FINANCIAL STATEMENT ANALYSIS SPRING 2006 CLASS

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FINANCIAL STATEMENT ANALYSISSPRING 2006CLASS
7LIABILITY ANALYSIS
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AGENDA
Why analyze liabilities? Basic liability FSA
issues Advanced liability FSA problems Manufacture
d Homes case
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WHY ANALYZE LIABILITIES?
GENERAL FSA MOTIVATION

• To improve the quality of an answer to a business
  question.

SPECIFIC FSA MOTIVATIONS

• LIABILITIES are a huge part of firms economic
  B/S.
• Operating financial (advanced ROCE analysis).
• Represent promised future OUTFLOWS of CASH,
  clearly affecting firms ability to be a going
  concern.
• Managers face strong incentives to
• Keep liabilities off-B/S
• If on-B/S, understate their magnitude

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TILT or TENDENCY in LIABILITIES
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TILT or TENDENCY in LIABILITIES
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No joke PARMALATs TILT (FRAUD!)

• 2002 ? Italys 8th largest company.
  Multinational dairy conglomerate. Success story.
  Operations in 30 countries.
• Oct. 2003 ? Parmalat reports its regular Q3
  data (9/30/03). It shows net debt of about 1.8
  bn.
• Dec. 2003 ? Scandal erupts into the open.
  Parmalat admits that it did not have a nearly 4
  bn. Bank of America account as it had earlier
  stated it was a FORGERY. And

• Jan. 2004 ? Actual net debt is about 14.3 bn!
  (X 8!)
• Core earnings Jan.-Sept. 2003 121 m. (not
  651 m.)

• See www.economist.com www.comer.org/2004/fraud.h
  tm

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AGENDA
Why analyze liabilities? Basic liability FSA
issues Advanced liability FSA problems Manufacture
d Homes case
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LIABILITY RECOGNITION CRITERIA
First criterion
Second criterion
An economic obligation has been incurred as a
result of benefits being received in the past
The amount timing of the obligation is
measurable with reasonable certainty
RECOGNIZE a LIABILITY
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WHERE DO VANILLA LIABILITIES COME FROM?
WAY
DESCRIPTION
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BASIC LIABILITY FSA PROBLEMS
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1. Has a liability actually been incurred?
e.g., Legal contingencies

• 1. SFAS No. 5 (1975) sets the rules
• A contingency (viz., economic liability) must be
  recognized on B/S when it is both probable and
  reasonably estimable
• If reasonably possible, do not recognize on
  B/S. Instead, disclose in footnotes.
• If remote, do not mention in financial
  statements.
• Creates BIAS NOISE in B/S and in I/S.

Problem Strategic incentives to misestimate
what is probable vs. reasonably possible vs.
remote
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2. Can the liability be reasonably measured?
e.g., Environmental remediation costs

• SEC, FASB, GAAS, PCAOB all have a say!
• Hot political / societal issue (though fading
  now )
• Tough measurement issues due to
• FERCLA (Superfund) joint several liability
• changing technology managerial learning
• 4. Creates big BIAS NOISE in B/S and in I/S.

Problems Big strategic incentives to
misestimate Genuine difficulties in knowing
true economic liability
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3. What if liabilitys fair value has changed?
e.g., Troubled debt restructurings

• A creditor grants concessions to a debtor
• Tanked Co. owes Wachovia 1 million
• Wachovia agrees that Tanked only has to repay
  0.4 million of original 1 million.
• Tanked recognizes gain on I/S of 0.6 million !
• May also involve change of terms.
• Big impacts on B/S and I/S at restructuring
  date.

Problems Watch outfirms that are doing
really badly can report big amounts of net
income!
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Example Global Crossing in fiscal 2003

• www.sec.gov 8-K, press release filed dated
  3/11/04
• Filed Ch. 11 bankruptcy on 1/28/02.
• Emerged from bankruptcy on 12/9/03.
• As part of rebirth, creditors get only pennies on
  the dollar. Old stockholders get zip, zero,
  zilch.
• GAAP ? Fresh Start accounting ? large gain from
  lowering the book value of its pre-bankruptcy
  liabilities.
• Today Global Crossing is a company with a clean
  balance sheet, minimal debt, strong corporate
  governance and a seasoned management team that
  will steer the company into a leadership position
  within the telecommunications industry," said
  John Legere, Global Crossing's CEO.

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• Net income in 2003 was US 24.7 bn, which
  included a net gain of US 24.8 bn related to the
  reorganization. This gain resulted from the
  accounting impact of recording the company's new
  debt and equity structure, the write down of
  pre-petition liabilities and deferred revenues
  from prior period Indefeasible Rights of Use
  (IRU) sales, vendor settlements, restructuring
  costs, retention plan costs and professional fees
  related to the bankruptcy.

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ADVANCED LIABILITY FSA PROBLEMS
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1.1 ON-B/S CASH FLOW MATURITY STRUCTURE
Example Valspar Corp.
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Valspar Corp., schedule of LTD maturity

• The IDRB becomes a current liability in 2005
  2006 in two equal installments of 560.
  Subtracting them from long-term maturities in
  2005 2006 yields repayment of the mortgage
  payable. The 6,791 long-term debt maturity in
  2007 can only be the repayment of the short-term
  notes to banks. The remaining amounts must be
  maturities of the mortgage payable.

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1.2 ON-B/S LOAN or DEBT COVENANTS

• WHY do lenders such as banks insurance
  companies put restrictive financial covenants
  into place?
• To maximize the expected value of how much money
  the borrower will ultimately repay !
• What types of restrictions?
• Firm must exceed quarterly / annual hurdles for
  the firms current ratio, cash flow coverage
  ratio, leverage ratio, level of earnings (or
  EPS), and book value.
• Disallow redemption, repurchase or retirement of
  any outstanding capital stock (debt or equity).
• Restrict payment of dividends, issuing new debt.
• Restrict acquisitions divestments.

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DEBT COVENANTS
Example GST Telecommunications (Vancouver)
Although GST can do certain types of equipment
financings, it cannot exceed 100 million in
general obligation debt (including 70 million in
notes payable to Tomen, a Japanese
telecommunications company). And GST's
investment in international companies is limited
to 13 million total. Domestically, GST cannot
invest more than 10 million unless it obtains
control, ruling out joint ventures and minority
interests. Provided GST obtains control,
however, its ceiling is limited only by the
resulting debt-to-equity ratio. GST cannot raise
any additional debt financing, however, unless it
simultaneously adds equity. Any new financing
must have a 2-to-1 debt-to-equity ratio. Those
covenants date from two 10-year high-yield
financings done in late 1995 that raised a total
of about 180 million with interest costs of
13-7/8.
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1.3 ON-B/S CAPITAL LEASES
What is a lease?

• Economic definition Contract between someone
  who owns an asset (lessor) and someone who wants
  to use it (lessee).
• Accounting definition Depends on how much
  of the assets lifetime use the lessee contracts
  for.

FASB rules
CAPITAL
OPERATING
Zero
100
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2.1 OFF-B/S OPERATING LEASES
Look less leveraged
Look more leveraged
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ON-B/S CAPITAL vs. OFF-B/S OPERATING LEASES
Enormous variation across within industries !
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ON-B/S CAPITAL vs. OFF-B/S OPERATING LEASES
WHY do firms strongly prefer Operating Leases?

• BIGGER QUESTION
• WHY do firms strongly prefer ANY kind of off-B/S
  debt?
• Humans have three basic needs
• Food, shelter, and keeping debt off the B/S.
  (Forbes, 11/28/80)

• Firms perceived risk is lower.
• Off-B/S debt can be more flexible cheaper.
• Off-B/S debt is out of (investor) sight, out of
  (investor) mind, so managers may be
  held-to-account less. Like RD!
• May be tax benefits.
• Operating lease accounting leads to lower I/S
  expense early in lease life ? Higher earnings in
  SHORT term.

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ON-B/S CAPITAL vs. OFF-B/S OPERATING LEASES
BIAS NOISE are both present for Operating
Leases
NET INCOME
LIABILITIES
ASSETS
OPERATING CF
FINANCING CF
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HOW DO YOU DEBIAS OPERATING LEASES?

• DEBIAS means adjust the B/S, I/S and SCF so that
  they show what would be the case if the Operating
  Leases were accounted for as Capital Leases.
• Ill focus on adjusting the B/S.
• Four steps
• Turn to Lease footnote of 10-K. This contains
  standardized disclosures.
• Determine the interest rate firm uses to
  calculate PV of its Capital Leases. Or a
  pro-forma interest rate.
• Apply that rate to compute the PV of minimum
  Operating Lease payments.
• Add / book that amount to firms assets
  liabilities Leasehold asset Lease liability.

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Debiasing Operating Leases
Compute PV
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Debiasing Operating Leases
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2.3 SPECIAL PURPOSE ENTITIES (now VIEs)
What is an VIE? Why are VIEs off-B/S liabilities?

• VIE / SPE is a dummy corporation created to own
  assets that a firm doesnt want on its books for
  good or for bad reasons.
• Example Suppose Risky Corp is in the business
  of speculating on gold futures. It wants to
  build for its own use an office building that
  costs 100, and it wants to arrange financing to
  do so. One thing Risky Corp might do is to
  approach Big Bank and ask for a loan.
• In deciding on an appropriate interest rate, Big
  Bank must consider the uncertainties involved in
  Risky Corp's business. Big Bank is likely to
  seek a relatively steep interest rate from Risky
  Corp because speculating in gold futures is a
  risky business.

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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VIE example

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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VIE example

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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VIE example

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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VIE example

• Now Risky faces a conundrum
• Risky wants to own as much of the equity of
  Office as possible in order to get as big a
  fraction as possible of the lower-interest-rate
  value that Office creates CAKE
• But the higher the fraction of Offices stock
  that Risky owns, the higher the probability that
  Risky will have to consolidate Office NOT
  EAT IT ON-B/S DEBT.
• Consolidation ? Offices building and its loan
  show up on Riskys consolidated B/S. Office
  building depreciation and interest payments to
  Big Bank show up on consolidated I/S.
• Can Risky have its CAKE and EAT IT?

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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CAN RISKY HAVE ITS CAKE EAT IT?

• At the time of Enron debacle, YES !
• GAAP said Risky, you do not need to consolidate
  Office if you can find outside investors that
  will buy equity in Office equal to no less than
  3 of Offices assets.
• This bright-line rule was abused by Enron
  other firms
• Although the 3 rule was designed for assets like
  office buildings where there was little risk of
  default, and so little equity was needed, Enron
  set up SPEs to hold all kinds of assets,
  including its own stock!
• Enron also guaranteed Offices debt to get an
  even lower interest rate.
• Enron booked revenues from transactions with
  Office.

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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VIE example

• Example is from The Crisis in Financial
  Reporting by Rick Antle (Yale 2002)

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SPE exploitation Whitewing Associates, one of
the many SPEs set up by Enron CFO Andy Fastow
 

• From Power Failure The Inside Story of the
  Collapse of Enron by Mimi Swartz, Sherron
  Watkins (p.373)

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CAN RISKY HAVE ITS CAKE EAT IT NOW?

• NO.
• GAAP has been sharply tightened under FIN. 46
• SPE ? VIE (variable interest entity)
• Risky MUST consolidate Office if is the party
  that absorbs or receives a majority of the
  variability of Offices risks or returns.
• Regardless of Riskys ownership in Office.
• Regardless of Riskys voting interest in Office.
• This judgment-based approach means that the
  default has changed Now, firms consolidate
  unless they can persuasively argue that they
  shouldnt, NOT the other way around!

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2.4 PENSIONS OPEBs
What is a Pension Liability?

• A pension is a contract between employee and firm
  in which the firm promises to pay you money
• Defined Contribution plan ? Firm give you .
  You put those into stocks, bonds, etc. so that
  by the time you retire, youll have a pot of
  money that will fund your retirement years.
• Defined Benefit plan ? Firm invests the for you
  in a legally separate entity or Trust.
• Only DB plans create potential liability problems
  for the sponsoring firm.

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2.4 Pension liabilities
Cash earmarked for pensions
PV pension plan promises
SE
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2.4 Pension liabilities
PV unbiased. ? TRUE underfunding.
PV BIASED too low. ? FALSE overfunding.

• Liability management
• higher net income
• (via lower pension expense) achieved by
• PV discount rate ?
• Ereturn on plan assets ?

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2.4 Wilshire Report on Corporate Pension Funding
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2.4 81 of large firms have UNDER-funded pensions
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Recent pension accounting research findings, 2
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TAKEAWAYS of LIABILITY ANALYSIS
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Last slide MANFUACTURED HOMES case