Chapter 8

Chapter 8, Slide #1

Financial Reporting, Financial Statement Analysis, and Valuation:A Strategic Perspective

Sixth Edition

Stickney/Brown/Wahlen

Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 8 Liability Recognition and Related Expenses

Slides Prepared by

Karen Foust

Tulane University

Chapter 8, Slide #2

Liability Recognition

Recognition (and nonrecognition) of accounting liabilitiesOff balance sheet financingLeasesDerivative financial instrumentsPensions and other postretirement benefitsIncome tax accountingReserve accounts

Chapter 8, Slide #3

Liability Recognition

• Obligation which requires a “probable future sacrifice of resources at a specified or determinable date.” Can be measured with reasonable precision

• Firm has little or no discretion to avoid the transfer

• Transaction/event that gave rise to the obligation has already occurred

Chapter 8, Slide #4

Reporting Liabilities—Valuation

• require future cash payments:– present value of the future cash flows

discounted at appropriate interest rate at time of issuance (also known as: historical interest rate)

– unless “hedged”

• require future delivery of goods/services:– estimated cost of those goods/services

• represent advances from customers:– amount of the cash advance

Chapter 8, Slide #5

Types of Liabilities

Fixed payment amounts and dates

Fixed payment amounts but uncertain dates

Uncertain amounts and dates

Advances from customers on unexecuted contracts

*Mutually unexecuted contracts

*Contingent obligations

Chapter 8, Slide #6

Hybrid Securities

Securities with both debt and equity characteristics

E.g., preferred stock subject to mandatory redemption or preferred stock subject to call option

Bonds convertible into common stock

Bonds for which interest is dependent on net income

Chapter 8, Slide #7

Off-Balance-Sheet Financing

• Usually one or combination of the following:– Sale of an existing asset

• e.g., accounts receivable

– Use of another entity to obtain financing• purchase commitments• joint ventures• special purpose entity (SPE)

Chapter 8, Slide #8

FASB Rules

• Sale of Receivables– Considered sale only if seller surrenders control– who controls the economic benefits/risks

• Product Financing Arrangements– must report liability IF: 1)firm agrees to

purchase the inventory at specified prices, and 2) payments made cover all acquisition, holding and financing costs

Chapter 8, Slide #9

FASB Rules continued• R & D Financing Arrangements

– Firm must recognize liability IF: 1) firm must repay any of the funds provided by the other parties regardless of outcome OR 2) firm bears risk of the R & D work (e.g., it guarantees debt of the partnership)

• Take-or-pay or Throughput Contracts– Guarantee to pay certain amount regardless of

actual use or product received– Disclosed in notes

Chapter 8, Slide #10

Leases

• Why lease?– Shift depreciation expense to lessor

– More flexible capacity

– Reduced risk of technological obsolescence

– Financing

Chapter 8, Slide #11

Leases—Accounting rules

• Capital lease IF meets any one of these conditions:– extends over at least 75% of asset’s life

– transfers ownership to lessee at end

– “bargain purchase” option, OR

– present value of the minimum lease payments > 90% of FMV of the asset

Chapter 8, Slide #12

Operating Leases

• Decrease cash for lease payments

• Decrease retained earnings (through increase in expense)

• Can be an important off-balance-sheet cash flow commitment

Chapter 8, Slide #13

Capital Leases

• The “lease” is treated as the acquisition of a long-term asset and simultaneous long-term liability

• Increase long-term assets

• Increase long-term liabilities

• Two expenses:– Interest expense– Depreciation expense

Chapter 8, Slide #14

Tax Criteria for Leases

• Operating lease for tax purposes IF:– possible for someone else to use property at end

of lease term– no bargain purchase option– at least 20% of lessor’s capital is at risk– lessor has positive cash flow and profit from

the lease before tax benefits– lessee has no investment in the lease and has

not loaned any of the purchase price to lessor

Chapter 8, Slide #15

Accounting Quality Issues

• May want to restate operating leases as capital leases

• Express lease commitment in PV terms– Using lessee’s incremental borrowing rate

• Balance sheet• Income statement

– Usually not as significant as balance sheet effects

• Statement of cash flows• Ratios will be affected!

Chapter 8, Slide #16

Derivative Instruments

• Gets value from some other financial instrument—many kinds

• Has one or more “underlyings”• One or more “notional amounts”• Not always initial investment (mutually

unexecuted contract)• Usually results in net settlement

Chapter 8, Slide #17

Accounting for Derivatives

• Governed by SFAS Nos. 133 & 138

• Must be recognized on balance sheet as either asset or liability

• Revalued to market value each period

• Gain/loss on revaluation may go to net income immediately or to other comprehensive income

Chapter 8, Slide #18

Accounting for Derivatives (cont.)

Types of hedges (per GAAP):

Speculative investments (revalue each period, include in net income)

Fair Value Hedges

Cash Flow Hedges

Usually one of last two—if not designated, must account for as speculative investment.

Chapter 8, Slide #19

Accounting for Derivatives (cont.)

• Fair Value Hedges: Derivative acquired to hedge change in value of an asset or liability: can be: – 1) hedge of recognized asset/liability OR – 2) hedge of unrecognized commitment

(purchase commitment)

• Gain/loss recognized in net income

• Also must restate hedged asset/liability to FMV and recognize resulting gain/loss

Chapter 8, Slide #20

Accounting for Derivatives (cont.)

• Cash Flow Hedges: hedges exposure to variability in future cash flows.

• 2 general types: 1. hedge of cash flows of existing asset/liability

2. hedge of cash flows of forecasted transactions

• Gain/loss included in Other Comprehensive Income to the extent that it effectively neutralizes the risk.

• Ineffective portion must be included in net income immediately.

Chapter 8, Slide #21

Disclosures• Book value and fair value of all financial instruments

(including derivatives)• Description of firm’s risk management strategy and

how derivatives are used• Fair Value and Cash Flow hedges: net gain or loss

included in earnings because ineffective• Cash Flow hedges – description of transactions/events

that will cause gain/loss to be reclassed as net income and estimate of that amount in the next 12 months

• Net amount of gain/loss included in net income because hedged firm commitment no longer qualifies as a fair value or cash flow hedge

Chapter 8, Slide #22

Accounting Quality Issues—Derivatives

• Some derivative transactions won’t have active markets—unreliable market valuation

• Classification as Fair Value vs. Cash Flow hedges—analyst needs to question

• If large or highly variable gain/loss each period, firm may be using derivatives ineffectively

Chapter 8, Slide #23

Retirement Benefits(Pensions & Other Postretirement

Benefits)• PENSIONS:

– Defined contribution plans– Defined benefit plans

• OTHER POSTRETIREMENT BENEFITS:– various– usually continued health & life insurance

Chapter 8, Slide #24

Pension Plans• Pension plans have separate accounting records• ASSETS earnings on investments and

employer contributions losses on investments and payments to those retired

• LIABILITIES passage of time and service cost / changes in actuarial assumptions or in pension benefit formula

Chapter 8, Slide #25

Pension Liabilities• VBO -- Vested Benefit Obligation: PV of

amount that employees will receive whether they work another day or not

• ABO -- Accumulated Benefit Obligation: PV of pension benefits that employees have earned as of balance sheet date based on current salaries

• PBO -- Projected Benefit Obligation: PV of pension benefits that employees have earned as of the balance sheet date based on future salaries

Chapter 8, Slide #26

Pension Cost• Service cost: PV of benefits earned in the current period

• Interest cost: Increase in PBO due to the passage of time

• Actuarial gains/losses: changes in assumptions such as turnover rates, retirement dates, discount rate, etc.

• Prior service cost: Plan amendments with retroactive provisions that increase the PBO give rise to prior service costs

• Foreign currency exchange rates

• Business acquisitions and divestitures

• Curtailments, settlements, special term. benefits

Chapter 8, Slide #27

Funded Status of Plan

• If plan assets < PBO, plan is underfunded

• If plan assets > PBO, plan is overfunded

Above gives economic position of the pension plan, BUT is not reported on the firm’s financial statements!

Chapter 8, Slide #28

Financial Reporting for Pensions

• Governed by SFAS Nos. 87 and 132

• Pension expense (note: not cost)– service cost– interest cost– expected return on plan assets– amortization of prior service costs (PSC)– corridor amortization of unrecognized gains/losses

(used for both asset gains/losses and actuarial gains/losses)

Chapter 8, Slide #29

Financial Reporting for Pensions (cont.)

Balance sheet:

• Employer reports prepaid/accrued costs equal to accumulated difference between reported pension expense and actual contribution to plan assets

• IF ABO > plan assets, must report “minimum liability”

• may result in intangible asset (if there are unrecognized PSC)

Chapter 8, Slide #30

Other Postretirement Benefits

• Very similar to pension plan reporting

• Must record expense at time employee works

• Most plans not funded

• Major reporting difference: Firms not required to report ABO > plan assets on the balance sheet—must disclose in notes

Chapter 8, Slide #31

Analyst’s Treatment of Pensions & Other PRBs

• Ignore

• Recognize underfunded PBO as liability and overfunded as asset

• Consolidate pension plan with firm

• Consider carefully:– discount rate– expected rate of return on plan assets– rate of compensation increase

Chapter 8, Slide #32

Income Tax Accounting

• Accounting income and taxable income are rarely the same in the U.S.

• Permanent differences• Temporary (or timing) differences• GAAP: firms measure income tax expense

on accounting income excluding permanent differences

• Usually different from income tax payable

Chapter 8, Slide #33

Income Tax Accounting

• Each period, firms must calculate difference between book basis and tax basis of assets, liabilities and loss carryforwards

• Eliminate any permanent differences

• Separate into those that will be future tax deductions and those that will be future taxable income--multiply by tax rate that will be in effect to give deferred tax assets and liabilities

• Assess valuation allowance

Chapter 8, Slide #34

Income Tax Expense

Income tax expense will equal:

• income taxes currently payable on taxable income

• plus (minus) net credit change (net debit change) in deferred tax assets/liabilities

Chapter 8, Slide #35

Required Income Tax Disclosures

• Components of income tax expense

• Components of income before taxes

• Reconciliation of income taxes at statutory rate with income tax expense

• Components of deferred tax assets and liabilities

Chapter 8, Slide #36

Reserves

• Use of “reserve” account in U.S. generally unacceptable

• Reserve or appropriation of retained earnings—keeps expenses out of income statement

• Revalue assets but delay recognition of expense