Liability and Equity Analysis

1

• Chapter 5
• Liability and Equity Analysis

2
Concepts of Liabilities

• Liabilities Liabilities are defined as economic
  obligations that arise from benefits received in
  the past. These are external claims on assets of
  the firm. These arise from contractual
  obligations and have reasonable certainty of
  amount and timing. Liabilities include
• Cash received from customers against future sales
  of product and services
• Credit purchases of goods and services in the
  current year of the operating cycle (e.g.,
  accounts payable)
• commitments to public and private providers of
  debt financing
• obligations to tax authority,
• commitment to employees for unpaid wages,
  pensions and other retirement benefits and
• obligations from court or government fines and
  environmental cleanup orders.

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Criteria for Recognizing Liabilities and
Implementation challenges
First Criterion An obligation has incurred
Second Criterion The amount and timing of the
obligation is measurable with reasonable
certainty
Record a liability

• Challenges of Liability reporting
• It is uncertain whether a firm has incurred an
  obligation
• The amount and timing of obligation is difficult
  to measure
• Liability values have changed

4
Reporting Challenges for Liabilities

• Has an obligation been incurred? Example Cash
  flows from a note receivables sold to a bank and
  bank has recourse against the firm should the
  receivable default. Is there any liability
  incurred?
• How to measure the obligation? Examples
• Obligations to laid off employees in case of
  restructuring.
• Frequent flyer obligation of airlines (Case
  study next slide).
• Obligation for environmental pollution. European
  Union regulation of disposal management cost to
  be borne by the producers is a potential cost not
  properly accounted.
• Pension and other post-employment benefit
  liabilities.
• Product warranties. Is liability created at the
  time of sales reflected by estimated cost of
  returns? Or, should the firm wait for the expiry
  of warranty period? Accounting suggests for a
  liability recognition on the basis of probable
  losses. Accordingly, GM reported in 1998 that it
  had a 14.6 billion liability for warranties,
  dealers, and customer allowances, claims and
  discounts. Intel had to make a huge replacement
  of chips in 1994 and suddenly created a 475
  million liability for that.
• Changes in the value of liabilities. Example
  Fixed rate liabilities are sometimes sensitive to
  changes in interest rate. Liabilities are
  reported at their historical costs, although fair
  value of interest bearing debt instrument is
  reported in the footnote. Fair value becomes
  imprecise when a firm is in financial distress.
  It is difficult to report the restructuring of
  troubled debt.

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Case Frequent Flyer Obligations

• Since 1980s, many airlines have frequent flyer
  programs for their passengers which offers bonus
  award miles every time the passenger flies with
  the same airline.
• Has the firm incurred liability?
• The argument of no is based on the fact that
  the airlines have discretion to modify and even
  abandon their mileage program. For example, in
  1987, United Airlines (UAL) made it difficult for
  passengers to earn free flights. Airlines can
  also regulate the commitment by limiting the
  number of seats available to frequent flyers.
• The amount of liability is questionable as well.
• Given normal load factors and the incremental
  costs of an additional passenger, the opportunity
  and out-of-pocket costs of frequent flyer awards
  could be minimal. Of course, changing the
  requirements for mileage awards can be costly as
  UAL was sued over its plan changes.
• Current accounting rules provide no definite
  guidance on how to report these obligations,
  potentially providing an opportunity for
  management to exercise judgment.
• In its 1999 annual report, United Airlines noted
  that approximately 6.1 million frequent flyer
  awards were outstanding. Based on historical
  data, the firm estimated that 4.6 million of
  these awards would ultimately be redeemed, and
  recorded a liability for 195 million.

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Common Misconceptions About Liability Accounting

• Its prudent to provide for a rainy day.
  Conservative accounting is not always good
  accounting. Because
• (i) It assumes that the investor can not see
  through the B/S.
• (ii) The basic purpose of B/S to reflect the
  firms true standing is violated.
• (iii) The purpose is not served as the investors
  over time recognizes which firm are conservative
  and which are not.
• Off-B/S financing is better than on B/S financing
  because unsophisticated financial statement users
  are then likely to underestimate the firms true
  leverage. It seems unlikely that investors are
  continuously be fooled by off balance sheet
  liabilities. Of course, operating lease financing
  may be necessary to reduce the risk of ownership
  and technological obsolescence.

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Concepts of Equity

• Equity Internal claims on assets that represent
  the gap between assets and liabilities. It is the
  residual claims. Equity funds can come from
  issues of common and preferred stock, from
  profits that are reinvested, and from any reserve
  set aside from profits. Valuation of equity plays
  the most important role in the valuation of the
  firm. Equityassets-liability?
• Controversy
• (i) Valuation of assets,
• (ii) hybrid securities, and
• (iii) allocation of equity values between
  reserves, capital, and retained earnings.
• Since equity is the residual claim so the
  valuation depends on the valuation of assets and
  liabilities. Consequently, the challenges of
  valuation of assets and liabilities also apply to
  equity valuation. In addition to that following
  challenges are specific to equity.

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Reporting Challenges of Equity

• 1. Hybrid securities Convertible debt is a
  hybrid security that commands a lower interest
  rate than straight debenture since the holder
  also receives the option to convert the debt into
  common stock. Accounting rules do not recognize
  the value attached to the conversion right. So,
  the convertible bond is just like ordinary bond
  until converted. If the debt converts, it can be
  recorded using either the book value or market
  value methods. The book value method does not
  recognize any gain or loss on conversion. The
  market value approach records the difference
  between book value and market value as operating
  gain or loss. This raises question about how to
  compare two firms that use same effective capital
  structure, but where one uses hybrid securities
  and other does not. The firm with hybrid
  securities will appear to be highly leveraged,
  using book values of debt and equity, because
  conversion right is not recorded. As a result,
  valuation of equity becomes questionable.

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Reporting Challenges of Equity(Contd.)

• 2. Classification of unrealized gains and looses.
  One method is to take it in income statement and
  then to retained earnings as soon as it accrues.
  This is called Clean surplus. Another method is
  to take as income only when it is realized called
  Dirty Surplus.
• These gains include
• i. Financial instruments that are available for
  sale.
• ii. Financial instruments used to hedge
  uncertain future cash flows including insurance
  policies, forward contract, options, swap, etc.
• iii. Foreign currency translations of foreign
  operations whose transactions occur in the local
  currency rather than parent currency.

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Foreign exchange risk exposure

• The degree to which the value of future cash
  transactions can be affected by exchange rate
  fluctuations is referred to as transaction
  exposure. If an exporter denominates its export
  in foreign currency, a 10 decline in the value
  of that currency (dollar) will reduce the taka
  value of its receivable by 10. Transaction
  exposure includes export denominated in foreign
  currency, interest received from overseas
  investment, import denominated in foreign
  currency, interest owed on foreign loan.
• Economic exposure refers to the degree to which a
  firms present value of future cash flows can be
  influenced by exchange rate fluctuations. Cash
  flows that do not require conversion of
  currencies do not reflect transaction exposure.
  Yet, these cash flows may also be influenced
  significantly by exchange rate movements, which
  is included in economic exposure.
• The exposure of the MNCs consolidated financial
  statements to exchange rate fluctuations is known
  as translation exposure. In particular,
  subsidiary earnings translated into the reporting
  currency on the consolidated income statement are
  subject to changing exchange rates.

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Managing Madison Inc.s Economic Exposure

• (Figures in Millions) C.75
  C.80 C.85
• Sales
• (1) U.S. 300.00 304.00 307.00
• (2) Canadian (C4) 3.0 3.20
  3.40
• (3) Total 303.00 307.20 310.40
• Cost of gods sold
• (4) U.S. 50.00 50.00 50.00
• (5) Canadian C200 150.00 C200
  160.00 C200 170.00
• (6) Total 200.00 210.00 220.00
• (7) Gross profit 103.00 97.20 90.40
• Operating expenses
• (8) U.S. - Fixed 30.00 30.00 30.00
• (9) U.S. Variable (ex., sales com) 30.30
  30.72 31.04
• (10) Total 60.30 60.72 61.04
• (11) EBIT 42.70 36.48 29.36
• Interest expense
• (12) U.S. 3.00 3.00 3.00 (13)
  Canadian C10 7.50 C10 8.00 C10
  8.50
• (14) Total 10.50 11.00 11.50
• (15) EBT 32.20 25.48 17.86