lecture 5 liabilities
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Reporting and Analyzing Nonowner Financing Activities
What is a Liability?
“Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”
Present obligations. Unavoidable obligations. Transaction or event must have already
happened.
The Balance Sheet Equation
Assets = Liabilities + Equity Investments in Non-owner Owner the business financing financing
What you own = How you paid for it$$ Borrowed by the company
$$ Invested by owners or$$ Earned by the company
Stuff Purchased by the company
Business Background
The mix of debt and equity for a company is called the capital structure:
Debt - funds from creditors
Equity - funds from owners
Liabilities Measurement
Liabilities are measured at their current cash equivalentcurrent cash equivalent (the amount a creditor would accept to cancel the
debt) at the time incurred.Maturity < 1 year Maturity > 1 year
Current Liabilities
Noncurrent Liabilities
Current Liabilities
Accruals
The term accrue means to build up gradually. Accruals refer to amounts in asset and liability
accounts that build up over time. Adjustments to record accruals are made at
the end of an accounting period.
End of accounting period.
Cash receivedor paid.
Revenues earnedor
expense incurred
Examples include interest earned during the period or wages earned by employees but not yet paid.
Examples include interest earned during the period or wages earned by employees but not yet paid.
Accruals
Warranty Accrual
105,106
Deferred revenue is recorded.
Deferred Revenues
Deferred revenue is a
liability account.
Deferred revenue is a
liability account.
Cash is collected from the customer before the revenue is actually earned.
Cash is received in advance.
Earned revenue is recorded.
As the earnings process is completed
. . .
Deferred Revenues
Cash is collected from the customer before the revenue is actually earned.
Deferred revenue is recorded.
Cash is received in advance.
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Pensions 101
Plan Assets
-
Projected Benefits
=
“Funded Status”
Pensions 101Plan Assets – Projected Benefits = “Funded Status”
Plan Assets:Fair Value at Beginning
+ Actual Return on Assets
+ Employer Contribution
- Benefit Payments
= Fair Value at End Straight forward, no judgment
Pensions 101Plan Assets – Projected Benefits = “Funded Status”
Projected Benefits:
Liability at Beginning+Service Cost : PV effect of 1 more year of employee service means higher benefit
when retire
+Interest Cost : PV effect of employees 1 year closer to retirement
+Actuarial Losses : PV effect of actuarial assumptions, e.g. life span
- Benefits Paid
= Liability at End Highly judgmental - Effected by assumptions on
Discount rate Interest rate Actuarial assumptions
HP Pensions
Footnote 16 Page 135 - 143
Example: Notes Payable
Current Portion of Long-Term Debt
Any portion of a note payable that is due within one year, or the operating cycle,
whichever is longer.
Total Notes
Payable
Current Notes Payable
Noncurrent Notes Payable
Sources for Long-Term Loans
Relatively small debt needs can be filled from single sources.
Relatively small debt needs can be filled from single sources.
BanksBanks
Insurance CompaniesInsurance Companiesoror Pension PlansPension Plansoror
Sources for Publicly Issued Debt
Significant debt needs are often filled by issuing bonds to
the public.
Significant debt needs are often filled by issuing bonds to
the public.
CashBonds
Understanding the Business
Advantages of bonds: Bonds are debt, not equity, so
the ownership and control of the company are not diluted.
Interest expense is tax-deductible.
The low interest rates on bonds allow for positive financial leverage.
Advantages of bonds: Bonds are debt, not equity, so
the ownership and control of the company are not diluted.
Interest expense is tax-deductible.
The low interest rates on bonds allow for positive financial leverage.
Disadvantages of bonds:
Risk of bankruptcy; the debt must be paid back regularly, or creditors will force legal action.
Negative impact on cash flows.
Disadvantages of bonds:
Risk of bankruptcy; the debt must be paid back regularly, or creditors will force legal action.
Negative impact on cash flows.
Characteristics of Bonds Payable
$ Bond Issue Price $
Bond Certificate
At Bond Issuance Date
Bonds payable are long-term debt for the issuing company.
Company Issuing Bonds
Company Issuing Bonds
Investor Buying Bonds
Investor Buying Bonds
Characteristics of Bonds Payable
PeriodicInterest Payments
At STATED RATE$ $
Face Value Payment at End of Bond Term
PAR VALUE$ $
Company Issuing Bonds
Company Issuing Bonds
Investor Buying Bonds
Investor Buying Bonds
Bond Issuance
Company decides what the stated rate will be on the bond – What rate of interest their bond will pay
This is often different from the market rate of interest – What the market is paying in general for like credit risks
Why the Difference in Rates??
Companies use rate to manage cash flow Gold Mine example
Need lots of money to dig the mine Will take 5 years to get to the gold Little money to pay interest in the meantime Can issue a bond with less interest than
market and still get their money “Discounted” Bond
Discounted Bond
Issuer offers to pay LESS than market rate of interest
Bond purchaser agrees in turn to pay LESS up front to the issuing company
Why the Difference in Rates??
Companies use rate to manage cash flow Biotech Example
Need $$ to develop new drug, 80% chance they will succeed
Have lots of money from other drugs to pay interest
Can offer above market interest to get people to buy the bonds, cover the risk
“Premium” Bond
Premium Bond
Issuer offers to pay MORE than market rate of interest
Bond purchaser agrees in turn to pay MORE up front to the issuing company
Debt Ratings: drive the market rate used for the calculation
lower rating = more discounting
Factors Affecting Bond Ratings
Selected Financial Ratios for Various Bond Rating Classes
123
124
Off Balance Sheet Liabilities
GAAP allows certain liabilities to be “off balance sheet”, not included in liabilities Contingent Liabilities Operating Leases SPE Liabilities
Contingent Liabilities
Contingent on some future event or activity; examples include warranties and lawsuits.
Alternative treatments for loss contingencies Ignore Disclose in footnotes Estimate and put on Balance Sheet
Changes in estimate may be made in subsequent periods, when future event is concluded.
Contingent Liabilities
ReasonablyProbability of Occurrence possible Remote
Yes No
Accounting Treatment On Financial IgnoreStatements
Highly Probable
Estimable?
Disclose in footnotes only
...highly judgmental disclosure rules
Capital Vs. Operating Leases
GAAP identifies two different approaches in the reporting of leases by the lessee:
Capital lease method Operating lease method
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Capital Leases
Must treat a lease as a capital lease if it meets any one of these tests:
1. Ownership is transferred at end of lease
2. Bargain purchase option at end of lease
3. Term is > 75% of life of asset
4. Present Value of payment stream > 90% of fair value of asset
Capital Vs. Operating Leases
144
SPE
SPE – Special Purpose Entities Separate “related” companies holding debt If properly structured, SPE is not
consolidated with parent company results Control Financing
SPE: Asset Securitization
Sponsoring company forms a subsidiary that is capitalized entirely with equity creates a bankruptcy remote transaction
Subsidiary purchases assets from the sponsoring company and sells them to a securitization (off-balance-sheet) trust (the SPE), which purchases the assets using borrowed funds.
Cash flows from the acquired assets are used by the SPE to repay its debt.
Ford Motor Credit SPE
Enron takes SPE’s to a new level
Next Week
Financing provided by owners:
Shareholders Equity