Com 4FK3
Financial Statement Analysis
Week 9, 2012
Controversial Issues in Liability Recognition
Forecasting
Hybrid Securities
• Mandatory redemption preferred shares:
cash flow of bonds, but don’t show up as
liabilities on balance sheet
• Convertible bonds: with some provisions
are almost certain to become equity
• Debt with coupon tied to income or
dividend yield: act like equity, but are
deductible for tax purposes
2
Off Balance Sheet Financing
• Any attempt to shift a liability off the
balance sheet, usually with an asset
• Improves debt and solvency ratios, giving
the appearance of less risk for the company
• GAAP rules try to prevent this sort of
treatment
3
Sale of Existing Asset
• A/R, inventory, PP&E and other assets that
could be used as collateral for a loan can be
sold instead.
• No debt on the balance sheet, but buyer has
to face risk… if significant risk is left with
the firm, it has to be treated as a loan, otherwise it is a sale and contingent liability
(shows in notes, but not in statements)
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Use of Another Company
• e.g. instead of buying a new factory, the
firm convinces another company to buy and
finance the factory, with a purchase
commitment from the original firm to buy
the majority of the factory’s output
• SPE (Special purpose entity): a company
created to buy and finance an asset
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Use of Another Company
• Major problem, if company has control, it
should consolidate the statements, so the
asset and liability show up on the statements
• Enron: created SPE (Limited partnership) in
which it had control, but claimed it did not
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Take-or-Pay Contracts
• Similar to throughput contracts (if product
is transportation or processing services)
• Two firms form a joint venture
• Both sign non-cancellable contracts to pay
fixed amounts every period which will
cover the joint venture’s operating expenses
even if they don’t make use of the joint
venture’s services that period
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Leases
• Benefits of a mid length lease
Shift tax benefits
 Flexibility to change capacity
 Reduce risk of technical obsolescence
 Ability to acquire when other forms of
financing may not be available

• Transference of risk to lessor makes the
lease more expensive
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Operating vs. Capital Lease
• Operating lease
No liability on balance sheet even if locked in
to contractual payments for 5 years or more
 Lease payments deductible

• Capital lease
Treated as asset and liability
 Interest expense and depreciation declared

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GAAP
• Capital lease if any of the following
Locked in for more than 75% of useful life
 Ownership transferred at end of lease
 Likely transfer of ownership due to “bargain”
purchase option
 Present value of contractual lease payments
equal or exceeds 90% of fair market value at
the time of purchase

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Tax Rules
• Operating only if all of the following
Property can be economically useful to
someone else after the lease
 No “bargain” purchase offer
 Lessor has min. of 20% of its capital at risk
 Lessor has positive cash flow and profit from
the lease independent of the tax effect
 Lessee has not lent the money to the lessor

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Converting Capital to Operating
• Deals can be made to allow use of operating
lease treatment; PV=89.5% of fair value
• Present value of lease obligations is
reported in the notes
• Analyst may decide to add present value of
payments to PPE and LTD for analysis, as
well as replacing lease expense with interest
and depreciation
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Possible Problems
• Lease payments may contain minimum
amounts of lease payments, plus contingent
lease payments

e.g. many malls charge X%of sales, with a
minimum of $Y per month
• Only the minimum payment is reported as
an obligation under lease commitments
• Income statement adjustment often ignored
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Impact of Capitalizing Leases
• Many firms have some operating lease
commitments, many are economically
capital leases
• Impact can be minor (e.g. Pepsi debt ratio
goes from 23.4% to 26.6%) or significant
(Delta from 67.5% to 90.2%)
• Can be material when combined with other
forms of off balance sheet financing
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Derivatives
• Forwards, swaps, futures, options, etc.
• Value is based on an underlying asset and
the price movements of that asset
• Many have no initial investment
• Many permit or require net settlement on a
notional amount
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Accounting for Derivatives
• Can appear on balance sheet as an asset or
liability depending on current market prices
and the firm’s commitment (marking to
market), futures contracts do this in cash
• Classified as; speculative, fair value hedge,
or cash flow hedge
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Speculative
• Firms engaged in derivatives for reasons
other than hedging must mark to market
every period
• Gains and losses are flowed through to net
income
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Fair Value Hedges
• Hedges to protect the value of an asset or
firm commitment; e.g. firm has a 5 year
floating rate liability and enters a swap
agreement to change to fixed rate
• Each period, asset/liability is revalued and
any gain or loss recognized and loss/gain in
other comprehensive income from marking
to market
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Cash Flow Hedge
• Hedges to make future cash flows more
predictable, e.g. a farmer enters a forward contract
to sell 500 bushels of frozen grapes for ice wine
production
• “highly effective” hedging is reported as other
comprehensive income and flows through to net
income on settlement

reasoning: matching principal
• ineffective hedging in current period net income
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Required Disclosure
• Description of the firm’s risk management
strategy, distinguish types of derivatives used for
fair value and cash flow hedges
• Net gain/loss from ineffective hedging
• Transactions/events that will move items from
comp. Income to net income and how much is
expected over the next year
• Net gain/loss from derivatives no longer classified
as hedges
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Accounting Quality
• For many derivatives, there is an active
market and marking to market is easy
• Where there is no active market, new
derivatives (Enron and broadband) or just
limited trading (ice wine grapes) there can
be a problem with accounting quality
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Retirement Benefits
• Two main types, cash (pension) and
benefits such as health and life insurance
• Matching principal requires expensing
while the employee is working and earning
the right to those benefits
• Estimating the value of those expenses
requires actuaries
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Pensions
• Two main types, defined contribution and
defined benefit
• Defined contribution has simple accounting
since the amount the employer has to pay
each period is contractually specified
• Defined benefit expenses can change based
on what happens in the future
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Pension Expense
• 5 steps
Current service costs
 Interest expense
 Expected return on assets reduction
 Amortization of unexpected changes
 Actuarial gains or losses

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Analyst’s Treatment
• How should an analyst assess the funding?
Make no changes, it is likely temporary
 Recognize under funding as a liability
 Recognize both as assets/liabilities
 Add the assets/liabilities to the firm’s

• No strong consensus
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Other Post-retirement Benefits
• Relatively new to the financial statements
• When first required the firm had the choice
to recognize the entire liability at once, or
amortize the obligation over the average
remaining working life of the employees
• Level of under funding not reported on
balance sheet but must be included in notes
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Pro Forma Statements
• One tool used in valuing companies is the
preparation of pro forma statements
• These statements try to forecast the look of
future financial statements of a company
• Why? To value the future cash flows or
earnings of a company, you need estimates
of what those cash flows will be
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General Forecasting Principles
• Forecasts should be objective and realistic
expectations of future value relevant
payoffs to investments

Forecasts should be unbiased, both conservative
and aggressive forecasting of the firm’s future
operations should be avoided
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General Forecasting Principles2
• Pro forma financial statements should be
comprehensive
Just forecasting sales growth and assuming a
constant net margin is not likely to give high
quality forecasts
 What drives the net margin?
 Does the firm have problems controlling costs?
 Are fixed costs being treated as variable?

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General Forecasting Principles3
• Assumptions and relations must be
internally consistent
Use the features of additivity and articulation
 Assumptions about the growth rate of sales
should have impact on cost of goods sold
 Forecasts of growth in PP&E should be
consistent with the growth in depreciation
 The balance sheet should balance

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General Forecasting Principles4
• Statements should be based on externally
valid assumptions
Is the growth rate assumed possible in light of
the competitive nature of the industry?
 Are the assumptions consistent with what has
happened in the past?
 Do the assumptions coincide with what the
management is likely to do?

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Forecasting Game Plan
• Six step process for preparing pro forma
financial statements
Project revenues
 Project operating expenses
 Project operating assets and liabilities
 Project the capital structure
 Determine the cost of the capital structure
 Derive the statement of cash flows

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Projecting Assets
• Balances for individual assets, such as
PP&E and accounts receivable, are forecast
since the asset mix often changes over time
• Historical growth trends and relation to
growth rates of sales and/or other drivers
are considered
• The use of turnover rates is often helpful
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Project Liabilities and
Shareholders Equity
• For firms that have a target capital structure
the analyst can use the common size ratios
to predict the balance between liabilities
and shareholders equity
• Individual accounts can be forecast using
historical common size weights or by using
turnover and growth rates
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Other Comprehensive Income
• The accumulated other comprehensive
income/loss account in the equity section
accounts for unrealized holding period gains
or losses, often related to foreign exchange
For Pepsi, this has been an increasing loss over
the time period, due to $US strength
 Forecasting changes in this account may be
challenging

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Shortcuts
• Projected sales and income
project sales and then assume a constant margin
 less accurate and flexible since turnovers and
other ratios are not allowed to change

• Projected total assets

based on the historic growth rate of total assets
and assuming that the common size balance
sheet is appropriate to the future
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Sensitivity Analysis
• The analyst can perform sensitivity analysis
to see how much of a difference changes in
various assumptions will make in the final
statements
• If the forecast is done in a spreadsheet or
similar analytical program, it can even be
used to revalue a company if management
releases some important news
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Summary
• Pro forma financial statements are a tool to
help forecast future earnings and cash flows
• Discounted cash flow models need such
forecasts to value a company
• The pro forma statements do require a lot of
assumptions, the reasonableness of those
assumptions has a great impact on the value
of the forecasts of cash flows
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