Overview of the Chapter
Overview of the Chapter
Current and Current and Noncurrent LiabilitieNoncurrent Liabilitiess
Lease ObligationsLease Obligations
Pension LiabilitiesPension Liabilities
Contingent Liabilities & CommitmentsContingent Liabilities & Commitments
Deferred credits or Deferred credits or incomeincome
Off-Balance-Sheet FinancingOff-Balance-Sheet Financing
Liabilities at the Edge of EquityLiabilities at the Edge of Equity
Equity FinancingEquity Financing
Analysis of
Analysis of
Liabilities
Liabilities
Areas of observations
Areas of observations::
We need to make sure We need to make sure that companies account for allthat companies account for all
of them with proper details as
of them with proper details as to their amounts, dueto their amounts, due dates including conditions, encumbrances and
dates including conditions, encumbrances and limitation
limitation
Most companies look for ways to reduce the amountMost companies look for ways to reduce the amount
of liabilities reported in the financial statements of liabilities reported in the financial statements
We must recognize that companies can misclassifyWe must recognize that companies can misclassify
or inadequately describe liabilities or inadequately describe liabilities
Where and How to Look?
Auditors are one source of assurance in our search Auditors tools include; direct confirmation, review
board minutes, reading contract and agreement, inquiry
In double entry system helps auditors and us Most difficult item includes commitment and
contingent liabilities require no entry
To understand it, we need to study management discussion, reconciliation, notes
Example of motivated transactions
SEC determined Ampex Corporation failed to fully disclose:
Its obligation to pay royalty guarantees of 80 million A several million dollar understatement in the
allowance for doubtful accounts receivable Income overstatement from inadequate credit
Important Features in Analyzing Liabilities
Terms of indebtedness ( maturity, interest rate)
Restrictions on deployment of resources and freedom in business activities
Ability and flexibility in pursuing further financing Working capital, debt to equity
Dilutive conversion features that liabilities are subject to
Prohibition on certain disbursements such as dividends
Current Liabilities
Commercial paper borrowings should be separately disclosed in the balance sheet
Average interest rate and terms to be separately stated for short term bank and commercial paper borrowings at the balance sheet date
Disclosure of amounts and terms of unused line sfor credit for short term borrowings arrangements
Noncurrent Liabilities
Information on noncurrent liabilities should include
interest rate, maturity date, conversion privileges, call features, subordination provision, and restrictions
Companies must disclose any defaults of debt
provisions, including defaults of interest and principal repayments
Important items: purchase commitments which is unconditional purchase obligations. Footnote
Purchase Obligations
Description and term of obligation
Total fixed in determinable obligation Description of any variable obligation Amounts purchased under obligation
For purchase obligations that are recognized on purchaser’s balance sheet, a company must report payment for each of the next five years
Analysis Implications of Liabilities
Since liabilities are claims against a company’s
assets, we need to assure that all of them are shown in details including conditions, encumbrances, and limitation s they impose on a company
We must also recognize that companies can misclassify or inadequately describe liabilities
Most difficult items are those relating to commitments and contingent liabilities requiring no entry
In this case we must rely on management comment and information provided in the notes
Lease Obligations
Lease obligations are contractual agreements
between a lessor and a lessee giving the lessee a right to use assets owned by a lessor for the lease term in return for rental payments
Most common classification is: capital lease, operating lease
Conditions for a lease to qualify as capital lease or finance lease
Sale and lease-back
Pension Liabilities
Pension Liabilities are obligation of an employer US size is 25 percent of NYSE common stock and
nearly one third of the daily trading volume
Pension invites costs for the organizations and also attracts accounting issues
Pension expense is a measure of the current cost of providing for future promised benefits under plan
Pension expense derives from accrual accounting and is distinct from funding of pension
Funding refers to transfer of cash or assets to the fund
Pension Liabilities
Defined benefit pension plans specify the amount of pension benefits, where company bears the risk of pension fund performance
Defined contribution pension plans specify
contributions required of the company. Benefits depends on performance
Our concern is accounting for defined benefit pension plans
Usually the benefits are determined by actuarial variables like age, life expectancies, turnover rate, future salary levels, future return on funds
Nature of Pension Liabilities
There are three different estimates of pension obligations:
Projected benefit obligation (PBO)
Accumulated benefit obligation (ABO) Vested benefit obligation (VBO)
Example in the Table…………
Disclosure requirements include: Desccription of coverage, Net periodic pension cost for the period, Reconciliation of funded status, various assumption Show Table in the book for detail
Analysis Implications of Pension Liabilites
Benefits on future pay, sometimes understates liability
It ignores inflation impact, future pay increase Discount rate is also an important issue
Preferred measure-difference between PBO and fair value of pension assets
High performing equity market reduce or eliminate pension liabilities and vice versa
Unfunded pension obligations are continually subject to change
Contingent Liabilities
Contingencies refer to potential gains or losses whose resolution depends on one or more future events
It may arise from litigation, collectivity of receivables, claims against product warranty, guarantees of
performance, tax assessments, self insured risks etc. Two criteria: (1) must be probable, (2) the loss must
be reasonably estimable….like uncollectible receivables or product warranty
Companies usually do not recognizes gain contingency
Off-Balance Sheet Financing
It refers to non recording of certain financing obligations like operating lease
Example: Through-put agreement, Take or pay arrangement
Creating separate entity with less than 50 percent ownership and not consolidation with balance sheet Product financing arrangements-Sells and agrees to
either repurchase or guarantee selling price to third parties
Liabilities at the “Edge” of Equity
We need to be alert to equity securities (typically preferred stock) that may become liability
Company may need to pay funds at specific dates Redeemable preferred stock significantly different
from equity stock and should not be included in the shareholders’ equity
Company should disclose the redemption terms and five year maturity data
Treasury Stock
It represents shares of a company’s stock reacquired after previously issued.
Purchasing treasury stock reduces both assets and shareholders equity
Treasury stock is not an asset it is a contra equity account
Treasury stock is typically recorded at cost In rare cases, it is reported as assets when
companies reserves it for purposes like profit sharing, acquiring another company
Deferred Tax
Deferred taxes are postponed tax effects attributed to temporary difference between taxable and
accounting income
Major items cause deferred tax are; depreciation, inventory, pensions, Nonpension benefits,
discontinued segments
A company may choose accelerated depreciation for tax purpose and straight line for accounting
Result: tax deferral in early years and tax catch up in later years
Book Value Par Share
Book value per share is the per share amount resulting from company’s liquidation at amounts reported on its balance sheet
In other words net asset value-total assets reduced by claims against them
The book value of common stock is equal to total assets less liabilities and claims of securities senior to common stock such as preferred stok
Liquidation premium on preferred stock can
