2952271 Fin Rep Anal Econ
Lecture 3: Analyzing Financing Activities
Part I: Liabilities
Pituwan Poramapojn
Second Semester Academic Year 2019
1
Financing Activities
• Companies operations are financed by various sources:
– Liabilities
– Shareholder Eq i
– Off-balance sheet transactions
2
1-3
3
Financing Activities
• Liabilities
– Financing obligations that require future payments
– Senior to equity holders
• Shareholder Eq i
– Claims of owners on net assets of a company
– Exposed to maximum risk
– Residual claims to all assets once claims of creditors are
satisfied
4
Outline
•
•
•
•
•
Liabilities
Debt Financing
Leases
Contingencies and Commitments
Off-Balance Sheet Financing
5
Liabilities
6
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Liabilities
• What are the two major types of liabilities?
– Operating Liabilities
• Obligations that arise from operating activities
• Examples are accounts payable, unearned revenue,
taxes payable, postretirement liabilities, and other
accruals of operating expenses.
– Financing Liabilities
• Obligations that arise from debt financing activities
• Examples are short- and long-term debt, bonds,
notes, leases, and the current portion of long-term
debt.
7
0114
Liabilities
• How are liabilities classified in the financial statements?
– Current (short-term) Liabilities
• Obligations whose settlement requires use of current
assets or the incurrence of another current liability
within one year or the operating cycle, whichever is
longer.
– Noncurrent (Long-Term) Liabilities
• Obligations not payable within one year or the
operating cycle, whichever is longer.
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Liabilities
definition
feature
• Important Features in Analyzing Liabilities
– Terms of indebtedness (such as maturity, interest rate,
payment pattern, and amount).
– Restrictions on deploying resources and pursuing
business activities.
– Ability and flexibility in pursuing further financing.
– Obligations for working capital, debt to equity, and other
financial figures.
– Dilutive conversion features that liabilities are subject to.
– Prohibitions on disbursements such as dividends.
Debt Financing
10
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Debt Financing
• Debt or financial liabilities
– Funds that a company has explicitly borrowed from
various providers of capital.
– Interest-bearing liabilities
bond cuts
• Public debt
Invuoon
– A firm borrows directly from investor by issuing
securities such as bonds.
• Private debt
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– A firm borrows from banks in the form of loans.
11
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Accounting for Debt
• A firm that issues bonds with a face value of $100,000
and a coupon rate of 6% payable annually for 3 years.
– Face value = ?
– Coupon payment = ?
• Effective interest rate is the rate that the market assigns
to the bond at the time of its issuance.
– Present value of the bond at the time of issuance.
– When proceeds differ from the face amount, the
difference is premium or discount.
12
Accounting for Debt
Bond
Contractual
Interest Rate 6%
Effective
Interest Rate
Bonds
Sold at
3%
Premium
6%
Par
(Face Value)
10%
Discount
13
Accounting for Debt
• Case 1: 6% interest-rate scenario
– PV of bond at t=0 is _________.
100,000
O
Dp Cash
Cr
Bondpayable
100,000
goo 000
O
e
orcrutggthenrense
o
14
Accounting for Debt
• Case 2: 3% interest-rate scenario premium
– PV of bond at t=0 is $108,486.
o
r
Cr
Cash
P
108,486
payable
100 000
and prem 9
8,486
15
Accounting for Debt
• Case 2: 3% interest-rate scenario
– PV of bond at t=0 is $108,486.
Year
Beg Amt
3.1
Mkt Interest
Rate Expense
Cash
Paid
1 108,486
2
34 3254.98 6000
1
6000
3
3.1
6000
Record interest
Dr
payment at
Interest expense
Bond premium
or
Cash
Amortization
End Amt
2745.42 105740.58
years
3,255
2,745
6,000
16
Accounting for Debt
• Case 3: 10% interest-rate scenario
– PV of bond at t=0 is $90,053.
Dr Cush
Cr
90,053
Band Payable
Band
discant
100,000
9947
17
Accounting for Debt
• Case 3: 10% interest-rate scenario
– PV of bond at t=0 is $90,053.
Year
1
2
3
Beg Amt
90,053
Mkt Interest
Rate Expense
Cash
Paid
toy
9005.3 6000
704
6000
104
6000
Amortization
End Amt
ma plus
3005.3
93058.3
1
Accounting for Debt
• Accounting Treatment
– Long-term debt reported on B/S at PV, not at face value.
Amor i ed Co
– I/S will reflect interest expense and not coupon
payment.
– Amortization of bond premium (Case 2) gets subtracted
from carrying value of bond .
– Amortization of bond discount (Case 3) gets added to
carrying value of bond .
1
Accounting for Debt
• Accounting Treatment - Fair value accounting
– B/S recognizes current fair value of bond and all changes
in fair value of debt are included in net income as
unrealized gain or loss on debt.
– From case 3, at the end of year 1, interest rate drops
from 10% to 7%, PV of bond at t=1 is $98,192.
20
Accounting for Debt
• Accounting Treatment - Fair value accounting
Year Coupon
0
1
2
3
Total
6,000
6,000
6,000
18,000
Book wake
Int Fair Value Interest fAmorting
Unrealized
Total
Rate
Loss
Expense
99389482
9009313005
10%
90,053 Hot
7%
1 3%
98,192
102,913
100,000
9,005
6,873
3,087
18,965
5,134
on
3,848
0
8,982
9005 6000
14,139
10,721
3,087
27,947
3005
21
Debt-Related Disclosures
• Anticipated future maturities of debt
• Details of contractual provisions such as collateral and
covenants
• Unused balances in lines of credit
22
Analyzing Debt Financing
• Amortized Cost versus Fair Value
– Debt is typically reported on B/S at amortized cost.
– Fair value measures liquidating value of the debt;
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therefore, it is useful if the company
plans to retire debt
immediately.
– Fair value is less useful as a measure of debt that is held
to maturity.
• Unrealized gains or losses are removed when
estimating sustainable income.
– Fair value accounting for debt makes sense for financial
institutions. bUN7 YUWMNm Iwm rbIw
23
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Analyzing Debt Financing
• Future Debt Retirement
– Examine future debt payment schedule
• Cash flow forecasting
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– Evaluate whether a company is able to repay its debt
when it matures.
• This could lead to bankruptcy.
• Unutilized Credit Lines ogbiwnrmmruivioujhir.int
– With available credit lines, the company has the ability
to increase its borrowing.
24
Protections
• Lenders often have explicit contracts with borrowing
companies which helps the lenders protect their money.
• Seniority
– Senior claims will be paid before junior claims.
– Unpaid taxes and wages get priority over all other
claims.
• Security (Collateral) Guintonow
– Assets that are set aside during dissolution.
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25
Protections
• Covenants agreements
– Loan contract terms and conditions designed to protect
lender against loss.
• Early warning signal regarding creditworthiness
– Affirmative covenant sortsfinancialstatement
tmrw
• Filing audited F/S in accordance with GAAP within a
specified time period.
26
Protections
• Covenants
– Negative covenant You4N restriction
• Restrictions on dividend payment, working capital,
further borrowing, issuing senior debt, capital
expenditures, and mergers and acquisitions.
• Minimum amount of R/E, maximum amount of debtto-equity ratio, minimum coverage ratios, etc.
– Viola ing a co enan
echnical defa l pro iding
lenders legal rights to demand immediate repayment of
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their debts.
– Violating a covenant poor financial health
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27
Leases
2
Leases
• 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.
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– Capital VS Operatingbin
• MLP minimum lease payments (MLP) of the lessee to
the lessor according to the lease contract.
– Lease terms obligate lessee to make a series of
payments over a specified future time period.
2
Lease Classification
• Capital Lease Accounting
– For leases that transfer substantially all benefits and
risks of ownership
– Accounted for as an asset acquisition and a liability
e
incurrence by the lessee, and as a sale and financing
transaction by the lessor
– Both leased assets and lease obligation are recognized
on B/S.
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30
Lease Classification
• Capital Lease Accounting
– A lessee classifies and accounts for a lease as a capital lease
if, at its inception, the lease meets any of four criteria:
– (i) lease transfers ownership of property to lessee by end of
the lease term
– (ii) lease contains an option to purchase the property at a
bargain price
– (iii) lease term is 75% or more of estimated economic life of
the property
– (iv) 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
31
Lease Classification
• Operating Lease Accounting oh
– For leases other than capital leases
– The lessee (lessor) accounts for the minimum lease
payment as a rental expense (income).
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– No asset or liability is recognized on B/S.
32
Accounting for Leases
• Capital Lease
amountat
now
– Amount of asset and liability = PV of MLP
• Excludes executory costs (cost of using assets) such
as insurance, maintenance, and taxes.
– Leased asset must be depreciated.
– Interest expense is accrued on lease liability.
Too
33
Accounting for Leases
• A company leases an asset on Jan 1, 2005 - it has no other
assets and liabilities.
• Estimated economic life of leased asset is 5 years with an
expected salvage value of zero.
• Lessee uses straight-line method to depreciate asset.
• The lease has a fixed noncancellable term of 5 years.
• Annual minimum lease payment of $2,505 is paid at the
end of each year.
• Interest rate on the lease is 8% per year.
• Operating or Capital Lease?
34
Accounting for Leases
= $2,505*3.99271
quits
= $10,000
• Table 4 page I4: PV of ordinary annuity (8%, 5 yrs)
• PV of MLP on Jan 1, 2005
Dr
lease asset
n
Cr lease liability
35
Exhibit 3.3: Lease Amortization Schedule
Year
2005
2006
2007
2008
2009
BOY Interest Principal Total
EOY
Liab
Liab
$10,000 $ 800 $ 1,705 $ 2,505 $ 8,295
8,295
664
1,841
2,505
6,454
6,454
517
1,988
2,505
4,466
4,466
358
2,147
2,505
2,319
2,319
186
2,319
2,505
0
Total
$ 2,525 $10,000 $12,525
36
capita
Accounting for Leases
Lessee month
Lessor antitasoitiros
• Jan 1, 2005
Dr Leased Asset
Cr Lease Liability
• Jan 1, 2005
Dr Lease Receivable
Cr Asset
Cr Unearned Income
• Dec 31, 2005
Dr Cash
Cr Lease Receivable
Dr Unearned Income
Cr Financing Income
• Dec 31, 2005
Dr Lease Liability
Dr Interest Expense
Cr Cash
Dr Depreciation
Cr Accum Depre
37
Accounting for Leases
**Suppose it is operating lease.**
Lessee
Lessor
• Jan 1, 2005
• Jan 1, 2005
• Dec 31, 2005
Dr Rent Expense
Cr Cash
• Dec 31, 2005
Dr Cash
Cr Rental Income
Dr Depreciation
Cr Accumulated
Depreciation
3
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Exhibit 3.4: Income Statement Effects
Operating
Lease
Year
Capital Lease
Rent Expense Interest Exp
Depre Exp
2005
$ 2,505
$ 800
$ 2,000
2006
2007
2008
2009
2,505
2,505
2,505
2,505
664
517
358
186
2,000
2,000
2,000
2,000
Total
$12,525
$2,525
$10,000
Total
Expense
$ 2,800
2,664
2,517
2,358
2,186
$12,525
3
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Exhibit 3.5: Balance Sheet Effects
M/D/Y
1/1/05
Cash
$
0
Leased Asset
Lease Liab
$10,000
$10,000
Equity
$
0
12/31/05
(2,505)
8,000
8,295
(2,800)
12/31/06
(5,010)
6,000
6,454
(5,464)
12/31/07
(7,515)
4,000
4,466
(7,981)
12/31/08
(10,020)
2,000
2,319
(10,339)
12/31/09
(12,525)
0
0
(12,525)
1/1/05
$
0
$
0
$
0
$
0
12/31/05
(2,505)
0
0
(2,505)
12/31/06
(5,010)
0
0
(5,010)
12/31/07
(7,515)
0
0
(7,515)
12/31/08
(10,020)
0
0
(10,020)
12/31/09
(12,525)
0
0
(12,525)
40
Accounting for Leases
• Summary
– If we consider this lease to be an operating lease, the
total operating lease payment is considered to be an
expense.
– If we consider the lease to be a capital lease, then we
must record an asset and a related liability associated
with the leased property.
– Capital leases and operating leases: both have an
interest and a principal portion of the payment.
41
Accounting for Leases
• Lease Disclosure
Report lease
– All companies must disclose future lease commitments
for both their capital and noncancellable operating
leases.
– Lessee must disclose:
• (1) future MLPs separately for capital leases and
operating leases for each of five succeeding years
and the total amount thereafter, and
• (2) rental expense for each period on income
statement is reported
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42
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43
Analyzing Leases
• If a company was concerned about having too much
debt related to equity, which of the following would
reflec le deb on he compan book
– Operating or Capital Leases?
• If we were concerned that a company may be
understating their total debt position by structuring
leases as operating lease instead of capital leases,
ha o ld be a red flag
rumors now
mum
– Operating lease term longer than five years.
44
Analyzing Leases
• Why Lessees Like the Operating Lease Method
– The lessee has financed the acquisition of asset services
without recognizing a liability on the balance sheet.
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– Off-Balance Sheet Financing
InofUs Balancesheet
• Keeping leased assets and lease liabilities off balance
sheet.
• Bo h are hidden
– Lessees are made better off.
4
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• Covenants: debt-to-equity ratios
• Improved return on assets (ROA)aratios
45
Analyzing Leases
• Off-Balance-Sheet Financing
misedonesmoreauinduct
– A lessee structures a lease so it is accounted for as an
operating lease when the economic characteristics of
the lease are more in line with a capital lease.
– Neither the leased asset (benefit) nor its
e
corresponding liability
(obligation) are recorded on the
balance sheet.
n'du
– If reading notes to F/S, off-balance sheet items are not
reall hidden
statement
financial
46
Converting Operating Leases to Capital Leases
mummmurn
hmm
• If we were concerned that a company may be
understating their total debt position by structuring
leases as operating lease instead of capital leases, what
actions could an analyst take?
– Adjust financial statement
47
Exhibit 3.6: Lease Disclosures of Best Buy
Fiscal Year
2005
2006
2007
2008
2009
Thereafter
Subtotal
Less: imputed interest
PV of capital lease
obligations
Capital Leases
$14
3
-
Operating Leases
$454
424
391
385
379
2,621
17
(1)
(16)
4
Converting Operating Leases to Capital Leases
• Determining the Present Value of Projected Operating
Lease (Exhibit 3.7 in 11th Edition)
4
Restated Financial Statements after Converting Operating Leases to
Capital Leases—Best Buy 2004 (Exhibit 3.8 in 11th Edition)
50
Converting Operating Leases to Capital Leases
Reca ing Be B
Income S a emen
• Operating expenses decrease by $177 million
(elimination of $454 million rent expense reported in
2004 and addition of $277 million of depreciation
expense).
• Interest expense increases by $193 million (to $201
million)
• Net income decreases by $10 million [$16 million pretax
x (1 - .35), the assumed marginal corporate tax rate] in
2004.
51
Converting Operating Leases to Capital Leases
Reca ing Be B
Balance Shee
• The balance sheet impact is more substantial.
• Total assets and total liabilities both increase markedly
by $3.321 billion at the end of 2004, which is the present
value of the operating lease liability.
• The increase in liabilities consists of increases in both
current liabilities ($261 million) and noncurrent liabilities
($3.06 billion).
52
Exhibit 3.9: Effect of Converting Operating Leases to
Capital Leases
Ratios
Current ratio
Before
1.27
Total debt to equity
Long-term debt to equity
Net income/Ending equity
Net income/Ending assets
Times interest earned
1.53
0.21
20.6%
8.1%
163.0
After
1.20
2.50
1.11
20.3%
5.8%
7.37
53
Impact of Operating Lease versus Capital Lease
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grinwinners
• Operating lease understates liabilities improves
solvency ratios such as debt to equity
Muad lease understates assets can improve return
• Operating
Mr
on investment ratios
hurrnoyd
• Operating
lease understates current liabilities by ignoring
current portion of lease principal payment inflates
current ratio & other liquidity measures
54
Impact of Operating Lease versus Capital Lease
• Operating lease delays expense recognition overstates
income in early term of the lease and understates income
later in lease term
• Operating lease includes interest with lease rental (an
operating expense)
– understates both operating income and interest
expense
– inflates interest coverage ratios e.g. times interest
earned
55
New Lease Obligations
• IFRS 16 & US GAAP-ASC 842: Effective 1 Jan 2019
• TFRS 16: Effective 1 Jan 2020
• To increase transparency and comparability by recognizing
the assets and liabilities that arise from lease transactions.
• In other words, current off-balance sheet leasing activities
will be required to be reflected on balance sheets so that
investors and other users of financial statements can more
readily and accurately understand the rights and
obligations associated with these transactions.
56
Contingencies and Commitments
57
Contingencies window oinks
• Contingencies -- potential losses and gains whose
resolution depends on one or more future events.
• Contingent liabilities -- contingencies with potential claims
on resources
– Litigation dramason
– Claims on warranties
Mr
– Tax assessments
ur
– Catastrophic losses of property metwirwinthrew
– Violations of environmental law
5
Contingencies
• Contingent liabilities
– To record a contingent liability (and loss), both
conditions must be met:
• (i) probable i.e. an asset will be impaired or a liability
incurred (the future event is likely to occur), and
• (ii) the amount of loss is reasonably estimated;
– To disclose a contingent liability (and loss), there must
be at least a reasonable possibility of incurrence
5
•
Contingencies
mBE
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Contingent assets -- contingencies with potential additions
to resources
– A contingent asset (and gain) is not recorded until the
contingency is resolved. (Conservatism)
– A contingent asset (and gain) can be disclosed if
probability of realization is very high.
60
Analyzing Contingencies
Sources of useful information:
• No e MD A and A di or Repor
Useful analyses:
• Scrutinize management estimates
• Analyze notes regarding contingencies, including
– Description of contingency and its degree of risk
– Amount at risk and how treated in assessing risk
exposure
Howie
– Charges, if any, against income
61
Contingencies
n'Now
Useful analyses:
• Recognize a bias to not record or underestimate contingent
liabilities (loss)
record lossVivo
y
• Beware of big baths loss reserves are contingencies
• Review SEC filings for details of loss reserves
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• Note: Loss reserves do not alter risk exposure, have no cash
flow consequences, and do not provide insurance.
just
in case
62
Commitments
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• Commitments -- po en ial claim again a compan
resources due to future performance under contract
– Not recognized in F/S since events such as signing of a
contract or issuance of purchase order is not a complete
transaction.
– Long-term non-cancellable contracts to purchase
products or services at specified prices
– Lease agreement
63
Analyzing Commitments
Sources of useful information:
• Notes and MD&A and SEC Filings
Useful analyses:
• Scrutinize management communications and press releases
• Analyze notes regarding commitments, including
– Description of commitment and its degree of risk
– Amount at risk and how treated in assessing risk
exposure
– Contractual conditions and timing
• Review SEC filings for details of commitments
64
Off-Balance Sheet Financing
65
Off-Balance-Sheet Financing
• Off-Balance-Sheet Financing is the non-recording of
financing obligations.
– Understate (misrepresent) reported liabilities
• Motivation mihir solvencyof
– To keep debt off the balance sheet.
– To reduce total amount of liabilities in contractual ratio
makes covenant violations less likely.
– To improve operating performance ratios such as return
on assets, assets turnover ratios, leverage ratios, etc.
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66
Off-Balance-Sheet Financing
itthe
• Special Purpose Entities gysequire
(SPE):
– A trust or corporation that is legally separated from
sponsoring company.
– Unconsolidated subsidiaries or joint ventures are
established to finance specialized projects.
– When one company owns 50% or less of another
compan
ock con olida ion i no req ired usersNov
– No con olida e B S Liabili ie are no recorded in B S
67
Off-Balance-Sheet Financing
• Note:
– Consolidation means that separate financial statements
of the parent and subsidiary are added together line-byline o form a ingle combined con olida ed e of
financial statements.
• Own more than 50% (Control)
6
Exhibit 3.16: Illustration of SPE Transaction to
Sell Accounts Receivable
Securitization
6
Off-Balance-Sheet Financing
As viwins sequritisection
• A special purpose entity (SPE) is formed by the sponsoring
company and is capitalized with equity investment, some of
which must be from independent third parties.
• The SPE leverages this equity investment with borrowings
from the credit markets and purchases earning assets from
the sponsoring company.
• The cash flow from the earning assets is used to repay the
debt and provide a return to the equity investors.
• SPE collateralizes bonds that it sells in credit markets with
the receivables and uses cash to purchase additional
receivables on an ongoing basis.
70
Off-Balance-Sheet Financing
• Transactions sometimes used as off-balance-sheet
financing:
– Operating leases that are indistinguishable from capital
leases
– Synthetic lease
• A company desires to construct an office building, but
does not want to record either asset or liability on its
B/S.
• A SPE agrees to finance and construct the building
and lease it to the company under operating lease.
71
Off-Balance-Sheet Financing
Transactions
• Transactions sometimes used as off-balance-sheet financing:
– Sell receivables with recourse and record them as sales
rather than liabilities
manhood
gain
of
• Recourse
– the legal right to demand compensation or payment.
– a turning to someone or something for help or protection
72
Off-Balance-Sheet Financing
• Benefits of SPEs:
– SPEs may provide a lower-cost financing alternative than
borrowing from the credit markets directly.
– Under present GAAP, so long as the SPE is properly
structured, the SPE is accounted for as a separate entity,
unconsolidated with the sponsoring company.
– Sponsoring Companies
• Bo h recei able and deb are off-balance- hee
• Sales rather than borrowing.
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annivorrow
• Gain on sale is recognized.
I
73
Analysis of Off-Balance-Sheet Financing
Sources of useful information:
• Notes and MD&A and SEC Filings
Companies disclose the following info about financial
instruments with off-balance-sheet risk of loss:
Face con rac or principal amo n
Term of he in r men and info on i credi and marke
risk, cash requirements, and accounting Loss incurred if a
party to the contract fails to perform
Colla eral or o her ec ri if an for he amo n a ri k
Info abo concen ra ion of credi ri k from a co n erpar
or groups of counterparties
74
Analysis of Off-Balance-Sheet Financing
Useful analyses:
Scrutinize management communications and press releases
Analyze notes about financing arrangements
Recognize a bias to not disclose financing obligations
Review SEC filings for details of financing arrangements
75
Conclusions
• Leases
– Operating VS Capital
• Contingencies and Commitments
• Off-Balance-Sheet Financing
– Understated liabilities
76
Homework
• Problem 3-2
• Problem 3-4 (a) and (b)
• Case 3-4
– Questions (d) and (e)
– Only AMR 1998 case
77