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Chapter 03 - Analyzing Financing Activities

Analyzing Financing Activities


REVIEW
Business activities are financed through either liabilities or equity. Liabilities are obligations
requiring payment of money, rendering of future services, or dispensing of specific assets.
They are claims against a company's present and future assets and resources. Such claims
are usually senior to holders of equity securities. Liabilities include current obligations,
long-term debt, capital leases, and deferred credits. This chapter also considers securities
straddling the line separating liabilities from equity. Equity refers to claims of owners to the
net assets of a company. While claims of owners are junior to creditors, they are residual
claims to all assets once claims of creditors are satisfied. Equity investors are exposed to
the maximum risk associated with a business, but are entitled to all residual rewards
associated with it. Our analysis must recognize the claims of both creditors and equity
investors, and their relationship, when analyzing financing activities. This chapter describes
business financing and how this is reported to external users. We describe two major
sources of financingcredit and equityand the accounting underlying reports of these
activities. We also consider off-balance-sheet financing, including Special Purpose Entities
(SPEs), the relevance of book values, and liabilities "at the edge" of equity. Techniques of
analysis exploiting our accounting knowledge are described.

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OUTLINE

Liabilities
Current Liabilities
Noncurrent Liabilities
Analyzing Liabilities

Leases
Lease Accounting and Reporting Lessee
Analyzing Leases

Postretirement benefits
Pension Accounting
Other Postretirement Benefits (OPEBs)
Analyzing Postretirement Benefits

Contingencies and Commitments


Contingencies
Commitments

Off-Balance-Sheet Financing
Through-put and Take-or-pay agreements
Product financing arrangements
Special Purpose Entities (SPEs)

Shareholders Equity
Capital Stock
Retained Earnings
Computation of Book Value Per Share

Liabilities at the Edge of Equity


Redeemable Preferred Stock
Minority Interest

Appendix 3A: Lease Accounting Lessor

Appendix 3B: Accounting Specifics for Postretirement Benefits

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ANALYSIS OBJECTIVES

Identify and assess the principal characteristics of liabilities and equity.

Analyze and interpret lease disclosures and explain their implications and the
adjustments to financial statements.

Analyze postretirement disclosures and assess their consequences for firm


valuation and risk.

Analyze contingent liability disclosures and describe risks.

Identify off-balance-sheet financing and its consequences to risk analysis.

Analyze and interpret liabilities at the edge of equity.

Explain capital stock and analyze and interpret its distinguishing features.

Describe retained earnings and their distribution through dividends.

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QUESTIONS
1. The two major source of liabilities, for both current and noncurrent liabilities, are
operating and financing activities. Current liabilities of an operating naturesuch as
accounts payable and operating expense accrualsrepresent claims on resources from
operating activities. Current liabilities such as notes payable, bonds, and the current
maturities of long-term debt reflect claims on resources from financing activities.
2. The major disclosure requirements (in SEC FRR, Section 203) for financing-related
current liabilities such as short-term debt are:
a. Footnote disclosure of compensating balance arrangements including those not
reduced to writing
b. Balance sheet segregation of (1) legally restricted compensating balances and (2)
unrestricted compensating balances relating to long-term borrowing arrangements if
the compensating balance can be computed at a fixed amount at the balance sheet
date.
c. Disclosure of short-term bank and commercial paper borrowings:
i. Commercial paper borrowings separately stated in the balance sheet.
ii. Average interest rate and terms separately stated for short-term bank and
commercial paper borrowings at the balance sheet date.
iii. Average interest rate, average outstanding borrowings, and maximum month-end
outstanding borrowings for short-term bank debt and commercial paper
combined for the period.
d. Disclosure of amounts and terms of unused lines of credit for short-term borrowing
arrangements (with amounts supporting commercial paper separately stated) and of
unused commitments for long-term financing arrangements.
Note that the above disclosures are required for filings with the SEC but not necessarily
for disclosures in published annual reports. It should also be noted that SFAS 6 states
that certain short-term obligations should not necessarily be classified as current
liabilities if the company intends to refinance them on a long-term basis and can
demonstrate its ability to do so.
3. The conditions required by SFAS 6 that demonstrate the ability of the company to
refinance it short-term debt on a long-term basis are:
a. The company has actually issued a long-term obligation or equity securities to
replace the short-term obligation after the date of the company's balance sheet but
before its release.
b. The company has entered into an agreement with a bank or other source of capital
that permits the company to refinance the short-term obligation when it becomes
due.
Note that financing agreements that are cancelable for violation of a provision that can
be evaluated differently by the parties to the agreement (such as a material adverse
change or failure to maintain satisfactory operations) do not meet the second
condition. Also, an operative violation of the agreement should not have occurred.

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4. Since the interest rate that will prevail in the bond market at the time of issuance of
bonds can never be predetermined, bonds usually are sold in excess of par (premium) or
below par (discount). This premium or discount represents, in effect, an adjustment of
the coupon rate to the effective interest rate. The premium received is amortized over the
life of the issue, thus reducing the coupon rate of interest to the effective interest rate
incurred. Conversely, the discount also is amortized, thus increasing the effective
interest rate paid by the borrower.
5. The accounting for convertibility and warrants impacts income and equity as follows:
a. The convertible feature is attractive to investors. As a result, the debt will be issued
at a slightly lower interest rate and the resulting interest expense is less (and
conversely, equity is increased). Also, diluted earnings per share is reduced by the
assumed conversion. At conversion, a gain or loss on conversion may result when
equity instruments are issued.
b. Similarly, warrants attached to bonds allow the bonds to pay a lower interest rate. As
a result, interest expense is reduced (and conversely, equity is increased). Also,
diluted earnings per share is affected because the warrants are assumed converted.
6. It is important to the analysis of convertible debt and stock warrants to evaluate the
potential dilution of current and potential shareholders if the holders of these options
choose to convert them to stock. This potential dilution would represent a real wealth
transfer for existing shareholders. Currently, this potential dilution is given little formal
recognition in financial statements.
7. SFAS 47 requires note disclosure of commitments under unconditional purchase
obligations that provide financing to suppliers. It also requires disclosure of future
payments on long-term borrowings and redeemable stock. Required disclosures include:
For purchase obligations not recognized on purchaser's balance sheet:
a. Description and term of obligation.
b. Total fixed and determinable obligation. If determinable, also show these amounts for
each of the next five years.
c. Description of any variable obligation.
d. Amounts purchased under obligation for each period covered by an income
statement.
For purchase obligations recognized on purchaser's balance sheet, payments for
each of the next five years.
For long-term borrowings and redeemable stock:
a. Maturities and sinking fund requirements for each of the next five years.
b. Redemption requirements for each of the next five years.
8. a.

Information about debt covenant restrictions are available in the details of the bond
indentures of a company. Moreover, key restrictions usually are identified and
discussed in the financial statement notes.
b. The margin of safety as it applies to debt contracts refers to the slack that the
company has before it would violate any of the debt covenant restrictions and be in
technical default. For example, if the debt covenant mandates a maximum debt to
assets ratio of 50% and the current debt to assets ratio is 40%, the company is said to
have a margin of safety of 10%. Technical default is costly to a company. Thus, as
the margin of safety decreases, the relative level of company risk increases.

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9. Analysis of the terms and conditions of recorded liabilities is an area deserving an


analyst's careful attention. Here, the analyst must examine critically the description of
debt, its terms, conditions, and encumbrances with a desire to satisfy him/her as to the
ability of the company to meet principal and interest payments. Important analyses in the
evaluation of liabilities are the examination of features such as:
Contractual terms of the debt agreement, including payment schedule
Restrictions on deployment of resources and freedom of action
Ability to engage in further financing
Requirements relating to maintenance of working capital, debt to equity ratio, etc.
Dilutive conversion features to which the debt is subject.
Prohibitions on disbursements such as dividends
Moreover, we review the audit report since we expect auditors to require satisfactory
recording and disclosure of all existing liabilities. Auditor tests include the scrutiny of
board of director meeting minutes, the reading of contracts and agreements, and inquiry
of those who may have knowledge of company obligations and liabilities.
The analysis of contingencies (and commitments) also is aided by financial statement
analysis. However, the analysis of contingencies and commitments is more challenging
because these liabilities typically do not involve the recording of assets and/or costs.
Here, the analyst must rely on information provided in notes to the financial statements
and in management commentary found in the text of the annual report and elsewhere.
Due to the uncertainties involved, the descriptions of commitments, and especially
contingent liabilities, in the notes are often vague and indeterminate. This means that the
burden of assessing the possible impact of contingencies and the probabilities of their
occurrence is passed to the analyst. Yet, the analyst assumes that if a contingency
(and/or commitment) is sufficiently serious, the auditor can qualify the audit report.
The analyst, while utilizing all information available, must nevertheless bring his/her own
critical evaluation to bear on the assessment of all existing liabilities and contingencies
to which the company may be subject. This process must draw not only on available
disclosures and reports, but also on an understanding of industry conditions and
practices.
10. a. A lease is classified and accounted for as a capital lease if at the inception of the
lease it meets one of four criteria: (1) the lease transfers ownership of the property to
the lessee by the end of the lease term; (2) the lease contains an option to purchase
the property at a bargain price; (3) the lease term is equal to 75 percent or more of the
estimated economic life of the property; or (4) the present value of the rentals and
other minimum lease payments, at the beginning of the lease term, equals 90 percent
of the fair value of the leased property less any related investment tax credit retained
by the lessor. If the lease does not meet any of those criteria, it is to be classified and
accounted for as an operating lease.
With regard to the last two of the above four criteria, if the beginning of the lease term
falls within the last 25 percent of the total estimated economic life of the leased
property, neither the 75 percent of economic life criterion nor the 90 percent recovery
criterion is to be applied for purposes of classifying the lease and as a consequence,
such leases will be classified as operating leases.

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b. Summary of accounting for leases by lessees:


1. The lessee records a capital lease as an asset and an obligation at an amount
equal to the present value of minimum lease payments during the lease term,
excluding executory costs (if determinable) such as insurance, maintenance, and
taxes to be paid by the lessor together with any profit thereon. However, the
amount so determined should not exceed the fair value of the leased property at
the inception of the lease. If executory costs are not determinable from provisions
of the lease, an estimate of the amount shall be made.
2. Amortization, in a manner consistent with the lessee's normal depreciation policy,
is called for over the term of the lease except where the lease transfers title or
contains a bargain purchase option; in the latter cases amortization should follow
the estimated economic life.
3. In accounting for an operating lease the lessee will charge rentals to expenses as
they become payable, except when rentals do not become payable on a
straight-line basis. In the latter case they should be expensed on such a basis or
on any other systematic or rational basis that reflects the time pattern of benefits
serviced from the leased property.
11. a. The major classifications of leases by lessors are:
1. Sales-type leases
2. Direct financing leases
3. Operating leases
The criteria for classifying each type are as follows: If a lease meets any one of the
four criteria for capitalization (see question 10a above) plus two additional criteria
(see below), it is to be classified and accounted for as either a sales-type lease (if
manufacturer or dealer profit is involved) or a direct financing lease. The additional
criteria are (1) collectibility of the minimum lease payments is reasonable predictable,
and (2) no important uncertainties surround the amount of unreimbursable costs yet
to be incurred by the lessor under the lease. A lease not meeting these criteria is to
be classified and accounted for as an operating lease.
b. The accounting procedures for leases by lessors are:
Sales-type leases
1. The minimum lease payments plus the unguaranteed residual value accruing to
the benefit of the lessor are recorded as the gross investment in the lease.
2. The difference between gross investment and the sum of the present value of its
two components is recorded as unearned income. The net investment equals
gross investment less unearned income. Unearned income is amortized to
income over the lease term so as to produce a constant periodic rate of return on
the net investment in the lease. Contingent rentals are credited to income when
they become receivable.
3. At the termination of the existing lease term of a lease being renewed, the net
investment in the lease is adjusted to the fair value of the leased property to the
lessor at that date, and the difference, if any, recognized as gain or loss. The
same procedure applies to direct financing leases (see below.)
4. The present value of the minimum lease payments discounted at the interest rate
implicit in the lease is recorded as the sales price. The cost, or carrying amount, if
different, of the leased property, and any initial direct costs (of negotiating and
consummating the lease), less the present value of the unguaranteed residual
value is charged against income in the same period.

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5. The estimated residual value is periodically reviewed. If it is determined to be


excessive, the accounting for the transaction is revised using the changed
estimate. The resulting reduction in net investment is recognized as a loss in the
period in which the estimate is changed. No upward adjustment of the estimated
residual value is made. (A similar provision applies to direct financing leases.)
Direct-financing leases
1. The minimum lease payments (net of executory costs) plus the unguaranteed
residual value plus the initial direct costs are recorded as the gross investment.
2. The difference between the gross investment and the cost, or carrying amount, if
different, of the leased property, is recorded as unearned income. Net investment
equals gross investment less unearned income. The unearned income is
amortized to income over the lease term. The initial direct costs are amortized in
the same portion as the unearned income. Contingent rentals are credited to
income when they become receivable.
Operating leases
The lessor will include property accounted for as an operating lease in the balance
sheet and will depreciate it in accordance with his normal depreciation policy. Rent
should be taken into income over the lease term as it becomes receivable except that
if it departs from a straight-line basis income should be recognized on such basis or
on some other systematic or rational basis. Initial costs are deferred and allocated
over the lease term.
12. Where land only is involved the lessee should account for it as a capital lease if either of
the enumerated criteria (1) or (2) is met. Land is not usually amortized.
In a case involving both land and building(s), if the capitalization criteria applicable to
land (see above) are met, the lease will retain the capital lease classification and the
lessor will account for it as a single unit. The lessee will have to capitalize the land and
buildings separately, the allocation between the two being in proportion to their
respective fair values at the inception of the lease.
If the capitalization criteria applicable to land are not met, and at the inception of the
lease the fair value of the land is less than 25 percent of total fair value of the leased
property both lessor and lessee shall consider the property as a single unit. The
estimated economic life of the building is to be attributed to the whole unit. In this case if
either of the enumerated criteria (3) or (4) is met the lessee should capitalize the land and
building as a single unit and amortize it.
If the conditions above prevail but the fair value of land is 25 percent or more of the total
fair value of the leased property, both the lessee and the lessor should consider the land
and the building separately for purposes of applying capitalization criteria (3) and (4). If
either of the criteria is met by the building element of the lease it should be accounted for
as a capital lease by the lessee and amortized. The land element of the lease is to be
accounted for as an operating lease. If the building element meets neither capitalization
criteria, both land and buildings should be accounted for as a single operating lease.
Equipment which is part of a real estate lease should be considered separately and the
minimum lease payments applicable to it should be estimated by whatever means are
appropriate in the circumstances. Leases of certain facilities such as airport, bus
terminal, or port facilities from governmental units or authorities are to be classified as
operating leases.

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13. In the books of the lessee, the primary consideration regarding leases is the appropriate
classification of operating leases. When leases are classified as operating leases, the
lease payment is recorded as rent expense. However, lease assets and liabilities are kept
off the balance sheet. Because of this, many companies avail themselves of operating
lease treatment even when the underlying economics justify capitalizing the leases. If
this is done, the asset and liabilities of a company are underreported and its debt-toequity ratios are biased downward. Often such leases are a form of off balance sheet
financing. Therefore, an analyst must carefully examine the classification of operating
leases and capitalize the leases when the underlying economic justify.
14. For the lessor, when a lease is considered an operating lease, the leased asset remains
on its books. For the lessee, it will not report an asset or an obligation on its balance
sheet.
15. When a lease is considered a capital lease for both the lessor and the lessee, the lessor
will report lease payments receivable on its balance sheet. The lessee will report the
leased asset and a lease obligation totaling the present value of future lease payments.
16. a. Rent expense
b. Interest expense and depreciation expense
17. a. Leasing revenue
b. Interest revenue (and possibly gain on sale in the initial year of the lease)
18.

Property, plant, and equipment can be financed by having an outside party acquire
the facilities while the company agrees to do enough business with the facility to provide
funds sufficient to service the debt. Examples of these kinds of arrangements are
through-put agreements, in which the company agrees to run a specified amount of
goods through a processing facility or "take or pay" arrangements in which the company
guarantees to pay for a specified quantity of goods whether needed or not.
A variation of the above arrangements involves the creation of separate entities for
ownership and the financing of the facilities (such as joint ventures or limited
partnerships) which are not consolidated with the company's financial statements and
are, thus, excluded from its liabilities.
Companies have attempted to finance inventory without reporting on their balance
sheets the inventory or the related liability. These are generally product financing
arrangements in which an enterprise sells and agrees to repurchase inventory with the
repurchase price equal to the original sales price plus carrying and financing costs or
other similar transactions such as a guarantee of resale prices to third parties.

19.

In a defined contribution plan, the employer promises to currently contribute a fixed


sum of money to the employees retirement fund, so it is the contribution that is
defined. In a defined benefit plan, the employer promises to pay a periodic pension
benefit to the employee after retirement (typically until death), so it is the benefit that
is defined. The risk (or reward) of the investment performance in the former case is
borne by the employee and in the latter by the employer.

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20.
Accounting for defined contribution plans is simple: whenever a contribution is made
it is recorded as an expense. Defined benefit plans accounting is complex and
involves currently recording a liability based on future expected benefit payments
and an asset to the extent the plan is funded. Pension expense in this case depends
on the changes in pension obligation and the return on plan assets.
21.

(a) Pension obligation: This is the present value of expected benefit payments to the
employee based on current service.
(b) Pension asset: this is the fair market value of the plan assets on the date of the
balance sheet.
(c) Net economic position of the plan: This is the difference between the fair market
value of the pension assets and the pension obligation. When this difference is
positive the plan is referred to as overfunded and when negative the plan is termed
underfunded.
(d) Economic pension cost: Economically, pension cost is equal to the change
(increase) in pension obligation minus return on plan assets. This is called the
funded status. Typically, pension obligation changes because of additional employee
service (service cost) and present value effects (interest cost).

22.

The common non-recurring components are: (a) Actuarial Gain/Loss: This arises
because of changes in actuarial assumptions such as discount rates and
compensation growth rates. (b) Prior Service Cost: This arises because of changes in
pension formulas, usually because of renegotiation of pension contracts. In addition,
the return on plan assets can have a recurring or expected component and an
unexpected component that is not expected to persist into the future.
SFAS 158 has a complex method by which the non-recurring amounts are first
deferred, i.e., excluded from current income, and then the opening net deferrals are
amortized over the remaining employee service. For this purpose, the excess of
actual plan asset return over expected return is netted against actuarial gains or
losses and then deferred/amortized using something called the corridor method.
Prior service cost is deferred and amortized separately on its own.

23.

The net periodic pension cost is a smoothed version of the economic pension cost.
For determining net periodic pension cost, all non-recurring or unusual components
of economic pension cost (e.g., actuarial gain/loss, prior service cost, excess of
actual plan return over expected return) are deferred and amortized using a complex
corridor method. The rationale for this smoothing mechanism is that the economic
pension cost is very volatile. Including this in income would cause income to be very
volatile and also hide the true operating profitability of the firm.

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24.

Under the current standard (SFAS 158), the balance sheet recognizes the funded
status of the plan. The income statement, however, does not recognize the net
economic cost, but a net periodic pension cost in which unusual or non-recurring
pension cost components are deferred and amortized. The cumulative net deferrals
are included in accumulated other comprehensive income. Under the older standard,
SFAS 87, the net periodic pension cost is recognized on the income statement. The
balance sheet however, merely recognized the accrued (or prepaid) pension cost,
which was simply the cumulative net periodic pension cost. The accrued (or prepaid)
pension cost was equal to the funded status minus cumulative net deferrals.

25.

Under SFAS 158, the difference between the economic pension cost (which
articulates with the change in the funded status which is recorded in the balance
sheet) and the smoothed net periodic pension cost (which is essentially the net
deferral for the period) is included in other comprehensive income for the period,
which is transferred to accumulated other comprehensive income on the balance
sheet.

26.

Other post employment benefits (OPEBs) are retirement benefits other than
pensions, such as post retirement health care benefits. OPEBs differ from pension on
two dimensions: (1) most of them are non-monetary and therefore create difficulties
in estimation and (2) because of tax laws, companies rarely fund these benefits.

27.

The pension note consists of five main parts: (1) an explanation of the reported
position in the balance sheet, (2) details of net periodic benefit costs, (3) information
regarding actuarial and other assumptions, (4) information regarding asset allocation
and funding policies, and (5) expected future contributions and benefit payments.

28.

Since the funded status of the plan is reported on the balance sheet under SFAS 158,
there is no adjustment to the balance sheet that is required. However, some analysts
note that netting pension assets and obligations tends to mask the underlying
pension risk exposure and thus recommend showing pension assets and liabilities
separately without netting them out.
Adjustments to the income statement depend on the purpose of the analysis. The net
periodic benefit cost that is reported under SFAS 158 is appropriate if the objective of
the analysis is identifying the permanent or core component of income. However, to
estimate a periods economic income it is advisable to use the economic pension
cost which includes all non-recurring items.

29.

The major actuarial assumptions underlying pension accounting are: (a) discount rate
(b) compensation growth rate and (c) expected rate of return on pension assets. Less
important assumptions include life expectancy and employee turnover. In addition
OPEBs also make assumptions about healthcare cost trends. Managers can affect
both the post-retirement benefit economic position (or economic cost) and the
reported cost. For example, choosing a higher discount rate can reduce the pension
obligation and thus improve economic position (funded status). Also, increasing the
expected rate of return on plan assets can reduce the reported pension cost (net
periodic pension cost).

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30.
31.

Pension risk exposure is the risk that a company is exposed to from its pension
plans. This risk arises because of a mismatch of the risk profiles of pension assets
and liabilities, primarily because companies invest pension assets whose returns are
not correlated with those of long-term bonds which form the basis for the discount
rate assumption affecting the measurement of the pension obligation.
The pensions crisis in the early 2000s in the U.S. was precipitated by an unusual
combination of declining equity values (which lowered the value of pension assets)
and declining long-term interest rates, which increased the pension obligations. The
net effect was a steep reduction in pension funded status which even resulted in
some companies filing for bankruptcy.
The three factors that an analyst needs to consider when evaluating pension
exposure are: (1) the plans funded status relative to the companys assets (2) the
pension intensity, i.e., the size of the pension obligation and assets (without netting)
relative to total assets and (3) the extent to which the assets and obligation is
mismatched, which can be determined by the proportion of pension assets invested
in non-debt securities or assets.

32.

Current cash flows for pensions (or OPEBs) measure the extent of company
contributions into the plan during the year. For pensions, this is obviously not a good
indicator of future cash contributions since contributions are affected by complex
factors which eventually affect the funded status of the plan. For OPEBs, current
contributions are a somewhat better indicator of future contributions since
contributions in a period typically equal benefits paid (since most OPEB plans are
unfunded), and benefits are more predictable over time.

33.

Accumulated benefit obligation (ABO): This is the present value of estimated future
pension benefit payments assuming current compensation. Projected benefit
obligations (PBO): This is the present value of estimated future pension benefit
payments assuming future compensation on the date of retirement. ABO is closer to
the legal obligation.

34.

The corridor method is used for determining the amount of amortization for net
gain or loss. Net gain or loss for the period is determined by netting the actuarial
gain/loss for the period with the difference between actual and expected return on
plan assets. Then the net gain or loss for the period is added to the cumulative net
gain or loss at the start of the period. Next a corridor for cumulative net gain/loss is
determined as the greater of 10% of PBO or 10% of plan assets (whichever is greater).
Only the amount of cumulative net gain/loss beyond this corridor (in either direction)
is amortized.

35.

Like the pension obligation, the OPEB obligation is the present value of expected
future benefits attributable to employee service to-date. The present value of the
expected future benefits is termed EPBO and that portion which is attributable to
service to-date is termed the APBO. The APBO is the obligation that is used to
estimate the funded status or the economic position of the plan reported on the
balance sheet.

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36.
While the estimation process for OPEB costs is similar to that of estimating pension
costs it is more difficult and more subjective. First, data about costs are more difficult
to obtain. Pension benefits involve either fixed dollar amounts or a defined dollar
amount, based on pay levels. Health benefits, by contrast, are estimates not easily
computed by actuarial formula. Many factors enter in to such estimates, including
deductibles, ages, marital status, number of dependents, etc. Second, more
assumptions than those governing pension calculations are needed. For example, in
addition to retirement dates, life expectancy, turnover, and discount rates, there is a
need for estimates of the medical costs trend rate, Medicare reimbursements, etc.
34. a. A loss contingency is any existing condition, situation, or set of circumstances
involving uncertainty as to possible loss that will be resolved when one or more
future events occur or fail to occur. Examples of loss contingencies are: litigation,
threat of expropriation, uncollectibility of receivables, claims arising from product
warranties or product defects, self-insured risks, and possible catastrophe losses of
property and casualty insurance companies.
b. The two conditions that must be met before a provision for a loss contingency can be
charged to income are: (1) it must be probable that an asset had been impaired or a
liability incurred at a date of a companys financial statements. Implicit in that
condition is that it must be probable that a future event or events will occur
confirming the fact of the loss. (2) the amount of loss must be reasonably estimable.
The effect of applying these criteria is that a loss will be accrued only when it is
reasonably estimable and relates to the current or a prior period.
35.

When a company decides to take a big bath, the company will recognize as many
discretionary expenses and losses as possible in the current year. Such a strategy
usually accompanies a period of unusually poor operating resultsthe managerial belief
is that the market will not further downgrade the stock from the one-time charge and
that the market will be less scrutinizing of such a charge. A major result of a big bath is
the inflated increase in future periods net income figures. Also, when a company takes
a big bath, it often causes reserves and/or liabilities to be overstated. For example, the
company might record an overstated restructuring charge or contingent liability. When a
company employs a big bath strategy, analysts should assess whether certain
reserves and liabilities are actually overstated and adjust their models accordingly. (The
income statement loss is probably overstated as well).

36.

Commitments are potential claims against a companys resources due to future


performance under a contract. Examples of commitments include contracts to purchase
products or services at specified prices, purchase contracts for fixed assets calling for
payments during construction, and signed purchase orders.

37.

Commitments are not recorded liabilities because commitments are not completed
transactions. Commitments become liabilities when the transaction is completed. For
example, consider a commitment by a manufacturer to purchase 100,000 units of
materials per year for 5 years. Each time a purchase is made at the agreed upon price,
part of the purchase commitment expires and a purchase is recorded. The remaining
part continues as an obligation by the manufacturer to purchase materials.

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38.
39.

Off-balance-sheet financing refers to the nonrecording of certain financing


obligations. Examples of off-balance-sheet financing include operating leases when they
are in-substance capital leases, joint ventures and limited partnerships, and many
recourse obligations on sold receivables.

39. Under SFAS 105, companies are required to disclose the following information about
financial instruments with off-balance-sheet risk of accounting loss:
a. The face, contract, or notional principal amount.
b. The nature and terms of the instruments and a discussion of their credit and market
risk, cash requirements, and related accounting policies.
c. The accounting loss the company would incur if any party to the financial
instruments failed completely to perform according to the terms of the contract, and
the collateral or other security, if any, for the amount due proved to be of no value to
the company.
d. The company's policy for requiring collateral or other security on financial
instruments it accepts, and a description of collateral on instruments presently held.
Information about significant concentrations of credit risk from an individual
counter-party or groups of counterparties for all financial instruments is also required.
These disclosures help financial analysis by revealing existing economic events that can
reduce the relevance and reliability of the balance sheet as reported by management.
With the information in these disclosures, the analyst can revise his/her personal models
to factor in the impact of off-balance-sheet items or otherwise adjust the analyses for
these items.
40.

SFAS 140 replaced SFAS 125 and defines new rules for the sale of accounts
receivable to special purpose entities (SPEs). In order to treat the transfer as a sale
(rather than a borrowing), the SPE must be a Qualifying SPE. Otherwise, the SPE must be
consolidated unless third-party investors make equity investments that are,
Substantive (more than 3% of assets)
Controlling (e.g., more than 50% ownership)
Bear the first dollar risk of loss
Take the legal form of equity
If any of the above conditions is not met, the transfer of the receivable is considered as a
loan with the receivables pledged as security for such loan.

41. Analysts should identify off-balance-sheet financing arrangements and either factor
these arrangements into their models or otherwise adjust the analyses for the additional
risk created by off-balance-sheet financing arrangements.
42. Some equity securities have mandatory redemption provisions that make them more
akin to debt than they are to equitya typical example is preferred stock. Whatever their
name, these securities impose upon the issuing companies various obligations to
dispense funds at specified dates. Such provisions are inconsistent with the true nature
of an equity security. The analyst must be alert to the existence of such equity
securities and examine for substance over form when making financial statement
adjustments.

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Chapter 03 - Analyzing Financing Activities

43.
43. In order to facilitate their understanding and analysis, reserves and provisions can be
redivided into a number of major categories.
The first category is most correctly described as comprising provisions for obligations
that have a high probability of occurrence, but which are in dispute or are uncertain in
amount. As is the case with many financial statement descriptions, neither the title nor
the location in the financial statement can be relied upon as a rule-of-thumb guide to the
nature of an account. The best key to analysis is a thorough understanding of the
business and the financial transactions that give rise to the account. The following are
representative items in this group: provisions for product guarantees, service
guarantees, and warranties that are established in recognition of future costs that are
certain to arise although presently impossible to measure. Another type of obligation
that must be provided for is the liability for unredeemed coupons such as trading
stamps. To the company issuing these coupons, there is no doubt about the liability to
redeem them for merchandise or cash. The only uncertainty concerns the number of
coupons that will be presented for redemption. Consequently, a provision is established
for these types of items by a charge to income at the time products covered by
guarantees (or
related to these coupons) are soldthe amount is established on the basis of experience
or on the basis of any other reliable factor.
The second category comprises reserves for expenses and losses, which by experience
or estimates are very likely to occur in the future and that should properly be provided
for by current charges to operations. One group within this category is comprised of
reserves for operating costs such as maintenance, repairs, painting, or overhauls. Thus,
for example, since overhauls can be expected to be required at regularly recurring
intervals, they are provided for ratably by charges to operations to avoid charging the
entire cost to the year in which the actual overhaul takes place.
A third category comprises provisions for future losses stemming from decisions or
actions already taken. Included in this group are reserves for relocations, replacement,
modernization, and discontinued operations.
A fourth category includes reserves for contingencies. For example, reserves for
self-insurance are designed to provide the accumulation against which specific types of
losses, not covered by insurance, can be charged. Although the term self-insurance
contradicts the very concept of insurance, which is based on the spreading of risks
among many business units, it nevertheless is a practice that has a good number of
adherents. Other contingencies provided against by means of reserves are those arising
from foreign operations and exchange losses due to official or de facto devaluations.
A fifth group of future costs that must be provided for is that of employee compensation.
These costs, in turn, give rise to provisions for vacation pay, deferred compensation,
incentive compensation, supplemental unemployment benefits, bonus plans, welfare
plans, and severance pay. The related category of estimated liabilities includes
provisions for claims arising out of pending or existing litigation.

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Chapter 03 - Analyzing Financing Activities

Of importance to the analyst is the adequacy of the reserves and provisions that are
often established on the basis of prior experience or on the basis of other estimates.
Concern with adequacy of amount is a prime factor in the analysis of all reserves and
provisions, whatever their purpose. Reserves and provisions appearing above the equity
section are almost invariably created by means of charges to income. They are designed
to assign charges to the income statement based on when they are incurred rather than
when they are paid in cash.
44. Reserves for future losses represent a category of accounts that require particular
scrutiny. While conservatism in accounting calls for recognition of losses as they can be
determined or clearly foreseen, companies tend, particularly in loss years, to
over-provide for losses not yet incurred. Such losses not yet incurred often involve
disposal of assets, relocations, and plant closings. Overprovision shifts expected future
losses to the present period, which likely already shows adverse results.
One problem with such reserves is that once established there is no further accounting
for the expenses and losses that are charged against them. Only in certain financial
statements required to be filed with the SEC (such as Form 10-K) are details of changes
in reserves required. Recent requirements have, however, tightened the disclosure rules
in this area.

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Chapter 03 - Analyzing Financing Activities

The reason why over-provisions of reserves occur is that the income statement effects
are often accorded more importance than the residual balance sheet effects. While a
provision for future expenses and losses establishes a reserve account that is
analytically in the "never-never land" between liabilities and equity accounts, it serves
the important purpose of creating a cushion that can absorb future expenses and losses.
This shields the all-important income statement from them and their related volatility.
The analyst should endeavor to ascertain that provisions for future losses reflect losses
that can reasonably be expected to have already occurred rather than be used as a
means of artificially benefiting future income by adding excessive provisions to present
adverse results.
45.

An ever increasing variety of items and descriptions are included in the "deferred
credits" group of accounts. In many cases these items are akin to liabilities; in others,
they either represent deferred income yet to be earned or serve as income-smoothing
devices. A lack of agreement among accountants as to the exact nature of these items or
the proper manner of their presentation compounds the confusion confronting the
analyst. Thus, regardless of category or presentation, the key to their analysis lies in an
understanding of the circumstances and the financial transactions that brought them
about.
At one end of the spectrum we find those items that have characteristics of liabilities.
Here we can find items such as advances or billings on uncompleted contracts,
unearned royalties and deposits, and customer service prepayments. The outstanding
characteristics of these items is their liability aspects even though, as in the case of
advances of royalties, they may, after certain conditions are fulfilled, find their way into
the company's income stream. Advances on uncompleted contracts represent primarily
methods of financing the work in progress while deposits of rent received represent, as
do customer service prepayments, security for performance of an agreement. At the
other end of the spectrum are deferred credits that exhibit many qualities similar to
equity. The key to effective analysis is the ability to identify those items most like
liabilities from those most like equity.

46. The accounting for the equity section as well as its presentation, classification, and note
disclosure have certain basic objectives. The most important of these are:
a. To classify and distinguish among the major sources of owner capital contributed to
the entity.
b. To set forth the priorities of the various classes of stockholders and the manner in
which they rank in partial or final liquidation.
c. To set forth the legal restrictions to which the distribution of capital funds are subject
to for whatever reason.
d. To disclose the contractual, legal, managerial, and financial restrictions that the
distribution of current and retained earnings is subject to.
The accounting principles that apply to the equity section do not have a marked effect on
income determination and, as a consequence, do not hold many pitfalls for the analyst.
From the analyst's point of view, the most significant information here relates to the
composition of the capital accounts and to the restrictions that they are subject to.

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Chapter 03 - Analyzing Financing Activities

The composition of equity capital is important because of provisions affecting the


residual rights of common equity. Such provisions include dividend participation rights,
and the great variety of options and conditions that are characteristic of the complex
securities frequently issued under merger agreements, most of which tend to dilute
common equity. Analysis of restrictions imposed on the distribution of retained earnings
by loan or other agreements will usually shed light on a company's freedom of action in
such areas as dividend distributions and the required levels of working capital. Such
restrictions also shed light on the company's bargaining strength and standing in credit
markets. Moreover, a careful analysis of restrictive covenants will enable the analyst to
assess how far a company is from being in default of these provisions.
47. Preferred stock often carries features that make it preferred in liquidation and preferred
as to dividends. Also, it is often entitled to par value in liquidation and can be entitled to
a premium. On the other hand, the rights of preferred stock to dividends are generally
fixedalthough they can be cumulative, which means that preferred shareholders are
entitled to arrearages of dividends before common stockholders receive any dividends.
These features of preferred stock as well as the fixed nature of the dividend give
preferred stock some of the earmarks of debt with the important difference that preferred
stockholders are not generally entitled to demand redemption of their shares. However,
there are preferred stock issues that have set redemption dates and require sinking
funds to be established for that purposethese issuances are essentially debt.
Characteristics of preferred stock that make them more akin to common stock are
dividend participation rights, voting rights, and rights of conversion into common stock.
48. Accounting standards state (APB 10): Companies at times issue preferred (or other
senior) stock which has a preference in involuntary liquidation considerably in excess of
the par or stated value of the shares. The relationship between this preference in
liquidation and the par or stated value of the shares may be of major significance to the
users of the financial statements of those companies and the Board believes it highly
desirable that it be prominently disclosed. Accordingly, the Board recommends that, in
these cases, the liquidation preference of the stock be disclosed in the equity section of
the balance sheet in the aggregate, either parenthetically or in short rather than on a per
share basis or by disclosure in notes."
Such disclosure is particularly important since the discrepancy between the par and
liquidation value of preferred stock can be very significant.
49. This question is answered in a SEC release titled Pro Rata Distribution to Shareholders:
Several instances have come to the attention of the Commission in which registrants
have made pro rata stock distributions that were misleading. These situations arise
particularly when a registrant makes distributions at a time when its retained earnings or
its current earnings are substantially less than the fair value of the shares distributed.
Under present generally accepted accounting rules, if the ratio of distribution is less than
25 percent of shares of the same class outstanding, the fair value of the shares issued
must be transferred from retained earnings to other capital accounts. Failure to make
this transfer in connection with a distribution or making a distribution in the absence of
retained or current earnings is evidence of a misleading practice. Distributions of over 25
percent (which do not normally call for transfers of fair value) may also lend themselves
to such an interpretation if they appear to be part of a program of recurring distribution
designed to mislead shareholders.

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Chapter 03 - Analyzing Financing Activities

It has long been recognized that no income accrues to the shareholder as a result of
such stock distributions or dividends, nor is there any change in either the corporate
assets or the shareholders' interest therein. However, it is also recognized that many
recipients of such stock distributions, which are called or otherwise characterized as
dividends, consider them to be distributions of corporate earnings equivalent to the fair
value of the additional shares received. In recognition of these circumstances, the
American Institute of Certified Public Accountants has specified in Accounting Research
Bulletin No. 43, Chapter 7, paragraph 10, that "... the corporation should in the public
interest account for the transaction by transferring from earned surplus to the category
of permanent capitalization (represented by the capital stock and capital surplus
accounts) an amount equal to the fair value of the additional shares issued. Unless this
is done, the amount of earnings which the shareholder may believe to have been
distributed will be left, except to the extent otherwise dictated by legal requirements, in
earned surplus subject to possible further similar stock issuances or cash distributions.
Both the New York and American Stock Exchanges require adherence to this policy by
their listed companies.
50. Accounting standards require that, except for corrections of errors in financial
statements of a prior period and adjustments that result from realization of income tax
benefits of preacquisition operating loss carry forwards of purchased subsidiaries, all
items of profit and loss recognized during a period (including accruals of estimated
losses from loss contingencies) be included in the determination of net income for that
period. The standard permits limited restatements in interim periods of a company's
current fiscal year.
51. a. Minority interests are the claims of shareholders of a majority owned subsidiary
whose total net assets are included in a consolidated balance sheet.
b. Consolidated financial statements often show minority interests as liabilities:
however, they are fundamentally different in nature from legally enforceable
obligations. Minority shareholders do not have any legally enforceable rights for
payments of any kind from the parent company. Therefore, the financial analyst can
justifiably classify minority interest as equity funds in most cases.

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Chapter 03 - Analyzing Financing Activities

EXERCISES
Exercise 3-1 (20 minutes)
a.
Long-term debt [46]
A
B

159.7
0.3

G
H

24.3
250.3

805.8

beg

0.1
99.8
100.0
199.6

C
D
E
F

1.9
772.6

I
end

A = Retirement of 13.99% Zero Coupon Notes.


B = Repayment of 9.125% Note.
C = Additional borrowing on 7.5% Note.
D = Borrowing on 9% Note
E = Borrowing on Medium-Term Notes.
F = Borrowing on 8.875% Debentures
G = Repayment of Other Notes
H = Reclassification of Note
I = Increase in capital lease obligation

b. Campbell Soups debt footnote indicates maturities of (in $millions) $227.7 in


Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year
16. The remaining long-term debt matures in excess of 5 years. Given Campbells
operating cash flow of $805.2 million, solvency does not appear to be a problem.
Further, Campbell reports net income of $401.5, well in excess of its interest
expense of $116.2 in Year 11, an interest coverage ratio of 6.7 [$667.4 + $116.2]/
$116.2). The company should also be able to meet its interest obligations.
Campbell reports total liabilities of $2,355.6 million ($1278+$772.6+$305) against
stockholders equity of $1,793.4 million, a 1.3 times multiple. The amount of debt
does not appear to be excessive. Nor does the company appear to be
underutilizing its equity.
Given present debt levels that are not excessive and adequate cash flow, the
company should be able to finance additional investments with debt if desired by
management.

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Chapter 03 - Analyzing Financing Activities

Exercise 3-2 (20 minutes)


a. The economic effects of a long-term capital lease on the lessee are similar to that
of an equipment purchase using installment debt. Such a lease transfers
substantially all of the benefits and risks incident to the ownership of property to
the lessee, and obligates the lessee in a manner similar to that created when
funds are borrowed. To enhance comparability between a firm that purchases an
asset on a long-term basis and a firm that leases an asset under substantially
equivalent terms, the lease should be capitalized.
b. A lessee should account for a capital lease at its inception as an asset and an
obligation at an amount equal to the present value at the beginning of the lease
term of minimum lease payments during the lease term, excluding any portion of
the payments representing executory costs, together with any profit thereon.
However, if the present value exceeds the fair value of the leased property at the
inception of the lease, the amount recorded for the asset and obligation should
be the fair value.
c. A lessee should allocate each minimum lease payment between a reduction of the
obligation and interest expense so as to produce a constant periodic rate of
interest on the remaining balance of the obligation.
d. Von should classify the first lease as a capital lease because the lease term is
more than 75 percent of the estimated economic life of the machine. Von should
classify the second lease as a capital lease because the lease contains a bargain
purchase option.
Exercise 3-3 (15 minutes)
a. A lessee would account for a capital lease as an asset and an obligation at the
inception of the lease. Rental payments during the year would be allocated
between a reduction in the obligation and interest expense. The asset would be
amortized in a manner consistent with the lessee's normal depreciation policy for
owned assets, except that in some circumstances the period of amortization
would be the lease term.
b. No asset or obligation would be recorded at the inception of the lease. Normally,
rental on an operating lease would be charged to expense over the lease term as
it becomes payable. If rental payments are not made on a straight-line basis,
rental expense nevertheless would be recognized on a straight-line basis unless
another systematic or rational basis is more representative of the time pattern in
which use benefit is derived from the leased property, in which case that basis
would be used.

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Chapter 03 - Analyzing Financing Activities

Exercise 3-4 (18 minutes)


a. The gross investment in the lease is the same for both a sales-type lease and a
direct-financing lease. The gross investment in the lease is the minimum lease
payments (net of amounts, if any, included therein for executory costs such as
maintenance, taxes, and insurance to be paid by the lessor, together with any
profit thereon) plus the unguaranteed residual value accruing to the benefit of the
lessor.
b. For both a sales-type lease and a direct-financing lease, the unearned interest
income would be amortized to income over the lease term by use of the interest
method to produce a constant periodic rate of return on the net investment in the
lease. However, other methods of income recognition may be used if the results
obtained are not materially different from the interest method.
c. In a sales-type lease, the excess of the sales price over the carrying amount of
the leased equipment is considered manufacturer's or dealer's profit and would
be included in income in the period when the lease transaction is recorded.
In a direct-financing lease, there is no manufacturer's or dealer's profit. The
income on the lease transaction is composed solely of interest.
Exercise 3-5 (25 minutes)
A number of major companies have a meager debt ratio. Still, even when a company
shows little if any debt on its balance sheet, it can have considerable long-term
liabilities. This situation can reflect one or more of several factors such as the
following:
Lease commitments, while detailed in notes, are not recorded in the balance sheets
of many companies. This could be a critical problem for companies that have
expanded by leasing rather than buying property. These lease commitments, while
reflecting different attributes of pure debt, are just as surely long-term obligations.
Many companies have very large unfunded postretirement liabilities. These often are
not recorded on the balance sheet, but are disclosed in the notes. At one time, a case
could have been made that such obligations were not a problem, for as long as the
business operated, payments would be made, and if it went bankrupt, the liability
would end. Now, under most laws, the company has a real long-term obligation to
employees.
Several companies guarantee the debt of another company. The most typical is a
nonconsolidated lease subsidiary. Although disclosed in the notes, this debt, which
is real and can be large, is not recorded on the parent's balance sheet.

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Chapter 03 - Analyzing Financing Activities

Exercise 3-5continued
Off-balance-sheet debtsuch as industrial revenue bonds or pollution control
financing where a municipality sells tax-free bonds guaranteed for paymentare
cases where a supposedly debt-free balance sheet could look much worse if these
obligations were recorded.
Finally, the practice of deferred taxessuch as taking some expenses for tax, but
not book purposes, or through differences in timing for recognition of salesis one
that, while recorded on the balance sheet, is normally not recognized as a long-term
obligation. However, if the rate of investment slows dramatically for some reason or
if the sales trend is reversed, the sudden coming due of these tax liabilities could be
a major problem.
(CFA Adapted)

Exercise 3-6 (20 minutes)


a. An estimated loss from a loss contingency is accrued with a charge to income if
both of the following conditions are met:

Information available prior to issuance of the financial statements indicates


that it is probable that an asset had been impaired or a liability had been
incurred at the date of the financial statements. It is implicit in this condition
that it must be probable that one or more future events will occur confirming
the fact of the loss.

The amount of loss can be reasonably estimated.

b. In this case, disclosure should be made for an estimated loss from a loss
contingency that need not be accrued by a charge to income when there is at
least a reasonable possibility that a loss may have been incurred. The disclosure
should indicate the nature of the contingency and should estimate the possible
loss or range of loss or state that such an estimate cannot be made.
Disclosure of a loss contingency involving an unasserted claim is required when
it is probable that the claim will be asserted and there is a reasonable possibility
that the outcome will be unfavorable.
Exercise 3-7 (15 minutes)
a. One reason that managers might want to resist recording a liability related to an
ongoing lawsuit is that the recorded liability can cause deterioration in the
financial position of the company. A second reason is that the opposing
attorneys may use the disclosure inappropriately as an admission of liability.

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Chapter 03 - Analyzing Financing Activities

Exercise 3-7continued
b. If a manager believes that it is inevitable that a liability will be recorded, the
manager may want to time the recognition of the liability opportunistically. For
example, if the company has a relatively bad period, the liability can be recorded
in conjunction with a big bath. If the company has a very good period, the
manager might find that the liability can be recorded in that period without
causing an unexpectedly bad earnings report.
Exercise 3-8 (40 minutes)
[Note: Unless otherwise indicated, much of the information to answer this exercise can be found in
item [68] of Campbells financial statements.]

a. The causes of the $101.6 million increase are identified in the table below (see
Campbells Consol. Statement of Owners Equity and Changes in Number of Shares):
Millions
Net Income ...........................................................
Cash Dividends ...................................................
Treasury Stock Purchase ...................................
Treasury Stock Issued
Capital Surplus ...............................................
Treasury Stock ...............................................
Translation Adjustment ......................................
Sale of foreign operations ..................................
Increase in Stockholders' Equity .......................
a

1,793.4
- 1,691.8
101.6

[54]

11
$401.5
(142.2) (89)
(175.6)

10
$ 4.4 (28)
(126.9) (87)
(41.1) (87)

45.4 (91)
12.4 (91)
(29.9) (92)
(10.0) (93)

11.1 (87)
4.6 (87)
61.4 (87)

101.6a

(86.5)b

1,691.8 [54]
1,778.3 [87]
(86.5)

b. The average price for treasury share purchases is computed as:


[($175.6 million1 / 3.395 million treasury shares purchased)] = $51.72
1

Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders Equity

c. Book Value per Share of Common Stock is computed as:


[$1,793.4 [54] / 127.0* ] = $14.12
*135.6 [49] - 8.6 [52] note: There is no preferred stock outstanding
(Note: This value equals the company's computed amount [185] of $14.12.)

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Chapter 03 - Analyzing Financing Activities

Exercise 3-8continued
d. The book value per share of common stock is $14.12. However, shares were
purchased during the year at an average of about $52 per share (an indicator of
market value during the year). In fact, according to note 24 to the financial
statements the stock traded in the $70 - $80 range in the fourth quarter of Year 11.
There are several reasons why the market value of the stock is much higher than the
book value of the stock. First, the market value impounds the investors beliefs
about the future earning power of the company. Investors apparently have high
expectations regarding future profitability. Second, the book value is recorded using
accounting conventions such as historical cost and conservatism. Each of these
conventions is designed to optimize the reliability of the information but can cause
differences between the market and book values of a companys stock.

Exercise 3-9 (30 minutes)


a. The principal transactions and events that reduce the amount of retained
earnings include the following:
1. Operating losses (including extraordinary losses and other debit adjustments).
2. Stock dividends.
3. Dividends distributing corporate assets such as cash or in-kind.
4. Recapitalizations such as quasi-reorganizations.
b. The principal reason for making the distinction between contributed capital and
retained earnings (earned capital) in the stockholders' equity section is to enable
stockholders and creditors to identify dividend distributions as actual
distributions of earnings or as returns of capital. This identification also is
necessary to comply with most state statutes that provide that there should be no
impairment of the corporation's legal or stated capital by the return of such
capital to owners in the form of dividends. This concept of legal capital provides
some measure of protection to creditors and imposes a liability upon the
stockholders in the event of such impairment.
Knowledge of the distinction between contributed capital and earned capital
provides a guide to the amount of dividends that can be distributed by the
corporation. Assets represented by the earned capital, if in liquid form, may
properly be distributed as dividends; but invested assets represented by
contributed capital should ordinarily remain for continued operation of the
corporation. If assets represented by contributed capital are distributed to
shareholders, the distribution should be identified as a return of capital and,
hence, is in the nature of a liquidating dividend. Knowledge of the amount of
capital that has been earned over a period of years after adjustment for dividends
also is of value to stockholders in judging dividend policy and obtaining an
indication of past profits to the extent not distributed as dividends.

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Chapter 03 - Analyzing Financing Activities

Exercise 3-9continued
c. The acquisition and reissuance of its own stock by a firm results only in the
contraction or expansion of the amount of capital invested in it by stockholders.
In other words, an acquisition of treasury shares by a corporation is viewed as a
partial liquidation and the subsequent reissuance of these shares is viewed as an
unrelated capital-raising activity. To characterize as gain or loss the changes in
equity resulting from a corporation's acquisition and subsequent reissuance of
its own shares at different prices is a misuse of accounting terminology. When a
corporation acquires its own shares, it is not "buying" anything nor has it
incurred a "cost." The price paid represents the amount by which the corporation
has reduced its net assets or "partially liquidated." Similarly, when the
corporation reissues these shares it has not "sold" anything. It has increased its
total capitalization by the amount received.
It is the practice of referring to the acquisition and reissuance of treasury shares
as a buying and selling activity that gives the superficial impression that, in this
process, the firm is acquiring and disposing of assets and that, if different
amounts per share are involved, a gain or loss results. Note, when a corporation
"buys" treasury shares it is not acquiring assets; nor is it disposing of any assets
when these shares are subsequently "sold."
Exercise 3-10 (25 minutes)
a. There are four basic rights inherent in ownership of common stock. The first right
is that common shareholders may participate in the actual management of the
corporation through participation and voting at the corporate stockholders
meeting. Second, a common shareholder has the right to share in the profits of
the corporation through dividends declared by the board of directors (elected by
the common shareholders) of the corporation. Third, a common shareholder has
a pro rata right to the residual assets of the corporation if it liquidates. Fourth,
common shareholders have the right to maintain their interest (percent of
ownership) in the corporation if the corporation issues additional common
shares, by being given the opportunity to purchase a proportionate number of
shares of the new offering. This fourth right is most commonly referred to as a
"preemptive right."
b. Preferred stock is a form of capital stock that is afforded special privileges not
normally afforded common shareholders in return for giving up one or more
rights normally conveyed to common shareholders. The most common right
given up by preferred shareholders is the right to participate in management
(voting rights). In return, the corporation grants one or more preferences to the
preferred shareholders. The most common preferences granted to preferred
shareholders are these:

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Chapter 03 - Analyzing Financing Activities

Exercise 3-10continued
1. Dividends are paid to common shareholders only after dividends have been
paid to preferred shareholders.
2. Claims of preferred shareholders are senior to common shareholders for
residual assets (after creditors have been paid) in the case of corporation
liquidation.
3. Although the board of directors is under no obligation to declare dividends in
any particular year, preferred shareholders are granted a cumulative provision
stating that any dividends not paid in a particular year must be paid in
subsequent years before common shareholders are paid any dividend.
4. Preferred shareholders are granted a participation clause that allows them to
receive additional dividends beyond their normal dividend if common
shareholders receive dividends of greater percentage than preferred
shareholders. This participation is on a one-to-one basis (fully participating);
common shareholders are allowed to exceed the rate paid to preferred
shareholders by a defined amount before preferred shareholders begin to
participate: or, the participation clause can carry a maximum rate of
participation to which preferred shareholders are entitled.
5. Preferred shareholders have the right to convert their preferred shares to
common shares at a set future price no matter what the current market price
of the common stock is.
6. Preferred shareholders also can agree to have their stock callable by the
corporation at a higher price than when the stock was originally issued. This
item is generally coupled with another preference item to make the issue
appear attractive to the market.
c. 1. Treasury stock is stock previously issued by the corporation but
subsequently repurchased by the corporation. It is not retired stock, but stock
available for issuance at a subsequent date by the corporation.
2. A stock right is a privilege extended by the corporation to acquire additional
shares (or fractional shares) of its capital stock.
3. A stock warrant is physical evidence of stock rights. The warrant specifies the
number of rights conveyed, the number of shares to which the rightholder is
entitled, the price at which the rightholder can purchase additional shares,
and the life of the rights (time period over which the rights can be exercised).

3-27

Chapter 03 - Analyzing Financing Activities

Exercise 3-11 (12 minutes)


a. These cash distributions are not dividends. Instead, they are returns of capital.
Dividends are distributions of past earnings of the company. Since this company
has not earned any net income, there are no retained earnings from which
dividends could be paid. Thus, these cash distributions are being made from
capital previously contributed to the company by the owners.
b. There are at least a couple of reasons why a return of capital might be made.
First, the company may be going out of business. Second, in a closely held
company, influential owners may have mandated the payments. A distribution of
capital is usually the result of special circumstances confronted by a company.
Exercise 3-12 (12 minutes)
a. Purchasing its own shares is similar to the payment of dividends in that cash
assets are reduced in both situations. That is, in each case, the company is
distributing cash to shareholders. In the case of dividends, all shareholders are
receiving cash in a proportionate manner. In the case of share repurchases, only
selected shareholders receive cash distributions from the company.
b. Managers might prefer to purchase its own companys shares because this
serves to increase financial performance measures such as earnings per share
and return on shareholders equity.
c. Investors are taxed on dividends received from companies. The tax rate on
dividends is often quite high. Investors also are taxed on gains on the sale of
shares. Thus, investors often would prefer that companies buy back shares
rather than pay a dividend. In this way, investors that are happy with the
performance of the company can maintain or increase their ownership (it can
increase as a percent of the total). Investors that would like to reduce their
investment in the company can choose to do so by selling shares back to the
company pursuant to the offer of the company to repurchase shares. Also, the
gain on sale of stock by investors is usually taxed at a lower rate than dividends.

3-28

Chapter 03 - Analyzing Financing Activities

Exercise 3-13 (15 minutes)


a. Defined contribution plans are not affected by variables such as stock market
performance and employee tenure and life span. As a result, pension expense
and liability associated with defined contribution plans is more predictable and
less variable than are pension expense and liability associated with defined
benefit plans.
b. If managers can attract adequate talent with defined contribution plans, they
would prefer the defined contribution plans because of the predictability of and
less volatility associated with pension expense.
c. Defined contribution plans place the investment risk on the employee whereas
defined benefit plans place the risk on the company. Under a defined
contribution plan, the company pays a defined contribution into the employees
pension plan and then the employee invests the assets according to their
tolerance for risk and investment strategy. Thus, employees with a low tolerance
for risk might prefer the defined benefit plan because they would not have to bear
any of the investment risk. Conversely, employees with a high tolerance for risk
might prefer the defined contribution plan because they might feel that they can
invest the funds better and reap higher benefits at retirement.
Exercise 3-14 (25 minutes)
a. Two major accounting challenges resulting from the use of a defined benefit
pension plan are:
Estimates or assumptions must be made concerning the future events that
will determine the amount and timing of benefit payments.
Some method of attributing the cost of pension benefits to individuals
years of service must be selected.
These two challenges arise because a company must recognize pension costs
before it pays pension benefits.
b. Carson determines the service cost component of the net pension cost as the
actuarial present value of pension benefits attributable to employee services
during a particular period based on the application of the pension benefit formula.
c. Carson determines the interest cost component of the net pension cost as the
increase in the projected benefit obligation due to the passage of time. Measuring
the projected benefit obligation requires accrual of an interest cost at an assumed
discount rate.
d. Carson determines the actual return on plan assets component of the net pension
cost as the change in the fair value of plan assets during the period, adjusted for
(1) contributions and (2) benefit payments.

3-29

Chapter 03 - Analyzing Financing Activities

PROBLEMS
Problem 3-1 (30 minutes)
a. 1. $200 million
2. As the maturity date approaches the liability will be shown at increasingly
larger amounts to reflect the accrual of interest that will be due at maturity.
3. The annual journal entry is:
Interest expense ......................................................
Unamortized discount ...................................
[Note: No cash is involved since it is a zero coupon note.]

#
#

b. This amount represents repayment of principal along with interestit is also


equal to the present value of the future principal and interest payments,
discounted at the interest rate in effect at the time of issuance. Cash outflows will
mimic the principal repayment and interest payment schedules per the debt
contract(s).
c. The $28 million amount will be paid out. This amount will include $6.5 million of
interest implicit in the leases.
d. This is reported in the notesNote 10 to the financial statements (the Lease
footnote). The lease payments will be expensed as they occur over the years.
e. The company paid an average interest rate of 11.53% on the beginning balance of
interest-bearing debt [($116.2 /($202.2 + $805.8)]. The debt structure did not
change substantially during Year 11. At the beginning of Year 12, the company
has interest bearing debt totaling $1,054.8 ($282.2 + $772.6). The relative mix of
debt has not changed substantially. Thus, it is reasonable to predict interest
expense by multiplying this beginning balance by the 11.53% average rate
experienced in the previous year. Therefore, the interest expense projection is
$121.6 million. (Note that the short-term debt is a bit larger in percent of the total
debt burden so the company may pay an average interest amount of slightly less
than the 11.53% paid in the previous year.)

3-30

Chapter 03 - Analyzing Financing Activities

Problem 3-2 (40 minutes)


a. 1/1/Year 1
Enter into Lease Contract
Leased Property under Capital Leases ...............................
Lease Obligation under Capital Leases ..........................

39,930
39,930

12/31/Year 1
Payment of Rental
Interest on Leases .................................................................
Lease Obligations under Capital Leases ............................
Cash .................................................................................

3,194.40 (1)
6,805.60

Amortization of Property Rights


Amor. of Leased Property under Capital Leases ...............
Leased Property under Capital Leases ..........................

7,986 (2)

10,000

7,986

(1) $39,930 x .08 = $3,194.40


(2) $39,930 5 = $7,986

b.

ASSETS
Leased property under
capital leases

Balance Sheet
December 31, Year 1
LIABILITIES
Lease Obligations under
$31,944 (1) capital leases.
$33,124.40 (2)

Income Statement
For Year Ended December 31, Year 1
Amortization of leased property .................................................
Interest on leases ..........................................................................
Total lease-related cost for Year 1 ..............................................

$ 7,986.00
3,194.40
$11,180.40 (3)

(1) $39,930 - $7,986 = $31,944


(2) $39,930 - $6,805.60 = $33,124.40
(3) To be contrasted to rental costs of $10,000 when no capitalization takes place.

3-31

Chapter 03 - Analyzing Financing Activities

Problem 3-2continued
c.
Payments of Interest and Principal
Total
Interest
Payment of
Payment
at 8%
Principal

Year
1
2
3
4
5

10,000
10,000
10,000
10,000
10,000
$50,000

$3,194.40
2,649.95
2,061.95
1,426.90
736.80
$10,070.00

$6,805.60
7,350.05
7,938.05
8,573.10
9,263.20
$39,930.00

Principal
Balance
$39,930.00
33,124.40
25,774.35
17,836.30
9,263.20

d.

Year
1
2
3
4
5

Expenses to Be Charged to Income Statement


Lease
Total
Expense
Amortization
Interest
Expenses
$10,000
$ 7,986.00
$ 3,194.40
$11,180.40
10,000
7,986.00
2,649.95
10,635.95
10,000
7,986.00
2,061.95
10,047.95
10,000
7,986.00
1,426.90
9,412.90
10,000
7,986.00
736.80
8,722.80
$50,000
$39,930.00
$10,070.00
$50,000.00

e. The income and cash flow implications from this capital lease are apparent in the
solutions to parts c and d. The student should note that reported expenses
exceed the cash flows in earlier years, while the reverse occurs in later years.

3-32

Chapter 03 - Analyzing Financing Activities

Problem 3-3 (30 minutes)


a. A lease should be classified as a capital lease when it transfers substantially all
of the benefits and risks inherent to the ownership of property by meeting any
one of the four criteria for classifying a lease as a capital lease. Specifically:
Lease J should be classified as a capital lease because the lease term is equal
to 80 percent of the estimated economic life of the equipment, which exceeds
the 75 percent or more criterion.
Lease K should be classified as a capital lease because the lease contains a
bargain purchase option.
Lease L should be classified as an operating lease because it does not meet
any of the four criteria for classifying a lease as a capital lease.
b. Borman records the following liability amounts at inception:
For Lease J, Borman records as a liability at the inception of the lease an
amount equal to the present value at the beginning of the lease term of
minimum lease payments during the lease term, excluding that portion of the
payments representing executory costs such as insurance, maintenance, and
taxes to be paid by the lessor, including any profit thereon. However, if the
amount so determined exceeds the fair value of the equipment at the inception
of the lease, the amount recorded as a liability should be the fair value.
For Lease K, Borman records as a liability at the inception of the lease an
amount determined in the same manner as for Lease J, and the payment
called for in the bargain purchase option should be included in the minimum
lease payments.
For Lease L, Borman does not record a liability at the inception of the lease.
c. Borman records the MLPs as follows:
For Lease J, Borman allocates each minimum lease payment between a
reduction of the liability and interest expense so as to produce a constant
periodic rate of interest on the remaining balance of the liability.
For Lease K, Borman allocates each minimum lease payment in the same
manner as for Lease J.
For Lease L, Borman charges minimum lease (rental) payments to rental
expense as they become payable.
d. From an analysis viewpoint, both capital and operating leases represent
economic liabilities as they involve commitments to make fixed payments. The
fact that companies can structure leases as "operating leases" to avoid balance
sheet recognition is problematic from the perspective of analysis of assets. If the
leased assets are used to generate revenues, they should be considered in ratios
such as return on assets and other measures of financial performance and
condition.

3-33

Chapter 03 - Analyzing Financing Activities

Problem 3-4 (25 minutes)


a. Detachable stock purchase warrants are equity instruments that have a separate
fair value at the issue date. Consequently, the portion of the proceeds from bonds
issued with detachable stock purchase warrants allocable to the warrants should
be accounted for as paid-in capital. The remainder of the proceeds should be
allocated to the debt portion of the transaction. This usually results in issuing the
debt at a discount (or, occasionally, a reduced premium).
b. A serial bond progressively matures at a series of stated installment dates, for
example, one-fifth each year. A term (straight) bond completely matures on a
single future date.
c. If a bond is issued at a premium, interest expense and the carrying value of the
debt will decrease over the life of the bond as the premium is amortized towards
zero. If a bond is issued at a discount, interest expense and the carrying value of
the debt will increase over the life of the bond as the discount is amortized
towards zero. In each case, the carrying value of the debt is the face value of the
debt at the maturity date (plus or minus any premium or discount).
d. The gain or loss from the reacquisition of a long-term bond prior to its maturity is
the difference between the amount paid to settle the debt and the carrying value
of the debt. The gain or loss should be included in the determination of net
income for the period reacquired. These gains (losses) are no longer treated as
extraordinary items, net of related income taxes, unless they meet the text of both
unusual and infrequent.
e. Accounting standards require many useful bond-related disclosures including:
amounts borrowed, interest rates, due dates, encumbrances, restrictive
covenants, and events of default. While bonds are reported at their fair value at
the date of issuance, subsequent changes in fair value are not recognized on the
balance sheet. If the analyst is interested in the fair value of a firms bonds, the
analyst must examine the note disclosures and make appropriate adjustments to
market.
(AICPA Adapted)

3-34

Chapter 03 - Analyzing Financing Activities

Problem 3-5 (45 minutes)


a. Ratio calculations for Jerrys Department Stores (JDS) and Miller Stores (MLS)
1. Price-to-book ratio:
Ratio

JDS

MLS

Book value

= $6,000 / 250 shares


= $24.00

= $7,500 / 400 shares


= $18.75

Price/book value

= $51.50 / $24.00
= 2.15

= $49.50 / $18.75
= 2.64

2. Total debt to equity ratio:


Ratio

JDS

MLS

Total debt to equity


[Total debt = (S-T debt
+ L-T debt)] / Equity

= $0 + 2,700 / $6,000

=$1,000 + $2,500 / $7,500

= $2,700 / $6,000
= 45.00%

= $3,500 / $7,500
= 46.67%

3. Fixed-asset utilization (turnover):


Ratio

JDS

MLS

Sales / fixed assets

= $21,250 / $5,700
= 3.73

= $18,500 / $5,500
= 3.36

b. Investment Choice and Justification Based on Part A


Based on Westfields investment criteria for investing in the company with the
lowest price-to-book ratio (P/B) and considering solvency and asset utilization
ratios, JDS is the better purchase candidate. The analysis justification
follows:
Ratio

JDS

MLS

Company Favored

i.

Price-to-book ratio (P/B)

2.15

2.64

JDS: lower P/B

ii.

Total debt to equity

45%

47%

JDS: lower debt or


ratios are very similar

iii.

Asset turnover

3.73

3.36

JDS: higher turnover

3-35

Chapter 03 - Analyzing Financing Activities

Problem 3-5continued
c.

Investment Choice and Justification Based on Note Information


Note: Details underlying the Balance Sheet Adjustments ($ millions):
JDS:
i.
Leases recognition of MDSs present value lease payments will add $1,000 to
JDSs property, plant, and equipment (PP&E) and is offset by a $1,000 addition
to JDSs long-term debt.
ii.
Receivables recognition of JDSs sale of receivables with recourse will
increase assets (accounts receivable) by $800 and short-term debt used to
finance accounts receivable by $800.
MLS:
iii.
Pension recognition of current excess funding for the pension plan will add
$1,600 to assets and $1,600 to owners equity ($3,400 plan assets - $1,800
projected benefit obligation).

Adjusted Calculations Made ($ millions)


JDS:
Needed adjustments:
Assets
(PP&E)
+$1,000
(Accounts receivable)
+$800
i.

ii.

Liabilities
(Long-term debt [LTD])
+$1,000
(Short-term debt [STD])
+$800

Book value per common share: No net adjustment to JDS owners equity of
$6,000; thus, $6,000 / 250 million shares = $24.00 book value per share
Adjusted total debt-to-equity ratio:
$2,700
+1,000
+ 800
$4,500
Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%

iii.

Historical LTD
LTD
STD
Adjusted total debt

Fixed-asset utilization (turnover) =


$5,700 Historical fixed assets
+1,000 PP&E (JDS leases)
$6,700 JDS adjusted fixed assets
Adjusted fixed-asset utilization (sales/adjusted fixed assets):
$21,250 / $6,700 = 3.17

MLS:
Needed adjustments:
Assets
(Pension) +$1,600

i.

Owners Equity
+$1,600

Book value per common share:


$7,500 historical equity + $1,600 = $9,100
Adjusted equity; thus,
$9,100 / 400 million shares = $22.75 adjusted book value per share

ii.

Adjusted total debt-to-equity ratio:


Debt (no adjustments) / Adjusted equity = Adjusted debt / equity
$3,500 / $9,100 = 38%

iii.

Fixed-asset utilization (turnover):


Sales / Fixed assets (no adjustments)
$18,500 / $5,500 = 3.36

3-36

Chapter 03 - Analyzing Financing Activities

Problem 3-5continued
Part c continued:

Summary of Adjustments
Ratio
Adjusted book value
Adjusted debt to equity
Fixed-asset utilization

JDS
$24.00
75%
3.17

MLS
$22.75
38%
3.36

Final Results of Analysis:


Based on Westfields investment criteria of investing in companies with low
adjusted Price-to-Book and considering the adjusted solvency and asset
utilization ratios, MLS is the better purchase candidate. The analysis
justification follows:
Ratio

JDS

MLS

i.

Price to adjusted book

2.15

2.18

ii.

Adjusted debt to equity

75%

36%

MLS lower adjusted debt to equity

iii.

Fixed-asset utilization

3.17

3.36

MLS higher asset utilization

$51.50 / $24.00 = 2.15.


$49.50 / $22.75 = 2.18.

3-37

Company favored
approximately equal

Chapter 03 - Analyzing Financing Activities

Problem 3-6 (20 minutes)


a. In the case of environmental liabilities, there are several unknowns that are
especially difficult to predict. The unknowns relate to the clean up and to the
lawsuits that result from the hazardous waste. Specifically:
The company cannot predict the timing of an environmental tragedy such as
that which occurred in the Union Carbide factory.
The company doesnt know if it will be identified as a potentially responsible
party in a yet uncovered hazardous waste site. This can include a former site
of the company.
If the company is identified as a potentially responsible party, we do not know
the portion of the clean up costs that it will be required to pay.
The company doesnt know what costs would be incurred in the actual clean
up of the site.
The company needs to determine which internal costs should be included in
the cost of the clean up. For example, if it uses its laborers for site clean up
activities, the direct cost of labor can become a part of the overall cost of
cleanup.
The company must guess whether lawsuits will be filed against the company
related to the hazardous waste site.
The company must estimate the probability of loss or settlement in the lawsuit
and the amount of the damages to be paid
b. We must factor the possibility of catastrophic environmental loss into the pricing
of the company. For some industries, the probability assigned to occurrence
might be very small. Thus, we will not assign a large weighting factor. However,
in some industries, the base-line probability can be significant. In addition, we will
update these probabilities based on additional information. For example, after the
Bhopal tragedy, analysts discounted the valuations of key competitors. This
indicates that analysts revised their beliefs about the possibility of loss upwards
from earlier estimations. In classic valuation models, an analyst can reflect this
risk in the discount factor applied to future earnings or future cash flows.
c. Some industries especially predisposed to environmental risks include: oil
producers, chemical manufacturers, tobacco producers, insulation manufacturers
and distributors, medical firms, bio-tech firms.

3-38

Chapter 03 - Analyzing Financing Activities

Problem 3-7 (30 minutes)


a. The service cost of $22.1 million for Year 11 is the present value of actuarial
benefits earned by employees in Year 11.
b. Year 11: Discount rate = 8.75%
Year 10: Discount rate = 9.00%
A higher discount rate will lead to a lower present value of service cost. In this
case, with the reduction in discount rate from 9% to 8.75%, the service cost is
increased.
c. The interest cost is computed by multiplying the projected benefit obligation
(PBO) as of the end of the prior year by the discount rate of 8.75%.
d. The actual return on assets in Year 11 is $73.4 million [113]. It consists of
investment income plus the realized or unrealized appreciation or depreciation of
plan assets during the year. The expected return on plan assets is computed by
multiplying the expected long-term rate of return (9%) on plan assets by the
market value of plan assets at the beginning of the period or $773.9 million [120].
This means the expected return is $69.65 million (computed as $773.9 x 9%).
The actual return subjects pension cost to more fluctuation from volatility in the
financial marketand, accordingly, increasing volatility in the annual pension
cost. As a result, expected return is used in determining pension expense. The
difference between actual and expected return will be amortized over an
appropriate period.
e. Accumulated benefit obligation (ABO) is the employer's obligation to employees'
pension based on current and past compensation levels rather than future levels.
Therefore, it could amount to the employer's current obligation if the plan were
discontinued presently.
f. The projected benefit obligation (PBO) is the employer's obligation to employees'
pension based on future compensation level. The difference between PBO and
ABO is due to the inclusion of a provision of 5.75% increase in future
compensation level by PBO. In Year 11, the difference between PBO and ABO is
$113.3 million [120].
g. Yes; indeed, there is prepaid pension expense of $172.5 million in Year 11 [120].
Problem 3-8 (20 minutes)
Periodic pension cost computation ($ millions)
Service Cost ($586 x 1.10) ...............................................................................
Interest Cost (PBO x Discount Rate = $2,212 x 0.085) .................................
Return on plan assets ($3,238 x 0.115) ..........................................................
Amortization of deferred loss ($48 / 30 years) ..............................................
Periodic pension cost ....................................................................................

3-39

$645
188
(372)
2
$463

Chapter 03 - Analyzing Financing Activities

CASES
Case 3-1 (60 minutes)
a. Colgate administers defined benefit plans for substantial majority of its
employees. The primary OPEBs provided by Colgate and health care and life
insurance benefits.
b.
1. The economic positions are follows (in $ millions):

Pensions

OPEB

Total

Domestic

International

2005

(225.6)

(303.0)

(400.8)

(929.4)

2006

(188.3)

(315.9)

(437.4)

(941.6)

Negative numbers indicate underfunded status. Colgates plans are


underfunded and so are net liabilities.
2. The position reported in the balance sheet is as follows ($ million):

Pensions
Domestic

OPEB

Total

International

2005

254.9

(142.2)

(200.5)

(87.8)

2006

(188.3)

(315.9)

(437.4)

(941.6)

Negative/positive numbers indicate liability/asset. Colgates


postretirement benefit plans are net liabilities on the balance sheet.
3. The amounts are primarily reported as noncurrent liabilities, but also
included in noncurrent assets and current liabilities.
4. In 2005, Colgate reported postretirement benefits under SFAS 87. This
standard reports only accumulated (or prepaid) pension cost on the
balance sheet instead of the net economic position (funded status).
This causes the divergence.
5. The projected benefit obligation (PBO) and accumulated benefit
obligation (PBO) are as follows ($ million):

3-40

Chapter 03 - Analyzing Financing Activities

Projected Benefit Obligation


(PBO)
Domestic

International

Accumulated Benefit Obligation


(ABO)
Total

Domestic

International

Total

2005

1462.4

658.8

2121.2

1381.1

572.5

1953.6

2006

1582.0

720.4

2302.4

1502.0

625.2

2127.2

The accumulated benefit obligation is closer to the legal liability related


to pensions. The PBO is used to determine the net funded status on the
balance sheet under SFAS 158.
6. If the plans were terminated, Colgate will be liable to pay the ABO
amounts to the employees for domestic plans. While it is unclear if
such liability exists in other countries, we assume this is the case.
Therefore, assuming that the assets can be sold at their reported fair
value, the net economic position of the pensions plans if terminated are
the difference between the fair value of plan assets and the ABO ($
million):

Pensions

Total

Domestic

International

2005

(144.3)

(216.7)

(361.0)

2006

(108.3)

(220.7)

(329.0)

There is no clear basis for determining the companys legal liability


regarding OPEBs. There is no legal requirement to provide OPEBs to
employees.

3-41

Chapter 03 - Analyzing Financing Activities

7. The closing value of plan assets is as follows ($ million):

Pensions

OPEB

Total

Domestic

International

2005

1236.8

355.8

12.2

1604.8

2006

1393.7

404.5

22.6

1820.8

Colgate invests its plan assets primarily in equity securities, with a


lower proportion in debt securities and a much small proportion in real
estate.
8. For 2006, Colgate net periodic benefit cost (reported cost) is $ 58.2
million ($ 37.6 million, $ 37.8 million) for its domestic pension
(international pension, OPEB) plans. Therefore a total postretirement
benefit expense of $ 133.6 million was charged to income. Its
components are the service cost, interest cost, expected return on plan
assets and amortization of actuarial gain/loss and prior service cost. In
addition, it should be noted that Colgate also charged unusual items
(largely termination benefits) termed other postretirement charges
totaling 115.3 million.
9. The two non-recurring items are actuarial gain/loss and prior service
cost/plan amendments. The movement in these two items is given
below ($ million):

3-42

Chapter 03 - Analyzing Financing Activities

Pensions

OPEB

Total

Domestic

Internation

Opening Balance (unrecognized)

470.8

150.8

198.8

820.4

Acturial Gain for the year

(36.7)

(7.1)

30.9

(12.9)

Actual less Expected Return

(54.3)

(0.1)

(1.5)

(55.9)

Amortization

(24.4)

(7.9)

(12.3)

(44.6)

9.8

0.5

10.3

355.4

145.5

216.4

717.3

9.7

10.0

1.5

21.2

Plan ammendments during the year

36.7

(2.3)

0.0

34.4

Amortization

(4.1)

(1.5)

0.0

(5.6)

(2.6)

0.2

(1.6)

1.3

51.6

Movement in Actuarial (Gain)/Loss

Adjustments
=

Closing Balance (Accumulated Other Compr Inc)

Movement in Prior Service Cost (Plan Ammendments)


Opening Balance (unrecognized)

0.8

Adjustments
Closing Balance (Accumulated Other Compr Inc)

41.5

8.8

Note: Because of foreign exchange translation effects on international


plans and the effects of first-time adoption of SFAS 158, the numbers
do not articulate exactly and so there is a need to introduce
adjustments.
Also note that, while the cumulative net deferral was unrecognized, i.e.,
kept off the balance sheet, in 2005 (under SFAS 87), in 2006 the
cumulative net deferrals are recorded as part of accumulated other
comprehensive income.
10. Colgates actual return on plan assets and expected returnthat is
included in incomeis given below ($ million):
Pensions
Domestic
Actual plan return

OPEB

Total

International

153.2

25.1

2.8

181.1

Expected return

98.9

25.0

1.3

125.2

Difference

54.3

0.1

1.5

55.9

11. The economic benefit cost (excluding unusual items such as


termination benefits, curtailments and settlements) and the reported
benefit cost are compared below:

3-43

Chapter 03 - Analyzing Financing Activities

Pensions

2006
Service cost
Interest cost
Actual return on plan assets

Actuarial gain
Plan amendments (prior service cost)
Economic benefit cost/(income)
Net periodic benefit cost (reported cost)
Difference

Domestic

Internation

45.2

21.1

OPEB

Total

11.9

78.2

83.4

32.1

28.7

144.2

(153.2)

(25.1)

(2.8)

(181.1)

(36.7)

(7.1)

30.9

(12.9)

36.7

(2.3)

0.0

34.4

(24.6)

18.7

68.7

62.8

58.2

37.6

37.8

133.6

(82.8)

(18.9)

30.9

(70.8)

The differences between the reported and economic benefit costs arise
primarily because of the treatment of the non-recurring items, actuarial
gain/loss (also called net gain/loss) and prior service cost. See answer
for (9) above for a detailed reconciliation of the balance sheet and
income statement effects for these items.
12. The primary actuarial assumptions used by Colgate are: (a) discount
rate (2) long-term rate of return on plan assets (3) long-term rate of
compensation growth and (4) ESOP growth rate.
In 2006, Colgate has changed only one assumption for domestic plans:
it has reduced the discount rate to 5.5% from 5.75%. This reduction is
expected to increase the pension obligation and create an actuarial loss
(note Colgate reports an actuarial gain for domestic pension plans in
2006, probably because of changes in certain other unreported actuarial
assumptions).
For international plans, Colgate decreased discount rate and
compensation growth rate. The decrease in discount rate will increase
the pension obligation but the decrease in compensation growth rate
will decrease the pension obligation. Colgate also reduced its expected
return on plan assets for international plans which would have reduced
the expected return recognized in the net periodic pension cost.
13. Colgates cash flows related to benefit plans are the contributions it
makes to the plans. In 2006, Colgate contributed $ 173.9 million to its
benefit plans ($ 113.6 million, $ 36.4 million and $ 23.9 million
respectively for its domestic pension, international pension and OPEB
plans). This contribution is a cash outflow.

3-44

Chapter 03 - Analyzing Financing Activities

Case 3.2 (45 minutes)


a.

The schedule below provides details of Colgates benefit plans economic


position (funded status) and the net amount recognized in the balance sheet for
2006 and 2005 ($ million):

2006

Pensions

OPEB

Total

Domestic

Internation

Plan Assets

1393.7

404.5

22.6

1820.8

Benefit Obligation

1582.0

720.4

460.0

2762.4

Net Economic Position (Funded Status)

(188.3)

(315.9)

(437.4)

(941.6)

Reported Position on Balance Sheet

(188.3)

(315.9)

(437.4)

(941.6)

OPEB

Total

NO ADJUSTMENTS

2005

Pensions
Domestic

Internation

Plan Assets

1236.8

355.8

12.2

1604.8

Benefit Obligation

1462.4

658.8

413.0

2534.2

Net Economic Position (Funded Status)

(225.6)

(303.0)

(400.8)

(929.4)

254.9

(142.2)

(200.5)

(87.8)

(480.5)

(160.8)

(200.3)

(841.6)

Reported Position on Balance Sheet


Adjustment

No adjustments are required in 2006, since the net economic position is reported
on the balance sheet under SFAS 158. In 2005, under the older standard (SFAS
87) the balance sheet reported a net deficit of only $ 87.8 million compared to
Colgates net underfunded status of $ 929.4 million. This necessitates an
adjustment of $ 841.6 million, which will involve increasing noncurrent liabilities
and reducing shareholders equity (retained earnings) by that amount. This
adjustment needs to be made irrespective of the analysis objective.
If the purpose of the analysis is to determine the liquidation value of Colgate,
then it is appropriate to determine the funded status using the ABO, rather than
the PBO. Using the ABO will improve the funded status by $ 167.6 million ($ 175.2
million) in 2005 (2006).
Since we are proposing no adjustments in 2006 to the balance sheet, there will be
no change to the debt-equity ratios. For 2005, Colgates total debt to equity ratio
before and after adjustment is 5.3 and 5.9. Long-term debt to equity ratio will not
be affected since postretirement benefits are not included in long-term debt.

3-45

Chapter 03 - Analyzing Financing Activities

The schedule below gives details of Colgates economic and reported benefit
costs for 2006 and 2005 ($ million):
2006

Pensions

Total

Domestic

Internation

Service cost

45.2

21.1

11.9

78.2

Interest cost

83.4

32.1

28.7

144.2

(153.2)

(25.1)

(2.8)

(181.1)

(36.7)

(7.1)

30.9

(12.9)

36.7

(2.3)

0.0

34.4

(24.6)

18.7

68.7

62.8

58.2

37.6

37.8

133.6

(82.8)

(18.9)

30.9

(70.8)

OPEB

Total

10.3

77.7

Actual return on plan assets

OPEB

Actuarial (gain)/loss
Plan ammendments (prior service cost)
Economic benefit cost/(income)
Net periodic benefit cost (reported cost)
Difference

2005

Pensions

Service cost
Interest cost
Actual return on plan assets
Actuarial (gain)/loss
Plan ammendments (prior service cost)

Domestic

Internation

47.4

20.0

76.1

33.3

26.4

135.8

(92.4)

(41.8)

(1.1)

(135.3)

83.4

49.4

63.7

196.5

2.6

0.0

10.2

12.8

117.1

60.9

109.5

287.5

Net periodic benefit cost (reported cost)

64.9

37.5

31.1

133.5

Difference

52.2

23.4

78.4

154.0

Economic benefit cost/(income)

On an economic basis, Colgate costs pertaining to its postretirement benefit


plans are $ 62.8 million and $ 287.5 million in 2006 and 2005 respectively.
However, it recognized net periodic benefit cost of $ 133.6 million and $ 133.5
million during these years. If the analysis objective is to ascertain economic
income, then pre-tax income increasing (decreasing) adjustments of $ 70.8
million ($ 154 million) should be made in 2006 (2005). No adjustments need to be
made when the analysis objective is measuring permanent (or core) income.

3-46

Chapter 03 - Analyzing Financing Activities

b. Overall, there is little to suggest that Colgates key actuarial assumptions are
unusual or unreasonable. It also appears that Colgate is somewhat conservative
in its assumptions choices. For example, the US discount rate is 5.5% which for
2006 is slightly below the yield on high yield bonds and closer to the treasury
yield. (One reason for the lower discount rates could be that Colgate is
benchmarking itself to shorter term bonds; being an old company, it has a mature
work force that is expected to retire sooner than that of average companies).
Colgates assumptions on expected rates of return are also conservative given
the high proportion of equity in its plan assets and also given the actual returns
in the recent past. Colgate has marginally lowered its discount rate in 2006, which
would have increased the value of the PBO and lowered its funded status.
Colgate uses somewhat lower discount rates and expected rates of return for its
international plans. This could reflect the different economic environments that it
operates in internationally. Colgate has also lowered both these rates in 2006,
which would have had adverse effects both on the balance sheet and income
statement, by increasing the pension obligation and decreasing expected return
from plan assets respectively.
Overall, there is little to suggest that Colgate is being aggressive in its choice of
actuarial assumptions or that it is using changes in these assumptions to
manage earnings.
c. An analyst needs to examine three dimensions with respect to pension risk
exposures:
The extent of underfunding: Colgates pension plans are underfunded,
but not seriously. In 2006, the underfunding for pension plans is around
$ 500 million, which translates to about 6% of total assets.
Pension intensity: In 2006, Colgates pension obligation (assets) are
15% (17%) of total assets, which is not very high. However, in light of
Colgates high leverage, the pension risk is much higher. For example,
the above percentages are around 100% of equity, which is very high.
Colgate also invests fairly heavily in equity securities: about 2/3 for
domestic and for international plans. This does create some pension
risk exposure.
Overall, Colgate has moderate risk exposure from its pension plans.

3-47

Chapter 03 - Analyzing Financing Activities

d. In 2006, Colgate contributed $ 173.9 million to its benefit plans ($ 113.6 million, $
36.4 million and $ 23.9 million respectively for its domestic pension, international
pension and OPEB plans). The level of these contributions are somewhat higher
than the reported postretirement benefit cost, which is something that an analyst
needs to note. However, given Colgates copious operating cash flows, these
contributions need not be cause for concern.
Generally, it is difficult to use current contributions to predict future
contributions. However, Colgate appears to follow a policy of slightly
underfunding its plans and contributing amounts that are not very different from
benefits paid. One can use the estimated benefits payable (which Colgate
forecasts all the way up to 2016 in the footnote) to reasonably forecast future
contributions.
Case 3-3 (30 minutes)
e. Campbell Soup reports the following categories of liabilities
Interest bearing (short-term and long-term)
Non-interest-bearing short-term operating obligations (payables and
accruals)
Other primarily deferred taxes (non-interest-bearing)
b.
Long-term debt [46]
A
B

159.7
0.3

G
H

24.3
250.3

805.8

beg

0.1
99.8
100.0
199.6

C
D
E
F

1.9
772.6

I
end

A = Retirement of 13.99% Zero Coupon Notes.


B = Repayment of 9.125% Note.
C = Additional borrowing on 7.5% Note.
D = Borrowing on 9% Note
E = Borrowing on Medium-Term Notes.
F = Borrowing on 8.875% Debentures
G = Repayment of Other Notes
H = Reclassification of Note
I = Increase in capital lease obligation

3-48

Chapter 03 - Analyzing Financing Activities

f. Campbell Soup has issued a number of long-term Notes and Debentures, all of
which appear to be fixed rate. Thus, the company does not require derivatives in
order to manage interest rate risk. Further, Campbell Soups debt footnote
indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in Year 13, $17.8 in
Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt
matures in excess of 5 years. Given Campbells operating cash flow of $805.2
million, solvency does not appear to be a problem.
Case 3-4 (30 minutes)
a. Book value of common stock is equal to total assets less liabilities and claims of
securities senior to the common stock (e.g., preferred stock) at amounts reported
on the balance sheet. Book value can also be reduced by unrecorded claims of
senior securities.
Year 11 Analysis:
Book value ($ millions) = ($1,793.4 - 0) = $1,793.4
Number of shares outstanding = 135,622,676-8,618,911=127,003,765
Book value per share = $14.12
b. The par value of Campbells common shares is $0.15. Its details follow:
(in millions)
Year 11
Authorized
140,000,000
Issued
135,622,676
Outstanding
127,003,765 (part a)
c.

Year 11
175.6 million
$175.6 million / $3.3954 million shares
= $51.72

Common shares purchased (mil)


Average share repurchase price

3-49

Chapter 03 - Analyzing Financing Activities

Case 3-5 (75 minutes)


a. Ratio Analysis
Liquidity
Current ratio
Solvency
Total debt to equity
Long-term debt to equity
Times interest earned
Return on Investment
Return on total assets
Return on equity

1998

AMR
1997

1998

Delta
1997

1998

UAL
1997

0.865

0.895

0.735

0.702

0.513

0.562

2.330
1.488
6.817

2.356
1.459
4.867

2.630
1.492
9.310

3.237
1.879
7.509

4.657
2.929
4.463

5.617
3.371
6.220

7.17%

8.18%

6.21%

20.23%

28.17%

29.23%

Note: We treat preference share capital as debt and include preference dividend with interest.

All three companies appear to be in poor liquidity position. UALs liquidity is


especially troubling. From a balance sheet perspective, all companies show an
excess of creditor financing in their capital structure. Once again, UAL is the
most worrisome with total debt (long-term debt) at 4.66 (2.93) times equity. Still,
these ratios seem to be improving over this short time period.
All three companies are profitable. The ROA is respectable and the ROE is
extremely goodROE is much higher than ROA partly because of extreme
leverage. Because of good profitability, all companies seem to be in a good
position to pay interest expenses, despite high debt-to-equity ratios.
Overall, the three companies (in particular UAL) reveal higher than usual liquidity
and solvency risk. Although the high profitability (at least at present) appears to
mitigate these risks to a large extent.
b. Sensitivity Analysis
The sensitivity analysis examines the impact of both a 5% and a 10% drop in
revenues on the profitability and key ratios of these companies during 1998. We
assume that 25% of operating expenses are variable (75% are fixed). We also
assume a 35% tax rate for the changes to income. Recast income statements
appear below:
AMR
Drop in Revenue

5%

10%

Delta
10%

5%

10%

13,431
12,724
(12,289) (12,134)
1142
590
141
141
(197)
(197)
1,086
534
(454)
(261)
632
273
36%
72%

16,683
(15,882)
801
133
(361)
573
(192)
381
54%

15,805
(15,681)
124
133
(361)
(104)
45
(59)
107%

5%

UAL

Revised Income Statement for Yr 8

Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision (35% tax rate)
Continuing Income
% drop in Continuing Income

18,245
17,285
(16,656) (16,445)
1,589
840
198
198
(372)
(372)
1,415
666
(596)
(333)
819
332
37%
75%

3-50

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
Part b continued: The profitability of the airlines is reduced dramatically by
moderate revenue shortfalls under our assumptions. A mere 5% drop in
revenues can reduce income by a third (half for UAL), while a 10% drop in
revenues can all but wipe out the airlines profits. This happens because of the
high proportion of fixed costs in the cost structure. We also examine the impact
of the changes on key 1998 ratios:
AMR
Drop in Revenue
Liquidity
Current Ratio
Solvency
Total Debt to Equity
Long Term Debt to Equity
Times Interest Earned
Return on Investment
Return on Total Assets
Return on Equity

5%

10%

5%

Delta
10%

5%

UAL
10%

0.865

0.865

0.735

0.735

0.513

0.513

2.330
1.488
4.803

2.330
1.488
2.788

2.630
1.492
6.511

2.630
1.492
3.712

4.657
2.929
2.587

4.657
2.929
0.712

4.91%
12.68%

2.66%
5.14%

5.56%
17.97%

2.94%
7.77%

3.62%
13.56%

1.03%
-2.10%

The balance sheet ratios do not change. The ROA and ROE mirror the drop in
profitability. The most interesting change occurs in interest coverage, which
drops significantly with reduced revenues. While AMR and Delta can still pay their
interest in the event of a demand slump, UAL may have difficulty meeting its
interest payments in the case of a 10% revenue drop.
c. Because of the volatile nature of profitability and consequent risk, airline
companies often find it difficult to raise debt at reasonable terms. Raising equity
is a possibility, but the equity cost of capital is high in this industry (airline
companies have some of the lowest P/E ratios in the market). Consequently,
leasing offers a convenient alternative to financing the high capital investment
requirements of this industry. The lessor is probably able to offer better terms
than other creditors for several reasons: (1) the lessor may be connected to
suppliers of capital equipment and can use leasing as a marketing tool; and (2) in
the event of insolvency the lessor is often in a better position to recover the
assets because ownership often rests with the lessor. Finally, the bigger airline
companies (such as AMR, Delta and UAL) prefer to maintain a young fleet of
aircraft, both because of obsolescence and because of the high maintenance cost
associated with maintaining older aircraft. In such a scenario, it is easier to lease
aircraft rather than purchase outright and sell it later.
d. Examine Capital and Operating Leases and Their Classification: All three
companies are increasingly structuring their leases to be operating leases. The
outstanding MLP on operating leases for AMR, Delta and UAL is approximately
$17 billion, $15 billion and $24 billion, respectively, compared to $2.7 billion, $0.4
billion and $3.4 billion for capital leases.

3-51

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
The lease classification appears arbitrary. The capital and operating leases do not
seem to differ either on the basis of the type of asset leased or the length of the
lease. The average remaining life on the operating leases, for all three companies,
varies between 16 to 20 years, which is much more than those on capital leases
(see part e below). Overall, there does not seem to be any logic underlying the
lease classification, except that the companies have structured the leases to avail
themselves of the benefits of operating lease accounting.
e. Reclassification of Operating Leases as Capital Leases and Restatement of
Financial Statements
AMR
Capital

Estimate Average Remaining Lease


Term (1998)
1 MLP in Later Years
1261
2 MLP in Last Reported Year
191
3 # of later years (1)/(2)
7
4 Add # of reported years
5
5 Average Remaining Lease
12
(3)+(4)

Capital

Operating

UAL
Capital

Operating

12480
919
14
5
19

71
48
1
5
6

10360
960
11
5
16

1759
242
7
5
12

17266
1305
13
5
18

13,366
887
15
5
20

118
57
2
5
7

9,780
850
12
5
17

1,321
277
5
5
10

19,562
1,357
14
5
19

1998

AMR
1997

1998

Delta
1997

1998

1997

273
154
119
1,918
6.20%

255
135
120
1,764
6.80%

100
63
37
312
11.86%

101
62
39
384
10.16%

317
176
141
2,289
6.16%

288
171
117
1,850
6.32%

Estimate Average Remaining Lease


Term (1997)
1 MLP in Later Years
1,206
2 MLP in Last Reported Year
247
3 # of later years (1)/(2)
5
4 Add # of reported years
5
5 Average Remaining Lease
10
(3)+(4)

Estimate Interest Rate on Capital


Leases
6 MLP During Next Year
7 Less Principal Component
8 Interest (6) - (7)
9 PV of Capital Leases
10 Interest Rate (8)/(9)

Delta

Operating

UAL

Note: The principal component is shown as a current liability on the balance sheet.

3-52

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
AMR
1997

1998

Delta
1997

1998

1997

Estimate Average MLP per year on


Operating Leases
11 Total MLP
17,215
12 Average Remaining Lease
19
Term
13 Average MLP (11) / (12)
927

18,115
20

15,120
16

14,020
17

23,798
18

26,515
19

903

957

849

1,305

1,366

Estimate Present Value of Operating


Leases
10.8505
14 Present Value Factor
15 Average MLP (13)
927
16 Present Value (14)X(15)
10,053

10.7762

6.9958

7.8515

10.7746

11.0047

903
9,727

957
6,698

849
6,669

1,305
14,065

1,366
15,029

1998

UAL

Note: Present value factor represents the present value of an annuity of $ 1 at a given interest rate and
lease term from the annuity tables. We use the interest rate on capital leases (estimated in (10) above)
as a surrogate interest rate for operating leases. The lease term for operating leases was estimated in
(5) above.
AMR
1998

Delta
1998

UAL
1998

E. Estimate Interest and Depreciation on Operating Lease


9,727
17 Present Value of Operating Leases
18 Interest Rate
7%
19 Interest Expense (17) X (18)
662

6,669
10%
677

15,029
6%
950

20

9,727

6,669

15,029

20
485

17
404

19
774

21
22

Value of Operating Lease Assets


Average Remaining Lease
Term (Lease Life)
Depreciation Expense

F. Estimate Efect of Operating Lease Conversion on Income Statement


(485)
(404)
23 Increase in Depreciation Expense
Decrease in Lease Rental
24 Expense
860
1,011
25 Effect on Operating Income
526
456

1,419
645

26
27

Increase in Interest Expense


Effect on Income before Tax

(662)
(135)

(677)
(221)

(950)
(306)

28
29

Decrease in Tax Provision


(35%)
Effect on Continuing Income

47
(88)

77
(144)

107
(199)

(774)

Note: For computing interest and depreciation for 1998, we use the lease asset/obligation we
estimated at the end of 1997.

3-53

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
AMR

Delta

UAL

G. Determine Principal and Interest Component of Next Year's MLP


30 Next Year MLP (1999)
1,012
950
31 Estimated Interest Component
624
794
32 Estimated Principal Component
388
156

1,320
866
454

H. Decompose Operating Lease Liability into Current and Non-Current Components


10,053
6,698
14,065
33 Total Operating Lease Liability
34 Estimated Current Portion
388
156
454
35 Estimated Non-Current Portion
9,665
6,543
13,611
Restated Balance Sheet
$ Millions
Assets
Current Assets
Freehold Assets (Net)
Leased Assets (Net)
Intangibles & Other
Total
Liabilities
Current Liabilities:
Current Portion of Capital Lease
Other Current Liabilities
Long Term Liabilities:
Lease Liability
Long Term Debt
Other Long Term Liabilities
Preferred Stock
Shareholder's Equity
Contributed Capital
Retained Earnings
Treasury Stock
Total
Restated Income Statement
$ Millions

Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision
Continuing Income
* Includes preference dividends.

AMR
1998

Delta
1998

UAL
1998

4,875
12,239
12,200
3,042
32,356

3,362
9,022
6,997
1,920
21,301

2,908
10,951
16,168
2,597
32,624

542
5,485

219
4,514

630
5,492

11,429
2,436
5,766

6,792
1,533
4,046
175

15,724
2,858
3,848
791

3,257
4,729
(1,288)
32,356

3,299
1,776
(1,052)
21,301

3,518
1,024
(1,261)
32,624

AMR
1998

Delta
1998

UAL
1998

19205
(16396)
2809
198
(996)
2011
(805)
1207

14138
(11919)
2219
141
(991)
1369
(553)
815

17561
(15535)
2026
133
(1227)
932
(318)
614

3-54

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
f. We made several assumptions in estimating the effects of the lease classification.
Some of the important assumptions are:

Interest Rate Parity across Capital and Operating Leases. We use the average
interest rate on the capital leases as a proxy for the interest rate on operating
lease. To the extent capital and operating leases are dissimilar, the interest rate
estimate is inaccurate or biased. This problem arises especially if the capital
leases and the operating leases, on average, have been contracted during
different time periods with different interest rate regimes.
In this particular case, the interest rate on Deltas capital leases is
substantially higher than that on either AMR or UAL. While it is not impossible,
it is improbable that lease rates could differ so markedly across similar
companies in the same industry. The average remaining lease term offers a
clue: for Deltas capital leases it is 6-7 years compared to 10-12 years for AMR
and UAL. Under the assumption that the average lease terms are similar across
companies, this implies that Deltas capital leases, on average, were contracted
4-5 years before AMR or UAL, which is consistent with the higher interest rate
on Deltas capital leases. To some extent, this problem is alleviated (at least on
a comparative basis) because Deltas operating leases also appear to have
been contracted around three years earlier to AMRs or UALs. It appears that
the capital leases for all three companies were entered into at an earlier time
than the operating leases. If these leases were entered at a time with a
sufficiently different interest rate regime, we need to make appropriate
corrections to our interest rate estimates.

Depreciation Policy. We set the lease asset and liability equal to each other. In
reality, the depreciation of the asset seldom equals the lease principal
payments. Some people use a simplifying assumption such as lease assets
should be equal to 80% the liability. However, these ad hoc rules are no better
than putting them equal to each other.

3-55

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
g. Ratio Analysis on Restated Financial Statements
AMR

Delta

1998
Liquidity
Current Ratio
0.809
Solvency
Total Debt to Equity
3.831
Long Term Debt to Equity 2.931
Times Interest Earned
3.020
Return on Investment*
Return on Total Assets
5.89%
18.69%
Return on Equity
*computed on adjusted yearend asset and equity
balances

UAL

1998

1998

0.710

0.475

4.295
3.118
2.380

8.943
7.078
1.759

7.17%

4.47%

23.20%

21.87%

Note: We treat preference share capital as debt and include preference dividend with interest.

Capitalizing the operating leases significantly worsens the liquidity and solvency
picture of all three companies. The impact on current ratio is not dramatic, but the
current ratios are bad to start with. In particular UALs current ratio of less than
50% is cause for concern.
The solvency picture deteriorates significantly after lease capitalization. We
realize that all three companies are extremely reliant on creditor financing,
particularly through lease financing that constitutes between 25% to 50% of the
total assets. The debt to equity ratios are significantly above acceptable levels.
UALs debt to equity is particular high. Part of the reason for the high debt equity
ratios is that these companies had all but wiped out their retained earnings during
the recession in the early 1990s, which makes their equity base very low. While
this is an explanation for the high debt to equity ratios, it does not absolve the
risk associated with such extreme debt orientation in the capital structure.
Despite the excellent profitability of all three companies, the interest coverage
ratios are not as impressive as they appeared before the operating leases were
capitalized. By classifying a significant part of their leases as operating, all three
companies were able to underreport interest expense by over two-thirds. In
particular, UALs interest coverage looks weak even when its profitability is
spectacularly high.
The ROA has not deteriorated significantly although total assets have increased
by at least a third for all companies. The reason is that operating income was
significantly underreported earlier because the interest costs pertaining to
operating leases were being treated as operating expenses. ROE has reduced
significantly for all three companies, mainly because of drop in continuing
income. The ROE is still good although not as spectacular as reported.

3-56

Chapter 03 - Analyzing Financing Activities

Case 3-5continued

Sensitivity Analysis after lease capitalization


AMR
Drop in demand

5%

UAL

5%

10%

5%

10%

17285
(15986)
1298

13431
(11770)
1661

12724
(11621)
1103

16683
(15340)
1343

15805
(15146)
659

198
(996)
501
(276)
225

141
(991)
811
(358)
453

141
(991)
253
(162)
90

133
(1227)
248
(78)
170

133
(1227)
(436)
161
(275)

81%

44%

89%

72%

145%

0.809

0.809

0.710

0.710

0.475

0.475

3.831
2.931
2.261

3.831
2.931
1.503

4.295
3.118
1.818

4.295
3.118
1.255

8.943
7.078
1.202

8.943
7.078
0.645

4.33%
10.69%

2.77%
3.36%

5.39%
11.26%

3.61%
2.24%

3.07%
5.18%

1.66%
-8.37%

Revised Income Statement for 1998


Operating Revenue
18245
Operating Expenses
(16191)
Operating Income
2054
Other Income &
Adjustments
198
Interest Expense*
(996)
Income before Tax
1256
Tax Provision
(540)
Continuing Income
716
% drop in Continuing
Income
41%
Revised Ratios (1998)
Liquidity
Current Ratio
Solvency
Total Debt to Equity
Long Term Debt to Equity
Times Interest Earned
Return on Investment
Return on Total Assets
Return on Equity

Delta
10%

The sensitivity analysis after the capitalization of operating leases further


highlights the high degree of risk in these companies. With a 10% drop in revenue
all the three companies have little or no cushion to pay their interest costs. UAL
in particular is highly unlikely to be able to meet its interest commitments in such
a scenario (also realize that for operating leases, both the interest and principal
portions need to be paid).
The results also highlight that the return on assets and equity will be
considerably affected with a downturn in demand. In short, capitalizing operating
leases shows that the solvency of the companies is clearly a risk, and this risk
could come to the forefront if and when these companies experience even a
moderate drop in revenues, which is not unlikely if history is any indicator.

3-57

Chapter 03 - Analyzing Financing Activities

Case 3-5continued
h. Accounting Motivations for Leasing and Lease Classification: In (c) above we
presented some economic arguments for the popularity of leasing in the airline
industry. After the analysis in g and h, we added an important motivation that is
purely related to financial reporting. By leasing a large proportion of their assets
and successfully classifying most leases as operating, the airlines attempt to
camouflage the high risk inherent in their capital structure.
The big question is whether managers can fool the market with these accounting
gimmicks. Research does indicate that the market seems to consider the
additional risk imposed by operating leases and to reflect what is not shown on
the financial statements. However, a surprising number of even sophisticated
investors fall prey to these window-dressing tacticsfor example, many analyst
reports and financial databases fail to adjust the solvency and other ratios for
operating leases.
This case highlights the importance for a financial analyst to understand the
accounting issues. It also highlights the importance of getting ones hands dirty
by doing a detailed and careful accounting analysis before embarking on further
financial analysis.

3-58

Chapter 03 - Analyzing Financing Activities

Case 3-6 (75 minutes)


a.
Pension Benefits
1998
1997

Health and Life Benefits


1998
1997

Difference

43,447 38,742
27,572 25,874
15,875 12,868
7,752 6,574
8,123 6,294

2,121
5,007
(2,886)
(2,420)
(466)

Balance Sheets

Original
1998
1997

Totals
1998

1997

Net Economic Position


Fair Market Value of Plan Assets

PBO
Net Economic Position
Reported Position on Balance Sheet

Assets
Current Assets
PP&E
Intangible Assets
Other
Total
Liabilities & Equity
Current Liabilities
Long Term Borrowing
Other Liabilities
Minority Interest
Equity Share Capital
Retained Earnings
Total
Relevant Ratios
Debt to Equity
Long-Term Debt to Equity
Return on Equity

212,755

243,662

212,755

35,730
23,635
52,908

32,316
19,121
39,820

355,935

304,012

355,935

304,012

141,579

120,668

141,579

120,668

59,663 46,603

59,663

46,603

111,538

98,621

103,881

92,739

4,275 3,682
7,402 5,028
31,478 29,410

4,275
7,402
39,135

3,682
5,028
35,292

304,012

355,935

304,012

7.25
6.98
3.97
3.81
21.54% 21.52%

6.00
3.22

355,935

45,568
32,579
12,989

40,659

5,332
7,657

4,128
5,882

30,649
10,010

Restated
1998
1997

35,730 32,316
23,635 19,121
52,908 39,820

243,662

1,917
4,775
(2,858)
(2,446)
(412)

5.91
3.17
18.29% 18.64%

Inference: Net assets (other liabilities) are understated (overstated) by $7.66 billion
in 1998 ($5.89 billion in 1997). Both the debt to equity and the return on equity ratios
decrease when the true economic position is depicted in the balance sheet.

3-59

Chapter 03 - Analyzing Financing Activities

Case 3-6continued
b.
Post Retirement Expense Restatement

Permanent Income
Reported Expense
One-time charge
Permanent Income
Economic Income
Actual Return on Assets
Service Cost
Interest Cost
Actuarial Changes
Early Retirement Costs
Economic Income or Expense

1998

Pension Benefits
Change
1997

Retiree Health and Life Benefits Total


1998
1997 Change 1998
1997

Change

1,016
0
1,016

331
412
743

685
(412)
273

(313)
0
(313)

(455)
165
(290)

142
(165)
(23)

703
0
703

(124)
577
453

827
(577)
250

6,363
(625)
(1,749)
(1,050)
0
2,939

6,587
(596)

(224)
(29)
(63)
338
412
434

316
(96)
(319)
(268)
0
(367)

343
(107)
(299)
(301)
(165)
(529)

(27)
11
(20)
33
165
162

6,679
(721)

6,930
(703)

(2,068)
(1,318)

(1,985)
(1,689)

0
2,572

(577)
1,976

(251)
(18)
(83)
371
577
596

(367)

(529)

2,572

1,976

268
(167)

301
(206)

1,318

1,689

(3,506)

(4,072)

(8)
0
(39)
(313)

11
0
(32)
(455)

(161)
154
326
703

(134)
154
263
(124)

(1,686)
(1,388)

(412)
2,505

Reconciliation of Economic and Reported Expense


2,939 2,505
Economic Income
Less One-Time Charges
Actuarial Changes
1,050 1,388
Diff. in expected & actual return (3,339) (3,866)
Add Amortization
Prior Service Cost
(153)
(145)
SFAS 87
154
154
Net Actuarial Gain
365
295
Reported Pension Income
1,016
331

c. Under SFAS 158, the net economic position (funded status) of $ 12.99 ($ 10.01)
billion in 1998 (1997) will be reported on the balance sheet (pension + OPEB).
Therefore, the balance sheet will correctly depict the economic position of the
plan.
In contrast, the income statement under SFAS 158 will continue to reflect the
smoothed net periodic benefit cost. For example, in 1998 $ 703 million will shown
as net periodic benefit income under SFAS 158 instead of economic income $
2.572 billion.
The articulation of the income statement and balance sheet effects under SFAS
158 are done through movement in accumulated other comprehensive. For
example in 1998 the following reconciliation will occur:
Opening Accumulated Comprehensive Income
(Difference between economic and SFAS 87 reported position in Balance sheet)
Other Comprehensive Income for 1998
(Difference between economic and smoothed benefit income)
Change in pension liability
=
Closing Accumulated Comprehensive Income
* This is an unusual item that General Electric kept off the balance sheet.

3-60

$ 5,882
1,869
(94)*
$ 7,657

Chapter 03 - Analyzing Financing Activities

d. The actuarial assumptions appear reasonable. (1) The expected return on assets
has been maintained at a steady 9.5%, which is marginally higher than the
average. Yet, this return appears somewhat conservative when compared to the
actual return on assets. (2) The discount rate has mirrored the long-term interest
rate, which has been decreasing over this period. (3) The compensation rate has
been slightly increased in 1998, which reflects the tighter labor market and wage
cost escalation occurring in the U.S. economy. Both the increase in
compensation rate and the reduction in discount rate have resulted in
considerably increasing the PBO. The lower discount rates have marginally
reduced interest cost by $64 million ($58 million) in 1998 (1997), when compared
to previous year. Overall, there appears to be no evidence of earnings
management using actuarial assumptions.
e. To suggest that any change in the reported net pension income (or expense)
must be excluded when determining the legitimate earnings growth rate implies
either that pension plans are not an integral part of the company or that pension
expense (or income) should be constant over time. Both assumptions are not
necessarily correct. As explained in the textbook, while pension plans are
administered by separate trustees, the net assets (or liabilities) of the plans are
the employers responsibility. Moreover, while reported pension expense is
generally not volatile, there is no reason why it must remain the same each year.
Therefore, to determine whether the change in the pension income is warranted
we need to examine the changes in the components of reported pension costs:
Pension Benefits
1998
1997 Change

($ Millions)
Effect on Operations
Expected Return on Plan Assets
Service Cost for Benefits Earned
Interest Cost on Benefit Obligation
Prior Service Cost
SFAS 87 Transition Gain
Net Actuarial Gain Recognized
Special Early Retirement Cost
Post Retirement Benefit Income(Cost)

3,024
(625)
(1,749)
(153)
154
365
1,016

2,721
(596)
(1,686)
(145)
154
295
(412)
331

303
(29)
(63)
(8)
0
70
412
685

This analysis reveals that the main reasons for the increase in pension income
are the expected rate of return ($303 million) and the early retirement costs ($412
million). Both appear to be genuine. The higher return on plan assets is fully
attributable to the increase in the beginning market value of plan assets (from
$33.69 billion on January 1, 1997 to $38.742 billion on January 1, 1998). In reality,
pension accounting has underreported the actual return on assets by over $3
billion (the actual return is $6,363 million versus reported $3,024 million). As our
analysis in (b) indicates, the reported pension cost underreports the true
economic cost by almost $3 billion. The $412 million increase in early retirement
cost arises not because GE over-reported pension income for 1998, but rather

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Chapter 03 - Analyzing Financing Activities

because GE underreported pension income for 1997, by taking a one-time charge


of $412 million. GE did reduce its discount rate by 0.25% in 1998, resulting in $64
million decrease in interest cost. However, this is less than 10% of the overall
increase in pension income. Also, this decrease appears legitimate, considering
that long-term interest rates dropped by more than 1% in 1998. Overall, Barrons
claim that the earnings growth rate for GE has been artificially inflated because of
its pension plan appears to be unsubstantiated.
Still, before we confidently conclude that GE is not managing its earnings, it
might be interesting to examine pension income before and after excluding the
one-time early retirement charge and then examine the pattern of reported
earnings:
Including One-Time Charge

Pension Income
Net Earnings
Earnings Growth Rate

1998
1,016
9,296
13.32%

1997
331
8,203
12.68%

Excluding One-Time Charge

1998
1,016
9,296
7.90%

1997
743
8,615
18.34%

When we examine the timing of the large one-time charge, it appears that there is
a kernel of truth to the Barrons complaint, although not in the sense that was
implied. If GE had not taken the $412 million charge in 1997, its earnings growth
would have been an outstanding 18.34% in 1997, thereby creating an expectation
of similar growth in 1998. The real growth rate in 1998, however would have been
a disappointing 8%, which may have had adverse market reactions. GE is adept at
smoothing its income across periods so that it can show a steady 13% growth in
earnings. By doing this, GE is not artificially increasing the long-term earnings
growth rate (as the Barrons editorial alleges), but rather it is reducing the
volatility in reported earnings, thereby creating an impression of a more stable
(and hence, less risky) company. For more details about GEs earnings
smoothing techniques, see the Wall Street Journal article (WSJ, 11/3/94).
f. The pension related cash flows for GE are the employers contributions of $68
million ($64 million) in 1998 (1997). Evidently these cash flows have little to do
with the economics of the pension plans or their effects on either GEs
performance or financial position. GEs situation is not unusual. Because defined
benefit pension plans can be either over or under funded, the actual cash
contributions by the company to the pension plans are entirely arbitrary (in
contrast, the cash contributions in the case of a defined contribution plan are a
real expense). Therefore, the pension cash flows have no connection with the
economic reality of the pension plans. The accounting standard setters
understand this and have progressively developed better pension accounting
standards that attempt to capture the economic reality

3-62

Chapter 03 - Analyzing Financing Activities

Case 3-7 (60 minutes)


a. The number of claims by categories are: (1) Smoking and health cases alleging
personal injury brought on behalf of individual plaintiffs510 cases; (2) Smoking
and health cases alleging personal injury and purporting to be brought on behalf
of a class of individual plaintiffs60 cases; and (3) Health care cost recovery
cases brought by governmental and nongovernmental plaintiffs seeking
reimbursement for health care expenditures allegedly caused by cigarette
smoking (actions by all 50 states, several commonwealths and territories of the
United States95 cases, as well as cases in several foreign countries27 cases
plus 6 foreign class actions suits).

b. The company recorded the following pre-tax charges related to tobacco litigation:
$3.081 billion and $1.457 billion during 1998 and 1997, respectively, to accrue for
the company's share of all fixed and determinable portions of the company's
obligations under the tobacco settlements with various states. In addition, the
company accrued $300 million during 1998 and $1.359 billion in total for its
unconditional obligations under an agreement in principle to contribute to a
tobacco growers' trust fund. These amounts relate to the third category.
c. Charges totaling $3.381 billion were recorded as losses in the 1998 income
statement related to tobacco litigation.
d. The eventual losses will likely dwarf what is currently recorded on the Balance
Sheet of Philip Morris. There are vast amounts of loss that are currently deemed
to not meet one of the 2 requirements to accrue contingent liability. In most
cases, the company likely contends that the amount of the loss is not yet
reasonably estimable.
e. While certain contingent losses do not meet the threshold for accrual and
recognition in the balance sheet, analysts should adjust their models to reflect
much greater exposure to losses from tobacco litigation. The current balance
sheet should be adjusted to report much greater amounts of liability and tobacco
litigation charges and losses.

3-63