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FSA 8e Ch03 SM
FSA 8e Ch03 SM
Analyzing Financing
Activities
REVIEW
Business activities are financed through either liabilities or equity. Liabilities are
obligations requiring payment of money, rendering of future services, or dispensing of
specific assets. They are claims against a company's present and future assets and
resources. Such claims are usually senior to holders of equity securities. Liabilities
include current obligations, long-term debt, capital leases, and deferred credits. This
chapter also considers securities straddling the line separating liabilities from equity.
Equity refers to claims of owners to the net assets of a company. While claims of owners
are junior to creditors, they are residual claims to all assets once claims of creditors are
satisfied. Equity investors are exposed to the maximum risk associated with a business,
but are entitled to all residual rewards associated with it. Our analysis must recognize the
claims of both creditors and equity investors, and their relationship, when analyzing
financing activities. This chapter describes business financing and how this is reported
to external users. We describe two major sources of financingcredit and equityand
the accounting underlying reports of these activities. We also consider off-balance-sheet
financing, including Special Purpose Entities (SPEs), the relevance of book values, and
liabilities "at the edge" of equity. Techniques of analysis exploiting our accounting
knowledge are described.
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OUTLINE
Liabilities
Current Liabilities
Noncurrent Liabilities
Analyzing Liabilities
Leases
Lease Accounting and Reporting Lessee
Analyzing Leases
Postretirement benefits
Pension Accounting
Other Postretirement Benefits (OPEBs)
Analyzing Postretirement Benefits
Off-Balance-Sheet Financing
Through-put and Take-or-pay agreements
Product financing arrangements
Special Purpose Entities (SPEs)
Shareholders Equity
Capital Stock
Retained Earnings
Computation of Book Value Per Share
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ANALYSIS OBJECTIVES
Analyze and interpret lease disclosures and explain their implications and the
adjustments to financial statements.
Explain capital stock and analyze and interpret its distinguishing features.
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QUESTIONS
1. The two major source of liabilities, for both current and noncurrent liabilities, are
operating and financing activities. Current liabilities of an operating naturesuch as
accounts payable and operating expense accrualsrepresent claims on resources
from operating activities. Current liabilities such as notes payable, bonds, and the
current maturities of long-term debt reflect claims on resources from financing
activities.
2. The major disclosure requirements (in SEC FRR, Section 203) for financing-related
current liabilities such as short-term debt are:
a. Footnote disclosure of compensating balance arrangements including those not
reduced to writing
b. Balance sheet segregation of (1) legally restricted compensating balances and (2)
unrestricted compensating balances relating to long-term borrowing
arrangements if the compensating balance can be computed at a fixed amount at
the balance sheet date.
c. Disclosure of short-term bank and commercial paper borrowings:
i. Commercial paper borrowings separately stated in the balance sheet.
ii. Average interest rate and terms separately stated for short-term bank and
commercial paper borrowings at the balance sheet date.
iii. Average interest rate, average outstanding borrowings, and maximum monthend outstanding borrowings for short-term bank debt and commercial paper
combined for the period.
d. Disclosure of amounts and terms of unused lines of credit for short-term
borrowing arrangements (with amounts supporting commercial paper separately
stated) and of unused commitments for long-term financing arrangements.
Note that the above disclosures are required for filings with the SEC but not
necessarily for disclosures in published annual reports. It should also be noted that
SFAS 6 states that certain short-term obligations should not necessarily be classified
as current liabilities if the company intends to refinance them on a long-term basis
and can demonstrate its ability to do so.
3. The conditions required by SFAS 6 that demonstrate the ability of the company to
refinance it short-term debt on a long-term basis are:
a. The company has actually issued a long-term obligation or equity securities to
replace the short-term obligation after the date of the company's balance sheet
but before its release.
b. The company has entered into an agreement with a bank or other source of
capital that permits the company to refinance the short-term obligation when it
becomes due.
Note that financing agreements that are cancelable for violation of a provision that
can be evaluated differently by the parties to the agreement (such as a material
adverse change or failure to maintain satisfactory operations) do not meet the
second condition. Also, an operative violation of the agreement should not have
occurred.
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4. Since the interest rate that will prevail in the bond market at the time of issuance of
bonds can never be predetermined, bonds usually are sold in excess of par
(premium) or below par (discount). This premium or discount represents, in effect, an
adjustment of the coupon rate to the effective interest rate. The premium received is
amortized over the life of the issue, thus reducing the coupon rate of interest to the
effective interest rate incurred. Conversely, the discount also is amortized, thus
increasing the effective interest rate paid by the borrower.
5. The accounting for convertibility and warrants impacts income and equity as follows:
a. The convertible feature is attractive to investors. As a result, the debt will be
issued at a slightly lower interest rate and the resulting interest expense is less
(and conversely, equity is increased). Also, diluted earnings per share is reduced
by the assumed conversion. At conversion, a gain or loss on conversion may
result when equity instruments are issued.
b. Similarly, warrants attached to bonds allow the bonds to pay a lower interest rate.
As a result, interest expense is reduced (and conversely, equity is increased).
Also, diluted earnings per share is affected because the warrants are assumed
converted.
6. It is important to the analysis of convertible debt and stock warrants to evaluate the
potential dilution of current and potential shareholders if the holders of these options
choose to convert them to stock. This potential dilution would represent a real wealth
transfer for existing shareholders. Currently, this potential dilution is given little
formal recognition in financial statements.
7. SFAS 47 requires note disclosure of commitments under unconditional purchase
obligations that provide financing to suppliers. It also requires disclosure of future
payments on long-term borrowings and redeemable stock. Required disclosures
include:
For purchase obligations not recognized on purchaser's balance sheet:
a. Description and term of obligation.
b. Total fixed and determinable obligation. If determinable, also show these amounts
for each of the next five years.
c. Description of any variable obligation.
d. Amounts purchased under obligation for each period covered by an income
statement.
For purchase obligations recognized on purchaser's balance sheet, payments for
each of the next five years.
For long-term borrowings and redeemable stock:
a. Maturities and sinking fund requirements for each of the next five years.
b. Redemption requirements for each of the next five years.
8. a.
Information about debt covenant restrictions are available in the details of the
bond indentures of a company. Moreover, key restrictions usually are identified
and discussed in the financial statement notes.
b. The margin of safety as it applies to debt contracts refers to the slack that the
company has before it would violate any of the debt covenant restrictions and be
in technical default. For example, if the debt covenant mandates a maximum debt
to assets ratio of 50% and the current debt to assets ratio is 40%, the company is
said to have a margin of safety of 10%. Technical default is costly to a company.
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Thus, as the margin of safety decreases, the relative level of company risk
increases.
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are through-put agreements, in which the company agrees to run a specified amount
of goods through a processing facility or "take or pay" arrangements in which the
company guarantees to pay for a specified quantity of goods whether needed or not.
A variation of the above arrangements involves the creation of separate entities for
ownership and the financing of the facilities (such as joint ventures or limited
partnerships) which are not consolidated with the company's financial statements
and are, thus, excluded from its liabilities.
Companies have attempted to finance inventory without reporting on their balance
sheets the inventory or the related liability. These are generally product financing
arrangements in which an enterprise sells and agrees to repurchase inventory with
the repurchase price equal to the original sales price plus carrying and financing
costs or other similar transactions such as a guarantee of resale prices to third
parties.
20. a. The accumulated benefit obligation (ABO) is an estimate of the employer's
obligation for pensions based on current and past compensation levels. No
assumption regarding future compensation levels is included and for pension
plans, such as flat benefit plans or those with non-pay related formulas the
accumulated benefit obligation accurately measures the entire or final obligation.
b. The projected benefit obligation (PBO) takes into consideration the effect of future
salary increases as is necessary in order to determine the full obligations in
pension plans such as those based on career-average pay or final pay.
SFAS 87 recognizes an additional minimum liability. Since this additional liability is
based on the accumulated rather than on the projected benefit obligation, it
represents a compromise position between the full fledged recognition of pension
liabilities and their much less adequate recognition before SFAS 87.
21. The recognition of certain pension costs is delayed for accounting purposes.
Prior service costs are amortized into pension expense and the pension liability
over the remaining service life of the benefiting employees.
The transition asset or liability is amortized into pension expense and the pension
asset or liability.
Excess gains or losses on plan assets (beyond the expected rate of return) are
recognized in periods after they occur.
Gains or losses on changes in the liability are recognized after occurrence.
Each of these items can create a difference between the reported pension liability and
the economic obligation of the plan.
22. The reason pension costs are reduced by the expected (rather than actual) return on
plan assets is that use of the actual return would subject pension costs to the
fluctuations of the financial markets, creating volatility in annual costs.
23. Periodic pension costs are smoothed by several aspects of pension accounting
including: (1) use of expected versus actual return on plan assets, (2) valuing pension
assets on a market-related versus a market basis (3) amortization of deferred cost
elements such as prior service cost, net gains/losses, and unrecognized transition
costs. This smoothed cost figure is less likely to reflect the underlying economics
when the elements being deferred are more permanent in nature.
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24. Postretirement accounting includes several estimates that affect net income and total
liabilities. For example, the following variables are often important for calculating
pension or other postretirement benefits:
Number of years the employee will work for the company
Turnover rate of workforce
Future salary levels of employees
Age of the employee at death
Actual return on plan assets in future years
Interest costs on pension liability
All of these variables are difficult to estimate but necessary in accounting for
postretirement benefit plans. In addition, postretirement benefits such as healthcare
insurance require assumptions about the future cost of healthcare or healthcare
insurance.
25. Management can exercise latitude over the amount of pension expense recorded
through its selection of expected return on plan assets and its choice of assumptions
regarding future levels of inflation (interest).
26. Pension costs can appear as part of a company's operating expenses (e.g., cost of
goods sold or compensation expense) or capitalized into assets such as inventory.
27. One major difference relates to the accounting for the unfunded OPEB obligation.
When a company adopts SFAS 106, the unfunded OPEB obligation at the date of
adoption, also referred to as the "transition obligation" can be recognized as either
(1) a cumulative effect of an accounting change (included as a charge to income) or
(2) over future periods as a component of the annual OPEB expense over a period
not to exceed 20 years. Thus, if a company elects to amortize its transition obligation
over future years, then, unlike under pension accounting, it will not be required to
recognize immediately a minimum liability on the balance sheet for the unfunded
OPEB obligation attributable to present retired and active employees that are eligible
to receive benefits.
Another major difference of OPEB accounting from pension accounting relates to
funding. Because there are no legal requirements for OPEB benefits, similar to ERISA
requirements for pensions, and also because funding OPEB benefits does not enjoy
the favorable tax treatment accorded to the funding of pension plans, few companies
fund their OPEB liabilities or are likely to do so in the near future. Thus, we have
sizable unrecorded, as well as increasing amounts of recorded, OPEB liabilities that
are unfundedthese are backed by assets under the control of companies rather
than assets in the hands of independent trustees.
28. Under SFAS 106, the required disclosures include:
a. Description of the plan
b. Net periodic postretirement benefit cost and its components.
c. Reconciliation of funded status of the plan with amounts reported in balance
sheet.
d. Assumed health-care cost trend rate used to measure covered benefit costs for
the next year. Also, a description of the direction and pattern of change in the
assumed trend rates thereafter.
e. Weighted average discount rate, rate of compensation, and expected long-term
rate of return used to measure the APBO.
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f.
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SFAS 140 replaced SFAS 125 and defines new rules for the sale of accounts
receivable to special purpose entities (SPEs). In order to treat the transfer as a sale
(rather than a borrowing), the SPE must be a Qualifying SPE. Otherwise, the SPE
must be consolidated unless third-party investors make equity investments that are,
Substantive (more than 3% of assets)
Controlling (e.g., more than 50% ownership)
Bear the first dollar risk of loss
Take the legal form of equity
If any of the above conditions is not met, the transfer of the receivable is considered
as a loan with the receivables pledged as security for such loan.
37. Analysts should identify off-balance-sheet financing arrangements and either factor
these arrangements into their models or otherwise adjust the analyses for the
additional risk created by off-balance-sheet financing arrangements.
38. Some equity securities have mandatory redemption provisions that make them more
akin to debt than they are to equitya typical example is preferred stock. Whatever
their name, these securities impose upon the issuing companies various obligations
to dispense funds at specified dates. Such provisions are inconsistent with the true
nature of an equity security. The analyst must be alert to the existence of such
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equity securities and examine for substance over form when making financial
statement adjustments.
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39. In order to facilitate their understanding and analysis, reserves and provisions can be
redivided into a number of major categories.
The first category is most correctly described as comprising provisions for
obligations that have a high probability of occurrence, but which are in dispute or are
uncertain in amount. As is the case with many financial statement descriptions,
neither the title nor the location in the financial statement can be relied upon as a
rule-of-thumb guide to the nature of an account. The best key to analysis is a
thorough understanding of the business and the financial transactions that give rise
to the account. The following are representative items in this group: provisions for
product guarantees, service guarantees, and warranties that are established in
recognition of future costs that are certain to arise although presently impossible to
measure. Another type of obligation that must be provided for is the liability for
unredeemed coupons such as trading stamps. To the company issuing these
coupons, there is no doubt about the liability to redeem them for merchandise or
cash. The only uncertainty concerns the number of coupons that will be presented
for redemption. Consequently, a provision is established for these types of items by a
charge to income at the time products covered by guarantees (or related to these
coupons) are soldthe amount is established on the basis of experience or on the
basis of any other reliable factor.
The second category comprises reserves for expenses and losses, which by
experience or estimates are very likely to occur in the future and that should properly
be provided for by current charges to operations. One group within this category is
comprised of reserves for operating costs such as maintenance, repairs, painting, or
overhauls. Thus, for example, since overhauls can be expected to be required at
regularly recurring intervals, they are provided for ratably by charges to operations to
avoid charging the entire cost to the year in which the actual overhaul takes place.
A third category comprises provisions for future losses stemming from decisions or
actions already taken. Included in this group are reserves for relocations,
replacement, modernization, and discontinued operations.
A fourth category includes reserves for contingencies. For example, reserves for
self-insurance are designed to provide the accumulation against which specific types
of losses, not covered by insurance, can be charged. Although the term
self-insurance contradicts the very concept of insurance, which is based on the
spreading of risks among many business units, it nevertheless is a practice that has a
good number of adherents. Other contingencies provided against by means of
reserves are those arising from foreign operations and exchange losses due to
official or de facto devaluations.
A fifth group of future costs that must be provided for is that of employee
compensation. These costs, in turn, give rise to provisions for vacation pay, deferred
compensation, incentive compensation, supplemental unemployment benefits, bonus
plans, welfare plans, and severance pay. The related category of estimated liabilities
includes provisions for claims arising out of pending or existing litigation.
Of importance to the analyst is the adequacy of the reserves and provisions that are
often established on the basis of prior experience or on the basis of other estimates.
Concern with adequacy of amount is a prime factor in the analysis of all reserves and
provisions, whatever their purpose. Reserves and provisions appearing above the
equity section are almost invariably created by means of charges to income. They are
designed to assign charges to the income statement based on when they are
incurred rather than when they are paid in cash.
3-16
40. Reserves for future losses represent a category of accounts that require particular
scrutiny. While conservatism in accounting calls for recognition of losses as they can
be determined or clearly foreseen, companies tend, particularly in loss years, to
over-provide for losses not yet incurred. Such losses not yet incurred often involve
disposal of assets, relocations, and plant closings. Overprovision shifts expected
future losses to the present period, which likely already shows adverse results.
One problem with such reserves is that once established there is no further
accounting for the expenses and losses that are charged against them. Only in
certain financial statements required to be filed with the SEC (such as Form 10-K) are
details of changes in reserves required. Recent requirements have, however,
tightened the disclosure rules in this area.
The reason why overprovisions of reserves occur is that the income statement
effects are often accorded more importance than the residual balance sheet effects.
While a provision for future expenses and losses establishes a reserve account that
is analytically in the "never-never land" between liabilities and equity accounts, it
serves the important purpose of creating a cushion that can absorb future expenses
and losses. This shields the all-important income statement from them and their
related volatility. The analyst should endeavor to ascertain that provisions for future
losses reflect losses that can reasonably be expected to have already occurred rather
than be used as a means of artificially benefiting future income by adding excessive
provisions to present adverse results.
41. An ever-increasing variety of items and descriptions are included in the "deferred
credits" group of accounts. In many cases these items are akin to liabilities; in others,
they either represent deferred income yet to be earned or serve as income-smoothing
devices. A lack of agreement among accountants as to the exact nature of these
items or the proper manner of their presentation compounds the confusion
confronting the analyst. Thus, regardless of category or presentation, the key to their
analysis lies in an understanding of the circumstances and the financial transactions
that brought them about.
At one end of the spectrum we find those items that have characteristics of liabilities.
Here we can find items such as advances or billings on uncompleted contracts,
unearned royalties and deposits, and customer service prepayments. The
outstanding characteristics of these items is their liability aspects even though, as in
the case of advances of royalties, they may, after certain conditions are fulfilled, find
their way into the company's income stream. Advances on uncompleted contracts
represent primarily methods of financing the work in progress while deposits of rent
received represent, as do customer service prepayments, security for performance of
an agreement. At the other end of the spectrum are deferred credits that exhibit many
qualities similar to equity. The key to effective analysis is the ability to identify those
items most like liabilities from those most like equity.
42. The accounting for the equity section as well as its presentation, classification, and
note disclosure have certain basic objectives. The most important of these are:
a. To classify and distinguish among the major sources of owner capital contributed
to the entity.
b. To set forth the priorities of the various classes of stockholders and the manner in
which they rank in partial or final liquidation.
3-17
c. To set forth the legal restrictions to which the distribution of capital funds are
subject to for whatever reason.
d. To disclose the contractual, legal, managerial, and financial restrictions that the
distribution of current and retained earnings is subject to.
The accounting principles that apply to the equity section do not have a marked
effect on income determination and, as a consequence, do not hold many pitfalls for
the analyst. From the analyst's point of view, the most significant information here
relates to the composition of the capital accounts and to the restrictions that they are
subject to.
The composition of equity capital is important because of provisions affecting the
residual rights of common equity. Such provisions include dividend participation
rights, and the great variety of options and conditions that are characteristic of the
complex securities frequently issued under merger agreements, most of which tend
to dilute common equity. Analysis of restrictions imposed on the distribution of
retained earnings by loan or other agreements will usually shed light on a company's
freedom of action in such areas as dividend distributions and the required levels of
working capital. Such restrictions also shed light on the company's bargaining
strength and standing in credit markets. Moreover, a careful analysis of restrictive
covenants will enable the analyst to assess how far a company is from being in
default of these provisions.
43. Preferred stock often carries features that make it preferred in liquidation and
preferred as to dividends. Also, it is often entitled to par value in liquidation and can
be entitled to a premium. On the other hand, the rights of preferred stock to dividends
are generally fixedalthough they can be cumulative, which means that preferred
shareholders are entitled to arrearages of dividends before common stockholders
receive any dividends. These features of preferred stock as well as the fixed nature of
the dividend give preferred stock some of the earmarks of debt with the important
difference that preferred stockholders are not generally entitled to demand
redemption of their shares. However, there are preferred stock issues that have set
redemption dates and require sinking funds to be established for that purposethese
issuances are essentially debt.
Characteristics of preferred stock that make them more akin to common stock are
dividend participation rights, voting rights, and rights of conversion into common
stock.
44. Accounting standards state (APB 10): Companies at times issue preferred (or other
senior) stock which has a preference in involuntary liquidation considerably in
excess of the par or stated value of the shares. The relationship between this
preference in liquidation and the par or stated value of the shares may be of major
significance to the users of the financial statements of those companies and the
Board believes it highly desirable that it be prominently disclosed. Accordingly, the
Board recommends that, in these cases, the liquidation preference of the stock be
disclosed in the equity section of the balance sheet in the aggregate, either
parenthetically or in short rather than on a per share basis or by disclosure in notes."
Such disclosure is particularly important since the discrepancy between the par and
liquidation value of preferred stock can be very significant.
3-18
45. This question is answered in a SEC release titled Pro Rata Distribution to
Shareholders:
Several instances have come to the attention of the Commission in which
registrants have made pro rata stock distributions that were misleading. These
situations arise particularly when a registrant makes distributions at a time when its
retained earnings or its current earnings are substantially less than the fair value of
the shares distributed. Under present generally accepted accounting rules, if the
ratio of distribution is less than 25 percent of shares of the same class outstanding,
the fair value of the shares issued must be transferred from retained earnings to
other capital accounts. Failure to make this transfer in connection with a
distribution or making a distribution in the absence of retained or current earnings
is evidence of a misleading practice. Distributions of over 25 percent (which do not
normally call for transfers of fair value) may also lend themselves to such an
interpretation if they appear to be part of a program of recurring distribution
designed to mislead shareholders.
It has long been recognized that no income accrues to the shareholder as a result
of such stock distributions or dividends, nor is there any change in either the
corporate assets or the shareholders' interest therein. However, it is also
recognized that many recipients of such stock distributions, which are called or
otherwise characterized as dividends, consider them to be distributions of
corporate earnings equivalent to the fair value of the additional shares received. In
recognition of these circumstances, the American Institute of Certified Public
Accountants has specified in Accounting Research Bulletin No. 43, Chapter 7,
paragraph 10, that "... the corporation should in the public interest account for the
transaction by transferring from earned surplus to the category of permanent
capitalization (represented by the capital stock and capital surplus accounts) an
amount equal to the fair value of the additional shares issued. Unless this is done,
the amount of earnings which the shareholder may believe to have been distributed
will be left, except to the extent otherwise dictated by legal requirements, in earned
surplus subject to possible further similar stock issuances or cash distributions.
Both the New York and American Stock Exchanges require adherence to this policy
by their listed companies.
46. Accounting standards requires that, except for corrections of errors in financial
statements of a prior period and adjustments that result from realization of income
tax benefits of preacquisition operating loss carry forwards of purchased
subsidiaries, all items of profit and loss recognized during a period (including
accruals of estimated losses from loss contingencies) be included in the
determination of net income for that period. The standard permits limited
restatements in interim periods of a company's current fiscal year.
47. a. Minority interests are the claims of shareholders of a majority owned subsidiary
whose total net assets are included in a consolidated balance sheet.
b. Consolidated financial statements often show minority interests as liabilities:
however, they are fundamentally different in nature from legally enforceable
obligations. Minority shareholders do not have any legally enforceable rights for
payments of any kind from the parent company. Therefore, the financial analyst
can justifiably classify minority interest as equity funds in most cases.
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EXERCISES
Exercise 3-1 (20 minutes)
a.
Long-term debt [79]
C
D
39.7
142.3
740.3
141.1
1.8
701.2
beg
A
B
end
39.1
32.3
39.7
32.9
beg
C
end
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3-21
3-22
3-23
b. In this case, disclosure should be made for an estimated loss from a loss
contingency that need not be accrued by a charge to income when there is at
least a reasonable possibility that a loss may have been incurred. The
disclosure should indicate the nature of the contingency and should estimate
the possible loss or range of loss or state that such an estimate cannot be
made.
Disclosure of a loss contingency involving an unasserted claim is required
when it is probable that the claim will be asserted and there is a reasonable
possibility that the outcome will be unfavorable.
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a. The causes of the $101.6 million increase are identified in the table below (see
Campbells Consol. Statement of Owners Equity and Changes in Number of
Shares):
Millions
10
Net Income............................................................
Cash Dividends.....................................................
Treasury Stock Purchase.....................................
Treasury Stock Issued
Capital Surplus................................................
Treasury Stock................................................
Translation Adjustment........................................
Sale of foreign operations...................................
Increase in Stockholders' Equity........................
a
1,793.4
- 1,691.8
101.6
[54]
11
$401.5
(142.2) (89)
(175.6)
$ 4.4 (28)
(126.9) (87)
(41.1) (87)
45.4 (91)
12.4 (91)
(29.9) (92)
(10.0) (93)
11.1 (87)
4.6 (87)
61.4 (87)
101.6a
(86.5)b
1,691.8 [54]
1,778.3 [87]
(86.5)
Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders
Equity
d. The book value per share of common stock is $14.12. However, shares were
purchased during the year at an average of about $52 per share (an indicator of
market value during the year). In fact, according to note 24 to the financial
statements the stock traded in the $70 - $80 range in the fourth quarter of Year 11.
There are several reasons why the market value of the stock is much higher than
the book value of the stock. First, the market value impounds the investors
beliefs about the future earning power of the company. Investors apparently have
high expectations regarding future profitability. Second, the book value is
recorded using accounting conventions such as historical cost and conservatism.
Each of these conventions is designed to optimize the reliability of the information
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but can cause differences between the market and book values of a companys
stock.
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$11.80 [130]
$3.77
10
1,017.5
1,137.1
(119.6)
169.0
(110.5)
16.1
(223.2)
27.3
-1.7
(119.6)
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3-28
Exercise 3-10continued
The creation of "secret reserves" also tends to shift income
between periods and usually has a smoothing effect on reported income. If an
asset is understated or a liability is overstated in the current period, it usually
means that some expense is going to be correspondingly overstated with the
result that current income is understated. In some subsequent period the
service potential of the unrecognized or undervalued asset will be consumed.
If its cost were understated or not recognized, expenses of the later period
also will be understated and income of the later period will be overstated.
Somewhat the same effect can be achieved through overaccrual of estimated
expenses. There are practical limits as to how large an estimated liability for
estimated expenses can become before it will be discovered and investigated.
In the period when the carrying value of the estimated liability reaches its
upper limit, usually no accrual or an inadequate accrual is recognized.
continued
(AICPA Adapted)
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c. The acquisition and reissuance of its own stock by a firm results only in the
contraction or expansion of the amount of capital invested in it by stockholders.
In other words, an acquisition of treasury shares by a corporation is viewed as a
partial liquidation and the subsequent reissuance of these shares is viewed as an
unrelated capital-raising activity. To characterize as gain or loss the changes in
equity resulting from a corporation's acquisition and subsequent reissuance of its
own shares at different prices is a misuse of accounting terminology. When a
corporation acquires its own shares, it is not "buying" anything nor has it
incurred a "cost." The price paid represents the amount by which the corporation
has reduced its net assets or "partially liquidated." Similarly, when the
corporation reissues these shares it has not "sold" anything. It has increased its
total capitalization by the amount received.
It is the practice of referring to the acquisition and reissuance of treasury shares
as a buying and selling activity that gives the superficial impression that, in this
process, the firm is acquiring and disposing of assets and that, if different
amounts per share are involved, a gain or loss results. Note, when a corporation
"buys" treasury shares it is not acquiring assets; nor is it disposing of any assets
when these shares are subsequently "sold."
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3-31
Exercise 3-12continued
c. 1. Treasury stock is stock previously issued by the corporation but
subsequently repurchased by the corporation. It is not retired stock, but
stock available for issuance at a subsequent date by the corporation.
2. A stock right is a privilege extended by the corporation to acquire
additional shares (or fractional shares) of its capital stock.
3. A stock warrant is physical evidence of stock rights. The warrant specifies
the number of rights conveyed, the number of shares to which the
rightholder is entitled, the price at which the rightholder can purchase
additional shares, and the life of the rights (time period over which the
rights can be exercised).
Exercise 3-13 (12 minutes)
a. These cash distributions are not dividends. Instead, they are returns of
capital. Dividends are distributions of past earnings of the company. Since
this company has not earned any net income, there are no retained earnings
from which dividends could be paid. Thus, these cash distributions are being
made from capital previously contributed to the company by the owners.
b. There are at least a couple of reasons why a return of capital might be made.
First, the company may be going out of business. Second, in a closely held
company, influential owners may have mandated the payments. A distribution
of capital is usually the result of special circumstances confronted by a
company.
Exercise 3-14 (12 minutes)
a. Purchasing its own shares is similar to the payment of dividends in that cash
assets are reduced in both situations. That is, in each case, the company is
distributing cash to shareholders. In the case of dividends, all shareholders
are receiving cash in a proportionate manner.
In the case of share
repurchases, only selected shareholders receive cash distributions from the
company.
b. Managers might prefer to purchase its own companys shares because this
serves to increase financial performance measures such as earnings per
share and return on shareholders equity.
c. Investors are taxed on dividends received from companies. The tax rate on
dividends is often quite high. Investors also are taxed on gains on the sale of
shares. Thus, investors often would prefer that companies buy back shares
rather than pay a dividend. In this way, investors that are happy with the
performance of the company can maintain or increase their ownership (it can
increase as a percent of the total). Investors that would like to reduce their
investment in the company can choose to do so by selling shares back to the
company pursuant to the offer of the company to repurchase shares. Also,
3-32
the gain on sale of stock by investors is usually taxed at a lower rate than
dividends.
3-33
3-34
3-35
PROBLEMS
Problem 3-1 (30 minutes)
a. 1. $200 million
2. As the maturity date approaches the liability will be shown at increasingly
larger amounts to reflect the accrual of interest that will be due at maturity.
3. The annual journal entry is:
Interest expense.......................................................
#
Unamortized discount....................................
[Note: No cash is involved since it is a zero coupon note.]
3-36
39,930
3,194.40 (1)
6,805.60
7,986 (2)
7,986
b.
ASSETS
Leased property under
capital leases
(2)
Balance Sheet
December 31, Year 1
LIABILITIES
Lease Obligations under
$31,944 (1) capital leases.
$33,124.40
Income Statement
For Year Ended December 31, Year 1
Amortization of leased property ..................................................
Interest on leases...........................................................................
Total lease-related cost for Year 1 ...............................................
$ 7,986.00
3,194.40
$11,180.40 (3)
3-37
Problem 3-2continued
c.
Payments of Interest and Principal
Total
Interest
Payment of
Payment
at 8%
Principal
Year
1
2
3
4
5
10,000
10,000
10,000
10,000
10,000
$50,000
$3,194.40
2,649.95
2,061.95
1,426.90
736.80
$10,070.00
$6,805.60
7,350.05
7,938.05
8,573.10
9,263.20
$39,930.00
Principal
Balance
$39,930.00
33,124.40
25,774.35
17,836.30
9,263.20
d.
Year
1
2
3
4
5
e. The income and cash flow implications from this capital lease are apparent in
the solutions to parts c and d. The student should note that reported
expenses exceed the cash flows in earlier years, while the reverse occurs in
later years.
3-38
3-39
3-40
3-41
Problem 3-5continued
c. Bond discount for bonds sold between interest dates should be amortized
over the period the bonds are outstanding. That is, the period from the date
of sale (November 1, Year 5) to the maturity date (October 1, Year 10).
d. Proceeds from the sale of the 9% nonconvertible bonds with detachable stock
purchase warrants should be accounted for as both paid-in capital and
long-term debt. The detachable stock purchase warrants are equity
instruments that have a separate fair value at the issue date. Therefore, the
portion of the proceeds allocable to the warrants should be accounted for as
paid-in capital. The bonds are debt instruments. Therefore, the remainder of
the proceeds, including the premium, should be accounted for as long-term
debt.
(AICPA Adapted)
3-42
JDS
MLS
Book value
Price/book value
= $51.50 / $24.00
= 2.15
= $49.50 / $18.75
= 2.64
JDS
MLS
= $0 + 2,700 / $6,000
= $2,700 / $6,000
= 45.00%
= $3,500 / $7,500
= 46.67%
JDS
MLS
= $21,250 / $5,700
= 3.73
= $18,500 / $5,500
= 3.36
JDS
MLS
Company Favored
i.
2.15
2.64
ii.
45%
47%
iii.
Asset turnover
3.73
3.36
3-43
Problem 3-7continued
c.
Liabilities
(Long-term debt [LTD])
+$1,000
(Short-term debt [STD])
+$800
Book value per common share: No net adjustment to JDS owners equity of
$6,000; thus, $6,000 / 250 million shares = $24.00 book value per share
Adjusted total debt-to-equity ratio:
$2,700
+1,000
+ 800
$4,500
Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%
iii.
Historical LTD
LTD
STD
Adjusted total debt
MLS:
Needed adjustments:
Assets
(Pension) +$1,600
i.
Owners Equity
+$1,600
ii.
iii.
3-44
Problem 3-7continued
Part c continued:
Summary of Adjustments:
Ratio
Adjusted book value
Adjusted debt to equity
Fixed-asset utilization
JDS
$24.00
75%
3.17
MLS
$22.75
38%
3.36
JDS
MLS
2.15a
Company favored
2.18b
approximately equal
ii.
Adjusted debt to equity
equity
75%
36%
iii.
3.17
3.36
Fixed-asset utilization
3-45
3-46
$645
188
(372)
2
(19)
$444
3-47
CASES
Case 3-1 (25 minutes)
a. Defined benefit plan
b. Net pension asset totaling $172.5 million (current 19.8 + long-term 152.7)
c. VBO (present value of pension benefits to vested employees at current salary
levels) = $679.6; ABO (present value of pension benefits to vested and nonvested employees at current salary levels) = ($714.4); PBO (present value of
vested and non-vested benefits at projected future salary levels) = $827.7.
d. $857.7million
e. Plan assets consist primarily of shares of or units in common stock, fixed
income, real estate, and money market funds.
f. Net economic position = Fair value of assets less fair value of obligation
= $857.7 - $827.7
= $30 million overfunded
g. Several costs are not yet in the pension liability including the unrecognized
net loss, unrecognized prior service cost, and unrecognized net assets at
transition. As a result, the reported pension asset is significantly larger than
the over funded economic position of the plan.
h. $54.9 million
i. The long-term rate of return on plan assets assumed by Campbell is 9%. This
is reasonable and similar to the assumptions of comparable companies.
j. The long-term rate of compensation increase of 5.75% is reasonable and in
line with the assumption used by comparable companies, which is fine from
the perspective of an equity analyst. From the viewpoint of a potential
employee, this suggests that the average raise for the typical performer will be
5.75%.
3-48
3-49
c.
Economic
2001 U.S. Pension Cost:
Service cost
Interest cost
Return on assets
Actuarial (gain) losses
Prior service cost
Transition asset
Net pension cost
94
406
4181
182
0
0
11003
Deferred
1017
182
0
1199
Amortized
Reported
0
1
(59)
(58)
94
406
(599)2
0
1
(59)
(157)4
Actual loss
Reported gain
3
Economic cost (expense)
4
Reported income
1
2
The true economic cost of the pension plan (the increase in the obligation
offset by any increase in net assets) is represented in the column titled
economic. As a permanent income component, the smoothed reported
number is a better estimate for analysis purposes.
d. The key actuarial assumptions made by Kodak appear reasonable and are in
line with comparably sized firms in comparable industries. Kodak does not
appear to be using the pension plan to manage its earnings.
3-50
2001
.947
$43.291
2000
21.575
$50.94
1999
13.482
$68.61
3-51
Year 8
AMR
Year 7
Year 8
Delta
Year 7
Year 8
UAL
Year 7
0.865
0.895
0.735
0.702
0.513
0.562
2.330
1.488
6.817
2.356
1.459
4.867
2.630
1.492
9.310
3.237
1.879
7.509
4.657
2.929
4.463
5.617
3.371
6.220
7.17%
8.18%
6.21%
20.23%
28.17%
29.23%
Note: We treat preference share capital as debt and include preference dividend with interest.
5%
10%
5%
Delta
10%
UAL
5%
10%
Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision
Continuing Income
% drop in Continuing Income
3-52
18,245
17,285
(16,656) (16,445)
1,589
840
198
198
(372)
(372)
1,415
666
(596)
(333)
819
333
37%
75%
13,431
12,724
(12,289) (12,134)
1142
590
141
141
(197)
(197)
1,086
534
(454)
(261)
632
273
36%
72%
16,683
15,805
(15,882) (15,681)
801
124
133
133
(361)
(361)
573
(104)
(192)
45
381
(59)
54%
107%
Case 3-5continued
The profitability of the airlines is reduced dramatically by
moderate revenue shortfalls under our assumptions. A mere 5% drop in revenues
can reduce income by a third (half for UAL), while a 10% drop in revenues can all
but wipe out the airlines profits. This happens because of the high proportion of
fixed costs in the cost structure. We also examine the impact of the changes on
key Year 8 ratios:
Part b continued:
AMR
Drop in Revenue
Liquidity
Current Ratio
Solvency
Total Debt to Equity
Long Term Debt to Equity
Times Interest Earned
Return on Investment
Return on Total Assets
Return on Equity
5%
10%
5%
Delta
10%
UAL
5%
10%
0.865
0.865
0.735
0.735
0.513
0.513
2.330
1.488
4.803
2.330
1.488
2.788
2.630
1.492
6.511
2.630
1.492
3.712
4.657
2.929
2.587
4.657
2.929
0.712
4.91%
12.68%
2.66%
5.14%
5.56%
17.97%
2.94%
7.77%
3.62%
13.56%
1.03%
-2.10%
The balance sheet ratios do not change. The ROA and ROE mirror the drop in
profitability. The most interesting change occurs in interest coverage, which
drops significantly with reduced revenues. While AMR and Delta can still pay their
interest in the event of a demand slump, UAL may have difficulty meeting its
interest payments in the case of a 10% revenue drop.
c. Because of the volatile nature of profitability and consequent risk, airline
companies often find it difficult to raise debt at reasonable terms. Raising equity
is a possibility, but the equity cost of capital is high in this industry (airline
companies have some of the lowest P/E ratios in the market). Consequently,
leasing offers a convenient alternative to financing the high capital investment
requirements of this industry. The lessor is probably able to offer better terms
than other creditors for several reasons: (1) the lessor may be connected to
suppliers of capital equipment and can use leasing as a marketing tool; and (2) in
the event of insolvency the lessor is often in a better position to recover the
assets because ownership often rests with the lessor. Finally, the bigger airline
companies (such as AMR, Delta and UAL) prefer to maintain a young fleet of
aircraft, both because of obsolescence and because of the high maintenance cost
associated with maintaining older aircraft. In such a scenario, it is easier to lease
aircraft rather than purchase outright and sell it later.
d. Examine Capital and Operating Leases and Their Classification: All three
companies are increasingly structuring their leases to be operating leases. The
outstanding MLP on operating leases for AMR, Delta and UAL is approximately
$17 billion, $15 billion and $24 billion, respectively, compared to $2.7 billion, $0.4
billion and $3.4 billion for capital leases.
The lease classification appears arbitrary. The capital and operating leases do not
seem to differ either on the basis of the type of asset leased or the length of the
lease. The average remaining life on the operating leases, for all three companies,
varies between 16 to 20 years, which is much more than those on capital leases
(see part e below). Overall, there does not seem to be any logic underlying the
lease classification, except that the companies have structured the leases to avail
themselves of the benefits of operating lease accounting.
3-53
Case 3-5continued
e. Reclassification of Operating Leases as Capital Leases and Restatement of
Financial Statements
AMR
Year 8
Capital
Operating
1012
951
949
904
919
12,480
100
67
57
57
48
71
312
10,066
3-54
950
950
940
960
960
10,360
UAL
Capital
317
308
399
341
242
1759
2,289
Operating
1320
1329
1304
1274
1305
17,266
7%
8,146
13,223
Delta
UAL
Year 8
Year 8
8,146
8.5%
692
13,223
7%
926
10,066
19
8,146
16
13,223
18
530
509
735
Operating
8.5%
AMR
Year 8
B. Estimate Interest and Depreciation on Operating Lease
Present Value of Operating Leases
10,066
Interest Rate
6.25%
Interest Expense
629
Value of Operating Lease Assets
Delta
Capital
Statement
(509)
(735)
950
1,320
441
585
(629)
(147)
(692)
(251)
(926)
(341)
51
(96)
88
(163)
119
(222)
Case 3-5continued
Part e continued:
AMR
Delta
Year 8
Year 8
D. Determine Principal and Interest Component of Next Year's MLP
Next Year MLP
1,012
950
Estimated Interest Component
629
692
Estimated Principal Component
383
258
UAL
Year 8
1,320
926
394
AMR
Delta
UAL
Year 8
Year 8
Year 8
4,875
12,239
12,213
3,042
32,369
3,362
9,022
8,445
1,920
22,749
2,908
10,951
15,326
2,597
31,782
537
321
570
5,485
4,514
5,492
11,447
2,436
5,766
8,137
1,533
4,046
14,942
2,858
3,848
175
791
3,299
1,776
(1,052)
22,749
3,518
1,024
(1,261)
31,782
3,257
4,729
(1,288)
32,369
AMR
Year 8
19205
(16,385)
2,820
198
(1,001)
2017
(807)
1,210
Delta
Year 8
14138
(12004)
2134
141
(889)
1386
(559)
827
UAL
Year 8
17561
(15498)
2063
133
(1287)
909
(310)
599
3-55
Case 3-5continued
f. We made several assumptions in estimating the effects of the lease
classification. Some of the important assumptions are:
Interest Rate Parity across Capital and Operating Leases. We use the
average interest rate on the capital leases as a proxy for the interest rate on
operating lease. To the extent capital and operating leases are dissimilar,
the interest rate estimate is inaccurate or biased. This problem arises
especially if the capital leases and the operating leases, on average, have
been contracted during different time periods with different interest rate
regimes.
In this particular case, the interest rate on Deltas capital leases is
substantially higher than that on either AMR or UAL. While it is not
impossible, it is improbable that lease rates could differ so markedly across
similar companies in the same industry. The average remaining lease term
offers a clue: for Deltas capital leases it is 6-7 years compared to 10-12
years for AMR and UAL. Under the assumption that the average lease terms
are similar across companies, this implies that Deltas capital leases, on
average, were contracted 4-5 years before AMR or UAL, which is consistent
with the higher interest rate on Deltas capital leases. To some extent, this
problem is alleviated (at least on a comparative basis) because Deltas
operating leases also appear to have been contracted around three years
earlier to AMRs or UALs. It appears that the capital leases for all three
companies were entered into at an earlier time than the operating leases. If
these leases were entered at a time with a sufficiently different interest rate
regime, we need to make appropriate corrections to our interest rate
estimates.
Depreciation Policy. We set the lease asset and liability equal to each other.
In reality, the depreciation of the asset seldom equals the lease principal
payments. Some people use a simplifying assumption such as lease assets
should be equal to 80% the liability. However, these ad hoc rules are no
better than putting them equal to each other. Another issue is that we
depreciate the asset over the remaining lease term. However, the length of
operating lease is often less than the economic life of the asset. To that
extent, we are overestimating the depreciation expense.
3-56
Case 3-5continued
g. Ratio Analysis on Restated Financial Statements
AMR
Year 8
Liquidity
Current Ratio
.81
Solvency
Total Debt to Equity
3.83
Long Term Debt to Equity
2.93
Times Interest Earned
3.01
Return on Investment*
Return on Total Assets
5.75%
18.07%
Return on Equity
*computed on adjusted yearend asset and equity
balances
Delta
UAL
Year 8
Year 8
.70
.48
4.65
3.45
2.56
8.69
6.84
1.71
6.18%
4.52%
20.56%
18.26%
Note: We treat preference share capital as debt and include preference dividend with interest.
3-57
Case 3-5continued
h. Sensitivity Analysis on Restated Financial Statements
AMR
5%
10%
Drop in Revenue
5%
Delta
10%
UAL
5%
10%
Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision
Continuing Income
% drop in Continuing Income
18245
17285
13431
12724
16683
15805
(16180)
(15975)
(11854)
(11704)
(15304)
(15111)
2065
198
(1,001)
1,262
(531)
731
40%
1310
198
(1,001)
507
(213)
294
76%
1577
141
(889)
829
(334)
495
60%
1020
141
(889)
272
(110)
162
80%
1379
133
(1287)
225
(76)
149
75%
694
133
(1287)
(460)
155
(305)
151%
0.810
0.810
0.695
0.695
0.480
0.480
3.833
2.934
3.014
3.833
2.934
1.506
4.419
3.267
1.932
4.419
3.267
1.306
6.805
5.316
1.175
6.805
5.316
0.643
3.74%
0.91%
2.18%
0.71%
18.07%
4.89%
11.79%
3.86%
0.469
%
3.659
%
-0.960%
-7.490%
3-58
Case 3-5continued
i. Accounting Motivations for Leasing and Lease Classification: In (c) above we
presented some economic arguments for the popularity of leasing in the
airline industry. After the analysis in g and h, we added an important
motivation that is purely related to financial reporting. By leasing a large
proportion of their assets and successfully classifying most leases as
operating, the airlines attempt to camouflage the high risk inherent in their
capital structure.
The big question is whether managers can so easily fool the market with these
accounting gimmicks. Research does indicate that the market seems to
consider the additional risk imposed by operating leases and to reflect what is
not shown on the financial statements. However, a surprising number of even
sophisticated investors fall prey to these window-dressing tacticsfor
example, many analyst reports and financial databases fail to adjust the
solvency and other ratios for operating leases.
This case highlights the importance for a financial analyst to understand the
accounting issues. It also highlights the importance of getting ones hands
dirty by doing a detailed and careful accounting analysis before embarking
on further financial analysis.
3-59
Difference
43,447
27,572
15,875
7,752
8,123
2,121
5,007
(2,886)
(2,420)
(466)
Balance Sheets
Original
Year 8 Year 7
PBO
Net Economic Position
Reported Position on Balance Sheet
Assets
Current Assets
PP&E
Intangible Assets
Other
Total
Liabilities & Equity
Current Liabilities
Long Term Borrowing
Other Liabilities
Minority Interest
Equity Share Capital
Retained Earnings
Total
Relevant Ratios
Debt to Equity
Long-Term Debt to Equity
Return on Equity
38,742
25,874
12,868
6,574
6,294
243,662
212,755
243,662
32,316
19,121
39,820
35,730 32,316
23,635 19,121
52,908 39,820
355,935
304,012
355,935
304,012
120,668
141,579
120,668
141,579
46,603
59,663 46,603
4,275
7,402
31,478
3,682
5,028
29,410
4,275
3,682
7,402
5,028
39,135 35,292
355,935
304,012
355,935
7.25
3.97
21.54%
6.98
3.81
6.00
3.22
21.52%
40,659
5,332
7,657
4,128
5,882
30,649
10,010
212,755
59,663
98,621
45,568
32,579
12,989
Restated
Year 8 Year 7
35,730
23,635
52,908
111,538
1,917
4,775
(2,858)
(2,446)
(412)
103,881
92,739
304,012
5.91
3.17
18.29% 18.64%
3-60
Case 3-6continued
b.
Post Retirement Expense Restatement
Permanent Income
Reported Expense
One-time charge
Permanent Income
Economic Income
Actual Return on Assets
Service Cost
Interest Cost
Actuarial Changes
Early Retirement Costs
Economic Income or Expense
Year 8
1,016
0
1,016
331
412
743
685
(412)
273
(313)
0
(313)
(455)
165
(290)
6,363
(625)
(1,749)
(1,050)
0
2,939
6,587
(596)
(224)
(29)
(63)
338
412
434
316
(96)
(319)
(268)
0
(367)
343
(107)
(299)
(301)
(165)
(529)
(367)
(1,686)
(1,388)
(412)
2,505
142
(165)
(23)
703
0
703
Change
(124)
577
453
827
(577)
250
(27) 6,679
11
(721)
(20) (2,068)
33 (1,318)
165
0
162 2,572
6,930
(703)
(251)
(18)
(83)
371
577
596
(529)
2,572
1,976
268
(167)
301
(206)
1,318
1,689
(3,506)
(4,072)
(8)
0
(39)
(313)
11
0
(32)
(455)
(161)
154
326
703
(134)
154
263
(124)
(1,985)
(1,689)
(577)
1,976
3-61
Case 3-6continued
d. To suggest that any change in the reported net pension income (or expense) must
be excluded when determining the legitimate earnings growth rate implies either
that pension plans are not an integral part of the company or that pension
expense (or income) should be constant over time. Both assumptions are not
necessarily correct. As explained in the textbook, while pension plans are
administered by separate trustees, the net assets (or liabilities) of the plans are
the employers responsibility. Moreover, while reported pension expense is
generally not volatile, there is no reason why it must remain the same each year.
Therefore, to determine whether the change in the pension income is warranted
we need to examine the changes in the components of reported pension costs:
($ Millions)
Effect on Operations
Expected Return on Plan Assets
Service Cost for Benefits Earned
Interest Cost on Benefit Obligation
Prior Service Cost
SFAS 87 Transition Gain
Net Actuarial Gain Recognized
Special Early Retirement Cost
Post Retirement Benefit Income(Cost)
Year 8
Pension Benefits
Year 7
Change
3,024
(625)
(1,749)
(153)
154
365
1,016
2,721
(596)
(1,686)
(145)
154
295
(412)
331
303
(29)
(63)
(8)
0
70
412
685
This analysis reveals that the main reasons for the increase in pension income
are the expected rate of return ($303 million) and the early retirement costs ($412
million). Both appear to be genuine. The higher return on plan assets is fully
attributable to the increase in the beginning market value of plan assets (from
$33.69 billion on January 1, Year 7 to $38.742 billion on January 1, Year 8). In
reality, pension accounting has underreported the actual return on assets by over
$3 billion (the actual return is $6,363 million versus reported $3,024 million). As
our analysis in (b) indicates, the reported pension cost underreports the true
economic cost by almost $3 billion. The $412 million increase in early retirement
cost arises not because GE overreported pension income for Year 8, but rather
because GE underreported pension income for Year 7, by taking a one-time
charge of $412 million. GE did reduce its discount rate by 0.25% in Year 8,
resulting in $64 million decrease in interest cost. However, this is less than 10% of
the overall increase in pension income. Also, this decrease appears legitimate,
considering that long-term interest rates dropped by more than 1% in Year 8.
Overall, Barrons claim that the earnings growth rate for GE has been artificially
inflated because of its pension plan appears to be unsubstantiated.
Still, before we confidently conclude that GE is not managing its earnings, it might
be interesting to examine pension income before and after excluding the one-time
early retirement charge and then examine the pattern of reported earnings:
Including One-Time Charge
Pension Income
Net Earnings
Earnings Growth Rate
3-62
Year 8
1,016
9,296
13.32%
Year 7
331
8,203
12.68%
Excluding One-Time
Charge
Year 8
1,016
9,296
7.90%
Year 7
743
8,615
18.34%
Case 3-6continued
When we examine the timing of the large one-time charge, it
appears that there is a kernel of truth to the Barrons complaint, although not in
the sense that was implied. If GE had not taken the $412 million charge in Year 7,
its earnings growth would have been an outstanding 18.34% in Year 7, thereby
creating an expectation of similar growth in Year 8. The real growth rate in Year 8,
however would have been a disappointing 8%, which may have had adverse
market reactions. GE is adept at smoothing its income across periods so that it
can show a steady 13% growth in earnings. By doing this, GE is not artificially
increasing the long-term earnings growth rate (as the Barrons editorial alleges),
but rather it is reducing the volatility in reported earnings, thereby creating an
impression of a more stable (and hence, less risky) company. For more details
about GEs earnings smoothing techniques, see the Wall Street Journal article
(WSJ, 11/3/94).
Part d continued:
e. The pension related cash flows for GE are the employers contributions of $68
million ($64 million) in Year 8 (Year 7). Evidently these cash flows have little to do
with the economics of the pension plans or their effects on either GEs
performance or financial position. GEs situation is not unusual. Because defined
benefit pension plans can be either over or under funded, the actual cash
contributions by the company to the pension plans are entirely arbitrary (in
contrast, the cash contributions in the case of a defined contribution plan are a
real expense). Therefore, the pension cash flows have no connection with the
economic reality of the pension plans. The accounting standard setters
understand this and have progressively developed better pension accounting
standards that attempts to capture the economic reality
3-63
3-64
While certain contingent losses do not meet the threshold for accrual and
recognition in the balance sheet, analysts should adjust their models to reflect
much greater exposure to losses from tobacco litigation. The current balance
sheet should be adjusted to report much greater amounts of liability and tobacco
litigation charges and losses