asset acquisition and a liability
incurrence by the lessee, and as a sale and financing transaction by the
lessor
A lessee classifies and accounts for a lease as a capital lease if, at its
inception, the lease meets any of four criteria:
◦ lease transfers ownership of property to lessee by end of the lease term
◦ lease contains an option to purchase the property at a bargain price
◦ lease term is 75% or more of estimated economic life of the property
◦ present value of rentals and other minimum lease payments at beginning
of lease term is 90% or more of the fair value of leased property less any
related investment tax credit retained by lessor
 Operating Lease: For leases other than capital leases—the lessee
(lessor) accounts for the minimum lease payment as a rental expense
(income)

18
 Myers Company signs a lease of an equipment
$45,000 for three years on January 1 and must
make payments on the lease on 31 Dec, year 1,
year 2 and year 3.
 Interest rate is 10% per annum
 Lease payment is $18,095
 $45,000 = $18,095 * 2.48685 (annuity factor)

19
A =L + OE
Cash Rent exp
-18,095 = -18,095

20
 A = L + OE
Cash PPE = Lease liab Int exp Deprn
+45,000 = +45,000
-15,000 = -15,000
-18,095 = -13,595 -4,500
_________ _________ __________
_________
-18,098 +30,000 = +31,405 -19,500

21
Year Lease liab Interest Payment Reduction Lease liab
Start of year expense in lease End of
liability year
(1) (2) (3) (4) (5)
1 45,000 4,500 18,095 13,595 31,405
2 31,405 3,141 18,095 14,954 16,451
3 16,451 1,644 18,095 16,451 0

(3) = 45,000/2.48685 (Annuity factor (i=10%, n=3) )

(2) = (1) * interest rate (10%)
(4) = (3) – (2)
(5) = (1) – (4)

22
 No assets and liabilities are recognized if the lease is treated as
an operating lease
 When leases are capitalized, an asset and a liability equal to PV
of lease payments are recognized.
 Lease capitalization increases asset balances, resulting in lower
asset turnover and return on assets ratio, as compared with the
operating lease method
 The operating lease method charges rental payments to
expense, whereas capitalization recognizes depreciation and
interest expense over the lease term.
 In general, firms with operating leases report higher profitability,
interest coverage, return on equity, and return on asset ratios

23
Investments in long lived assets
 Capitalization sets up the expenditure as an asset
on the balance sheet and then expenses it to the
income statement over the asset's useful life
 Expensing charges the full expenditure to the

current income statement in the period the

expenditure is incurred. No asset is recorded

22
Investments in long lived assets
 Property, plant and equipment purchases are
recorded at cost. Cost includes the purchase price
and costs to get the asset ready to use
 Improvements and repairs are capitalized if they

will benefit future periods and increase the quality

or life of the tangible asset
 If a company constructs a long-term tangible asset,

the related interest costs during the construction

period are capitalized and added to the cost of the
constructed asset

23
Investments in long lived assets
 Acquired intangible assets are recorded at the
purchase price
 The research and development costs of internally

developed intangible assets are generally

expensed, although certain development costs
may be capitalized

24
Depreciation
 Analysing depreciation
◦ Assess the choice of depreciable lives by comparing
across firms in the same industry
◦ Analyse plant asset age

Average total life span = Gross plant and equipment assets /

Current year depreciation expense
Average age = Accumulated depreciation /
Current year depreciation expense
Average remaining life = Net plant and equipment assets /
Current year depreciation expense

25
Impairment of long lived assets
 An impairment loss is recognized when the
carrying value of a long- lived asset is not
recoverable.
◦ Indefinite life intangible assets are analyzed for
impairment at least annually.
◦ Tangible long-lived assets and finite life intangible assets
are analyzed for impairment when an event occurs that
indicates possible impairment.

26
Investments in securities
 Management must classify a firm's investment in
marketable securities as either:
◦ Held-to-Maturity: Debt securities that management
intends and is able to hold to maturity. Report at amortized
cost.
◦ Available-for-Sale: Debt or equity securities that
management does not expect to trade on a short-term
basis (and for debt securities – that are not likely to be held
to maturity). Report at fair (market) value.
◦ Trading Securities: Debt or equity securities that
management intends to actively trade on a short-term
basis. Report at fair (market) value.

27
Investments in securities
 Held-to-Maturity Securities
I/S – Interest earned ± Realized gains/losses
B/S – Amortized cost

 Available-for-Sale Securities
I/S – Dividends or interest earned ± Realized G/L
B/S – Fair value with Unrealized G/L treated as a
direct-to-equity adjustment

 Trading Securities
I/S – Dividends or interest earned ± Realized G/L ±
Unrealized G/L
B/S – Fair (market) value"Other Comprehensive Income" 28
 Exercise 6.10
 Problem 6.17
 Problem 6.20
 Problem 7.15
 Problem 7.18

28