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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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