Business Analysis using financial statements

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Business Analysis using financial statements

• Chapter 5
• Liability and Equity Analysis

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Overview of liability and equity

• Liabilities are defined as economic obligation
  that arise from benefits received from the past ,
  and for which the amount and timing is known with
  reasonable certainty.
• Obligations to customers that have paid in
  advance
• Commitments to providers of debt financing
• Obligations to governments for taxes
• Commitments to employees for unpaid benefits
• Equity financing is defined as the claim on the
  gap between assets and liabilities(residual
  claim).
• Equity funds come from issues of stock, from
  profits that are reinvested, and from reserves
  set aside from profits
• Analysis of liability and equity is for assessing
  the financial risks faced by both debt and equity
  investors.

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Liabilities
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
the company has a present obligation...
Because of a past event...
...for future sacrifices.
Past
Present
Future
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Shareholders Equity
Basics of Equity Financing
Equity refers to owner (shareholder)
financing its usual characteristics include
Reflects claims of owners (shareholders) on net
assets Equity holders usually subordinate to
creditors Exposed to maximum risk and return
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
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Criteria for Recording Liabilities and
Implementation Challenges
First Criterion An obligation has been incurred
Second Criterion The amount and timing of the
obligation is measurable with reasonable
certainty
Record a liability

• Challenging
  Transactions
• It is uncertain whether the firm has incurred an
  obligation.
• The amount and timing of future obligations is
  difficult to measure
• Liability values have changed.

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Challenge one Has an obligation been incurred

• Restructuring Reserveswhether a restructuring
  announcement creates an economic liability
• For example, on Oct. 12,1994, McCormick Co.
  announced plans to lay off 7 percent of its
  8600-person staff, close two spice plants, and
  sell off a money-losing onion-ring operation. In
  its financial statements for the fourth quarter
  of 1994, the company created a 70.5 million
  liability for the costs of the restructuring.
• Accounting rules require firms to create a
  liability when management has a formal
  restructuring plan(APB 30 and SFAS 5). The
  liability includes estimates for costs of
  eliminating product lines, relocating plants and
  workers, new system costs, retraining costs, and
  severance pay.
• SEC has expressed concerns that managers have
  overstated restructuring charges by making
  aggressive asset write-downs called taking a bath.

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Challenge one Has an obligation been incurred

• Frequent flyer obligationswhether the airlines
  have incurred a liability for the future travel
  commitments under the mileage programs.
• Current accounting rules provide no definitive
  guidance on how to report obligations under the
  mileage programs, potentially providing an
  opportunity for management to exercise judgment .
• In 1999 annual report, United Airlines noted
  that about 6.1 million frequent flyer awards were
  outstanding. Based on historical data, the firm
  predicted that 4.6 million of these awards would
  ultimately be redeemed. The firm recorded a
  liability for 195 million for award redemption,
  reflecting the additional costs of providing
  service

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Challenge one Has an obligation been incurred

• Litigation How should legal claims be reflected
  in financial statements
• FASB recognized that the most difficult issue in
  reporting contingencies was for litigation. In
  most cases litigations are reflected only in
  the footnotes.
• Management has a strong incentive to
  under-estimate potential loses of litigation.
• In Nov. 1988, research found that silicone
  gel implants cause cancer. The major
  manufacturerDow Corning Corp. subsequently faced
  a litigation deluge. Between 1988-1993, the
  company provided no liability for the litigation.
  In Sep. 1993, the company reached an agreement
  with plaintiffs for a settlement of up to 4.75
  billion to be paid out for 30 years. As a result
  , in Jan. 1994, 640 million charge was taken for
  the fourth quarter of 1993.

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Accounting for Contingencies
Contingent Loss
Probability of Occurrence
Accounting Treatment
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Contingencies and Commitments
Basics of Contingencies
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   Cont
ingent 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
Contingencies should be . . .
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Contingencies and Commitments
Frequency of Contingent Liabilities
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Contingencies and Commitments
Analyzing Contingencies
Sources of useful information Notes, MDA, 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
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Contingencies and Commitments
Basics of Commitments
Commitments -- potential claims against a
companys resources due to future performance
under contract
Frequency of Commitments
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Challenge Two Can the obligation be
measured?Environmental liabilities

• There are two challenges in estimates the costs
  of superfund cleanups
• Responsibility for the damage and cleanup is
  uncertain.
• There is considerable uncertainty about the
  actual costs of cleanup
• Accounting rules permit firms to delay recording
  a liability for environmental costs until much of
  the uncertainty over the cost of cleanup and the
  firms responsibility have been resolved.

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Challenge Two Can the obligation be
measured?Pension and other postemployment
benefit liabilities

• Many firms make commitments to employees under
  defined benefit plan for prespecified pension or
  retirement benefits at some point in the future.
• The challenges in reporting on these commitments
  comes from the difficulty in making actuarial
  assumptions about employees working lives and
  retirement decisions.
• Under SFAS No.87, companies disclose the market
  value of pension plan assets and the projected
  benefit obligations of the plans but do not
  recognize them on their B/S.

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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
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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 employees 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
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Postretirement Benefits
Elements of the Pension Process
Employer
Pension Fund
Employee
Benefits (Disbursements)
Contributions
Investment
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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
Annual benefits of 20,000 paid to
employee for 10 years
Benefits 20,000 per annum
Contributions 4,942 per annum
10 years
15 years
Postretirement
Preretirement
Retirement
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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
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Challenge Two Can the obligation be
measured?Insurance loss reserves

• Insurance companies recognize revenues before the
  amount and timing of claims for the period have
  been fully resolved.
• Insurance manager must estimate the expected
  costs of unreported claims and reported claims,
  but how difficult to forecast future claims.
• There are potential opportunities for managers to
  make mistakes in forecasting for regulatory
  purposes.

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Challenge Two Can the obligation be
measured?Warranties

• Accounting rules
• Record expense and liability when products are
  sold (matching concept)
• As costs are incurred, charge expenditure to
  warranty liability
• Warranty cost is a kind of uncertain future cost
  and there are sometimes sizable errors in
  managements estimates.

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Challenge Three Changes in the value of
liabilitiesTroubled debt

• A troubled debt restructurings occurs when a
  creditor grants a concession to the debtor
• A troubled debt restructuring involves the two
  basic types of transactions
• (1)Settlement of debt at less than its
  carrying amount
• (2)Continuation of debt with a modification
  of terms
• How would the troubled debt restructuring itself
  be recorded?
• Under SFAS 15, there would be no change in
  the valuation of the debt until a formal
  restructuring takes place
• Impairments in asset values should be
  recorded as asset write-down
• Continue to show liabilities at their
  historical cost, but disclose the fair value of
  interest-bearing debt instruments in a footnotes.

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Equity reporting challenge oneHybrid Securities

• Convertible debt is a hybrid security. Is this
  security a debt instrument or an equity claim? It
  depends on whether the claim will be converted to
  equity in the future.
• Accounting rules do not recognizes any value
  attached to the conversion right as it is
  non-convertible debt.

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Equity reporting challenge twoClassification of
Unrealized gains and losses

• How to allocate certain unrealized gains and
  losses within the equity segment of the B/S,
• Be included in the income statement and then in
  retained earnings
• Be treated as separate non-operating items that
  can only go through income when they have been
  realized.
• Accounting rules the following unrealized gains
  and losses to be charged to a reserve rather than
  going through the income statement
• Financial instruments that are available for sale
• Financial instruments used to hedge future cash
  flows
• Foreign currency translations for foreign
  operations

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Study questions and problems

• Question 1. What are the economic costs and
  benefits to airlines from frequent flyer
  programs? What information would you need to
  measure these costs and benefits? As a financial
  analyst, what questions would you raise with the
  firms CFO about its frequent flyer program?

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Study questions and problems

• Question2 The cigarette industry is subject to
  litigation for health hazards posed by its
  products. The industry has been negotiating a
  settlement of these claims with state and federal
  governments. As the CFO for Philip Morris, one
  of the larger firms in the industry, what
  information would you report to investors in the
  annual report on the firms litigation risks?
  How would you assess whether the firm should
  record a liability for this risk, and if so, how
  would you assess the value of this liability? As
  a financial analyst following Philip Morris, what
  questions would you raise with the CEO over the
  firms litigation liability?

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Study questions and problems

• Question 3. For the first quarter of 1998,
  Microsoft reported the following reconciliation
  between net income and comprehensive income
• Three Months Ended September 30
• (millions of dollars)
  1997 1998
• Net income 663 1,683
• Net unrealized investment gains 56
  150
• Translation adjustments and other (117)
  43
• Comprehensive income
  602 1,876
• What types of events give rise to the
  adjustments made by Microsoft?
• As a financial analyst, what questions would you
  have for the CFO
• about the comprehensive income statement?