lecture 5 liabilities

Reporting and Analyzing Nonowner Financing Activities

What is a Liability?

“Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

Present obligations. Unavoidable obligations. Transaction or event must have already

happened.

The Balance Sheet Equation

Assets = Liabilities + Equity Investments in Non-owner Owner the business financing financing

What you own = How you paid for it$$ Borrowed by the company

$$ Invested by owners or$$ Earned by the company

Stuff Purchased by the company

Business Background

The mix of debt and equity for a company is called the capital structure:

Debt - funds from creditors

Equity - funds from owners

Liabilities Measurement

Liabilities are measured at their current cash equivalentcurrent cash equivalent (the amount a creditor would accept to cancel the

debt) at the time incurred.Maturity < 1 year Maturity > 1 year

Current Liabilities

Noncurrent Liabilities

Current Liabilities

Accruals

The term accrue means to build up gradually. Accruals refer to amounts in asset and liability

accounts that build up over time. Adjustments to record accruals are made at

the end of an accounting period.

End of accounting period.

Cash receivedor paid.

Revenues earnedor

expense incurred

Examples include interest earned during the period or wages earned by employees but not yet paid.

Examples include interest earned during the period or wages earned by employees but not yet paid.

Accruals

Warranty Accrual

105,106

Deferred revenue is recorded.

Deferred Revenues

Deferred revenue is a

liability account.

Deferred revenue is a

liability account.

Cash is collected from the customer before the revenue is actually earned.

Cash is received in advance.

Earned revenue is recorded.

As the earnings process is completed

. . .

Deferred Revenues

Cash is collected from the customer before the revenue is actually earned.

Deferred revenue is recorded.

Cash is received in advance.

106

Pensions 101

Plan Assets

-

Projected Benefits

=

“Funded Status”

Pensions 101Plan Assets – Projected Benefits = “Funded Status”

Plan Assets:Fair Value at Beginning

+ Actual Return on Assets

+ Employer Contribution

- Benefit Payments

= Fair Value at End Straight forward, no judgment

Pensions 101Plan Assets – Projected Benefits = “Funded Status”

Projected Benefits:

Liability at Beginning+Service Cost : PV effect of 1 more year of employee service means higher benefit

when retire

+Interest Cost : PV effect of employees 1 year closer to retirement

+Actuarial Losses : PV effect of actuarial assumptions, e.g. life span

- Benefits Paid

= Liability at End Highly judgmental - Effected by assumptions on

Discount rate Interest rate Actuarial assumptions

HP Pensions

Footnote 16 Page 135 - 143

Example: Notes Payable

Current Portion of Long-Term Debt

Any portion of a note payable that is due within one year, or the operating cycle,

whichever is longer.

Total Notes

Payable

Current Notes Payable

Noncurrent Notes Payable

Sources for Long-Term Loans

Relatively small debt needs can be filled from single sources.

Relatively small debt needs can be filled from single sources.

BanksBanks

Insurance CompaniesInsurance Companiesoror Pension PlansPension Plansoror

Sources for Publicly Issued Debt

Significant debt needs are often filled by issuing bonds to

the public.

Significant debt needs are often filled by issuing bonds to

the public.

CashBonds

Understanding the Business

Advantages of bonds: Bonds are debt, not equity, so

the ownership and control of the company are not diluted.

Interest expense is tax-deductible.

The low interest rates on bonds allow for positive financial leverage.

Advantages of bonds: Bonds are debt, not equity, so

the ownership and control of the company are not diluted.

Interest expense is tax-deductible.

The low interest rates on bonds allow for positive financial leverage.

Disadvantages of bonds:

Risk of bankruptcy; the debt must be paid back regularly, or creditors will force legal action.

Negative impact on cash flows.

Disadvantages of bonds:

Risk of bankruptcy; the debt must be paid back regularly, or creditors will force legal action.

Negative impact on cash flows.

Characteristics of Bonds Payable

$ Bond Issue Price $

Bond Certificate

At Bond Issuance Date

Bonds payable are long-term debt for the issuing company.

Company Issuing Bonds

Company Issuing Bonds

Investor Buying Bonds

Investor Buying Bonds

Characteristics of Bonds Payable

PeriodicInterest Payments

At STATED RATE$ $

Face Value Payment at End of Bond Term

PAR VALUE$ $

Company Issuing Bonds

Company Issuing Bonds

Investor Buying Bonds

Investor Buying Bonds

Bond Issuance

Company decides what the stated rate will be on the bond – What rate of interest their bond will pay

This is often different from the market rate of interest – What the market is paying in general for like credit risks

Why the Difference in Rates??

Companies use rate to manage cash flow Gold Mine example

Need lots of money to dig the mine Will take 5 years to get to the gold Little money to pay interest in the meantime Can issue a bond with less interest than

market and still get their money “Discounted” Bond

Discounted Bond

Issuer offers to pay LESS than market rate of interest

Bond purchaser agrees in turn to pay LESS up front to the issuing company

Why the Difference in Rates??

Companies use rate to manage cash flow Biotech Example

Need $$ to develop new drug, 80% chance they will succeed

Have lots of money from other drugs to pay interest

Can offer above market interest to get people to buy the bonds, cover the risk

“Premium” Bond

Premium Bond

Issuer offers to pay MORE than market rate of interest

Bond purchaser agrees in turn to pay MORE up front to the issuing company

Debt Ratings: drive the market rate used for the calculation

lower rating = more discounting

Factors Affecting Bond Ratings

Selected Financial Ratios for Various Bond Rating Classes

123

124

Off Balance Sheet Liabilities

GAAP allows certain liabilities to be “off balance sheet”, not included in liabilities Contingent Liabilities Operating Leases SPE Liabilities

Contingent Liabilities

Contingent on some future event or activity; examples include warranties and lawsuits.

Alternative treatments for loss contingencies Ignore Disclose in footnotes Estimate and put on Balance Sheet

Changes in estimate may be made in subsequent periods, when future event is concluded.

Contingent Liabilities

ReasonablyProbability of Occurrence possible Remote

Yes No

Accounting Treatment On Financial IgnoreStatements

Highly Probable

Estimable?

Disclose in footnotes only

...highly judgmental disclosure rules

Capital Vs. Operating Leases

GAAP identifies two different approaches in the reporting of leases by the lessee:

Capital lease method Operating lease method

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Capital Leases

Must treat a lease as a capital lease if it meets any one of these tests:

1. Ownership is transferred at end of lease

2. Bargain purchase option at end of lease

3. Term is > 75% of life of asset

4. Present Value of payment stream > 90% of fair value of asset

Capital Vs. Operating Leases

144

SPE

SPE – Special Purpose Entities Separate “related” companies holding debt If properly structured, SPE is not

consolidated with parent company results Control Financing

SPE: Asset Securitization

Sponsoring company forms a subsidiary that is capitalized entirely with equity creates a bankruptcy remote transaction

Subsidiary purchases assets from the sponsoring company and sells them to a securitization (off-balance-sheet) trust (the SPE), which purchases the assets using borrowed funds.

Cash flows from the acquired assets are used by the SPE to repay its debt.

Ford Motor Credit SPE

Enron takes SPE’s to a new level

Next Week

Financing provided by owners:

Shareholders Equity