Com 4FK3

Financial Statement Analysis

Week 9, 2012

Controversial Issues in Liability Recognition

Forecasting

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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

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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

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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, other-wise 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