3
CHAPTER
Analyzing Financing
Activities
A liability is a probable future payment of assets or
services that a company is presently obligated to
make as a result of past transactions or events,
Definition
Liabilities
Past Present Future
Because of a
past event..,
...for future
sacrifices,
… the
company
has a
present
obligation..,
Current (short-term)
Liabilities
Noncurrent (Long-
Term) Liabilities
Obligations whose
settlement requires use of
current assets or the
incurrence of another
current liability within one
year or the operating
cycle,whichever is
longer,
Obligations not
payable within one
year or the operating
cycle,whichever is
longer,
Liabilities
Classification
Operating
Liabilities
Financing
Liabilities
Obligations that arise from
operating activities--examples
are accounts payable,unearned
revenue,advance payments,
taxes payable,postretirement
liabilities,and other accruals of
operating expenses
Obligations that arise from
financing activities--examples
are short- and long-term debt,
bonds,notes,leases,and the
current portion of long-term debt
Liabilities
Alternative Classification
Liabilities
Disclosures for Current (Financing) Liabilities
n Compensating balance arrangements,including those not required by law
n Balance sheet segregation of (1) legally restricted compensating balances
and (2) unrestricted compensating balances related to long-term borrowing
arrangements if balances are computable at a fixed amount
n Short-term bank and commercial paper borrowings,including,
? Commercial paper borrowings separately listed in balance sheet
? Weighted-average interest rate and terms separately stated for
short-term bank and commercial paper borrowings
? Weighted-average interest rate,average outstanding borrowings,and
maximum month-end outstanding borrowings for short-term bank debt
and commercial paper combined for the period
n 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
Liabilities
Accounting-Based Liability Restrictions (Covenants)
Aim,Safeguard creditors’ investments
Common restrictions include,
n Dividend distribution restrictions
n Working capital restrictions
n Debt-to-equity ratio restrictions
n Seniority of asset claim restrictions
n Acquisition and divestment restrictions
n Liability issuance restrictions
Potential information sources,Liability
prospectus,annual report,SEC filings,and
creditor information services (e.g.,Moody’s)
Leases
Leasing Facts
Lease – contractual agreement between a
lessor (owner) and a lessee (user or renter)
that gives the lessee the right to use an asset
owned by the lessor for the lease term
MLP – minimum lease payments
(MLP) of the lessee to the lessor
according to the lease contract
Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all benefits
and risks of ownership—accounted for as an asset acquisition and a liability incurrence
by the lessee,and as a sale and financing transaction by the lessor
A lessee classifies and accounts for a lease as a capital lease if,
at its inception,the lease meets any of four criteria,
(i) lease transfers ownership of property to lessee by end of the lease term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the property
(iv) present value of rentals and other minimum lease payments at beginning of
lease term is 90% or more of the fair value of leased property less any related
investment tax credit retained by lessor
(2) Operating Lease Accounting For leases other than capital leases—the lessee
(lessor) accounts for the minimum lease payment as a rental expense (income)
Leases
Lease Disclosure and Off-Balance-Sheet Financing
Lease Disclosure
Lessee must disclose,(1) future MLPs separately for capital
leases and operating leases—for each of five succeeding years
and the total amount thereafter,and (2) rental expense for each
period an income statement is reported
Off-Balance-Sheet Financing
Off-Balance-Sheet financing is when a lessee structures a
lease so it is accounted for as an operating lease when the
economic characteristics of the lease are more in line with a
capital lease—neither the leased asset nor its corresponding
liability are recorded on the balance sheet
Leases
Frequency of Capital and Operating Leases
Capital Only
3%
Operating Only
43%
Both Capital &
Operating
44% Neither
10%
Leases
Accounting for Leases – An Illustration
Lease Facts
? A company leases an asset on January 1,
2000 -- it has no other assets or liabilities
? Estimated economic life of leased asset
is 5 years with no salvage value -- company will
depreciate the asset on a straight-line basis over its life
? Lease has a fixed non-cancelable term of 5 years
with annual MLPs of $2,505 paid at the end of each year
? Interest rate on the lease is 8% per year
Leases
Accounting for Leases – Illustration (continued)
Lease Amortization Schedule
Straight-line depreciation
$2,000 per year ([$10,000 - $0]/5 years)
Year
Beginning
Year
Liability
Interest and Principal
Components of MLP
Year-
end
Liability
Interest Principal Total
2000
2001
2002
2003
2004
Totals
$10,000
8,295
6,454
4,466
2,319
$ 800
664
517
358
186
$2,525
$ 1,705
1,841
1,988
2,147
2,319
$10,000
$ 2,505
2,505
2,505
2,505
2,505
$12,525
$8,295
6,454
4,466
2,319
0
Leases
Accounting for Leases – Illustration (continued)
Year
Operating Lease Capital Lease
2000
Rental Expense
Total Expense
$2,505
Depreciation Expense
Interest Expense
Total Expense
$2,000
800
$2,505
$2,800
2001
Rental Expense
Total Expense
$2,505
Depreciation Expense
Interest Expense
Total Expense
$2,000
664
$2,505 $2,664
2002
Rental Expense
Total Expense
$2,505
Depreciation Expense
Interest Expense
Total Expense
$2,000
517
$2,505 $2,517
2003
Rental Expense
Total Expense
$2,505 Depreciation Expense
Interest Expense
Total Expense
$2,000
358
$2,505 $2,358
2004
Rental Expense
Total Expense
$2,505 Depreciation Expense
Interest Expense
Total Expense
$2,000
186
$2,505 $2,186
Income Statement Effects of Lease Methods
Leases
Accounting for Leases – Illustration (continued)
Balance Sheet Effects of Lease Methods
Assets
Liabilities
Assets
Liabilities
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
$ 0
0
$ 0
$ (2,505)
0
$ (2,505)
$ (5,010)
0
$ (5,010)
$ (7,515)
0
$ (7,515)
$ (10,020)
0
$ (10,020)
$ (12,525)
0
$ (12,525)
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
$ 0
0
$ 0
$ 0
(2,505)
$ (2,505)
$ 0
(5,010)
$ (5,010)
$ 0
(7,515)
$ (7,515)
$ 0
(10,020)
$ (10,020)
$ 0
(12,525)
$ (12,525)
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
$ 0
10,000
$ 10,000
$ (2,505)
8,000
$ 5,495
$ (5,010)
6,000
$ 990
$ (7,515)
4,000
$ (3,515)
$ (10,020)
2,000
$ (8,020)
$ (12,525)
0
$ (12,525)
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
$ 10,000
0
$ 10,000
$ 8,295
(2,800)
$ 5,495
$ 6,454
(5,464)
$ 990
$ 4,466
(7,981)
$ (3,515)
$ 2,319
(10,339)
$ (8,020)
$ 0
(12,525)
$ (12,525)
Operating Leases Capital Leases Date
Jan,1,2000
Dec 31,2000
Dec 31,2001
Dec 31,2002
Dec 31,2003
Dec 31,2004
Leases
Accounting for Leases – Illustration (continued)
Implicit Depreciation under Capital and Operating Leases
1500
1700
1900
2100
2300
2500
2000 2001 2002 2003 2004
Y e a r
D
e
p
r
e
c
i
a
ti
o
n
Ex
p
e
n
s
e
C a p i t a l
O p e r a t i n g
Leases
Effects of Lease Accounting
Impact of Operating Lease when Capital Lease is Apt,
? Operating lease understates liabilities—improves solvency ratios
such as debt to equity
? Operating lease understates assets—can improve return on
investment ratios
? Operating lease delays expense recognition—overstates income in
early term of the lease and understates income later in lease term
? Operating lease understates current liabilities by ignoring current
portion of lease principal payment—inflates current ratio & other
liquidity measures
? Operating lease includes interest with lease rental (an operating
expense)—understates both operating income and interest
expense,inflates interest coverage ratios,
understates operating cash flow,& overstates
financing cash flow
Leases
Converting Operating Leases to Capital Leases
Panel A,Estimate Average Remaining Lease Term
1997
Capital Operating Capital Operating
(1) MLP – Later years ($) 2,052 6,232 2,508 6,140
(2) MLP – Last reported year ($) 238 486 304 491
(3) Number of later years [(1) ?(2)] 9 13 8 13
(4) Add number of years reported 5 5 5 5
(5) Remaining lease term (years) [(3) + (4)] 14 18 13 18
1996
Panel B,Estimate Interest Rate on Capital Lease
(6) MLP in next year ($) 286 367
(7) Less principal component ($) 87 115
(8) Interest ($) [(6) – (7)] 199 252
(9) Total MLP ($) 3,355 4,186
(10) Less amount reflecting interest ($) 1,163 1,438
(11) Present value of lease ($) [(9) – (10)] 2,192 2,748
(12) Interest rate [(8) ? (11)] 9% 9%
Panel C,Estimate Average MLP per Year on Operating Lease
(13) Total MLP ($) 8,766 8,749
(14) Executory cost($) [27.6%* x (13)] 2,419 2,415
(15) MLP net executory cost ($) [(13) – (14)] 6,347 6,334
(16) Average remaining lease term (years) [5] 18 18
(17) Average MLP per year ($) [(15) ? (16)] 353 352
Panel D:Estimate Present Value of Operating Lease
(18) Present value of annuity for 18 years at 9% 8.756 8.756
(19) Present value of operating lease ($) [(18) x (17)] 3,091 3,082
Leases
Converting Operating Leases to Capital Leases--Continued
Panel E:Estimate Interest,Executory Costs,and Depreciation on Operating Lease Conversion
(20) Present value of operating lease ($)[19] 3091 3082
(21) Interest expense ($) [(19) x (12)] 278 277
(22) MLP in next year ($) 528 556
(23) Executory cost ($) [27.6%* x (22)] 146 153
(24) Depreciation expense ($) [(20) ? (16)] 172 171
Panel F:Estimate Effect of Operating Lease Conversion on Income Statement
(25) Increase in executory cost ($) [23] (146) (153)
(26) Increase in depreciation expense ($)[24] (172) (171)
(27) Decrease in lease rental expense ($) 528 556
(28) Effect on operating income ($) 210 232
(29) Increase in interest expense ($) [21] (278) (277)
(30) Effect on income before tax ($) (68) (45)
(31) Decrease in tax provision ($) [35% x (30)] 24 16
(32) Effect on Income after tax ($) (44) (29)
Panel G,Principal and Interest Components of Next Year’s Operating Lease MLP
(33) MLP in next year ($) [22] 528 556
(34) Interest ($) [21] 278 277
(35) Principal component ($) [(33) – (34)] 250 279
Panel H:Decompose Operating Lease Liability into Current and Noncurrent Components
(36) Total operating lease liability ($) [19] 3,091 3,082
(37) Current liability ($) [35] 250 279
(38) Noncurrent liability ($) [(36) – (37)] 2,841 2,803
1998 1997
1997 1996
Leases
Restated Financial Statements after Converting
Operating Leases to Capital Leases—Kmart
Income Statements
Before
After
Sales $32,183 $32,183
Operating expenses
(31,402)
(31,170)
Operating income before interest & taxes $781 $1,013
Interest expense
(412)
(689)
Income taxes (120) (104)
Net income
$249
$220
Balance Sheets
Before After Before After
Current assets
$ 7,476
$ 7,476
Current liabilities
$ 3,274
$ 3,524
Leased assets (net)
1,032
4,123
Lease obligations
1,179
4,020
Other assets
5,050
5,050
Other liabilities
3,671
3,671
-- -- Shareholders' equity 5,434 5,434
Total assets
$13,558
$16,649
Total liab,and equity
$13,558
$16,649
Postretirement Benefits
Defined -- Employer-provided benefit(s) to employees after
retirement
Pension benefits -- Employer-provided monetary pension benefits
to employees after retirement,e.g.,monthly stipend
until death
Other Postretirement Employee Benefits (OPEB) -- Employer-
provided non-pension (usually nonmonetary) benefits
after retirement,e.g.,health care and life insurance
Postretirement Benefits Facts
Two kinds of Postretirement Benefits
Postretirement Benefits
Pension Basics
Pension Plan – agreement with employer to provide pension benefits involving 3entities,
employer-who contributes to the plan; employee-who derives benefits; and pension fund
Pension Fund Assets – account administered by a trustee,independent of employer,
entrusted with responsibility of receiving contributions,investing them in a proper
manner,& disbursing pension benefits to employees
Vesting – specifies employee’s right to pension benefits regardless of whether employee
remains with the company or not; usually conferred after employee serves some
minimum period with the employer
Pension Plan Categories
Defined benefit – a plan specifying amount of pension benefits that employers promise
to provide retirees; employer bears risk of pension fund performance
Defined contribution – a plan specifying amount of pension contributions that employers
make to the pension plan; employee bears risk of pension fund performance
Focus of Pension Analysis
Defined benefit plans constitutes the major share of pension plans and are
the focus of analysis given their implications to future company
performance and financial position
Postretirement Benefits
Elements of the Pension Process
Employer
Investment
Benefits
(Disbursements) Contributions
Pension
Fund
Employee
Postretirement Benefits
Illustration of Pension Accumulation and
Disbursement for a Defined Benefits Plan
Funds required at employees’
retirement,
Present value of 10 payments of
$20,000 per annum with a
discount rate of 8% per annum
$134,200
Annual payments into the fund
required to accumulate to
$134,200 in 15 years with
a discount rate of 8%
per annum
10 years
Annual benefits of
$20,000 paid to
employee for 10 years
Postretirement Preretirement Retirement
Benefits =
$20,000 per annum
Contributions =
$4,942 per annum
15 years
Postretirement Benefits
Accumulated benefit obligation (ABO) – actuarial present value of pension benefits payable
to employees at retirement based on their current compensation and service to-date
Project benefit obligation (PBO) – actuarial estimate of future pension benefits payable to
employees on retirement based on expected future compensation and service to-date
Vested benefit obligation (VBO) – actuarial estimate of future pension benefits payable to
employees at retirement based on current compensation & benefits vested to employees
Funded Status – Difference between the value of the plan assets and the PBO
Note,Plan is overfunded (underfunded) when value of plan assets exceeds (is less than) PBO
Net Economic Position – PBO less the value of the plan assets
Three Alternative Definitions of Pension Obligation
Relation between Plan Assets and Funded Status
Postretirement Benefits
Economic pension cost -- net cost arising from changes in net economic position
for a period; includes both recurring and nonrecurring components along with return
on plan assets
Recurring pension costs consist of two components,
Service cost – actuarial present value of pension benefit earned by employees
Interest Cost – increase in projected benefit obligation arising when pension
payments are one-period closer to being made; computed by multiplying
beginning-period PBO by the discount rate
Nonrecurring pension costs consist of two components,
Actuarial Gain or Loss – change in PBO that occurs when one or more
actuarial assumptions are revised in estimating PBO
Prior Service Cost – effects of changes in pension plan rules on PBO
Return on plan assets,
Actual return on plan assets – pension plan’s earnings,consisting
of investment income—capital appreciation and dividend and interest
received,less management fees; plus realized and unrealized
appreciation (or minus depreciation) of other plan assets
Economic Pension Cost
Postretirement Benefits
Pension Accounting Example – The Facts
? A pension plan with a single employee,J,Smith,who joins the plan
exactly 5 years ago on January 1,1996; Smith is due to retire on
Dec,31,2020,and is expected to live for 10 years after retirement
? J,Smith’s current compensation is $10,000 per year; actuarial
estimates indicate compensation is expected to increase 4% per year
over the next 20 years
? Pension plan specifies the following formula for determining an
employee's pension benefit,―Annual pension is equal to one week’s
compensation at time of retirement for each year with the plan‖;
employees vest 4 years after joining the plan
? At Dec,31,2000,the fair value of assets in the pension fund is $2,000;
in 2001,the employer contributes $200 to the pension fund
? Return on pension assets is 22% in 2001; long-term
return is expected to be 10% per year
? Discount rate is 7% per year
Postretirement Benefits
Pension Accounting Example – Pension Obligation
Determining Pension Obligations under Different Assumptions—J,Smith Example
Actual Projected Projected
At Dec,31,2020 (Retirement)
Salary per year
$10,000
$21,911
$21,911
$26,533
$26,533
Pension per year 962 2,107 2,528 3,061 4,592
Value of pension
6,753
14,798
17,757
21,503
32,254
At Dec,31,2000
Present value of pension
1,745
3,824
At Dec,31,2001
Present value of
pension
4,091
4,910
5,946
8,919
2000
Formula
2001
Formula
Assumption Change
Actuarial Plan
Vested benefits (VBO) $1,745
+ Benefits not vested 0
= Accumulated benefit obligation (ABO) $1,745
+ Effect of estimated increase in compensation 2,079
= Projected benefit obligation (PBO) $3,824
Note,PBO ? ABO ? VBO
Postretirement Benefits
Pension Accounting Example – Economic Pension Cost
Recurring costs for J,Smith example,
? PBO increases by $819 in 2001 because Smith works an extra year – hence,the term service cost
? Present value increases from $3,824 in 2000 to $4,092 in 2001—this $267 increase arises from the
time value of money – hence,the term interest cost (also computed as 7% x $3,824)
Nonrecurring costs for J,Smith example,
? Actuarial change (4% to 5% growth) increases estimated compensation at retirement from $21,911
to $26,533 and increases the PBO at end of 2001 by $1,036 (from $4,910 to $5,946) — an actuarial
loss
? Pension formula changes to one-and-one-half week’s compensation per year of service results in
the pension benefit per year increasing by 50% from $3,061 to $4,592,which increases PBO by
$2,973 ($8,919 - $5,946) — a prior service cost
Return on plan assets for J,Smith example,
? Actual return on plan assets is
$440 (22% of $2,000)
In sum,net economic pension
cost for the J,Smith example is,
Recurring costs,
Service cost $ 819
Interest cost 267
Nonrecurring costs,
Actuarial gain or loss 1,036
Prior service cost 2,973
Gross economic pension cost $ 5,095
Less return on plan assets (440)
Net economic pension cost $ 4,655
Postretirement Benefits
Pension Accounting Example – Articulation of Net Economic Position
and Economic Pension Cost,J,Smith Example
Pension Obligation
Beginning balance 3,824
Service cost 819
Interest cost 267
Actuarial gain or loss 1,036
Benefits paid 0 Prior service cost 2,973 5,095
Ending balance 8,919
Pension Asset
Beginning balance 2,000
Contributions 200
Return on assets 440 Benefits paid 0
Ending balance 2,640
Net Economic Position (Funded Status)
Contributions 200 Beginning balance 1,824
Return on assets 440 Gross pension cost 5,095
Ending balance 6,279
Economic Pension Cost
Recurring costs
Service cost 819
Interest cost 267
Nonrecurring costs
Actuarial gain or loss 1,036
Prior service cost 2,973
Gross pension cost 5,095
Less return on assets (440)
Net pension cost 4,655
Postretirement Benefits
Reported pension cost -- defers recognition of economic effects vis-à-vis economic pension
cost; each deferral (and amortization) follows,
Expected return on plan assets reduces reported pension cost -- gains and losses
from the difference between expected and actual returns are deferred and amortized to
reduce volatility; expected return on plan assets is computed by multiplying the expected
long-term rate of return on plan assets by the market value of plan assets at the
beginning of the period,
Deferral and amortization of net gains and losses arise from the delayed recognition of
deviations from expectations regarding both pension obligations and pension
assets—net gains and losses consist of (1) the difference between actual and expected
return on plan assets and (2) actuarial gains and losses
Deferral and amortization of prior service cost is the process of delaying recognition of
prior service cost effects on reported pension cost (through amortization)
Deferral and amortization of transition loss or gain arise when a plan is initially adopted—
amortized over the average remaining service period of qualified employees
Net Reported Position -- is the cumulative reported pension cost net of cumulative
contributions—for this reason,the liability (or asset) reported in the balance sheet is called
Accrued (or Prepaid) Pension Cost,
Reported (or Net Periodic) Pension Cost
Net Reported Position (or Reported Status)
Postretirement Benefits
? Expected return on plan assets — $200 (10% of $2,000) in the J,Smith example
? Deferral and amortization of net gains and losses — deferred net gains or losses is
$796 ($1,036 actuarial loss less $240 nonrecurring return),of which $21 (1/20 of the
excess of $796 over 10% of $3,824) is amortized in 2001 for the J,Smith example
? Deferral and amortization of prior service cost — prior service cost of $2,973 is
deferred and $149 (1/20 x $2,973) is amortized in the J,Smith example
? Deferral and amortization of transition loss or gain — no transition gain or loss in the
J.Smith example
Pension Accounting Example – Reported Pension Cost
Economic pension cost Smoothing Reported pension cost*
Service cost $ 819 $ — Service cost $ 819
Interest cost 267 — Interest cost 267
Actual return (440) (240) Expected return (200)
Actuarial gain or loss 1,036 1,036 —
Net gain or loss — $ 796 —
Prior service cost 2,973 2,973 —
Amortization,
(21) Net gain or loss 21
(149) Prior service cost 149
Total $ 4,655 $ 3,612 $ 1,056
* This also is referred to as Net Periodic Pension Cost,
Economic Pension Cost versus Reported Pension Cost—J,Smith Example
Postretirement Benefits
Pension Accounting Example – Net Reported Position
(Reported Status)
Reported Status of Pension Fund in Balance Sheet— J,Smith Example
Projected benefit obligation $(8,919)
Plan assets 2,640
Funded status $(6,279)
Unrecognized transition asset 0
Unrecognized net gain or loss 775
Unrecognized prior service cost 2,824
Accrued pension cost (reported status) $(2,680)
Postretirement Benefits
Distribution of PBO,Plan Assets and Funded Status - Evidence
M e a n
0 1 00 200 300 400 500
PBO
A s s e t s
F u n d e d
S t a t u s
$ M i l l i o n
Postretirement Benefits
Distribution of PBO,Plan Assets and Funded Status as % of Total
Assets - Evidence
M e a n
0 5 10 15 20
PBO
A s s e t s
F u n d e d S t a t u s
P e r c e n t a g e
Postretirement Benefits
(similar to pension accounting)
Net cost reporting – consequences of events and transactions affecting OPEB plans are
reported as a single amount—this amount includes at least three components,(1) present
value of the accrued cost of deferred compensation promised in exchange for employee
service,(2) interest cost accruing from the passage of time until these benefits are paid,and (3)
returns from the investment in the plan’s assets
Delayed recognition -- certain changes in postretirement obligations,including those
arising as a result of a plan initiation or amendment,and certain changes in the value of plan
assets that are set aside to meet these obligations,are recognized through a process of
deferral and amortization
Offsetting -- plan assets restricted for payment of postretirement benefits offset the
accumulated postretirement benefit obligation in determining amounts recognized in the
balance sheet
Accumulated Postretirement Benefit Obligation (APBO) – employer’s OPEB obligation
Expected Postretirement Benefit Obligation (EPBO) – total actuarially determined costs
of providing future OPEB,recognized over the employee’s expected service period
Note,APBO is the portion of EPBO ―earned‖ by employee services as of a given date
(accumulated benefits recognized to-date),Funded status of OPEB is the difference
between APBO and the value of OPEB plan assets
Features of OPEB Accounting
Language of OPEB Accounting
Postretirement Benefits
Reported OPEB cost includes these components,
Service costs — actuarial present value of OPEB ―earned‖ by employees during the
period; portion of EPBO attributable to the current year
Interest costs — imputed growth in APBO during the period using an assumed discount
rate; interest is compounded because APBO is recognized on a present value basis
Amortization of net gains and losses — amounts arising when actual experience of
the plan differs from initial estimates or,alternatively,if the expected return on assets
differs from actual return; these amounts are deferred and amortized
Amortization of prior service costs — costs arising from plan amendments that
change benefits and are attributed to employee service rendered prior to the amendment date;
these costs are deferred and amortized
Amortization of transition obligation — costs arising from initial adoption,called
transition obligation,are identified and measured as the difference between APBO and plan
assets (if any) minus any postretirement liabilities previously recorded; either immediately
recognize the transition obligation with a charge to income or amortize it
Expected return on plan assets — this return reduces the net annual postretirement
expense if the plan is funded; the difference between actual and expected return is deferred
and included in the unrecognized portion of net gains and losses
Reported OPEB Cost
Postretirement Benefits
Pension and Other Postretirement Benefits Disclosures—Allied Signal
Other
Pension Postretirement
Benefits Benefits
-----------------------------------------
1998 1997 1998 1997
-----------------------------------------
Change in benefit obligation
Benefit obligation at January 1 $ 5,941 $ 5,419 $ 1,634 $ 1,533
Service cost 139 124 21 21
Interest cost 422 412 103 111
Plan amendments 20 -- 5 (121)
Actuarial (gains) losses 352 470 (27) 188
Acquisitions 91 -- -- 16
Benefits paid (447) (454) (127) (114)
Settlements and curtailments (65) (8) (32) --
Translation effect 2 (22) -- --
----------------------------------------------------------------------------------------------
Benefit obligation at December 31 6,455 5,941 1,577 1,634
----------------------------------------------------------------------------------------------
Change in plan assets
Fair value of plan assets at January 1 6,428 5,843 -- --
Actual return on plan assets 853 1,018 -- --
Company contributions 46 40 -- --
Participants' contributions -- 1 -- --
Acquisitions 63 -- -- --
Settlements (48) (9) -- --
Benefits paid (447) (454) -- --
Translation effect (10) (11) -- --
----------------------------------------------------------------------------------------------
Fair value of plan assets at December 31 6,885 6,428 -- --
----------------------------------------------------------------------------------------------
Postretirement Benefits
Pension and Other Postretirement Benefits Disclosures—Allied Signal
(continued)
Funded status of plans 430 487 (1,577) (1,634)
Unrecognized transition (asset) (22) (26) -- --
Unrecognized net (gain) loss (569) (659) (99) (77)
Unrecognized prior service cost 102 93 (188) (221)
----------------------------------------------------------------------------------------------
(Accrued) benefit cost $ (59) $ (105) $(1,864) $(1,932)
=============================================================================================
Assumptions as of December 31
Discount rate 6.75% 7.25% 6.75% 7.25%
Assumed rate of return on plan assets 10.00% 10.00% -- --
Assumed annual rate of compensation increase 5.00% 5.00% -- --
=============================================================================================
The projected benefit obligation,accumulated benefit obligation and fair value of plan assets for the pension plans with
accumulated benefit obligations in excess of the fair value of plan assets were $328,$281 and $43 million,respectively,
as of December 31,1998 and $285,$246 and $31 million,respectively,as of December 31,1997,
Postretirement Benefits
Pension and Other Postretirement Benefits Disclosures—Allied Signal
(continued)
Net periodic pension and other postretirement benefit costs include the following components,
Other
Pension Postretirement
Benefits Benefits
------------------------------------------------------
1998 1997 1996 1998 1997 1996
------------------------------------------------------
Service cost $139 $124 $133 $21 $21 $ 24
Interest cost 422 412 398 103 111 111
Assumed return on plan assets (580) (519) (458) -- -- --
Amortization of transition asset (4) (7) (7) -- -- --
Amortization of prior service cost 12 11 11 (19) (15) (10)
Recognition of actuarial (gains) losses 1 1 1 (2) (9) (4)
---------------------------------------------------------------------------------------------------
Benefit cost (credit) $(10) $22 $78 $103 $108 $121
==================================================================================================
Assumed health care cost trend rates have a significant effect on the amounts reported for the retiree medical plans,A one-
percentage-point change in assumed health care cost trend rates would have the following effects,
One-Percentage- One-Percentage-
Point Increase Point Decrease
--------------------------------------
Effect on total of service
and interest cost components $11 $(10)
Effect on postretirement
benefit obligation $122 $(109)
===============================================================================
Postretirement Benefits
Economic and Reported Postretirement Costs—Allied Signal
Pension
Service cost
Interest cost
Return on assets
Actuarial (gains) losses
Prior service cost
Transition asset
Net pension cost
OPEB
Service cost
Interest cost
Return on assets
Actuarial (gains) losses
Prior service cost
Transition asset
Net cost
Total
Service cost
Interest cost
Return on assets
Actuarial (gains) losses
Prior service cost
Transition asset
Net cost
Economic
$ 139
422
(853)
352
20
_0
$ 80
$ 21
103
0
(27)
5
_0
$ 102
$ 160
525
(853)
325
25
0
$ 182
Deferred
$ 0
0
$ 273
(352)
(20)
_0
$ (99)
$ 0
0
0
27
(5)
_0
$ 22
$ 0
0
273
(325)
(25)
0
$ (77)
Amortized
$ 0
0
0
1
12
(4)
$ 9
$ 0
0
0
(2)
(19)
_
$ (21)
$ 0
0
0
(1)
(7)
(4)
$ (12)
Reported
$ 139
422
(580)
1
12
(4)
$ (10)
$ 21
103
0
(2)
(19)
0
$ 103
$ 160
525
(580)
(1)
(7)
(4)
$ 93
Postretirement Benefits
Reconciliation of Economic and Reported Changes—Allied Signal
Economic cost
$ (80)
$(102) $ (182)
Translation effect
(12)
0 (12)
Acquisition and settlements—net
(11) 32 21
Benefits paid
0 127 127
Contributions
46 0 46
Change in funded position (economic)
$ (57) $ 57 $ 0
Deferred return
$(273) $ 0 $ (273)
Deferred actuarial change
352 (27) 325
Deferred prior service cost
20 5
25
Amortization
(9)
21
12
Other
13
12
25
Change in unrecognized
$ 103
$ 11
$ 114
Pension OPEB Total
Change in accrued cost (reported)
$ 46 $ 68 $ 114
Liabilities and Equity
Current liabilities $ 5,185 $ 5,185 $ 4,436 $ 4,436
Noncurrent liabilities 5,078 4,302 4,885 3,995
Shareholders’ equity 5,297 6,073 4,386 5,276
$15,560 $15,560 $13,707 $13,707
Postretirement Benefits
Financial Statement Effects of Postretirement Benefit Adjustments
— Allied Signal
Panel A,Income Statement (1998)
Reported Economic
Sales $15,128 $15,128
Operating expenses (13,166) (13,255)
Operating income $ 1,962 $ 1,873
Interest and other expenses (19) (19)
Income before taxes $ 1,943 $ 1,854
Income taxes (612) (581)
Net income $ 1,331 $ 1,273
Panel B,Balance Sheet 1998 1997
Reported Economic Reported Economic
Assets
Current assets $ 5,593 $ 5,593 $ 5,573 $ 5,573
Noncurrent assets 9,967 9,967 8,134 8,134
$15,560 $15,560 $13,707 $13,707
Postretirement Benefits
Effect of Actuarial Assumptions on Benefit Obligation and Cost
Assumption
Direction
of Change
Direction of Effect on
Economic*
Reported*
Position
Cost Position
Cost
Discount Rate
+
-
+
-
-
+
Indefinite
Indefinite
Indefinite
Indefinite
Expected
Return
+
-
No effect
No effect
No effect
No effect
+
-
-
+
Growth Rate**
+
-
-
+
+
-
-
+
+
-
Notes,* Economic position refers to funded status
and reported position refers to accrued
benefit or cost,
** Growth rate pertains to both compensation
and health care costs,
Postretirement Benefits
Frequency Distribution of Actuarial Assumptions
D i s c o u n t R a t e
0 10 20 30 40 50
6 o r l e s s
6, 5
7
7, 5
8
8, 5 o r m o r e
D
i
s
c
o
u
n
t
R
a
t
e
%
P e r c e n t a g e
Postretirement Benefits
Frequency Distribution of Actuarial Assumptions
E x p e c t e d R a t e o f R e t u r n
0 10 20 30
6, 5 o r l e s s
7, 5
8, 5
9, 5
1 0, 5
E
x
p
e
c
t
e
d
R
a
t
e
o
f
R
e
t
u
r
n
%
P e r c e n t a g e
Postretirement Benefits
Frequency Distribution of Actuarial Assumptions
C o m p e n s a t i o n I n c r e a s e
0 5 10 15 20 25 30 35 40
4, 5 o r l e s s
5
5, 5
6
6, 5
7
7, 5
8
C
o
m
p
e
n
s
a
ti
o
n
G
r
o
w
th
%
Pe r c e n ta g e
Contingencies and Commitments
Contingencies -- potential losses and gains whose resolution depends on
one or more future events,
Contingent liabilities -- contingencies with potential claims on resources
-- to record a contingent liability (and loss) two
conditions must be met,
(i) probable an asset is impaired or a liability
incurred,and
(ii)the amount of loss is reasonably estimable;
-- to disclose a contingent liability (and loss) there
must be at least a reasonable possibility of
incurrence
Contingent assets -- contingencies with potential additions to resources
-- a contingent asset (and gain) is not recorded until
the contingency is resolved
-- a contingent asset (and gain) can be disclosed if
probability of realization is high
Basics of Contingencies
Contingencies
should be,,,
Frequency of Contingent Liabilities
Contingencies and Commitments
0 20 40 60 80 100
L i t i g a t i o n
E n v i r o n m e n t a l
I n s u r a n c e
T a x
G o v e r m e n t a l
O t h e r
P e r c e n t
Contingencies and Commitments
Sources of useful information,
Notes,MD&A,and Deferred Tax Disclosures
Useful analyses,
? Scrutinize management estimates
? Analyze notes regarding contingencies,including
Description of contingency and its degree of risk
Amount at risk and how treated in assessing risk exposure
Charges,if any,against income
? Recognize a bias to not record or underestimate contingent liabilities
? Beware of big baths — loss reserves are contingencies
? Review SEC filings for details of loss reserves
? Analyze deferred tax notes for undisclosed provisions for future losses
Note,Loss reserves do not alter risk exposure,
have no cash flow consequences,and do not
provide insurance
Analyzing Contingencies
0 20 40 60 80 100
D i v i d e n d R e s tr i c ti o n s
C a p i ta l Ex p e n d i tu r e s
A c q u i s i ti o n R e l a te d
Sa l e s A g r e e m e n ts
Pe r c e n t
Contingencies and Commitments
Commitments -- potential claims against a company’s resources due to future
performance under contract
Basics of Commitments
Frequency of Commitments
Off-Balance-Sheet Financing
Sources of useful information,
Notes and MD&A and SEC Filings
Useful analyses,
? Scrutinize management communications and press releases
? Analyze notes regarding commitments,including
Description of commitment and its degree of risk
Amount at risk and how treated in assessing risk exposure
Contractual conditions and timing
? Recognize a bias to not disclose commitments
? Review SEC filings for details of commitments
Analyzing Commitments
Off-Balance-Sheet Financing
Off-Balance-Sheet Financing -- is the non-recording of financing obligations
Motivation
To keep debt off the balance sheet—part of ever-changing landscape,where as one
standard tries to better reflect obligations from a certain off-balance-sheet
financing transaction,there are new and innovative means to take its place
Transactions sometimes used as off-balance-sheet financing,
? Operating leases that are indistinguishable from capital leases
? Through-put agreements,where a company agrees to run
goods through a processing facility
? Take-or-pay arrangements,where a company guarantees to pay
for goods whether needed or not
? Certain joint ventures and limited partnerships
? Product financing arrangements,where a company sells and agrees to
either repurchase inventory or guarantee a selling price
? Sell receivables with recourse and record them as sales rather than liabilities
? Sell receivables as backing for debt sold to the public
? Outstanding loan commitments
Basics of Off-Balance-Sheet Financing
GAAP
Off-Balance-Sheet Financing
Sources of useful information,
Notes and MD&A and SEC Filings
Companies disclose the following info about financial
instruments with off-balance-sheet risk of loss,
? Face,contract,or principal amount
? Terms of the instrument and info on its credit and market risk,cash
requirements,and accounting Loss incurred if a party to the
contract fails to perform
? Collateral or other security,if any,for the amount at risk
? Info about concentrations of credit risk from a counterparty or
groups of counterparties
Useful analyses,
? Scrutinize management communications and press releases
? Analyze notes about financing arrangements
? Recognize a bias to not disclose financing obligations
? Review SEC filings for details of financing arrangements
Analysis of Off-Balance-Sheet Financing
Shareholders’ Equity
Basics of Equity Financing
Equity Analysis — involves analyzing equity characteristics,including,
? Classifying and distinguishing different equity sources
? Examining rights for equity classes and priorities in liquidation
? Evaluating legal restrictions for equity distribution
? Reviewing restrictions on retained earnings distribution
? Assessing terms and provisions of potential equity issuances
Equity Classes — two basic components,
? Capital Stock
? Retained Earnings
Equity — refers to owner (shareholder)
financing; its usual characteristics include,
? Reflects claims of owners (shareholders) on
net assets
? Equity holders usually subordinate to
creditors
? Variation across equity holders on seniority
? Exposed to maximum risk and return
Shareholders’ Equity
Reporting Capital Stock
Sources of increases in capital stock outstanding,
? Issuances of stock
? Conversion of debentures and preferred stock
? Issuances pursuant to stock dividends and splits
? Issuances of stock in acquisitions and mergers
? Issuances pursuant to stock options and warrants exercised
Sources of decreases in capital stock outstanding,
? Purchases and retirements of stock
? Purchases of treasury stock
? Reverse stock splits
Shareholders’ Equity
Contributed (or Paid-In) Capital — total financing received from
shareholders for capital shares; usually consists of two parts,
? Common (or Preferred) Stock — financing equal to par or
stated value;if stock is no-par,then equal to total financing
? Contributed (or Paid-In) Capital in Excess of Par or Stated
Value — financing in excess of any par or stated value
Components of Capital Stock
Shareholders’ Equity
Preferred Stock — capital stock with features not possessed by
common stock; typical preferred stock features include,
? Dividend distribution preferences
? Liquidation priorities
? Convertibility (redemption) into common stock
? Call provisions
? Sinking fund provisions
Common Stock — capital stock with ownership interest and
bearing ultimate risks and rewards (residual interests)
Two Types of Capital Stock
Shareholders’ Equity
Retained Earnings — earned capital of a company; reflects
accumulation of undistributed earnings or losses since inception;
retained earnings is the main source of dividend distributions
Cash and Stock Dividends
? Cash dividend — distribution of cash (or assets) to shareholders
? Stock dividend — distribution of capital stock to shareholders
Prior Period Adjustments — mainly error corrections of prior periods’
statements
Appropriations of Retained Earnings — reclassifications of retained
earnings for specific purposes
Restrictions (or Covenants) on Retained Earnings — constraints or
requirements on retention of retained earnings
Basics of Retained Earnings
CHAPTER
Analyzing Financing
Activities
A liability is a probable future payment of assets or
services that a company is presently obligated to
make as a result of past transactions or events,
Definition
Liabilities
Past Present Future
Because of a
past event..,
...for future
sacrifices,
… the
company
has a
present
obligation..,
Current (short-term)
Liabilities
Noncurrent (Long-
Term) Liabilities
Obligations whose
settlement requires use of
current assets or the
incurrence of another
current liability within one
year or the operating
cycle,whichever is
longer,
Obligations not
payable within one
year or the operating
cycle,whichever is
longer,
Liabilities
Classification
Operating
Liabilities
Financing
Liabilities
Obligations that arise from
operating activities--examples
are accounts payable,unearned
revenue,advance payments,
taxes payable,postretirement
liabilities,and other accruals of
operating expenses
Obligations that arise from
financing activities--examples
are short- and long-term debt,
bonds,notes,leases,and the
current portion of long-term debt
Liabilities
Alternative Classification
Liabilities
Disclosures for Current (Financing) Liabilities
n Compensating balance arrangements,including those not required by law
n Balance sheet segregation of (1) legally restricted compensating balances
and (2) unrestricted compensating balances related to long-term borrowing
arrangements if balances are computable at a fixed amount
n Short-term bank and commercial paper borrowings,including,
? Commercial paper borrowings separately listed in balance sheet
? Weighted-average interest rate and terms separately stated for
short-term bank and commercial paper borrowings
? Weighted-average interest rate,average outstanding borrowings,and
maximum month-end outstanding borrowings for short-term bank debt
and commercial paper combined for the period
n 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
Liabilities
Accounting-Based Liability Restrictions (Covenants)
Aim,Safeguard creditors’ investments
Common restrictions include,
n Dividend distribution restrictions
n Working capital restrictions
n Debt-to-equity ratio restrictions
n Seniority of asset claim restrictions
n Acquisition and divestment restrictions
n Liability issuance restrictions
Potential information sources,Liability
prospectus,annual report,SEC filings,and
creditor information services (e.g.,Moody’s)
Leases
Leasing Facts
Lease – contractual agreement between a
lessor (owner) and a lessee (user or renter)
that gives the lessee the right to use an asset
owned by the lessor for the lease term
MLP – minimum lease payments
(MLP) of the lessee to the lessor
according to the lease contract
Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all benefits
and risks of ownership—accounted for as an asset acquisition and a liability incurrence
by the lessee,and as a sale and financing transaction by the lessor
A lessee classifies and accounts for a lease as a capital lease if,
at its inception,the lease meets any of four criteria,
(i) lease transfers ownership of property to lessee by end of the lease term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the property
(iv) present value of rentals and other minimum lease payments at beginning of
lease term is 90% or more of the fair value of leased property less any related
investment tax credit retained by lessor
(2) Operating Lease Accounting For leases other than capital leases—the lessee
(lessor) accounts for the minimum lease payment as a rental expense (income)
Leases
Lease Disclosure and Off-Balance-Sheet Financing
Lease Disclosure
Lessee must disclose,(1) future MLPs separately for capital
leases and operating leases—for each of five succeeding years
and the total amount thereafter,and (2) rental expense for each
period an income statement is reported
Off-Balance-Sheet Financing
Off-Balance-Sheet financing is when a lessee structures a
lease so it is accounted for as an operating lease when the
economic characteristics of the lease are more in line with a
capital lease—neither the leased asset nor its corresponding
liability are recorded on the balance sheet
Leases
Frequency of Capital and Operating Leases
Capital Only
3%
Operating Only
43%
Both Capital &
Operating
44% Neither
10%
Leases
Accounting for Leases – An Illustration
Lease Facts
? A company leases an asset on January 1,
2000 -- it has no other assets or liabilities
? Estimated economic life of leased asset
is 5 years with no salvage value -- company will
depreciate the asset on a straight-line basis over its life
? Lease has a fixed non-cancelable term of 5 years
with annual MLPs of $2,505 paid at the end of each year
? Interest rate on the lease is 8% per year
Leases
Accounting for Leases – Illustration (continued)
Lease Amortization Schedule
Straight-line depreciation
$2,000 per year ([$10,000 - $0]/5 years)
Year
Beginning
Year
Liability
Interest and Principal
Components of MLP
Year-
end
Liability
Interest Principal Total
2000
2001
2002
2003
2004
Totals
$10,000
8,295
6,454
4,466
2,319
$ 800
664
517
358
186
$2,525
$ 1,705
1,841
1,988
2,147
2,319
$10,000
$ 2,505
2,505
2,505
2,505
2,505
$12,525
$8,295
6,454
4,466
2,319
0
Leases
Accounting for Leases – Illustration (continued)
Year
Operating Lease Capital Lease
2000
Rental Expense
Total Expense
$2,505
Depreciation Expense
Interest Expense
Total Expense
$2,000
800
$2,505
$2,800
2001
Rental Expense
Total Expense
$2,505
Depreciation Expense
Interest Expense
Total Expense
$2,000
664
$2,505 $2,664
2002
Rental Expense
Total Expense
$2,505
Depreciation Expense
Interest Expense
Total Expense
$2,000
517
$2,505 $2,517
2003
Rental Expense
Total Expense
$2,505 Depreciation Expense
Interest Expense
Total Expense
$2,000
358
$2,505 $2,358
2004
Rental Expense
Total Expense
$2,505 Depreciation Expense
Interest Expense
Total Expense
$2,000
186
$2,505 $2,186
Income Statement Effects of Lease Methods
Leases
Accounting for Leases – Illustration (continued)
Balance Sheet Effects of Lease Methods
Assets
Liabilities
Assets
Liabilities
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
$ 0
0
$ 0
$ (2,505)
0
$ (2,505)
$ (5,010)
0
$ (5,010)
$ (7,515)
0
$ (7,515)
$ (10,020)
0
$ (10,020)
$ (12,525)
0
$ (12,525)
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
Lease liab
Equity
Total
$ 0
0
$ 0
$ 0
(2,505)
$ (2,505)
$ 0
(5,010)
$ (5,010)
$ 0
(7,515)
$ (7,515)
$ 0
(10,020)
$ (10,020)
$ 0
(12,525)
$ (12,525)
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
Cash
Leased asset
Total
$ 0
10,000
$ 10,000
$ (2,505)
8,000
$ 5,495
$ (5,010)
6,000
$ 990
$ (7,515)
4,000
$ (3,515)
$ (10,020)
2,000
$ (8,020)
$ (12,525)
0
$ (12,525)
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
Lease liability
Equity
Total
$ 10,000
0
$ 10,000
$ 8,295
(2,800)
$ 5,495
$ 6,454
(5,464)
$ 990
$ 4,466
(7,981)
$ (3,515)
$ 2,319
(10,339)
$ (8,020)
$ 0
(12,525)
$ (12,525)
Operating Leases Capital Leases Date
Jan,1,2000
Dec 31,2000
Dec 31,2001
Dec 31,2002
Dec 31,2003
Dec 31,2004
Leases
Accounting for Leases – Illustration (continued)
Implicit Depreciation under Capital and Operating Leases
1500
1700
1900
2100
2300
2500
2000 2001 2002 2003 2004
Y e a r
D
e
p
r
e
c
i
a
ti
o
n
Ex
p
e
n
s
e
C a p i t a l
O p e r a t i n g
Leases
Effects of Lease Accounting
Impact of Operating Lease when Capital Lease is Apt,
? Operating lease understates liabilities—improves solvency ratios
such as debt to equity
? Operating lease understates assets—can improve return on
investment ratios
? Operating lease delays expense recognition—overstates income in
early term of the lease and understates income later in lease term
? Operating lease understates current liabilities by ignoring current
portion of lease principal payment—inflates current ratio & other
liquidity measures
? Operating lease includes interest with lease rental (an operating
expense)—understates both operating income and interest
expense,inflates interest coverage ratios,
understates operating cash flow,& overstates
financing cash flow
Leases
Converting Operating Leases to Capital Leases
Panel A,Estimate Average Remaining Lease Term
1997
Capital Operating Capital Operating
(1) MLP – Later years ($) 2,052 6,232 2,508 6,140
(2) MLP – Last reported year ($) 238 486 304 491
(3) Number of later years [(1) ?(2)] 9 13 8 13
(4) Add number of years reported 5 5 5 5
(5) Remaining lease term (years) [(3) + (4)] 14 18 13 18
1996
Panel B,Estimate Interest Rate on Capital Lease
(6) MLP in next year ($) 286 367
(7) Less principal component ($) 87 115
(8) Interest ($) [(6) – (7)] 199 252
(9) Total MLP ($) 3,355 4,186
(10) Less amount reflecting interest ($) 1,163 1,438
(11) Present value of lease ($) [(9) – (10)] 2,192 2,748
(12) Interest rate [(8) ? (11)] 9% 9%
Panel C,Estimate Average MLP per Year on Operating Lease
(13) Total MLP ($) 8,766 8,749
(14) Executory cost($) [27.6%* x (13)] 2,419 2,415
(15) MLP net executory cost ($) [(13) – (14)] 6,347 6,334
(16) Average remaining lease term (years) [5] 18 18
(17) Average MLP per year ($) [(15) ? (16)] 353 352
Panel D:Estimate Present Value of Operating Lease
(18) Present value of annuity for 18 years at 9% 8.756 8.756
(19) Present value of operating lease ($) [(18) x (17)] 3,091 3,082
Leases
Converting Operating Leases to Capital Leases--Continued
Panel E:Estimate Interest,Executory Costs,and Depreciation on Operating Lease Conversion
(20) Present value of operating lease ($)[19] 3091 3082
(21) Interest expense ($) [(19) x (12)] 278 277
(22) MLP in next year ($) 528 556
(23) Executory cost ($) [27.6%* x (22)] 146 153
(24) Depreciation expense ($) [(20) ? (16)] 172 171
Panel F:Estimate Effect of Operating Lease Conversion on Income Statement
(25) Increase in executory cost ($) [23] (146) (153)
(26) Increase in depreciation expense ($)[24] (172) (171)
(27) Decrease in lease rental expense ($) 528 556
(28) Effect on operating income ($) 210 232
(29) Increase in interest expense ($) [21] (278) (277)
(30) Effect on income before tax ($) (68) (45)
(31) Decrease in tax provision ($) [35% x (30)] 24 16
(32) Effect on Income after tax ($) (44) (29)
Panel G,Principal and Interest Components of Next Year’s Operating Lease MLP
(33) MLP in next year ($) [22] 528 556
(34) Interest ($) [21] 278 277
(35) Principal component ($) [(33) – (34)] 250 279
Panel H:Decompose Operating Lease Liability into Current and Noncurrent Components
(36) Total operating lease liability ($) [19] 3,091 3,082
(37) Current liability ($) [35] 250 279
(38) Noncurrent liability ($) [(36) – (37)] 2,841 2,803
1998 1997
1997 1996
Leases
Restated Financial Statements after Converting
Operating Leases to Capital Leases—Kmart
Income Statements
Before
After
Sales $32,183 $32,183
Operating expenses
(31,402)
(31,170)
Operating income before interest & taxes $781 $1,013
Interest expense
(412)
(689)
Income taxes (120) (104)
Net income
$249
$220
Balance Sheets
Before After Before After
Current assets
$ 7,476
$ 7,476
Current liabilities
$ 3,274
$ 3,524
Leased assets (net)
1,032
4,123
Lease obligations
1,179
4,020
Other assets
5,050
5,050
Other liabilities
3,671
3,671
-- -- Shareholders' equity 5,434 5,434
Total assets
$13,558
$16,649
Total liab,and equity
$13,558
$16,649
Postretirement Benefits
Defined -- Employer-provided benefit(s) to employees after
retirement
Pension benefits -- Employer-provided monetary pension benefits
to employees after retirement,e.g.,monthly stipend
until death
Other Postretirement Employee Benefits (OPEB) -- Employer-
provided non-pension (usually nonmonetary) benefits
after retirement,e.g.,health care and life insurance
Postretirement Benefits Facts
Two kinds of Postretirement Benefits
Postretirement Benefits
Pension Basics
Pension Plan – agreement with employer to provide pension benefits involving 3entities,
employer-who contributes to the plan; employee-who derives benefits; and pension fund
Pension Fund Assets – account administered by a trustee,independent of employer,
entrusted with responsibility of receiving contributions,investing them in a proper
manner,& disbursing pension benefits to employees
Vesting – specifies employee’s right to pension benefits regardless of whether employee
remains with the company or not; usually conferred after employee serves some
minimum period with the employer
Pension Plan Categories
Defined benefit – a plan specifying amount of pension benefits that employers promise
to provide retirees; employer bears risk of pension fund performance
Defined contribution – a plan specifying amount of pension contributions that employers
make to the pension plan; employee bears risk of pension fund performance
Focus of Pension Analysis
Defined benefit plans constitutes the major share of pension plans and are
the focus of analysis given their implications to future company
performance and financial position
Postretirement Benefits
Elements of the Pension Process
Employer
Investment
Benefits
(Disbursements) Contributions
Pension
Fund
Employee
Postretirement Benefits
Illustration of Pension Accumulation and
Disbursement for a Defined Benefits Plan
Funds required at employees’
retirement,
Present value of 10 payments of
$20,000 per annum with a
discount rate of 8% per annum
$134,200
Annual payments into the fund
required to accumulate to
$134,200 in 15 years with
a discount rate of 8%
per annum
10 years
Annual benefits of
$20,000 paid to
employee for 10 years
Postretirement Preretirement Retirement
Benefits =
$20,000 per annum
Contributions =
$4,942 per annum
15 years
Postretirement Benefits
Accumulated benefit obligation (ABO) – actuarial present value of pension benefits payable
to employees at retirement based on their current compensation and service to-date
Project benefit obligation (PBO) – actuarial estimate of future pension benefits payable to
employees on retirement based on expected future compensation and service to-date
Vested benefit obligation (VBO) – actuarial estimate of future pension benefits payable to
employees at retirement based on current compensation & benefits vested to employees
Funded Status – Difference between the value of the plan assets and the PBO
Note,Plan is overfunded (underfunded) when value of plan assets exceeds (is less than) PBO
Net Economic Position – PBO less the value of the plan assets
Three Alternative Definitions of Pension Obligation
Relation between Plan Assets and Funded Status
Postretirement Benefits
Economic pension cost -- net cost arising from changes in net economic position
for a period; includes both recurring and nonrecurring components along with return
on plan assets
Recurring pension costs consist of two components,
Service cost – actuarial present value of pension benefit earned by employees
Interest Cost – increase in projected benefit obligation arising when pension
payments are one-period closer to being made; computed by multiplying
beginning-period PBO by the discount rate
Nonrecurring pension costs consist of two components,
Actuarial Gain or Loss – change in PBO that occurs when one or more
actuarial assumptions are revised in estimating PBO
Prior Service Cost – effects of changes in pension plan rules on PBO
Return on plan assets,
Actual return on plan assets – pension plan’s earnings,consisting
of investment income—capital appreciation and dividend and interest
received,less management fees; plus realized and unrealized
appreciation (or minus depreciation) of other plan assets
Economic Pension Cost
Postretirement Benefits
Pension Accounting Example – The Facts
? A pension plan with a single employee,J,Smith,who joins the plan
exactly 5 years ago on January 1,1996; Smith is due to retire on
Dec,31,2020,and is expected to live for 10 years after retirement
? J,Smith’s current compensation is $10,000 per year; actuarial
estimates indicate compensation is expected to increase 4% per year
over the next 20 years
? Pension plan specifies the following formula for determining an
employee's pension benefit,―Annual pension is equal to one week’s
compensation at time of retirement for each year with the plan‖;
employees vest 4 years after joining the plan
? At Dec,31,2000,the fair value of assets in the pension fund is $2,000;
in 2001,the employer contributes $200 to the pension fund
? Return on pension assets is 22% in 2001; long-term
return is expected to be 10% per year
? Discount rate is 7% per year
Postretirement Benefits
Pension Accounting Example – Pension Obligation
Determining Pension Obligations under Different Assumptions—J,Smith Example
Actual Projected Projected
At Dec,31,2020 (Retirement)
Salary per year
$10,000
$21,911
$21,911
$26,533
$26,533
Pension per year 962 2,107 2,528 3,061 4,592
Value of pension
6,753
14,798
17,757
21,503
32,254
At Dec,31,2000
Present value of pension
1,745
3,824
At Dec,31,2001
Present value of
pension
4,091
4,910
5,946
8,919
2000
Formula
2001
Formula
Assumption Change
Actuarial Plan
Vested benefits (VBO) $1,745
+ Benefits not vested 0
= Accumulated benefit obligation (ABO) $1,745
+ Effect of estimated increase in compensation 2,079
= Projected benefit obligation (PBO) $3,824
Note,PBO ? ABO ? VBO
Postretirement Benefits
Pension Accounting Example – Economic Pension Cost
Recurring costs for J,Smith example,
? PBO increases by $819 in 2001 because Smith works an extra year – hence,the term service cost
? Present value increases from $3,824 in 2000 to $4,092 in 2001—this $267 increase arises from the
time value of money – hence,the term interest cost (also computed as 7% x $3,824)
Nonrecurring costs for J,Smith example,
? Actuarial change (4% to 5% growth) increases estimated compensation at retirement from $21,911
to $26,533 and increases the PBO at end of 2001 by $1,036 (from $4,910 to $5,946) — an actuarial
loss
? Pension formula changes to one-and-one-half week’s compensation per year of service results in
the pension benefit per year increasing by 50% from $3,061 to $4,592,which increases PBO by
$2,973 ($8,919 - $5,946) — a prior service cost
Return on plan assets for J,Smith example,
? Actual return on plan assets is
$440 (22% of $2,000)
In sum,net economic pension
cost for the J,Smith example is,
Recurring costs,
Service cost $ 819
Interest cost 267
Nonrecurring costs,
Actuarial gain or loss 1,036
Prior service cost 2,973
Gross economic pension cost $ 5,095
Less return on plan assets (440)
Net economic pension cost $ 4,655
Postretirement Benefits
Pension Accounting Example – Articulation of Net Economic Position
and Economic Pension Cost,J,Smith Example
Pension Obligation
Beginning balance 3,824
Service cost 819
Interest cost 267
Actuarial gain or loss 1,036
Benefits paid 0 Prior service cost 2,973 5,095
Ending balance 8,919
Pension Asset
Beginning balance 2,000
Contributions 200
Return on assets 440 Benefits paid 0
Ending balance 2,640
Net Economic Position (Funded Status)
Contributions 200 Beginning balance 1,824
Return on assets 440 Gross pension cost 5,095
Ending balance 6,279
Economic Pension Cost
Recurring costs
Service cost 819
Interest cost 267
Nonrecurring costs
Actuarial gain or loss 1,036
Prior service cost 2,973
Gross pension cost 5,095
Less return on assets (440)
Net pension cost 4,655
Postretirement Benefits
Reported pension cost -- defers recognition of economic effects vis-à-vis economic pension
cost; each deferral (and amortization) follows,
Expected return on plan assets reduces reported pension cost -- gains and losses
from the difference between expected and actual returns are deferred and amortized to
reduce volatility; expected return on plan assets is computed by multiplying the expected
long-term rate of return on plan assets by the market value of plan assets at the
beginning of the period,
Deferral and amortization of net gains and losses arise from the delayed recognition of
deviations from expectations regarding both pension obligations and pension
assets—net gains and losses consist of (1) the difference between actual and expected
return on plan assets and (2) actuarial gains and losses
Deferral and amortization of prior service cost is the process of delaying recognition of
prior service cost effects on reported pension cost (through amortization)
Deferral and amortization of transition loss or gain arise when a plan is initially adopted—
amortized over the average remaining service period of qualified employees
Net Reported Position -- is the cumulative reported pension cost net of cumulative
contributions—for this reason,the liability (or asset) reported in the balance sheet is called
Accrued (or Prepaid) Pension Cost,
Reported (or Net Periodic) Pension Cost
Net Reported Position (or Reported Status)
Postretirement Benefits
? Expected return on plan assets — $200 (10% of $2,000) in the J,Smith example
? Deferral and amortization of net gains and losses — deferred net gains or losses is
$796 ($1,036 actuarial loss less $240 nonrecurring return),of which $21 (1/20 of the
excess of $796 over 10% of $3,824) is amortized in 2001 for the J,Smith example
? Deferral and amortization of prior service cost — prior service cost of $2,973 is
deferred and $149 (1/20 x $2,973) is amortized in the J,Smith example
? Deferral and amortization of transition loss or gain — no transition gain or loss in the
J.Smith example
Pension Accounting Example – Reported Pension Cost
Economic pension cost Smoothing Reported pension cost*
Service cost $ 819 $ — Service cost $ 819
Interest cost 267 — Interest cost 267
Actual return (440) (240) Expected return (200)
Actuarial gain or loss 1,036 1,036 —
Net gain or loss — $ 796 —
Prior service cost 2,973 2,973 —
Amortization,
(21) Net gain or loss 21
(149) Prior service cost 149
Total $ 4,655 $ 3,612 $ 1,056
* This also is referred to as Net Periodic Pension Cost,
Economic Pension Cost versus Reported Pension Cost—J,Smith Example
Postretirement Benefits
Pension Accounting Example – Net Reported Position
(Reported Status)
Reported Status of Pension Fund in Balance Sheet— J,Smith Example
Projected benefit obligation $(8,919)
Plan assets 2,640
Funded status $(6,279)
Unrecognized transition asset 0
Unrecognized net gain or loss 775
Unrecognized prior service cost 2,824
Accrued pension cost (reported status) $(2,680)
Postretirement Benefits
Distribution of PBO,Plan Assets and Funded Status - Evidence
M e a n
0 1 00 200 300 400 500
PBO
A s s e t s
F u n d e d
S t a t u s
$ M i l l i o n
Postretirement Benefits
Distribution of PBO,Plan Assets and Funded Status as % of Total
Assets - Evidence
M e a n
0 5 10 15 20
PBO
A s s e t s
F u n d e d S t a t u s
P e r c e n t a g e
Postretirement Benefits
(similar to pension accounting)
Net cost reporting – consequences of events and transactions affecting OPEB plans are
reported as a single amount—this amount includes at least three components,(1) present
value of the accrued cost of deferred compensation promised in exchange for employee
service,(2) interest cost accruing from the passage of time until these benefits are paid,and (3)
returns from the investment in the plan’s assets
Delayed recognition -- certain changes in postretirement obligations,including those
arising as a result of a plan initiation or amendment,and certain changes in the value of plan
assets that are set aside to meet these obligations,are recognized through a process of
deferral and amortization
Offsetting -- plan assets restricted for payment of postretirement benefits offset the
accumulated postretirement benefit obligation in determining amounts recognized in the
balance sheet
Accumulated Postretirement Benefit Obligation (APBO) – employer’s OPEB obligation
Expected Postretirement Benefit Obligation (EPBO) – total actuarially determined costs
of providing future OPEB,recognized over the employee’s expected service period
Note,APBO is the portion of EPBO ―earned‖ by employee services as of a given date
(accumulated benefits recognized to-date),Funded status of OPEB is the difference
between APBO and the value of OPEB plan assets
Features of OPEB Accounting
Language of OPEB Accounting
Postretirement Benefits
Reported OPEB cost includes these components,
Service costs — actuarial present value of OPEB ―earned‖ by employees during the
period; portion of EPBO attributable to the current year
Interest costs — imputed growth in APBO during the period using an assumed discount
rate; interest is compounded because APBO is recognized on a present value basis
Amortization of net gains and losses — amounts arising when actual experience of
the plan differs from initial estimates or,alternatively,if the expected return on assets
differs from actual return; these amounts are deferred and amortized
Amortization of prior service costs — costs arising from plan amendments that
change benefits and are attributed to employee service rendered prior to the amendment date;
these costs are deferred and amortized
Amortization of transition obligation — costs arising from initial adoption,called
transition obligation,are identified and measured as the difference between APBO and plan
assets (if any) minus any postretirement liabilities previously recorded; either immediately
recognize the transition obligation with a charge to income or amortize it
Expected return on plan assets — this return reduces the net annual postretirement
expense if the plan is funded; the difference between actual and expected return is deferred
and included in the unrecognized portion of net gains and losses
Reported OPEB Cost
Postretirement Benefits
Pension and Other Postretirement Benefits Disclosures—Allied Signal
Other
Pension Postretirement
Benefits Benefits
-----------------------------------------
1998 1997 1998 1997
-----------------------------------------
Change in benefit obligation
Benefit obligation at January 1 $ 5,941 $ 5,419 $ 1,634 $ 1,533
Service cost 139 124 21 21
Interest cost 422 412 103 111
Plan amendments 20 -- 5 (121)
Actuarial (gains) losses 352 470 (27) 188
Acquisitions 91 -- -- 16
Benefits paid (447) (454) (127) (114)
Settlements and curtailments (65) (8) (32) --
Translation effect 2 (22) -- --
----------------------------------------------------------------------------------------------
Benefit obligation at December 31 6,455 5,941 1,577 1,634
----------------------------------------------------------------------------------------------
Change in plan assets
Fair value of plan assets at January 1 6,428 5,843 -- --
Actual return on plan assets 853 1,018 -- --
Company contributions 46 40 -- --
Participants' contributions -- 1 -- --
Acquisitions 63 -- -- --
Settlements (48) (9) -- --
Benefits paid (447) (454) -- --
Translation effect (10) (11) -- --
----------------------------------------------------------------------------------------------
Fair value of plan assets at December 31 6,885 6,428 -- --
----------------------------------------------------------------------------------------------
Postretirement Benefits
Pension and Other Postretirement Benefits Disclosures—Allied Signal
(continued)
Funded status of plans 430 487 (1,577) (1,634)
Unrecognized transition (asset) (22) (26) -- --
Unrecognized net (gain) loss (569) (659) (99) (77)
Unrecognized prior service cost 102 93 (188) (221)
----------------------------------------------------------------------------------------------
(Accrued) benefit cost $ (59) $ (105) $(1,864) $(1,932)
=============================================================================================
Assumptions as of December 31
Discount rate 6.75% 7.25% 6.75% 7.25%
Assumed rate of return on plan assets 10.00% 10.00% -- --
Assumed annual rate of compensation increase 5.00% 5.00% -- --
=============================================================================================
The projected benefit obligation,accumulated benefit obligation and fair value of plan assets for the pension plans with
accumulated benefit obligations in excess of the fair value of plan assets were $328,$281 and $43 million,respectively,
as of December 31,1998 and $285,$246 and $31 million,respectively,as of December 31,1997,
Postretirement Benefits
Pension and Other Postretirement Benefits Disclosures—Allied Signal
(continued)
Net periodic pension and other postretirement benefit costs include the following components,
Other
Pension Postretirement
Benefits Benefits
------------------------------------------------------
1998 1997 1996 1998 1997 1996
------------------------------------------------------
Service cost $139 $124 $133 $21 $21 $ 24
Interest cost 422 412 398 103 111 111
Assumed return on plan assets (580) (519) (458) -- -- --
Amortization of transition asset (4) (7) (7) -- -- --
Amortization of prior service cost 12 11 11 (19) (15) (10)
Recognition of actuarial (gains) losses 1 1 1 (2) (9) (4)
---------------------------------------------------------------------------------------------------
Benefit cost (credit) $(10) $22 $78 $103 $108 $121
==================================================================================================
Assumed health care cost trend rates have a significant effect on the amounts reported for the retiree medical plans,A one-
percentage-point change in assumed health care cost trend rates would have the following effects,
One-Percentage- One-Percentage-
Point Increase Point Decrease
--------------------------------------
Effect on total of service
and interest cost components $11 $(10)
Effect on postretirement
benefit obligation $122 $(109)
===============================================================================
Postretirement Benefits
Economic and Reported Postretirement Costs—Allied Signal
Pension
Service cost
Interest cost
Return on assets
Actuarial (gains) losses
Prior service cost
Transition asset
Net pension cost
OPEB
Service cost
Interest cost
Return on assets
Actuarial (gains) losses
Prior service cost
Transition asset
Net cost
Total
Service cost
Interest cost
Return on assets
Actuarial (gains) losses
Prior service cost
Transition asset
Net cost
Economic
$ 139
422
(853)
352
20
_0
$ 80
$ 21
103
0
(27)
5
_0
$ 102
$ 160
525
(853)
325
25
0
$ 182
Deferred
$ 0
0
$ 273
(352)
(20)
_0
$ (99)
$ 0
0
0
27
(5)
_0
$ 22
$ 0
0
273
(325)
(25)
0
$ (77)
Amortized
$ 0
0
0
1
12
(4)
$ 9
$ 0
0
0
(2)
(19)
_
$ (21)
$ 0
0
0
(1)
(7)
(4)
$ (12)
Reported
$ 139
422
(580)
1
12
(4)
$ (10)
$ 21
103
0
(2)
(19)
0
$ 103
$ 160
525
(580)
(1)
(7)
(4)
$ 93
Postretirement Benefits
Reconciliation of Economic and Reported Changes—Allied Signal
Economic cost
$ (80)
$(102) $ (182)
Translation effect
(12)
0 (12)
Acquisition and settlements—net
(11) 32 21
Benefits paid
0 127 127
Contributions
46 0 46
Change in funded position (economic)
$ (57) $ 57 $ 0
Deferred return
$(273) $ 0 $ (273)
Deferred actuarial change
352 (27) 325
Deferred prior service cost
20 5
25
Amortization
(9)
21
12
Other
13
12
25
Change in unrecognized
$ 103
$ 11
$ 114
Pension OPEB Total
Change in accrued cost (reported)
$ 46 $ 68 $ 114
Liabilities and Equity
Current liabilities $ 5,185 $ 5,185 $ 4,436 $ 4,436
Noncurrent liabilities 5,078 4,302 4,885 3,995
Shareholders’ equity 5,297 6,073 4,386 5,276
$15,560 $15,560 $13,707 $13,707
Postretirement Benefits
Financial Statement Effects of Postretirement Benefit Adjustments
— Allied Signal
Panel A,Income Statement (1998)
Reported Economic
Sales $15,128 $15,128
Operating expenses (13,166) (13,255)
Operating income $ 1,962 $ 1,873
Interest and other expenses (19) (19)
Income before taxes $ 1,943 $ 1,854
Income taxes (612) (581)
Net income $ 1,331 $ 1,273
Panel B,Balance Sheet 1998 1997
Reported Economic Reported Economic
Assets
Current assets $ 5,593 $ 5,593 $ 5,573 $ 5,573
Noncurrent assets 9,967 9,967 8,134 8,134
$15,560 $15,560 $13,707 $13,707
Postretirement Benefits
Effect of Actuarial Assumptions on Benefit Obligation and Cost
Assumption
Direction
of Change
Direction of Effect on
Economic*
Reported*
Position
Cost Position
Cost
Discount Rate
+
-
+
-
-
+
Indefinite
Indefinite
Indefinite
Indefinite
Expected
Return
+
-
No effect
No effect
No effect
No effect
+
-
-
+
Growth Rate**
+
-
-
+
+
-
-
+
+
-
Notes,* Economic position refers to funded status
and reported position refers to accrued
benefit or cost,
** Growth rate pertains to both compensation
and health care costs,
Postretirement Benefits
Frequency Distribution of Actuarial Assumptions
D i s c o u n t R a t e
0 10 20 30 40 50
6 o r l e s s
6, 5
7
7, 5
8
8, 5 o r m o r e
D
i
s
c
o
u
n
t
R
a
t
e
%
P e r c e n t a g e
Postretirement Benefits
Frequency Distribution of Actuarial Assumptions
E x p e c t e d R a t e o f R e t u r n
0 10 20 30
6, 5 o r l e s s
7, 5
8, 5
9, 5
1 0, 5
E
x
p
e
c
t
e
d
R
a
t
e
o
f
R
e
t
u
r
n
%
P e r c e n t a g e
Postretirement Benefits
Frequency Distribution of Actuarial Assumptions
C o m p e n s a t i o n I n c r e a s e
0 5 10 15 20 25 30 35 40
4, 5 o r l e s s
5
5, 5
6
6, 5
7
7, 5
8
C
o
m
p
e
n
s
a
ti
o
n
G
r
o
w
th
%
Pe r c e n ta g e
Contingencies and Commitments
Contingencies -- potential losses and gains whose resolution depends on
one or more future events,
Contingent liabilities -- contingencies with potential claims on resources
-- to record a contingent liability (and loss) two
conditions must be met,
(i) probable an asset is impaired or a liability
incurred,and
(ii)the amount of loss is reasonably estimable;
-- to disclose a contingent liability (and loss) there
must be at least a reasonable possibility of
incurrence
Contingent assets -- contingencies with potential additions to resources
-- a contingent asset (and gain) is not recorded until
the contingency is resolved
-- a contingent asset (and gain) can be disclosed if
probability of realization is high
Basics of Contingencies
Contingencies
should be,,,
Frequency of Contingent Liabilities
Contingencies and Commitments
0 20 40 60 80 100
L i t i g a t i o n
E n v i r o n m e n t a l
I n s u r a n c e
T a x
G o v e r m e n t a l
O t h e r
P e r c e n t
Contingencies and Commitments
Sources of useful information,
Notes,MD&A,and Deferred Tax Disclosures
Useful analyses,
? Scrutinize management estimates
? Analyze notes regarding contingencies,including
Description of contingency and its degree of risk
Amount at risk and how treated in assessing risk exposure
Charges,if any,against income
? Recognize a bias to not record or underestimate contingent liabilities
? Beware of big baths — loss reserves are contingencies
? Review SEC filings for details of loss reserves
? Analyze deferred tax notes for undisclosed provisions for future losses
Note,Loss reserves do not alter risk exposure,
have no cash flow consequences,and do not
provide insurance
Analyzing Contingencies
0 20 40 60 80 100
D i v i d e n d R e s tr i c ti o n s
C a p i ta l Ex p e n d i tu r e s
A c q u i s i ti o n R e l a te d
Sa l e s A g r e e m e n ts
Pe r c e n t
Contingencies and Commitments
Commitments -- potential claims against a company’s resources due to future
performance under contract
Basics of Commitments
Frequency of Commitments
Off-Balance-Sheet Financing
Sources of useful information,
Notes and MD&A and SEC Filings
Useful analyses,
? Scrutinize management communications and press releases
? Analyze notes regarding commitments,including
Description of commitment and its degree of risk
Amount at risk and how treated in assessing risk exposure
Contractual conditions and timing
? Recognize a bias to not disclose commitments
? Review SEC filings for details of commitments
Analyzing Commitments
Off-Balance-Sheet Financing
Off-Balance-Sheet Financing -- is the non-recording of financing obligations
Motivation
To keep debt off the balance sheet—part of ever-changing landscape,where as one
standard tries to better reflect obligations from a certain off-balance-sheet
financing transaction,there are new and innovative means to take its place
Transactions sometimes used as off-balance-sheet financing,
? Operating leases that are indistinguishable from capital leases
? Through-put agreements,where a company agrees to run
goods through a processing facility
? Take-or-pay arrangements,where a company guarantees to pay
for goods whether needed or not
? Certain joint ventures and limited partnerships
? Product financing arrangements,where a company sells and agrees to
either repurchase inventory or guarantee a selling price
? Sell receivables with recourse and record them as sales rather than liabilities
? Sell receivables as backing for debt sold to the public
? Outstanding loan commitments
Basics of Off-Balance-Sheet Financing
GAAP
Off-Balance-Sheet Financing
Sources of useful information,
Notes and MD&A and SEC Filings
Companies disclose the following info about financial
instruments with off-balance-sheet risk of loss,
? Face,contract,or principal amount
? Terms of the instrument and info on its credit and market risk,cash
requirements,and accounting Loss incurred if a party to the
contract fails to perform
? Collateral or other security,if any,for the amount at risk
? Info about concentrations of credit risk from a counterparty or
groups of counterparties
Useful analyses,
? Scrutinize management communications and press releases
? Analyze notes about financing arrangements
? Recognize a bias to not disclose financing obligations
? Review SEC filings for details of financing arrangements
Analysis of Off-Balance-Sheet Financing
Shareholders’ Equity
Basics of Equity Financing
Equity Analysis — involves analyzing equity characteristics,including,
? Classifying and distinguishing different equity sources
? Examining rights for equity classes and priorities in liquidation
? Evaluating legal restrictions for equity distribution
? Reviewing restrictions on retained earnings distribution
? Assessing terms and provisions of potential equity issuances
Equity Classes — two basic components,
? Capital Stock
? Retained Earnings
Equity — refers to owner (shareholder)
financing; its usual characteristics include,
? Reflects claims of owners (shareholders) on
net assets
? Equity holders usually subordinate to
creditors
? Variation across equity holders on seniority
? Exposed to maximum risk and return
Shareholders’ Equity
Reporting Capital Stock
Sources of increases in capital stock outstanding,
? Issuances of stock
? Conversion of debentures and preferred stock
? Issuances pursuant to stock dividends and splits
? Issuances of stock in acquisitions and mergers
? Issuances pursuant to stock options and warrants exercised
Sources of decreases in capital stock outstanding,
? Purchases and retirements of stock
? Purchases of treasury stock
? Reverse stock splits
Shareholders’ Equity
Contributed (or Paid-In) Capital — total financing received from
shareholders for capital shares; usually consists of two parts,
? Common (or Preferred) Stock — financing equal to par or
stated value;if stock is no-par,then equal to total financing
? Contributed (or Paid-In) Capital in Excess of Par or Stated
Value — financing in excess of any par or stated value
Components of Capital Stock
Shareholders’ Equity
Preferred Stock — capital stock with features not possessed by
common stock; typical preferred stock features include,
? Dividend distribution preferences
? Liquidation priorities
? Convertibility (redemption) into common stock
? Call provisions
? Sinking fund provisions
Common Stock — capital stock with ownership interest and
bearing ultimate risks and rewards (residual interests)
Two Types of Capital Stock
Shareholders’ Equity
Retained Earnings — earned capital of a company; reflects
accumulation of undistributed earnings or losses since inception;
retained earnings is the main source of dividend distributions
Cash and Stock Dividends
? Cash dividend — distribution of cash (or assets) to shareholders
? Stock dividend — distribution of capital stock to shareholders
Prior Period Adjustments — mainly error corrections of prior periods’
statements
Appropriations of Retained Earnings — reclassifications of retained
earnings for specific purposes
Restrictions (or Covenants) on Retained Earnings — constraints or
requirements on retention of retained earnings
Basics of Retained Earnings
